The global financial markets are going through a spasm. Emerging markets, long the flavour of the month as poor countries got richer, have seen money flow out of their economies at historical rates.

Russia’s currency is in free-fall and there’s very little that the Russian authorities can do about it, proving that these days it is easier to invade Ukraine than to defend the Rouble.

The price of oil is collapsing, so too is the price of coal, steel and copper.

But what is happening in global financial markets right now, and how will it affect you? Is it something far away that you need not worry about? Or is it something that will affect all of us in 2015?

To understand what is happening, you have to appreciate the extent to which financial markets panic, regularly. Once there is leverage, once traders borrow someone else’s money to buy stuff, there will always be the potential for panic.

This panic can become self-propelling where the panic itself makes the panic legitimate. As things get more fragile, good assets are sold to pay for the losses incurred in bad assets and the selling can become widespread.

The contagious nature of financial markets became clear to me many years ago – in 1997 to be precise – when I worked in the financial markets.

In October 1997, I pulled up a chair in the enormous foyer of the Grand Hyatt overlooking the harbour in Hong Kong.

There was a good view of the Star ferry as it shuttled thousands of workers to and from Kowloon.

The investor I was meeting explained that he was busy selling his assets in Russia and Eastern Europe because of the events in Asia. This puzzled me. I’d thought Russia did little trade with the Asian Tigers. Why would the crisis in Asia affect it?

The answer lay in the dynamics of financial globalisation, which I, an economist in a global bank, had not yet fully grasped.

Many investment banks have proprietary trading desks. These desks use bank depositors’ money to gamble on the markets. Their objective is to dramatically increase the return on the bank’s money.

In order to have some level of security, each bank sets a limit on the trading desk: the amount of the bank’s capital that can be put at risk. The bank I was working for, BNP, was using French deposits to speculate in Asia and Russia. Many traders, who believe themselves to be infallible, view such limits as a nuisance that restricts their genius and become adept at finding ways to circumvent them.

Trading desks can also leverage the bank’s reputation to get additional credit facilities from other banks.

The trader using other banks’ money in this way will normally be required to lodge a deposit of perhaps 10pc of the value of the investment with the bank from which he’s borrowing. This deposit is known as the ‘margin’. So let’s say the bank lends him €1,000: this gives him €900 of a stock, over which the bank has a charge; and he deposits €100 at the bank. As long as the end-day position equals the €1,000 lent, everything is fine.

What happens if the value of the stock falls to €800? This triggers a margin call: the margin between the value of the shares and the value of the loan has grown, and the trader now has to make up the difference by adding another €100 in cash to the €100 already on deposit.

The trader now probably has to sell something in his portfolio to get the cash to pay the margin call. This, in microcosm, is contagion: it illustrates the way a crisis in one market can provoke selling in another, perhaps entirely unconnected, market. One trader selling one asset to make one margin call is no big deal; but when a crisis causes heavy falls in asset prices in a certain area, and when the markets are dominated by heavily leveraged traders operating in a wide range of sectors, it’s not hard to see how a panic in Thailand can spread across Asia and thence to faraway places like Russia.

This is what causes small crises to blow up into much bigger ones – and it is why the financial world has become less stable in the era of globalisation and easy credit.

When asset prices are rising, everything is fine. But when asset prices are falling, everyone suddenly needs cash to pay for the margin calls coming at them from all angles. Banks find themselves forced into the interbank market by the need to borrow from each other, in the hope of shoring up their balance sheets.

If central banks don’t step in and inject as much liquidity as possible, a short-term cash-flow problem rapidly becomes a credit crunch.

In the foyer of the Hong Kong hotel that day, the trader’s position had nothing to do with economics, trade, investment, the stuff you learn in textbooks.

The arithmetic of the trader’s position was simple: he had just lost money in Indonesia, so he had to raise it elsewhere to cover his losses.

This was a classic ‘Minsky moment’ – the moment when investors must sell assets to cover their obligations – and it was being played out here in the vertiginous lobby of the Grand Hyatt in Hong Kong.

The same thing is happening now in various corners of the globe, in banks, hotels and other financial institutions.

Billions of euros, dollars or sterling of borrowed money has been used to gamble on assets in the past five years. As central banks cut interest rates and made cheap money available to boost growth, the financial markets used this money to place bets on oil, commodities and IOUs from governments.

As these leveraged bets turn sour, the traders have to sell good assets to shore up cash losses on bad assets.

Already developed markets in Europe and the United Kingdom are wobbling. If this goes on it will have a material impact on our economy.

Also, the impact of a deeply unstable Russia for both the Ukraine and for European business confidence is obvious.

That’s the nature of contagion; you never know where it will stop.

0 0 votes
Article Rating
Would love your thoughts, please comment.x