Global Financial Markets: The Dr. Jeckyll and Mr. Hyde Syndrome

``Historically, the government has kept the Taiwan dollar under a tight reign, so as to deter unwanted appreciation that might harm exporters' competitiveness. In my view, this same policy has hindered the country's ability to develop a robust service sector. Top-tier knowledge workers rarely derive their advantage from a "cheap" currency, but rather from the sheer global competitiveness of their skills and services. Given that such workers can sell their services most anywhere in the world, they have little incentive to reside in a country whose currency policy steadily erodes the purchasing power of their income and savings.” Andrew T. Foster, Director of Research, Portfolio Manager, Matthews International Capital Management, LLC

An 1886 classic by Scottish novelist Robert Louis Stevenson, “A Strange Case of Dr. Jekyll and Mr. Hyde” depicts a tale of a person’s internal “good versus evil” conflict; a personality switch struggle triggered by a scientific experiment which transmogrifies the respectable Dr. Henry Jeckyll into a hideous murderer in Mr. Edward Hyde. The story ends with the dearth of the potion required to bring Mr. Hyde back to his original state or Dr. Jeckyll, where “both” eventually dies.

The financial markets today seem to illuminate of a Dr. Jeckyll and Mr. Hyde syndrome.

On one hand, Dr. Jeckyll appears to be represented by the equities side, which has seemingly been placid and convalescent following the recent bouts of transformation from Mr. Hyde, prompted by the August subprime led shakeout.

On the other hand, the vicious strains of Mr. Hyde have been quite evident in the persistent arterial blockages in the global credit market, the continuing maelstrom in the currency markets and the accelerating perceptions of a sharp economic downturn in the US possibly percolating to the rest of the world.

Where the balancing of the asymmetric conditions of Dr. Jeckyll and Mr. Hyde requires a certain magical potion, its functional equivalent in today’s milieu is the financial engineered credit-driven liquidity structure that has underpinned the sustainability of the current system as shown by derivatives expert, Satyajit Das in Figure 1.

Figure 1: Satyajit Das: The New Liquidity Factory

Mr. Das describes of the transformation of the credit system from the traditional banking driven process to a “borrowing money from borrowed money” structure, we quote Mr. Satyajit Das (highlight mine),

``In the new liquidity factory, investors did the borrowing - hedge funds borrowed against investments; traders borrowed cheap money (especially yen at zero interest rates) to fund high yielding assets in the famous carry trade. Financial engineering disguised leverage so that an investor’s balance sheet today does not tell you the amount of leverage being employed.

``The new liquidity factory is self-perpetuating. If you bought assets with borrowings then as the asset went up in price you borrowed more money against it. In an accelerating spiral, asset prices rise as debt fuels demand for the asset. Higher prices decrease the returns forcing the investors to borrow more to increase returns. Bankers became adept at stripping money out of existing assets that had appreciated in price, such as homes. In the USA, UK and Australia – the fast debt nations - home equity borrowing funded a frantic debt addiction.”

In a pyramid framework, the present liquidity has principally been built from the bottom, where layers and layers of leverages consisting of securitized debt and derivatives comprise the majority of what drives the global financial markets.

The astounding degree of leverage has been estimated as a percentage of GDP and as a share of liquidity distribution by Mr. Das, which implies that the present financial system has increasingly been über sensitive to interest rates, price actions and volatility fluctuations.

The recent perky equity markets adamantly believe that global central banks led by the US Federal Reserve will be able to successfully plug and repair the recently punctured structure as a result of the deepening US housing recession impelled security losses, and the sustain the party.

We hope they are right and Dr. Jeckyll prevails.