This week The Financial Times published two pieces reviewing the newly emerging global finance lansdscape. No analysis of how new players are contributing to the stability of the world economy, but a mere view of what is taking place in markets, and some caution ahead of what is shaping to be a new model in global finance:
The fall of a financial model
Recent changes in the world economy and financial markets mark the end of the present standard model of financial capitalism, built up over the last decade or so. In this model, financial stability is mainly based on the self-regulation of the financial sector, which alone assesses the risks produced by its financial innovations.
Moreover, the link between finance and the real economy hinges on an adequate return on investment for shareholders, who punish poor management by making share prices fall, leaving the company open to takeover. The only role assigned to governments is to guarantee free circulation of capital between companies and between countries. As alternative economic models collapsed over the past two decades, public opinion came to accept this model of financial capitalism. Today, governments and labour unions accept profit as the most relevant criterion for assessing a company’s efficiency. This model is experiencing three crises, all of which refer to changes in the relationship between governments and markets.
The first concerns the significant, yet silent, return of governments to the economic playing field. Three of the five richest nations by total gross domestic product have become de facto neo-mercantilist, setting their sights on trade surpluses. China is keeping its currency artificially low in order to increase its trade surplus and lower its costs of production vis-a-vis competitor countries. Japan is pursuing government-oriented policies to bolster its position in high-technology markets. Finally, and to a lesser degree, Germany has been carrying out reforms to restore industrial competitiveness. In addition, countries that have access to natural resources, notably oil and gas, have revenues that serve as both an instrument and aim of their international policy. Trade surpluses have resulted, demonstrating the capacity of governments to acquire massive amounts of foreign assets through sovereign wealth funds. The problems that arise are not economic, but political. Governments may use technology transfer or control of strategic national assets as a means to increase bargaining power in international affairs.
The second change involves company ownership. Three transformations should be noted. The first relates to the emergence of active shareholders, who build up significant stakes with the aim of exerting strong influence on management. The second relates to activist shareholders and their demand for short-term returns, resulting in decisions that are not in the company’s long-term interests. The third involves leveraged buy-outs, closely linking the interests of managers and shareholders and taking advantage of easy credit.
These shifts in the distribution of power raise questions: what is the relationship between shareholder meetings and boards? To what extent should companies be allowed to protect themselves from hostile bids or creeping takeovers? In what form and how frequently should accounting information be provided to shareholders?
Company ownership has not yet found a new balance, as shown in Europe by the absence of agreement on the takeover directive and on one share/one vote rather than multiple voting rights. Regulators’ desire to increase supervision of creeping takeovers is telling. The trends are risky: a shareholder can pursue speculative or self-interested aims to the detriment of other shareholders and against the company’s best interest by breaking up the business or by avoiding taking risk.
The third crisis is the one rocking financial markets. Unlike the internet bubble, this is not a crisis based on irrational behaviour but one of sophistication and disintermediation. The new risks produced by financial innovation were left to a sector that alone was considered able to understand its instruments. The crisis demonstrates the costs to the real economy and lack of an efficient self-regulating system.
All these risks call for a new relationship between the workings of financial markets and regulatory actions of governments. Democratic governments will have to deal for a long time with less democratic economies that use financial market mechanisms for political ends. Each sovereign investor must clarify its intentions and define its code of conduct. Governments must also define with greater precision the sectors they consider strategic.
The changes in company ownership also call for greater transparency in order to prevent actions that offend business ethics, such as creeping takeovers and speculative strategies that undermine companies’ long-term interests. The board’s role of defining solutions that satisfy shareholders’ divergent interests will have to be strengthened. It should allow for corporate governance that encourages long-term strategies while satisfying shareholder interests. Finally, regulators should supervise the whole of financial markets to assess systemic risk, eliminate off-balance-sheet ambiguities and bring within the scope of supervision actors that have eluded market authorities.
How governments deal with these crises will depend on their national interests. These issues will be difficult to deal with in Europe where country responses will diverge. One can expect to see the co-existence of various models, varying by level of government intervention in financial markets. There is a great distance, however, between co-existence and compatibility.
