The Need for Futures Markets in an Emerging World Economy

By Leo Melamed

Presented at the Future of Fund Management in India
Second Annual Conference
Mumbai, India The Taj Mahal Hotel

16-17 April, 1998

"The Mediterranean is the ocean of the past, the Atlantic the ocean of the present and the Pacific the ocean of the future," so said John Hay, the American Secretary of State at the turn of the century. While it can certainly be argued that the future took its good time in getting here, make no mistake, the future of the Pacific Rim has arrived.

Today, the countries of the Pacific Rim represent a combination of developed and developing nations that jointly embody an economic force equal to any region of the world. "Today," states John Naisbitt, in his Megatrends 2000, "the Pacific Rim is undergoing the fastest period of economic expansion in history, growing at five times the growth rate during the industrial revolution."

The geographic area involved is as large as it is diverse. By its all-inclusive definition, it accounts for two-fifths of the world's surface and nearly half of the world's population. By any standard, the nations that encompass the Pacific Rim are dissimilar in many fundamental respects, with differences ranging from culture to political systems to economic orders. Their differences also run the gamut from those, in the words of the Economist, that are "as rich and stable as Japan and as poor and turbulent as China, as big and open as America and as small and closed as North Korea."

Japan is, of course, the financial colossus of region encompassing a vast and complex business infrastructure which includes some of the world's largest securities firms and banks. Australia and New Zealand provide the anchor on the South. Australia, almost as large as the continental U.S., is more British than Asian but its location makes it imperative for the continent to think Asian. The newly industrialized countries, or NICs as they are sometimes called, include Singapore, Hong Kong, South Korea and Taiwan. Hong Kong, of course, will revert back to China in 1997 and become an uncommon segment of this vast and underdeveloped giant. Then there are the members of the Association of South East Asian Nations, which include Indonesia, Malaysia, the Philippines and Thailand.

Although there are many ties other than geographical between these nations, for the purposes of this publication there is a sufficient common denominator based on a similar economic evolution which brought some of these states to employ or consider employing the markets of futures and options. While their current experience with these markets is of recent vintage, as most learned observers are aware, futures markets are nothing new to the region. Indeed, it was in Japan during the Edo period (1600-1867) that centralized futures markets were born. The place was Osaka, where feudal lords established warehouses to store and sell rice that was paid to them as land tax by their villagers. In 1730, to protect themselves from wide price fluctuations between harvests, these merchants established the Dojima Rice Market, the first organized futures exchange.

Over the span of the next 200 years, there were from time to time some small agriculturally based futures markets in Japan. However, it was not until the birth of the Sidney Futures Exchange (SFE) in 1960 that futures again made their presence felt in the Pacific Rim. The SFE was also the first Asian futures exchange to launch a financial contract in 1979. Then came the critical catalyst in the modern development of futures and options markets in the Pacific basin; it was the revolutionary link in 1984 between Singapore's SIMEX and the Chicago Mercantile Exchange (CME). This innovation served to spur the race for financial futures dominance in the region. A year later, Japan re-entered the futures markets arena in a meaningful fashion when the Tokyo Stock Exchange (TSE) launched its successful Japanese Government Bond contract. This important event was quickly followed by the inception of futures trading at the Osaka Securities Exchange (OSE) and the birth of the Tokyo International Financial Futures Exchange (TIFFE). There was no stopping the process now. The community of nations of the Pacific Rim had fully embraced the financial futures revolution.

Nor could it be otherwise. The vibrancy and native talent of Pacific-based populations, the wealth achieved as a consequence of decades of successful manufacturing and export, the resulting potential of their financial centers, all combined to make the region a vast store of financial strength and a force equal to any in the world. This expanding base of capital markets could not continue very long or compete on a global scale without the development of futures markets. The advent of globalization, greater interdependence, modern telecommunications capabilities, instant informational flows, immediate recognition of financial risks and opportunities, and intensified competition made the management of risk an essential prerequisite of success for every financial community. To address this new financial imperative, it was mandatory for the nations of the Pacific Rim to turn to the unique mechanisms provided by futures and options markets.

It was axiomatic. The financial futures revolution, launched in Chicago in 1972, blazed the trail for much of what has since followed in world capital centers. The CME was the first major exchange to recognize the significance of the demise of the Bretton Woods Agreement, the post-World War II pact that instituted a fixed exchange-rate regime for the major world nations. To capture the potential of the free market epoch that was about to ensue, the CME created the International Monetary Market (IMM), the first futures exchange for the specific purpose of trading in financial instruments. The era of financial futures was thus born. While the new wave of futures began with currency contracts, it was quickly followed by futures contracts on U.S. government securities -- Treasury bills at the Merc, and Ginnie Mae certificates and Treasury bonds at the Chicago Board of Trade (CBOT). Later, when in the early 1980s the concept of cash settlement in lieu of physical delivery was instituted, the stage was set for the CME's introduction of Eurodollar futures. This led the way for stock index futures and initiated the era of index markets.

