Financial Markets : Mission Impossible?

The approach

In autumn 1991, the Fondation pour le Progrès de l'Homme asked the independent economic research institute Eco'Diagnostic to investigate the role and functioning of financial markets in today's economy. Some months later, a preliminary report entitled "La bourse : une vocation trahie?" ("Stock exchanges - mission impossible?") was discussed by a group of professionals, academics and users of financial systems meeting in Geneva. The report aroused such interest that it was decided to launch a broader discussion and exchange of information on the subject.

In September 1992, an introductory booklet entitled "Financial markets - mission impossible?", published in French and English, was sent free of charge to some 10,000 people all over the world. It included a questionnaire on which readers could record their opinion of the arguments put forward in the booklet. Over the next three months, some 250 replies were received (in various forms) from users of financial systems, from experts in finance and financial regulation, and from academics with an interest in the subject.

The views they expressed served to confirm our initial impression, namely that financial markets were changing without anyone really trying to find out why. The replies emphasized the relevance of our enquiry and encouraged us to proceed further with it. The introductory booklet, reproduced in Part 1 below, merely outlined the process of "financial globalization" and its implications. Even at this basic level, differences in terminology became very apparent. Those who replied to our questionnaire included very few bankers - the implication being that this topic was not a matter of concern to them, or that the terminology used in the booklet had failed to strike a chord with them. In contrast, there were numerous replies from regulatory authorities, businesses and academics.

Following a critical analysis of the replies, personal contacts with some readers and detailed discussions with others, we were able to refine our survey by focusing on the relationship between financial markets and productive investment. As a result, a second booklet (reproduced in Part 2) appeared in April 1993. Our purpose this time was to seek answers to the questions raised earlier. Since the issues covered by our enquiry were usually studied by different disciplines (finance, macroeconomics, business economics), the main problem was to establish links between fields which, although closely related, had difficulty in communicating with one another, to identify common ground, and to enhance the quality of the analysis with the help of new data.

This second booklet, which was sent to only 1500 people, was more specifically targeted than its predecessor. It also contained a questionnaire - a more detailed one this time - which was to prove an excellent means of creating a worldwide network of correspondents. This booklet elicited over a hundred responses, with a fuller amount of information, proposals and suggestions. Apart from establishing contacts, these responses marked the beginning of a real debate on the functioning and the future role of financial markets.

Finally, in September 1993, a third booklet (Part 3 below) examined what are known as "emerging" financial markets in 19 countries, the majority of which are just beginning to "take off" economically. This third booklet also outlined the specific problems facing post-Communist countries, with reference to the Warsaw stock exchange.

In addition to contacts by mail, the project team had formal and informal meetings with various people in Switzerland, France and the United Kingdom, as well as in Poland and Romania. These meetings were invaluable in that they enabled us to test our preliminary hypotheses concerning specific aspects of how financial markets function. Informal contacts with experts in international organisations, both governmental (such as the World Bank, UNCTAD and the OECD) and non-governmental, gave us an opportunity to identify the prevailing concerns, as well as any parallels between them. As we progressed, it became increasingly apparent to us how unique this enquiry on behalf of the Fondation pour le Progrès de l'Homme really was. This was due to a combination of two factors which are seldom found together: a naïve (and therefore irreverent) approach; and freedom from outside influence.

In an academic world which is sharply divided into clans, each with its own set ways of doing things, a naïve approach is a rare luxury. Such an approach disregards the well-trodden paths of economic "science", and does not automatically defer to supposedly "scientific" evidence. Its only concern, its only purpose, is to find out the truth about how today's financial markets actually operate.

Freedom from outside influence is not in itself unusual - the same can be said of all truly academic research. But here, in combination with the naïve approach we have just mentioned, the term "freedom from outside influence" takes on their full meaning. In this case, it includes freedom from the influence of dogmatism, which is always inclined to draw conclusions first and ask questions afterwards; from the influence of particular financial centres or groups of financial experts; and from the influence of government policy.

There is no universal, unchanging answer to the question "Financial markets - mission impossible?". Indeed, if our enquiry is to be relevant, it must take full account of the experiences of financial markets all over the world. From this point of view, we can now divide the countries of the world into four basic groups: OECD countries; "emerging markets"; "emerging market economies" (i.e. post-Communist countries); and the rest of the world. Accordingly, our original question can now be rephrased as follows: "What are the roles of the stock market, and what kinds of stock markets can fulfil these roles?"

