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6 gen 2011

Executive - From hub to web

This article was published on Executive magazine January issue.

During the credit crisis triggered by the Lehman Brothers bankruptcy, a paradoxical consequence arose for the United Arab Emirates: the loans portfolio of its banking system was somewhat larger than its stock of deposits. Definitely not a large gap, more or less in the order of 10 percent, well within the internationally accepted norm of prudential parameters. Yet, as a result of the global money market convulsions and the extreme risk aversion which prevailed in the last tense months of 2008, the UAE banks had severe problems in funding this gap on the international market, which translated into a credit crunch for domestic businesses and consumers.

Hence the paradox: the UAE (and the other Gulf Cooperation Council countries) have been net exporters of capital for decades; they supplied a critical lifeline to the international banking system by supporting the recapitalization of major financial institutions in the United States and the United Kingdom when they were torpedoed by the sub-prime mortgage fiasco. But when, at a critical juncture, the need arose for the UAE banks — which were essentially sound and had only minimal exposure to toxic assets — to borrow, international financers deserted them.

This episode highlights a peculiar arrangement: emerging economies with large capital export use the financial services of heavily indebted countries where they are charged hefty fees for channeling this capital to borrowers. But if these emerging economies need finance during a crisis, largely provoked by the incompetence of Western bankers and regulators, these same bankers and regulators decide who is deemed creditworthy. This oddity was even more striking in the case of trade finance, on which depend virtually all exports from emerging markets. In the aftermath of the Lehman bankruptcy, loans to exporters, despite carrying very low risk, were drastically curtailed — leading to one of the most spectacular drops in international trade ever recorded.

Time for a system overhaul

This asymmetry is not acceptable anymore and has opened wide cracks in the “hub and spoke” model of international finance. Essentially, the main finance centers preside over all major financial relations in the world. A deal between, say, a Brazilian company and an Indian investor (the spokes) is likely to be mostly handled in London or New York (the hubs). While this was justified when the US was a net capital exporter, and therefore played a key role in the allocation of their own funds to the rest of the world, today it represents a vestige of the past. Worse, as the crisis has demonstrated, it is a fundamental element of financial fragility and therefore a threat to the stability of the world economy.

The current “hub and spoke” system needs to be replaced by a network of financial centers, a web of interrelation that would make it more flexible, efficient and resilient. In other words, if an Indian investor wishes to invest in a Brazilian company he will be able to bypass New York and arrange the operation directly in Mumbai, or maybe in Dubai, or through accessing expertise and resources in more than one location.

It is conceivable that even in the “web” system not all nodes will be equal, some will be specialized in certain areas, others will enjoy economies of scale in human capital and knowledge. But essentially, while each financial center will play a useful function, none will be indispensable for the stability of the global system.

A trend is already discernible. Sizeable deals between emerging markets — which until recently would have been arranged through a major financial center — now take place through direct links. China, with its huge current account surplus and accumulated net foreign assets, is at the forefront of this new wave, but other areas — including the GCC — are increasingly active outside the traditional financial perimeter. The foreign direct investments among emerging markets, which in the jargon of policy makers are called South-South flows, are booming, thereby dislocating the traditional capital flows.

With Asia’s emerging economies enjoying a quick rebound from the crisis — unlike the mature economies — this process is bound to intensify, but the speed at which it will develop depends on many factors. One of the most important is the creation of a liquid and deep debt market in the peripheral nodes.

A new market is born

Deep and liquid fixed income security markets represent the leading source of funds for governments, public companies, agencies and financial institutions. Their functioning is key for the efficiency and stability of financial intermediation, while providing a boost to economic growth. While some emerging countries have made notable progress in this area, the Middle East and the GCC still lag behind. According to data from the International Monetary Fund, capital markets in the Middle East are an anomaly when compared with other areas because they are dominated by bank assets and equities, which together make up 94.4 percent of finance; the corresponding figure for the world as a whole is approximately 60 percent.

Specifically, in the GCC, bond financing is out of favor, because it is deemed superfluous in a region flush with capital and hydrocarbon wealth. The swings in hot money flows, the drop in the region’s equity markets and the prohibitive cost of long-term borrowing have exposed the danger of relying on external capital markets. With a precarious financial lifeline in the face of the continued global liquidity crunch, GCC countries are now eagerly tapping the abundant domestic wealth and foreign capital looking for relatively safe investment.

This noteworthy trend was initiated this year with large sovereigns issuance (Qatar, for example, broke the record for the largest debt by an emerging market with a $7 billion issuance), to match governments’ commitment to maintain the infrastructure expenditure at pre-crisis levels. Now an embryo of a market has been created in the region with the appearance of a yield curve on which to price new securities and manage risk. But more is required to get on par with other emerging markets in terms of liquidity, depth, investors’ involvement, governance, debt management, etc. In particular, governments should take a leading role by committing to a plan of bond issuance across the maturities spectrum, conducted periodically over a number of years with appropriate pre-announcement of auction dates, size of the issue, characteristics of the securities, primary dealers and secondary market listings. Issuance must be large enough to attract active trading, while their features (coupons, legal obligations, transaction costs, custody fees, etc.) ought to maintain consistency across maturities. Equally crucial would be the legal and regulatory framework, which must enjoy the trust and confidence of lenders and borrowers, and hinge on transparency, timely information and solid governance.

The development of local currency debt markets is akin to any other public investment (e.g. in infrastructure, health, education, etc.), and has strategic significance. Once the debt markets in the GCC reach maturity, the peculiar arrangement described above — by which the wealth accumulated in the region has to be invested in traditional markets — will be reversed. In other words, international borrowers wishing to tap the enormous pool of liquidity will have to list their securities in the GCC, paying fees for the provision of financial intermediation. So there is a chance that in a few years we could be hearing the final notes of the requiem for the “hub and spoke” model.