The financial futures revolution was destined to profoundly alter the history of markets. It established that there was a need for a new genre of risk management tools suitable for sophisticated strategies and responsive to professional and institutional money management. As a consequence, it proved the necessity of futures and options within the infrastructure of finance and alongside other traditional structures of capital markets. Most significantly, from their inception, the markets of futures and options understood and embraced the common denominator of recent world upheavals: the spectacular advances in technology. Clearly, no other single factor was more instrumental in influencing political and economic change than was the technological revolution of recent years.

On the political front, modern telecommunications fostered instant mass and personal informational flows in total disregard of national boundaries. It offered everyone a stark, uncompromising comparison of political and economic life, making it nearly impossible for governments to hide the truth from its people. On the economic front, modern telecommunications made instantaneous price information available to everyone around the globe and fostered massive capital flows in unencumbered fashion. It dramatically changed the nature of global capital markets forever. The markets of futures and options recognized this march of technology, understood its inexorable impact on commerce and trade, and willingly adapted to its demands. It is no accident that our markets thus represent one of the greatest growth arenas of the last two decades.

As logic would dictate, events in Eastern Europe and the Soviet Union during the last several years have dramatically confirmed the significance of the financial history of the last two decades. The bankruptcy of command economic order, the downfall of communist rule and the collapse of the Soviet empire serve as undeniable testimony to the value of capitalism and market driven economics. The markets of futures and options are integral to that victory. Indeed, what markets better epitomize price determination by virtue of the free forces of supply and demand than do the markets of futures and options?

During the past decade, beginning with the 1982 establishment of the London International Financial Futures Exchange (LIFFE), new financial futures exchanges have opened in virtually every major world financial center, including the Marché à Terme International de France (MATIF) in Paris, the Swiss Options and Financial Futures Exchange (SOFFEX) in Zurich, the Deutsche Terminbörse (DTB) in Frankfurt, not to mention the exchanges in the Pacific Rim itself. The dramatic success of this history prompted Nobel laureate Merton Miller, University of Chicago professor of finance, to nominate financial futures as "the most significant financial innovation of the last twenty years."

Indeed, if financial futures and options were not yet in place, they would have to be invented:

• They are indispensable in a world that demands the ability to swiftly institute complex strategies or to cost-effectively adjust portfolio exposure between securities and cash.
  
  
• They are ideally suited for a world where tailored risk management strategies is on the increase and where opportunities rapidly appear and disappear on a constantly changing financial horizon.
  
  
• They are a vital option in a world in which it is often imperative to utilize a credit worthy mechanism that preserves credit lines.
  
  
• They are without equal in providing a vast array of products combined with an envious measure of liquidity and an incomparably narrow bid/ask spread.
  
  
• Finally and most significantly, they are well-positioned for a world where professional money management is the wave of the future.

Thus, what was imperative for the financial structures of other global regions became equally imperative for the Pacific basin. Nor should we forget that the process is incomplete. Some of the Pacific Rim communities are just beginning to emerge from their formative development stage. More to the point, the vast financial potential of mainland China is yet to be unleashed. Is there any doubt that the same forces which brought about the downfall of command order economics in the Soviet Union will achieve a similar result in China? Is there any doubt that its highly competent people will someday in the coming decade join the market rebirths occasioned by the other Asian populations? I dare say no. And, when it happens, it will exponentially effect the strength and vitality of the Pacific Rim.

Although there are some heavy macroeconomic clouds overhead, the long-term direction in the evolution of global markets is unmistakable. In a world where the distinctions between the major time zones has vanished, in a world where geographical borders that once could limit the flow of capital are but history, in a world where traditional internal protections that could insulate one's citizenry from external price and value influences are no longer valid, in such a world market-driven economic order is quintessential and futures and options a critical component. For the expanding region such as the Pacific Rim, with its vast and diverse cultures and infrastructure, and with its still-untapped and developing potential, there can be no other course.

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This leads us directly to the recent problems and controversies in Southeast Asia. Last August, an Indonesian newspaper close to the government ran an advertisement with a picture of a currency trader wearing a terrorist mask made of American $100 bills. “Defend the Rupiah,” the ad urged, “Defend Indonesia.” Indeed, recent financial troubles in Southeast Asia have resulted in some of its leaders accusing currency speculation as the main culprit of their problems. Nothing new about that. Currency speculators have been a convenient scapegoat throughout the centuries whenever government policies fail and a country’s currency begins to devalue.

The main villain in the current attack has been George Soros, the billionaire financier who is clearly the most colorful and notorious of the speculator lot. Soros was called a “moron” and a “rogue” by Malaysian Prime Minister Mahathir Mohamad at the recent IMF World Bank Conference in Hong Kong. He declared that “currency trading is unnecessary, unproductive, and immoral... and should be made illegal.” He accused the “great powers” of pressing Asian countries to open their markets and then manipulating their currencies to knock them off as competitors.