Findings

The process of research and enquiry described above has produced a number of findings which, although not firmly established by scientific methods, are nevertheless well substantiated and should not be confused with mere hypotheses.

General findings

Financial markets are institutions which, like any other institution, perform a number of functions in society. Their characteristics and functioning are ultimately shaped by context and external pressures. Financial markets should not, therefore, be idolised or treated as though they were an entirely separate entity.

Over the past twenty years, finance has grown far more rapidly than other sectors of the economy. Its contribution to employment and added value in developed countries is still growing. However, although a source of income, finance is also a source of costs to other sectors of the economy.

Over the same period, finance has come to play a dominant part in all developed societies, with financial dealings constantly extending to new kinds of assets.

The process of "financial globalization" began even before the expression was coined. International integration has increased the power of financial markets, and on a number of occasions they have forced governments to alter their policies.

The financing of production and trade is a matter of purely marginal concern to financial markets. Instead, they are chiefly concerned with managing previously accumulated wealth. It is only a slight exaggeration to state that a society of producers is gradually making way (at least in people's imagination) for a society of interest-earners.

Despite their geographic range, international financial markets are relatively small in terms of the numbers of operators, intermediaries, and listed companies involved.

Financial markets have never been convincingly shown to be efficient, especially when it comes to allocation. It is impossible to tell whether they significantly help to improve the allocation of resources within an economy and thus increase production or whether, on the contrary, they are a source of additional costs.

The growth of financial markets has seriously reduced the effectiveness and relevance of the classic precepts of monetary policy. In this new setting, monetary authorities have been forced to rethink their entire approach to the problem.

Monetary authorities have allowed share prices to explode without taking action, whereas monetary controls have been systematically relaxed whenever stock markets have been threatened with collapse.

There is fierce competition between financial centres. This may tempt local supervisory authorities to engage in competitive deregulation in order to attract more business.

Stock markets in OECD countries

From a purely financial point of view, stock markets play a crucial part in developed economies, even though they only involve a small number of enterprises.

Use of the capitalization system as the predominant method of financing pensions has led to the collectivization of savings, which have abandoned more traditional domains in favour of pension funds. The latter show a marked preference for investment in financial assets.

Self-financing continues to be the main means of financing production. Throughout the OECD, the contribution by financial markets to the financing of production has either stopped increasing or is actually falling.

The part played by financial markets in domestic financial systems has clearly increased over the past twenty years while at the same time banks have become intermediaries in financial dealings rather than lenders. As for the international financial system, it is clearly dominated by the markets.

Since the beginning of the 1980s, security prices ceased to reflect returns on other economic assets (as the lack of correlation with GDP growth rates makes clear).

The growth in capitalization needs to be financed (assuming that the securities actually change hands). The financial system responds to this need both by creating new methods of financing and by diverting resources originally intended to finance production.

Less than 5% of stock-market trading involves new share issues. In other words, the financing of production has become a marginal activity on today's stock markets.

During the 1980s, shares in the better-known enterprises were in very great demand, leading to the emergence of a "liquidity premium" which was solely related to the breadth of the market.

Stock markets are an extremely cheap source of financing for blue-chip companies. Such privileged access to financing gives these major companies a potentially decisive competitive advantage over small and medium-sized enterprises (SMEs).

Listed companies produce between 10 and 15% of GDP, whereas they appear to mobilize a far greater proportion of the available capital stock within the economy. The implication is that listed companies are not the most efficient.

Although institutional investors now hold an increasing proportion of shares, they are still reluctant to become actively involved in the policies of the companies whose shares they hold. This gives management considerable room for manoeuvre in determining company strategy.

Through share prices, financial markets can exert considerable pressure on company performance, thereby inducing enterprises to go for short-term financial results rather than long-term competitive advantage.

Stock markets in developing countries

The so-called "emerging" stock markets (in 19 countries) grew stronger during the 1980s. However, only in a few cases was stock-market capitalization higher than 10% of GDP.

In 13 of the 19 countries, the discrepancy between the cumulative increase in the stock-market index and cumulative GDP growth was greater than in the United States.