Jean-Louis Beffa is chairman of Saint-Gobain and co-president of the Cournot Centre for Economic Studies. Xavier Ragot is associate professor at the Paris School of Economics
A new force in global finance
How can it be that Merrill Lynch, Citigroup, Morgan Stanley, Bear Stearns, UBS and other big banks have been turning to foreign governments for financial lifelines with so little public controversy? Perhaps it is because the dangerous broader context of what is happening – the rise of “state capitalism” – is not sufficiently recognised. Indeed, the reality may be that the era of free markets unleashed by Margaret Thatcher and reinforced by Ronald Reagan in the 1980s is fading away. In place of deregulation and privatisation are government efforts to reassert control over their economies and to use this to enhance their global influence. It is an ill wind that blows.
Exhibit A is a quantum increase of regulation nationally and globally. The issues of product and food safety will spawn new and highly complex trade regulations in the US, the European Union, China and the World Trade Organisation. The blizzard of energy and environmental legislation in a number of countries is mind-boggling. The subprime debacle will probably lead to new rules for every type of institution that securitises debt.
Evidence of the rise of state capitalism can also be found in increasing public sector ownership of natural resources. Government-run energy companies from Saudi Arabia, China, India and Brazil now own more than 80 per cent of the world’s reserves. Their reach is growing. Russian and Chinese government entities also look poised to make a run for global domination of aluminium and iron ore.
Finance is being taken over too. Beijing’s state-controlled banks are now moving into the US and taking large stakes in important banks such as South Africa’s Standard Bank . Last year sovereign wealth funds in the Gulf and east Asia invested more than $60bn in foreign financial institutions and the amounts are rising rapidly. Assets in these funds will, in the years ahead, exceed the combined capital in private equity and hedge funds.
We should not be surprised by these trends. Since the mid-1980s the world economy has been on steroids, resulting in exceptional growth and wealth creation. Now governments are reacting against the excesses of free markets. A lot of people were left behind as soaring income inequality accompanied the boom. In trade, product quality went unsupervised. In finance, risk management was neglected by bankers, regulators and credit agencies. The 27-nation EU, being more prone to intervention in markets than the US, has taken the lead in reasserting a robust role for regulation. China and India, neither of which has any deregulatory DNA, have also become influential in changing the global gestalt .
Government officials also turned a blind eye towards dangerous financial imbalances. The very countries that had little history of free markets accumulated massive reserves, while the US accepted large deficits and became hungry for money from anywhere it could find it. In a world economy where power has become highly decentralised and in which international institutions are weak, governments backed by huge reserves have discovered they have significant leverage in global markets. That is especially true in downturns, such as now.
The implications are worrying. While prudent regulation in selected areas can be justified, the new zeitgeist is likely to produce too much government intervention, too fast. We can expect less productivity, less innovation and less growth, since governments have many goals that the private sector does not. These include employment generation, income redistribution and the aggrandisement of political power. The expansion of regulation will also open up new possibilities for trade disruption. For example, countries may block the importation of goods that do not meet their precise national environmental standards.
Beyond that, trade and finance will become more politicised as governments leverage the companies they control as instruments of their foreign policies. Russia’s president, Vladimir Putin, has used Gazprom’s natural gas to influence his neighbours’ economic and political directions. China has provided aid to repressive regimes to open up opportunities for companies such as Sinopec. President Nicolas Sarkozy seems poised to use the combination of France’s Atomic Energy Commission, the state-controlled nuclear power company Areva and the national engineering champion Alstom to sell civilian nuclear power in the Gulf and China.
Unfortunately, the trend is unstoppable. But officials from market-friendly finance ministries could acknowledge the momentum behind the rise of state capitalism to demand their own governments produce impact statements that spell out all the costs of new laws and regulations. They could commission reviews in the International Monetary Fund and the WTO of all the implications of growing government intervention. Think-tanks and universities should gear more research to the costs and benefits of state capitalism.
When it comes to foreign investment by state-owned companies or from sovereign wealth funds, the US and the EU need to set common standards for transparency, ownership and reciprocity. The rules should be enforceable – not milk-toast, voluntary guidelines.
In the late 18th century, capitalism was replacing feudalism. In the 20th century, freer markets won the day. Now the world is flirting with another big transformation in the philosophy and rules of global commerce. Unlike the changes of the past, this new trajectory does not represent progress.
Juan Trippe professor of international trade and finance at the Yale School of Management
Source: The Financial Times Limited 2008