The Democratic Disruption of Finance

Mohamed A. El-Erian

APR 22, 2014
Newsart for The Democratic Disruption of Finance

LAGUNA BEACH There seems to be no limit to the exciting possibilities that come from combining technical innovations, the Internet, and social media. It is a phenomenon that has been revolutionizing journalism and entertainment; and, by helping to overcome coordination challenges, it has also had political consequences in a growing number of countriesall of which means an ever-evolving set of opportunities and risks.

What is less appreciated, however, is the extent to which a broadly similar phenomenon may be starting to play out in finance, via a democratization process that could gradually reconfigure a notable part of the institutional landscape, particularly in consumer finance, while challenging regulators to adapt.

Bitcoin is the most visiblealbeit far from a good example of this nascent development, having attracted attention from specialists, regulators, and, slowly but surely, the public. But the crypto-currency phenomenon is far from the only example, and it is certainly not the most consequential one. Its impact, both actual and potential, is relatively limited when compared to ongoing attempts to enhance and democratize lending, borrowing, investing, and payments and settlements.

The underlying sequence of disruptive technology is historically familiar. A bold innovation suddenly lowers entry barriers for certain activities. Mechanisms emerge to enable a larger part of the population to participate in what is deemed desirable but, until now, had been hard to access. As the disruptive forces gain traction, existing business models face difficult adaptation challenges, and regulators begin to fall behind. The situation is often amplified by a natural human tendency to overproduce and over-consume hitherto restricted goods and services.

This, of course, is what has been occurring in media for several years. The result is a proliferation of platforms for producing, aggregating, disseminating, and consuming content. Falling entry barriers and lower access costs have significantly democratized participation, whether in production or consumption. And, as hard as they try, many traditional media outletsespecially those unable to claim quite distinctive content find it increasingly difficult to compete.

Now something somewhat similar is starting to happen in finance as well, albeit at a less frantic pace and – at least until now – in a less disruptive manner. And, as with media, the main innovations are being spearheaded by those outside the traditional institutional setup. Most consequentially, an emerging cohort of technology entrepreneurs understand the power of online/social media innovation to disrupt components of traditional finance, and are now leading efforts that include behavioral scientists and finance experts.

Recall that Bitcoin started in 2009 as an attempt to produce a “better currency, championed especially by those who mistrust central banks’ management of fiat money. These early adopters were joined by a growing number of financial speculators attracted by highly volatile price movements. But Bitcoin’s success, which remains highly uncertain, ultimately depends on it attaining sufficient stability to perform the most essential function of any currency (as opposed to a speculative commodity) – that of providing a relatively predictable medium of exchange.

Fulfilling that function would require a lot to happen. At a minimum, Bitcoin would need a more solid institutional foundation; and broad acceptance of it would require much greater clarity concerning regulatory and supervisory approaches.

More promising examples, albeit less well-known, may be found in Internet-driven lending and borrowing clubs or, more generally, the peer-to-peer initiatives in consumer financial services. By seeking to compress net interest margins, including through lower expenses and more efficient data assessments and aggregation, and by targeting an enhanced consumer experience, such empowerment schemes could serve to reduce the cost of financial intermediation while providing for fairer risk-pooling outcomes and better credit underwriting. Likewise, so-called digital wallets and mobile transfers are efforts to improve payments and settlement in a retail financial sector that gets a lot less attention than its institutional peers.

The prospects for each of these democratizing developments vary significantly, as do the probable cost-benefit equations. Much will depend on whether the underlying technology is stable and secure, trust is established, transparency is convincing, consumer protection is effective, new content is coupled well with strong distribution channels, and broad-based validation and institutional verification boost credibility.

Looking ahead, we should expect the underlying forces of innovation to remain strong. Some existing businesses will fend off disruptive threats, including through takeovers; others will adjust (for example, Walmart recently announced an expansion of its financial-services offerings); but many may well prove insufficiently agile. Regulators will also likely lag initially in their response to new structures and activities.

The challenges of getting this right in finance are considerably more difficult than they are in media; and the consequences are far more profound, given the centrality of finance to broad swaths of the real economy. Anyone who doubts that should recall how last decade’s securitization boom and bustanother example of a disruptive financial innovation that was over-produced and over-consumedcontributed to a credit and liquidity crisis that pushed the global economy to the verge of Great Depression II.