Serious accusations. Unfortunately, they rang a bit hollow. They came from a man who loudly applauded his government’s string of economic successes of recent years --- built on foreign capital --- and who pronounced grandiose plans to build airports, dams, and a Southeast Asian Silicon Valley. The same leader who gladly used foreign investments to build the world’s tallest building, Southeast Asia’s largest airport, and harbored visions of a glittering new capital.

Suddenly, he sings a different tune. Now he proclaims his theory of Western desires to suppress Asian competitors. The reason for his change in opinion is obvious. After a decade of advances in this region’s journey toward open and efficient markets, serious problems have erupted. Indeed, Southeast Asia was and still is in a financial crisis. It began in Thailand, one of the most successful of the “tiger” economies which attracted billions of dollars in foreign investment, more than it could wisely invest. Thailand’s currency, the ringgit, has plunged 30 percent against the dollar, its banking system began to creak, and the Thai stock market crashed. Foreign investors fled, and the crisis quickly spread to Indonesia and Malaysia. It is instructive to examine why this happened, what mistakes were made, and how to avoid them.

While there have been financial crises before --- Latin America in the early 1980s and Mexico in 1995 --- the feel of what has happened in Southeast Asia is in some ways quite different. From afar, it is easy to think of Asia as a seamless whole. But, in fact, it is made up of distinct regional economies that these days find themselves competing against one another. The explosive boom in exports to the developed world from low-wage China, for instance, is a large part the underlying cause of Southeast Asia’s slump. A few years ago, the VCRs, televisions, and toys that lined the shelves of American stores most likely had a Made in Thailand or Made in Malaysia label. Today they say Made in China.

Asia’s southeastern emerging markets unfortunately came to regard the private foreign investors as a virtually unlimited source of funds. Only seven years ago, private investment in developing nations around the world was a mere $30 billion, compared with official development aid of nearly $65 billion. Now the proportions are starkly different. Official aid has declined to $45 billion last year, and private investment ballooned to roughly $245 billion. When the money was flowing in, Asian leaders had no complaints. They were being rewarded, they said, for hard work, rising productivity, and emergence of an educated middle-class that saved at rates that put Americans to shame. Now that the money has begun to flow the other way, leaving many countries with huge debts denominated in dollars that must be paid back with devalued local currencies, their attitudes have begun to change. Quickly the argument has become a debate over “Asian values” versus “Western values.” Never mind the facts. Never mind that the market always reacts to perceived realities. Never mind that the credit rating of Malaysian paper was lowered by Standard &Poor’s from stable to negative because of Malaysian reluctance to curb rapid credit growth when inflation was building in the economy.

It is always easier to blame currency problems on speculators than to admit to excessive government spending or lax monetary policy. And the perfect whipping boy in all this is the United States, the champion of financial liberalization. Thus it was left for U.S. Treasury Secretary Robert Rubin to lead the defense on behalf of free markets during the Hong Kong conference. He remained the standard-bearer of Western view that markets impose discipline on nations, economies, and most of all, politicians. His 26 years in investment banking at Goldman Sachs & Company steeped him in the belief that markets go to extremes but that, in the long run, they reward countries that keep their houses in order and punish those that do not. He countered Mr. Mahathir by saying that currency speculation is “part of the total activity in secondary markets” which “increases liquidity and lowers costs.”

The real problem in Southeast Asia is not George Soros. It’s the lack of sound economic policies, sober banking practices, and open markets. Put simply, Southeast Asian nations were living beyond their means. It began with several years of excessive money and credit growth. The problem was accentuated when huge amounts of foreign capital in the form of loans and direct investments poured into the region. All this encouraged the local population to spend freely and splurge on imported goods. The predictable result was that the countries’ trade deficits ballooned and their currencies came under severe pressure. The gravest deficiency was inadequate government supervision, particularly in the Thai banking sector. This was a formula for serious trouble. “We became too rich too quickly,” said Thai Finance Minister Thanong Bidaya, in a display of abject honesty.

Of course, we don’t need to feel sorry for George Soros. He was fully capable of defending himself and did. The outspoken financier was eminently correct when he said that the Malaysian prime minister’s suggestion to ban currency trading is so inappropriate that it does not deserve serious consideration. “He is using me,” declared Soros, “as a scapegoat to cover up his own failure.” A failure that was exacerbated when Prime Minister Mahathir ordered restrictions on short sales and moved to prop up stock prices for Malaysians, but not for foreign investors. That led investors to flee, and Mr. Mahathir was soon forced to make a sharp reverse turn. But the damage to his country’s financial credibility was done and will last for a long time. As Soros told the government officials who gathered in Hong Kong, “Interfering with the convertibility of capital at a moment like this is a recipe for disaster."

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