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Global capital markets are not perfect. Nor are they rational, or even oftentimes effective. A quick look at the performance of the capital markets over the last 15 years just confirms this. In 1993, foreign investors pumped billions of dollars into short term, local currency, fixed income instruments in Mexico, otherwise known as Cetes. The logic was simple. Cetes were yielding more than 10% in pesos when short-term US treasuries were yielding 3% or less. Of course foreign investors were taking currency risk but as long as more of them kept piling into Mexico, the peso kept appreciating — making it a lucrative trade. In February 1994, the US Federal Reserve started increasing interest rates. Through the rest of the year smart locals kept pulling their funds out of Mexico while ;herd mentality; foreign investors kept piling in. In December, the Mexican Central Bank, in the face of a huge trade deficit, was forced to devalue the currency, and as a consequence, Cetes investors were forced to take a significant bath on their investments.

Similar episodes occurred later in 1998 after the Asian crisis during the devaluation of the Brazilian real, and again during the Russian GKO crisis. In each instance, the smart early investors “discovered” the trade, others then piled herd like into securities they understood little, and were eventually suckered into huge losses amounting to billions of dollars. The improbable run up of the Nasdaq to more than 5,000 in 1999-2000 , on the back of an “internet revolution” , after which it has been languishing at around 2,000 for the last 10 years is yet another example of this irrationality , but this time in one of the world;s so called “developed” capital markets.

Unfortunately the current global financial crisis takes the cake. After the US real estate crash of 1987, house prices started rising in 1995 and continued their upward movement for the next several years. By 2003, i.e., less than seven years later, the housing index had more than doubled and it was already becoming apparent that real estate was reaching unsustainable levels. Nevertheless from 2003 to ;07, the index increased by another 50%. It was also accompanied by a frenetic period of activity in the mortgage market during which all sorts of risky structures were peddled to willingly gullible and increasingly leveraged consumers. These included back-ended principal and interest payments, ARMs, interest only, zero equity mortgages , etc. These mortgages were then repackaged and sold on to more highly paid but just as gullible investors and bankers in the US and other countries.

It should have been pretty clear to most capital markets players, and certainly to those in senior positions or in the risk departments , that given the steep run up in asset prices the market would correct, and would do so rapidly when it did. And yet, even though by mid-2008 real estate prices had declined only about 10% to 15% from their peaks, we had the cataclysmic collapse of Bear Stearns in March, followed by the near collapse of the entire global financial system. In hindsight, it is quite remarkable that a set of the most highly paid professionals in the world could have got it so insanely and totally wrong. And we are talking about highly sophisticated institutions, employing some of the best and brightest talent from all over the world. What made these investors take such really awful decisions which cost their investors so much? What in the world were they thinking?

It;s almost as if the markets collectively get into a self-induced, mass hypnosis. To a point where reality is willingly suspended. As a result of such occurrences, faith in the efficiency of global capital markets has surely been shaken, if not lost entirely. The market has got it wrong so often and so spectacularly that one wonders whether all the research that is done and market theories that are espoused — random walk, efficient markets, technical analysis, etc, — are anywhere close to reality.

Now there is the possibility that the next big bubble is beginning to inflate. Again the capital markets are wilfully suspending credulity. And this one could be really big. For many years China has been growing rapidly. Its stock market has been among the best performing in the world. On the back of a deliberately cheap currency policy China;s exports have swamped the world. It will shortly cross Japan to become the world;s second largest economy. Per capita income has almost trebled in the last 10 years. Infrastructure has boomed and the country is unrecognisable to those who revisit it after a gap of a few years. In many sectors China adds capacity in a single year equivalent to India;s cumulative installed capacity. It has become the world;s largest consumer of many commodities (and the world;s largest polluter). By any measure, these are phenomenal achievements.

And yet uneasy lies the crown. Much of the capacity that has been created is not being used. In sector after sector, there are excess capacities. The currency cannot be kept cheap forever and when it gets to realistic levels, it will surely impact the external sector negatively. Worryingly, the response of the government to the current crisis has been a further opening of the bank lending pigot to create even more capacities. Economic growth cannot endlessly come from capacity creation. Chinese planners understand this and are now doing their best to ensure that consumer demand manifests sufficiently to absorb all the excess capacity, being created But if this does not happen the banking sector will be left with a huge amount of non-performing and unproductive assets. Markets will go into a tail spin, the government will be forced to step in and things could well go out of control.

As an aside, funding to the US deficit will stop. Managing this transition from an investment-driven model to one where consumer demand takes up the slack, with the consequential impact that higher consumer spending will reduce the savings rate and thereby the investment rate and the government;s ability to spend, will be a huge economic challenge. And there is a risk, however small, that it might well fail.

Still the Chinese stock market is trading at multiples higher than that of most other markets. Several of the world;s 10 largest banks by market cap are Chinese. The systemic risk is high and growing, but once again, global capital markets are willfully turning a blind eye. In reality, the situation is potentially quite sticky and the continued rise of Chinese asset prices, and by consequence, global commodity prices, is potentially the next big bubble built on misplaced optimism and hope, and the herd mentality disease. There is an increasing element of systemic risk in the global markets and this will continue — until the next big correction hits the “irrational” capital markets right between the eyes.

Source: Economic Times