In their recent book, Google’s Jared Cohen and Eric Schmidt brilliantly remind us of the opportunities and risks afforded by multi-speed developments in the real and virtual worlds. Having redefined media, similar developments are slowly beginning to play out in finance – in a rather isolated way for now, but soon likely to start transforming how capital is mobilized and allocated in support of economic growth and employment. Individuals, companies, and governments would be well advised to devote more time and other resources to comprehending this important and transformative phenomenon.

Mohamed A. El-Erian, Chief Economic Adviser at Allianz and a member of its International Executive Committee, is Chairman of President Barack Obama’s Global Development Council. He previously served as CEO and co-Chief Investment Officer of PIMCO. He was named one of Foreign Policy's Top 100 Global Thinkers in 2009, 2010, 2011, and 2012. His book When Markets Collide was the Financial Times/Goldman Sachs Book of the Year and was named a best book of 2008 by The Economist.

Markets Insight

April 21, 2014 9:02 am

Risks in buying Russian bonds on dips

By Mohamed El-Erian

Strategy has worked so far but chance of disruption is rising

Credit markets today are excessively fuelled by a yield-at-any-price mentality. When this happens investors’ increasingly indiscriminate appetite for credit risk leads to significant reductions in credit risk premiums, particularly for lowly rated securities. Narratives develop to rationalise overcrowded trades, providing a basis for morealbeit ultimately reversibleprice overshoots. And rather than signalling turbulence, pullbacks are seen as buying opportunities.

Today’s yield-hungry investors rightly draw comfort from two factors: a generally stable to slightly improving global economy, and the commitment of central banks to suppressing interest rate volatility. But as they stretch far and wide to meet return targets, their investment decisions are increasingly driven by the relative price of credit (credit spreads) as opposed to value (overall yield).

Tight credit spreads are increasingly justified by over-optimistic assessments of both default probability and market volatility. And investors downplay liquidity risks (ie, the eventual cost of repositioning portfolios should circumstances change).

All this helps to explain several notable developments in the credit markets in recent weeks – from Greece issuing more than $4bn in five-year bonds at just below 5 per cent, and only two years after it imposed large losses on investors, to Italian sovereigns setting record low yields.

Venezuela model

In such an environment, investors also tend to pay too much attention to the longstanding advice to “buy on dips”. Sell-offs are embraced as an opportunity to add credit exposures, particularly where securities are deemed vulnerable to “noise that is unrelated to the underlying creditworthiness of the borrower, such as particular emerging market bonds.

Being part of a narrower and technically more vulnerable asset class, emerging market bonds offer a yield pick-up over their corporate brethren in investment grade and high yield. And being prone to a lot more domestic social and political noise, some of them also provide more opportunity for mixing tactical and strategic investment decisions.

For years, Venezuela was the model in this regard. Savvy investors ignored the populist anti-west rhetoric of former president Hugo Chávez, focusing instead on the country’s solid oil revenues and its relatively comfortable international reserve levels. Moreover, given the global networks associated with energy supply chains, they correctly attached only a low probability to the likelihood of Venezuela defaulting, not because of an inability to pay, but an unwillingness to do so.

More recently, Russia has been treated as an attractive candidate for the buy-on-dips trade. At about $475bn, international reserves are a large multiple of the country’s outstanding external debt. Monthly oil revenues provide it with significant liquidity management flexibility. And, like Venezuela, integration into the global energy network supports the country’s willingness to service its external debt obligations in a timely manner.

Cycle of disruption

With the Ukrainian crisis developing in unexpected ways , international investors have been given ample opportunity to buy Russian bonds on dips. And the strategy has worked, as spreads have repeatedly narrowed after initially widening in response to the latest set of geopolitical developments.

Yet the underlying risks in this Russian trade are becoming quite different from those in Venezuela. While the spread disruptions have not been part of a direct internal deterioration in Russia’s willingness and ability to pay its external creditors, they are part of a process that is bringing the country ever closer to the risk of serious economic and financial disruptions being imposed from outside.

