Do derivatives make economic policy more difficult?
By Jon Fernquest[Introduction|Vocabulary|Article]
[Reading Questions|Answers]
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Government policy makers already have a difficult job managing the Thai economy.
It's a lot like steering a great ship with 65 million people on it through the rough and unpredictable seas of global markets.
The government sets the course of the ship with monetary and fiscal policy, but it is difficult for any government to get enough economic information to actually know where they are on the great ocean of the global economy.
Throw in derivatives and the problems get even worse, that is, if the use of derivatives is not properly regulated.
It's useful to remember that Enron's growth was fueled by by its innovations in derivatives markets, a growth that led to its being named "America's Most Innovative Company" by Fortune magazine for six consecutive years, from 1996 to 2001 (Source: Wikipedia on Enron). Derivatives are sophisticated financial instruments whose full impact on an economy has yet to be adequately evaluated.
Today's article is written by a high level government official in Thailand and sketches the problems to look out for in a general sort of way. There is a lot of useful vocabulary and language used to describe financial markets in this article. It is the first part of a multiple part series.
Reading Questions
Here are some questions to guide your reading (See answers at end):1. How could derivatives help increase capital flows into Thailand? (Note: Some inference required here.)
2. If facilitating capital investment inflows to Thailand is the good side of derivatives, what is the bad side?
3. According to the author, what are some of the "unproductive activities that derivatives can be used for? (Note: Have to skip forward a bit in the article).
4. What aspect of derivatives helps capital flows?
5. Do derivatives dampen or amplify the economic impact of large changes in the exchange rate?
6. What are the two ways that derivatives reduce transparency?
7. Are publicly traded or over the counter derivatives more transparent?
8. How are derivatives used to manipulate reported financial reports in the United States? How might this lead to distortions?
9. What role did derivatives play in the 1997 financial crisis? What financial instruments were involved?
Article
Part one: The dangers of derivatives
DR CHODECHAI SUWANAPORNDerivatives facilitate the growth in private capital flows by unbundling the risks associated with investment vehicles such as bank loans, stocks, bonds and direct physical investment, and then repackaging and reallocating the risks more efficiently.
Over the past decade, different forms of capital flows to developing countries have emerged. Foreign capital flows now shift most of the market risk into the hands of borrowers through derivatives.
The financial innovation of derivatives allows these traditional arrangements of risk to be redesigned in order to better meet the desired risk profiles of the issuers and holders of the capital instruments.
However, the good side of facilitating capital flows also comes with a dark side of facilitating unproductive activities and lowering transparency.
While the risk-shifting function of derivatives serves the useful role of hedging and thereby facilitating capital flows, the increased use of derivatives also poses dangers to the financial system and the economy as a whole.
The extensive use of derivatives can and does lead to lower levels of transparency between counterparties and between regulators and market participants. They can be used unproductively for speculating, leveraging or raising risk-to-capital ratios, dodging and outflanking regulations, manipulating accounting profits and evading taxation.
Due to the use of derivatives, in the event of a large change in the exchange rate or other market prices, the greater will be the speed and depth of the impact on the financial sector and economy. Derivatives lead to transparency problems in two basic ways. One, they can distort the meaning of balance sheets as the basis for measuring the risk-return profile of businesses, central banks and national accounts. Two, when traded or booked over the counter, derivatives lack adequate reporting requirements and government surveillance.
A recent survey of US firms reveals that 42% use derivatives mainly to manage reported earnings by moving income from one period to another. The lack of transparency results in market distortions.
An export-import firm, for example, may have equal amounts on its balance sheet of foreign assets and liabilities, reflecting a natural or balanced foreign-exchange position. And yet it may have derivatives that create substantially large short foreign-exchange positions off the balance sheet. These derivatives then alter the firm's risk exposure from that reflected in the balance sheet.
Lack of transparency can be created at central bank level when, for example, a central bank reports the value of its foreign reserves, but does not report the amount of foreign currency derivatives that it has contracted through forwards and swaps.
This can mislead the public about the true level of international reserves that it has and its ability to intervene in the foreign-exchange market. Just such an incident actually happened in the case of the Bank of Thailand's disclosure of its foreign-exchange positions in 1997.
Another aspect on the national level is that a country's balance-of-payments account can lack transparency if materially composed of derivatives. The currency denomination of assets and liabilities such as foreign loans can be changed with foreign-exchange derivatives. Interest-rate swaps can alter the interest rate exposure on assets and liabilities. Long-term loans can become short-term ones if attached with put options.
Even the form of capital or the investment vehicle can be transformed with derivatives. A certain swap arrangement can make short-term loans (liabilities) appear as portfolio investments (assets). The requirement to meet margin or collateral calls on derivatives may generate sudden, large foreign-exchange flows that would not be indicated by the amount of foreign debt and securities in a nation's balance-of-payments accounts.
