FINANCIALIZATION & THE BOND MARKET

SHAMSUL GHANI 
(feedback@pgeconomist.com)
Apr 18 - 24, 2011

'Financialization' refers to the structural shift in the economy from the industrial, manufacturing and agriculture sector growth to the financial sector growth. Pakistan has also undergone this shift - the service sector growth increasing from 49 percent in FY-05 to 85 percent in FY-08.

Contrary to the common yet misguided belief that this shift occurred owing to the inapt economic policies of the rulers, the change took place in step with the changing global economic trends. The financial derivatives market controlled by the Wall Street bankers was witnessing an unprecedented boom around 2007. The trickledown effects of this financial sector boom were being transmitted to almost every part of the world. The leading sovereign funds were lining up to grab as much of the dollar-denominated collateralized debt bonds (in the shape of strangely developed securities and obligations) as possible.

The US financial sector boom hinged on a single variable - real estate prices. As the real estate prices started to nose dive, down came the entire spurious financial structure of derivatives. The rest is history. For Pakistan, a strong banking sector and a virtually non-existent bond market were the two factors that minimized the impact of global financial crisis.

Pakistan's bond market, measuring around 5.5 percent of GDP - according to December 2010 SBP figures - consists of Rs655 billion of local currency bonds and $1674 million of foreign currency bonds (Euro/Sukuk global bonds $1550 million and private non-guaranteed bonds $124 million). The local currency bond figures include PIBs Rs522 billion and GOP Ijara Sukuk Rs131 billion.

Pakistan economy's shift to a high financial sector growth is a phenomenon that took place in the second half of the last decade. In case of US, however, the shift had started much earlier -in 1970s.

US FINANCIAL MARKET OPERATIONS
(ANNUAL BILLION DOLLARS)

PARTICULARS 1970 1980 1990 2000
Equity market trading 136 522 1,671 14,222
US government securities trading 1,891 4,840 26,888 67,056
Future trading 330 5,584 152,717 343,138
Foreign exchange trading 111 5,449 36,000 60,960
Corporate debt trading 170 821 3,972 3,960
State and municipal bonds 112 542 2,622 2,112
Mortgage derivatives NA NA 3,697 16,680
Total financial turnover 2,749 17,804 227,448 508,456
US GDP 1,030 2,790 5,803 9,817
GDP as percent of financial turnover 37.8 15.7 2.6 1.9

The concept of bond market is alien to the Pakistani people at large. Both household and institutional investors look to the equity and government saving schemes for deployment of their excess liquidity and savings. Equity market, requiring a certain degree of financial acumen, remains the domain of institutional investors and inveterate gamblers and speculators. A common household investor is generally attracted by the simple NSS (National Saving Schemes) market. His occasional straying into the domain of gamblers and speculators has created a history of tragic financial episodes. Shares, government securities, and bonds, all are fixed income generating markets. In case of shares, it takes an educated and prudent investment decision to benefit from a sustained flow of dividend income. The added advantage, in case of shares, is a possibility of capital gain but this advantage is offset by a perpetual threat of falling share prices. NSS investment, while ensuring a sustained flow of fixed income, rules out any possibility of loss or gain ensuing from price fluctuations. Bond market, strangely, combines the features of shares and NSS markets. Since bonds are usually tradable, fixed income in the shape of profit coupons combines with the possibility of capital gain in case the bond prices start rising. A safety mechanism for bond investors, in contrast to equity investors, is provided by his will and capacity to hold the bond till maturity to redeem the full amount of principal investment.

How much the US and the developed world economies depend on bond market can be inferred from the historic remarks made by James Carville, the campaign manager of Bill Clinton. Referring to 'reincarnation', Carville remarked 'I wanted to come back as the president or the pope or a 400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody.' Fed Chairman Alan Greenspan once remarked "if bond prices continued to rally, it would be by far the most potent [economic] stimulus that I can imagine."

Tracing the history of bond market, Niall Ferguson writes in his book The Ascent of Money: 'After the creation of credit by banks, the birth of the bond was the second great revolution in the history of ascent of money... .From modest beginnings in the city-states of northern Italy some eight hundred years ago, the market for bonds has grown to a vast size. The total value of internationally traded bonds today is around $18 trillion. The value of bonds traded domestically is a staggering $50 trillion. All of us, whether we like it or not (and most of us even do not know it), are affected by the bond market in two important ways. First, a large part of the money we put aside for our old age ends up being invested in the bond market. Secondly, because of its huge size, and because big governments are regarded as the most reliable of borrowers, it is the bond market that sets long-term interest rates for the economy as a whole. When bond prices fall, interest rates soar, with painful consequences for all borrowers.'

Most of the financial history owes its birth to the phenomenon of 'war'. The government debt system was an invention of Italian Renaissance. The medieval, infighting city-states, Tuscany, Florence, Pisa, Siena and others, all needed a debt system to finance wars. The bond market provided that system. Niall Ferguson writes: 'It is no coincidence that the year 1499, when Venice was fighting both on land in Lombardy and at sea against the Ottoman Empire, saw a severe financial crisis as bonds crashed in value and interest rates soared. Likewise, the bond market rout of 1509 was a direct result of the defeat of the Venetian armies at Agnadello.'

How far the financial and warfare industries are interlinked can be understood from the following example. Nathan Rothschild, the founder of the Rothschild Financial Empire is known to have played a vital role in Napoleon's defeat at Waterloo. Duke of Wellington, the British commander, needed gold and silver - not currency notes - to provide arms and sustenance to his army at the battlefield - too far away from his home country. Nathan Rothschild, with his vast courier and banking networks took the commission-based job of transferring gold in breach of the blockades set by Napoleon. He did the job putting Wellington in a far better position than his adversary does. Rothschild continued to purchase gold for onward supply to the British army commander. He made a fatal miscalculation about the timing of the war, which ended much earlier than his estimates. Thanks to his courier network, he got the news of British victory 48 hours ahead of the world. He was, at that time, sitting on a huge pile of gold the prices of which were bound to crash with the war having ended. He took advantage of the inside information on war and entered the British bond market with a bang. Legend has it that he spread disinformation about the British loosing the battle. The bond market reacted to this rumor and prices came sharply down. Rothschild went incredibly long on British bonds by investing a major portion of his gold and cash. Later, when the news of British victory broke, the bond market started soaring. Rothschild made a fortune that was worth around Pound 600 million today.