M. Umer Chaprawealthy individuals” for risky speculation when it is well-known that the
higher the leverage, the greater the risk of default. The unwinding of
leveraged positions can cause major disruption in financial markets by
exaggerating market movements and generating knock-on effects (IMF,
December 1998, pp.51-53).
This shows that a crisis can come not merely because of improper
regulation of banks, as it did in East Asia, but also in a properly regulated and
supervised system, as it did in the U.S. Even though the hedge funds were
not regulated, the banks were. Then why did the banks lend huge amounts to
the LTCM and other funds? What were the supervisors doing and why were
they unable to detect and correct this problem before the crisis? Is there any
assurance that the regulation of hedge funds would, without any risk-sharing
by banks, stop excessive flow of funds to other speculators?
4.3 Foreign Exchange Market Instability
The heavy reliance on short-term borrowing has also injected a
substantial degree of instability into the international foreign exchange
markets. According to a survey conducted by the Bank for International
Settlements, the daily turnover in traditional foreign exchange markets,
adjusted for double-counting, had escalated to $1,490 billion in April 1998,
compared with $590 billion in April 1989, $820 billion in April 1992 and
$1,190 billion in April 1995 (BIS, April 1998).^5 The daily foreign exchange
turnover in April 1998 was more than 49 times the daily volume of world
merchandise trade (exports plus imports).^6 Even if an allowance is made for
services, unilateral transfers, and non-speculative capital flows, the turnover is
far more than warranted. Only 39.6 per cent of the 1998 turnover was related
to spot transactions, which have risen at the compounded annual rate of
about 6.0 per cent per annum over the 9 years since April 1989, very close to
the growth of 6.8 per cent per annum in world trade. The balance of the
turnover (60.4 per cent) was related largely to outright forwards and foreign
exchange swaps, which have registered a compounded growth of 15.8 per
cent per annum over this period.^7 If the assertion normally made by bankers
that they give due consideration to the end use of funds had been correct,
such a high degree of leveraged credit extension for speculative transactions
may not have taken place.
The dramatic growth in speculative transactions over the past two
decades, of which derivatives are only the latest manifestation, has resulted in
an enormous expansion in the payments system. Greenspan, sitting at the
nerve centre of international finance, himself finds this expansion in cross
border finance relative to the trade it finances as startling (Winter 1998, p.3).