The speculative debacle of the hedge funds continue to remain a closely-guarded secret. What is clear now is that hedge funds have leveraged highly and taken bets on currency and interest positions around the globe, some of which bets have gone awry. Long Term Capital Management (LTCM) and Ellington Capital Management are the first two casualities, and further losers are expected to unfold over the next several months.
The large-scale speculative losses has heightened the turmoil at the financial markets leading to reassessment of risk, and raising corcerns on the health of the banks which lent money to the hedge funds. At the biennial International Conference of Banking Supervisors, Federal Reserve Bank president William McDonough intimated the increased risk aversion of bankers which could, if it continued, lead to a serious credit crunch. The concern was to ensure that the pendelum of risk-taking, which had swung wildly to the side of excessive risk-taking did not now go equally wildly to the other extreme where worthy borrowers were not spurned.
The lessons of the Asian financial crisis serve us a reminder. International Monetary Fund (IMF) attributed the serious financial losses of Asian banks categorically to crony capitalism and inherent structural weaknesses in the financial system. The IMF remedy was to close the failed banks, raise interest rates, and reduce credit lending. The remedy led to a severe cash crunch in the region, a malaise in aggregate demand and near-zero new private sector investments -- all of which led to severe falls in imports and a reduction in global trade.
William McDonough's concens re-echos the view that is about time IMF took cognizance of the error in its policy dictum, and acknowledge the role of the hedge funds in the Asian crisis.
Importantly, there is a definite need for a greater scrunity and regulation of the activities of the hedge funds. As Ian Macfarlane, the Governer of the Reserve Bank of Australia remarked, the size and potential impact of hedge funds alone suggested that they were due to cume under regulations. Since the hedge funds are important enough to have systemic consequences, they should not escape supervision in some form or other.
The easiest and effective measure will be to limit the gearing level. Disclosure of trading strategies will prove difficult as some hedge funds operate proprietary trading systems. However, periodic disclosure of aggregate exposed positions will bring about greater transparency and prior assessment of potential losses.
Implementing and supervision of the measures will however prove difficult. Peter Costello, Australian Treasurer, pointed out the LTCM illustrates one of the problems of supervision. With technological development and financial innovation, new institutions can emerge and bypass supervision. The regulators themselves need to encompass new trends and development, and any new areas of potential risk. And since hedge funds operate globally, the global (not national) forum is required for effective supervison. Could such role be played by IMF? Yes, but IMF first needs a revamp.
Nancy Kimelman, the chief economist of Thomson Global Market voiced that IMF has been misguided especially in its policies and prescriptions to Asian countries in handling the financial crisis, and IMF needs to realise it cannot impose conditions based on a rigid US perspective of what capitalism and democracy should be. IMF must "take off its blinkers" and treat each country differently. She told the media conference in Singapore recently that the solution for Asian countries in trouble was to reflate their economies - not IMF's tough contractionary measures, and thus IMF had to ease up and have some tolence of countries which impose capital controls.
So, is Malaysian Prime Minister Mahathir right after all? He candidly pointed the fingers at Soros and the hedge funds some six months ago and said that the hedge funds have amassed substantial capital resources and need to regulated, and it is the massive capital flows that can disrupt an otherwise expanding economy. IMF needs a rethink, a revamp, and after having done so, IMF could prove to be just the right agency for putting together a package of controls to regulate and supervise the activities of hedge funds.