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Trimming the hedge funds is not all good news

May 5, 2000

A MONTH ago Julian Robertson, the once high-flying hedge fund manager, announced the closure of his Tiger funds after the recent financial market volatility had dealt a big blow to their performance. Last week George Soros and his right-hand man Stan Druckenmiller also threw in the towel, announcing a radical shake-up of the Soros Fund Management group. One by one, the hedge funds, which once conquered the global financial markets, are bowing out of the battlefield of high finance. Welcome to the world of financial chaos.

The fall from grace of the Tiger and Soros funds, coupled with the demise of the world's largest hedge fund, Long-Term Capital Management (LTCM) in 1998, is sending a clear but worrisome message that financial capitalism is entering a dangerous, if not unsustainable, phase.

LTCM went down the tube because the Russia crisis in August 1998 went against its positions. With a tiny capital of US$4 billion, this hedge fund, advised by two Nobel laureates in economics, leveraged its positions to US$1 trillion. Naturally, the US investment banks jointly took over LTCM to prevent a systemic breakdown of the global financial system. Most hedge funds have been in trouble ever since the Russia crisis.

"We're no longer apprehensive from the threat of the hedge funds because most of them were wiped out by the Russia crisis," MR Chatu Mongol Sonakul, the Bank of Thailand governor, said some time ago. After the baht crisis, the Thai authorities moved quickly to curb baht trading in offshore markets. Local banks have been restricted from lending baht to offshore borrowers, hence cutting off the local currency supply to speculators. Malaysia went further and imposed strict capital controls.

With the chaotic developments in global finance, it was only a matter of time before the mighty hedge funds lowered their chins and came down to earth. Robertson's Tiger funds got stuck in the "Old Economy" as stocks and prices had been moving maddeningly beyond rationality. "Price has been eliminated from the market. People believe (they should) buy the best company. It doesn't matter what it costs," he said.

Soros also lamented prophetically over the loss of his old art - the alchemy of finance - that he practised for the most part of his fund management career, which reaped in 30 per cent in annual returns. "Our large macro bet days are over," he said. Hedge funds ravage the global financial markets by betting in stocks, currencies, interest rate swaps and other sophisticated financial products all at the same time. Soros added that he would be happy if his funds, which will become more conservative, can make 15 per cent a year.

At the height of the baht crisis in 1997, Robertson emerged as the number one enemy of the Bank of Thailand. His Tiger fund bet about $3 billion against the baht and made huge profits after the baht was forced into a devaluation. Soros also was viewed as an enemy of the state, gambling some $800 million against the baht. But Soros earned his fame in the Asia crisis by trading verbal taunts with Dr Mahathir Mohamad, the Malaysian prime minister. Mahathir described the hedge funds from the West as an evil force which brought down the Asia miracle. Indeed, most of the hedge funds benefited substantially from the Asia crisis, riding on the high tide of invincibility.

From the Asian perspective, hedge funds are the pirates of modern finance. Some of the highly leveraged hedge funds are managed secretly. They register in offshore financial centres to escape the watchful eyes of the regulatory authorities.

When the hedge funds took on the financial markets with their enormous leverage power and intense speculative practices, they created instability in financial systems.

The US authorities made virtually no effort to regulate the hedge funds, viewing their operations as part of the free market.

Only after the collapse of LTCM did they try to improve supervision against the hedge funds, particularly by imposing prudence on the banks which lent money freely to them without adequate risk management.

The demise of the hedge funds is not all good news for central banks in emerging markets. For it signals growing financial turbulence ahead. How the emerging markets, including Thailand, can cope with the turbulence has become one of the most important policy challenges.

Evidently, there is an absence of rules in the international financial system that would ensure stability. A shake-up in the international financial architecture is needed to rein in the turbulence.

In today's world, three most prominent themes - globalisation, stock market turbulence and IT revolution - are transforming global capitalism.

For Thailand and other medium-sized open-market economies, it is a time of danger and opportunity.

Danger will descend on countries that fail to keep up with what Eisuke Sakakibara, Mr Yen, calls the great transformation from old industrial-financial capitalism to information or cyber-capitalism.

"The process is irreversible and will probably accelerate dramatically in the coming years. Asian countries, including Japan and Thailand, need to structurally change their economies and societies to adapt to the new environment," Sakakibara said.

With the free flow of capital, guided by real-time information, it will become necessary for countries to build up mechanisms to guard against the extremely volatile financial markets. The trouble is that a big mechanism, whether of a regional or a global nature, to guard against instability has yet to be put into place.




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