The relative proportion of new issues is slightly higher on emerging stock markets than on those in developed countries. However, expansive growth in capitalization has more often been associated with changes in the stock-price index than with the number of listed companies.

Although the volume of trading is very unstable, more than three-quarters of new issues are made by already-listed companies. The number of listed companies on emerging stock markets is very small and relatively stable.

The contribution that stock markets make to development cannot be determined unless we know the contribution made by listed companies to GDP and the extent to which this changes over time.

The expansion of financial markets has had a definite effect on local financial systems. However, in the absence of comparable statistics, it is impossible to tell what this effect has been.

Conditions governing the admission of foreign capital vary from one emerging market to another. Over the last five years or so, emerging markets as a whole have received considerable foreign inflow in the form of portfolio investment. This inflow has helped to boost prices and has reduced the amount of resources diverted from local financial systems by booming markets.

This inflow of foreign capital is chiefly due to diversification strategies adopted by investors in OECD countries. There is always the risk that such capital may be repatriated without warning, with serious consequences for local financial systems.

Multinational companies create a link between the major financial centres where they raise capital and the developing countries in which they make direct investments.

Since the debt crisis, direct investment has taken over from bank loans to developing countries.

The proportion of direct investment, expressed in terms of the internal investment capacity of the host economies remains low (in most cases less than 10%).

The net effect of the expansion of the emerging stock markets is uncertain. Even if the effect is beneficial, the only beneficiaries are listed companies (which are few in number) and intermediaries.

Stock markets in countries in transition

With the possible exception of the Warsaw stock exchange, stock markets in post-Communist countries are still in their infancy.

The supply of securities is only increasing very slowly, owing to the difficulties involved in privatizing State enterprises. This means that the market is very narrow, and thus potentially very unstable.

Practically all listed companies are enterprises that have been sold off by the State. The stock market is therefore not a source of company financing, but merely a source of income for the State.

Serious problems have arisen in setting issue prices, owing to the absence of methods of valuation that are appropriate to transitional economies. The initial blunders committed in this area have dealt the fledgling post-Communist stock markets a serious blow from which they have not yet recovered.

The Warsaw stock exchange has taken a full 24 months to get over its teething troubles, and is now experiencing a boom which could destabilize the entire financial system.

The stakes

Finance is playing an increasingly dominant part in market economies. This trend is accompanied by a more general shift towards intangibles (services, know-how, etc.) which some would say typifies post-industrial society. What is clear is that new financial assets have been growing increasingly dissociated from material reality. Since the end of the Second World War, this trend has led to an astonishing increase in per capita income in the OECD countries, but at the same time it has left society increasingly vulnerable.

The operation of financial markets and the directions in which they develop are matters of crucial importance to society. An ever-expanding network of financial relationships is influencing the lives of more and more people. Today, in the OECD countries, a major change in interest rates or a stock-market crash will sooner or later affect every member of society. In developing countries, the impact of financial variables is not yet so marked. In any case, the supervision and regulation of financial markets can clearly no longer be left entirely to the specialists - the social implications are too great.

Faced with the ever-increasing integration (globalization) of the international financial system, domestic monetary authorities have found they have far less room for manoeuvre, for two interconnected reasons. First, no central bank possesses the necessary resources to stand up to "the market" for any length of time; second, the proliferation of financial assets and the dematerialization of money have reduced the relevance of central banks' issuing policies. In short, the instruments that domestic monetary authorities have traditionally used appear to be largely ineffective in the present circumstances. The only way for governments to regain control of the situation may, in fact, be to regulate financial systems more strictly.

Financial markets are merely a secondary source of capital for enterprises as a whole, whereas for listed companies they are the favourite source. It seems likely that the cost of capital is lower for listed companies than for others, giving listed companies a significant competitive advantage. One result of the explosive growth of financial markets has been a tendency towards industrial concentration.

Financial institutions are gathering together an increasing volume of savings, but are finding it more and more difficult to invest these savings outside the purely financial sector. The growing tendency of banks to act as intermediaries rather than lenders suggests that the financing of production - and especially SMEs - may suffer. This may mean that the financial system is developing in a manner that is harmful to the real economy, rather than - as has generally been assumed - beneficial to it.

The financing of pensions for today's working population is increasingly coming to depend on the performance of financial markets. However, the latter must be considered an intangible factor rather than part of the "real" economy, given that financial investment is more often based on changes in the prices of financial assets than on increases in the productive capacity of the economy. This means that the system is inherently vulnerable.

