What makes a global financial centre?

Saturday August 15, 2009
What makes a global financial centre?
Think Asian by ANDREW SHENG


We grow up thinking the world is balanced – that good cancels out evil, that assets equal liabilities, that life is a simple bell-shaped curve.

But it is not. There is a lot of inequality around. We like buying, but we do not sell that often, except if forced to.

Risks in the financial world are like that. George Soros recently pointed out a simple fact that I had taken for granted, but realised that common sense is not common. The reason why financial markets are dangerous is because the risks of going long (buying only but not selling) is not the same as going short (selling or borrowing what you do not have).

If you buy anything and the price goes to zero, all you lose is your asset. However, if you borrow or you short a product, you can lose not only everything you have but owe far more than you realise.

This was the common sense that AIG failed to appreciate. If you insure cars or life, you are working with the law of large numbers. As long as your premium covers the estimated losses, you are still making money.

But if you insure banks (which are highly leveraged institutions) or borrowers, which is what the derivative trading subsidiary of AIG did in London, the losses are amplified by the embedded derivatives.

Imagine anyone trying to insure the recent global bank losses of nearly US$3 trillion.

The banks lost a lot because they are highly leveraged institutions.

The lower the price of assets that they hold, the more they became bankrupt.

So AIG needed more than US$180bil to bail out, compared with the initial request for funding of only US$10bil.

This brings us back to the use of domestic currency as international reserve currency. When a domestic currency is circulating only within its own country, it is one citizen lending to another.

The left hand is borrowing from the right hand. If someone does not pay his debt, there are laws to protect the lender and even if the corporate sector overborrowed and collapsed, the state can intervene by either nationalising the debt or taxing the rest of the population to pay for the losses.

In the 19th century, Asians have not forgotten that foreign debt was enforced through gunboats and also military invasion.

So, it does not pay to owe foreign debt too much, because a central bank cannot print foreign currency. So why should a country want its currency to be an international reserve currency? There are two basic reasons.

The first is seigniorage, which is the fact that anyone who issues currency is actually borrowing money without interest.

All central banks earn seigniorage from the currency issue. In a sense, it is the premium citizens pay to the central bank for safeguarding the value of their currency.

Therefore, the country that issues a global reserve currency enjoys seigniorage from foreigners who hold its currency. This amount can be very large indeed, as the United States clearly is in that position.

But the actual benefits received for trade and commercial services when the currency is the reserve standard are larger.

In the days of the British Empire, London benefited hugely from being the financial centre for sterling, as well as the trading centre for commodities, international loans and related legal and commercial services.

Although sterling lost its role as a major reserve currency to the US dollar, London became the centre for the offshore eurodollar market and also an important complement to New York.

The biggest commercial banks, brokers, fund managers and insurance companies were located in both London and New York, because they shared the same language, common law and also similar business practices.

So what makes an international financial centre? After working in Hong Kong, I finally understood that an international financial centre must satisfy three basic conditions – it must protect property rights, it must have lower transaction costs and thirdly, it must have high transparency.

The first condition is obvious and yet not so obvious. Most Western economists say that London and New York have superior property rights because they have well accepted common law and excellent and fair judiciary.

But protection of property rights is more than just laws and enforcement.

Protection of property rights means also political stability, the absence of nationalisation, predatory taxation and the power of a strong military.

To put it bluntly, no successful international financial centre operates in a war zone or a banana republic.

The second condition of low transaction costs is very important.

No financial centre will succeed if it is not convenient to do business with low regulatory costs, with good communications infrastructure. The best financial centres have excellent telecommunication, transport and living conditions.

Transaction costs are also associated with geography.

It is no coincidence that New York dominates in the American time zone and London dominates in the European and African time zone. Asia has no dominant financial centre for reasons that I will discuss later.

The third condition is high transparency, because markets thrive on information. If information is not accurate, timely and accessible, investors do not know how to protect their funds and make good decisions.

Next, I shall look at why Japan failed to make yen a dominant global reserve currency.

Andrew Sheng is adjunct professor at Tsinghua University, Beijing and Malaya Universiti. He was formerly the chairman of the Securities and Futures Commission, Hong Kong.