Dr Chodechai Suwanaporn is the director of the financial policy section of the Fiscal Policy Office. He can be reached at chodechai@fpo.go.th
Vocabulary (in discussion above)
monetary policy - government policy for controlling interest rates, credit, and the money supply
fiscal policy - government policy for increasing or decreasing government spending and especially how it is financed with taxes or by borrowing money with treasury bonds
"The use of government spending and taxation, as opposed to monetary policy (interest rates and money supply), to try to influence the level of economic activity. An expansionary fiscal policy means lower taxes and higher government spending. The effect of these policies would be to encourage more spending and boost the economy. Conversely, a contractionary fiscal policy means raising taxes and cutting spending" (Source: The Guardian).
facilitate - help, make it easier to happen
unbundling the risks - separating the risks, trying to separate out the different risks of price fluctuation that the owner or producer of an asset faces and sell them off to other people in a securities market
investment vehicles - securities
transparency - details are public, not private, so people can see them (no hidden illegal secrets), See Wikipedia
hedging - making an investment to protect against potential loss in another investment, offsetting an investment to minimize the impact of price fluctuations (this can help someone whose business is to produce and sell a product for export, for example, but cannot predict future fluctuations in exchange rates) See Wikipedia
risk-to-capital ratios -
outflanking - going around ("flank" means "side")
reporting requirements - the information that must be made public in a companies financial statements according to the law
government surveillance - government checking to see if people are breaking the law in their actions
reported earnings - revenue and profit for a company made public
foreign exchange position - foreign currencies held by a company in doing business
long foreign exchange positions - foreign currencies held by a company in doing business
selling short - selling something you don't have for future delivery, you are "short" this thing, you don't have it (since you don't have it when you sell it for future delivery, you are betting that it will decline in price, if it declines in price the price you sold it for will be greater than the price you bought it for)
short foreign exchange positions - selling foreign currency that you don't yet own (in anticipation of a fall in price)
forwards - forward contracts, a contract to deliver a certain asset on a future date
swaps - when two people temporarily swap the cash flows from two assets, used to hedge risks such as interest rate risk, they are also used by central banks to control the supply of credit and the money supply of an economy (See Wikipedia)
put options - "The right but not the obligation to sell an underlying security at a particular price (strike price) on or before the expiration date of the contract" (Source; also see Wikipedia on Put Options)
margin buying - "buying securities with some of one's own cash together with cash borrowed from a broker"(See Wikipedia).
margin - the collateral that the investor provides the broker for the loan
margin calls, collateral calls - when the securities bought on margin decline in value the investor must pay money to the broker he borrowed from to make up for the loss in value (a decline in value of the asset that served as collateral in a loan to buy the asset, means the value of the collateral has declined, the investor must replenish it), See Wikipedia
Answer Key:
1. How could derivatives help increase capital flows into Thailand? (Note: Some inference required here.)
They could help increase capital investment flows into Thailand by separating out the risks in these investments, allowing those who are more willing to take risks to hold them.
2. If facilitating capital investment inflows to Thailand is the good side of derivatives, what is the bad side?
Derivatives can lower transparency and make it easier to engage in "unproductive activities" that can "pose dangers to the financial system and the economy as a whole."
3. According to the author, what are some of the "unproductive activities that derivatives can be used for? (Note: Have to skip forward a bit in the article)
Derivatives can be used unproductively for "speculating, leveraging or raising risk-to-capital ratios, dodging amd outflanking regulations, manipulating accounting profits and evading taxation."
Many economists would disagree, holding that speculators actually provide a useful function as market makers (a buyer when there are no buyers, a seller when there are no sellers), adding liquidity and continuity to thin markets with few participants (See Wikipedia on the economic benefits of speculation)
4. What aspect of derivatives helps capital flows?
The risk-shifting function of derivatives can be used to hedge risks.
5. Do derivatives dampen or amplify the economic impact of large changes in the exchange rate?
They amplify large changes in exchange rates. The "speed and depth of the impact on the financial sector and economy" will be greater.
6. What are the two ways that derivatives reduce transparency?
First, balance sheets become less useful for "measuring the risk-return profile of businesses." An example is given:
"An export-import firm, for example, may have equal amounts on its balance sheet of foreign assets and liabilities, reflecting a natural or balanced foreign-exchange position. And yet it may have derivatives that create substantially large short foreign-exchange positions off the balance sheet. These derivatives then alter the firm's risk exposure from that reflected in the balance sheet."
Second, when derivatives are privately traded, they can avoid the reporting requirements for publicly traded derivatives making it more difficult for the government to know what is going on.
7. Are publicly traded or over the counter derivatives more transparent?
Publicly traded options are more transparent, as implied by #6 above.
8. How are derivatives used to manipulate reported financial reports in the United States? How might this lead to distortions?
Derivatives are used to move income between periods.
For example, a bank might want to defer the impact of default non-performing loans on its balance sheet. It might want to defer this impact definitely and avoid writing off the loans.
Yet the bad loans are there waiting to be written off in the future and astute investors know this. The Savings and Loan crisis in the United States was overcome by writing off the bad loans. Japan never wrote off their loans and faced a very long recession.
(See Wikipedia on the American Savings and Loan
Crisis)
9. What role did derivatives play in the 1997 financial crisis? What financial instruments were involved?
The central bank reported foreign reserves, but not off-balance sheet short foreign exchange positions created by derivatives.
Foreign currency derivatives used forward and swap financial instruments.