Developments affecting financial markets have a direct impact on the internal functioning of listed companies. Increasingly, shareholders are impermanent, scattered groups of individuals who are more concerned with the short-term financial performance of their shares than they are with the economic potential and strategy of the companies that they partly own. The result is that company managers are not subject to supervision of any kind, provided financial performance remains satisfactory. Managers of listed companies thus tend to become as short-sighted as financial investors, which in the long run weakens the economic fabric.

Institutional investors are starting to become leading financial operators, and are already majority shareholders in numerous listed companies. However, they have so far proved reluctant to become actively involved in running the companies whose shares they hold.

The expansion of financial markets in countries outside the OECD is evidence both of the vigour of the economies concerned and of their appeal to international financiers. However, even if such expansion is a sign of economic strength, it may also be a source of weakness: the stock market may undermine the banking sector, and the inherent impermanence of foreign portfolio investment may expose domestic financial systems to shocks which they cannot absorb without putting local institutions and currencies at risk.

Assuming that financial dealings do generate wealth - and there is no doubt that they have been a major source of growth over the past twenty years - financial centres may start competing more fiercely to attract more business. This could lead to competitive deregulation of the financial sector, making the system more vulnerable still.

First steps towards meeting the challenge

As we have seen, the recent growth in financial markets has wideranging implications, each representing a major challenge to society. These challenges can only be identified and faced if the diagnosis outlined above is acknowledged as correct. This diagnosis can be summed up as follows.

Finance is coming to play an increasingly predominant role in global society, and this development is making the economic and social fabric more and more vulnerable. Rather than attempt to reverse this trend, the challenge is to find ways of controlling it so that it does not produce the damaging effects we have described.

Keeping control of the financial system, whether domestic or international, is no longer solely a matter for the financial sector - the implications for society are too great. It is therefore essential for more people to take an active part in the debate on the development of financial systems, in order that far-reaching decisions on the subject are not taken by small groups of specialists. Such active involvement is required at both domestic and international level (for example, through a non-governmental organization set up for the purpose).

In its current state the financial system offers various opportunities, particularly for establishing new kinds of institutions which could channel financing into productive investment. Pension funds, and institutional investors in general, now appear to be in the best position to stimulate such a development. However, the necessary contacts and channels of communication must also be established to ensure that experience acquired in one field can be put to use elsewhere.

Given the dependence of small and medium-sized enterprises on bank loans, and the reluctance of banks to become more deeply involved in this area, fiscal measures must be taken to discourage households from keeping their savings in bank accounts and to encourage direct investment in new or developing family businesses

The collectivization of savings is a clearly discernible trend in the OECD countries. There must be a frank public debate as to the long-term viability of pension systems based on such savings, and whether such a trend is beneficial. This is a matter of the utmost priority. If the trend towards collectivization of savings were called into question, this would affect the role of finance in society.

Although rising stock-market prices have traditionally been considered a blessing, this is not necessarily so. Monetary authorities should therefore base their policies not only on the consumer price index, but also on the stock-exchange index (which is basically a price index for financial assets).

In developing and post-Communist countries, finance has not yet come to dominate the economy as it has in the OECD. Before joining in with the prevailing trend, these countries (and the organizations that advise them) should take a good look at how financial systems in the OECD actually operate, and then ask themselves the following key question: does development depend upon finance, or is it the other way around? Financial transfers in the form of aid (during the 1960s) and loans (during the 1970s) were unable to create a basis for healthy growth. Why should portfolio investment succeed where both aid and loans have failed?

Today's shareholders seem only interested in how their securities are behaving. As a result of this attitude, the internal equilibrium that operates among the various groups concerned is altered in favour of company management. In order to curb any tendency on the part of managers to kowtow to financial markets, the other social groups that are involved in companies must introduce various safeguards. This means reconsidering how, in the current situation, responsibilities can best be distributed and assumed within listed companies.

Paradoxically, financial globalization has led to fierce competition between international financial centres. With a foreign exchange system verging on chaos, such competition is potentially dangerous. The situation can only be stabilized by an international convention to combat unfair competition and underbidding. Better still would be a convention on "non-proliferation of financial centres", but the discrimination that this would involve would be difficult to justify.