The more Russia is seen to interfere in eastern Ukraine – as is clearly the perception in the west – the more Europe and the US will be urged to add sanctions targeting sectors to those against individuals. And the closer these new sanctions get to two areas in particular – energy and financethe greater the cost for Russia and the higher the probability of retaliatory steps that could fuel a vicious cycle of economic, financial and payments disruptions. Should this occur, investors would face a significantly different credit paradigm.

Rather than react to noise-induced spikes in yields, Russian investors are now underwriting a higher level of actual credit risk on account of externally induced disruptions. The trade may still work; but it now requires a quicker and more meaningful de-escalation of the Ukrainian crisis.

Mohamed El-Erian is chief economic adviser to Allianz, chair of President Barack Obama’s Global Development Council, and author of ‘When Markets Collide

Copyright The Financial Times Limited 2014.

The End of the New World Order

Christopher R. Hill

APR 21, 2014
Newsart for The End of the New World Order

DENVER Russia’s annexation of Crimea and ongoing intimidation of Ukraine appears to mean the end of a 25-year period whose hallmark was an effort to bring Russia into greater alignment with Euro-Atlantic goals and traditions. Now the question is: What comes next?

As the weeks pass, it is increasingly clear that the challenge is not so much Ukraine – which will continue to lurch from one crisis to the next, as it has since independence 23 years ago – as it is Russia and its regression, recidivism, and revanchism.

Exactly 25 years ago, in the spring of 1989, Poland and other countries of what was then known as the “Eastern Bloctook the first steps to break free from their forced alliance with the Soviet Union. Indeed, these countries’ relationship with the Soviet Union was no true alliance at all; rather, they were accurately described as “satellites” – states with limited sovereignty, whose main role was to serve Soviet interests.

As subjugating and ahistorical as those relationships were, much of the world accepted the binding of “Eastern Europe” to the Soviet Union as a logical state of affairs, one in keeping with the world order that emerged at the close of WWII. But what seemed like a permanent division of the world into competing spheres of interest suddenly ended in 1989, when the Eastern Bloc left the Soviet orbit, soon followed by the republics of the Soviet Union itself.

Russia emerged not as a renamed Soviet Union, but rather as a state with its own history and symbols, a member of the international state system that had been absent for some time, but had suddenly returned. And the reborn Russia seemed to be dedicated, in its own way, to the same goals as its post-Soviet neighbors: membership in Western institutions, a market economy, and a multi-party parliamentary democracy, albeit with a Russian face.

This new world order held for almost 25 years. Except for Russia’s brief war with Georgia in August 2008 (a conflict generally seen as instigated by reckless Georgian leadership), Russia’s acquiescence and commitment to the “new world order,” however problematic, was one of the great accomplishments of the post-Cold War era. Even Russia’s reluctance to support concerted Western action, such as in Bosnia and Kosovo in the 1990’s, was based on arguments that could be heard in other European countries. Russian democracy certainly had its share of flaws, but that hardly made it unique among post-communist countries.

Russia’s historical relationship with Ukraine is far more complex and nuanced than many Western pundits suggest. It is difficult to talk about Russian civilization without talking about Ukraine. But, whatever the complexities, Russia’s recent behavior toward its smaller neighbor is not rooted in the legacy of their shared history.

It is rooted in a different legacythat of a Russian Empire whose habits did not die during the Soviet period. Ukraine did not – and perhaps could notdevelop its sovereignty in the way that Poland and others have succeeded in doing since 1989; nonetheless, it is entitled to chart its own future. Russia’s challenge to Ukraine’s status as an independent state is thus a challenge to the entire world, which is why the crisis has risen to the top of the global agenda.

In the United States, the media often point out that most Americans would be hard pressed to find Ukraine on a map. They don’t need to. But Americans do need to understand the challenge they are facing from a Russia that no longer seems interested in what the West has been offering for the last 25 years: special status with NATO, a privileged relationship with the European Union, and partnership in international diplomatic endeavors. All of these seem to be off the table for now.

So what should the West do? An approach based on sanctions that target the Russian economy (and therefore its people) is the preferred alternative of those with the least at stake (US politicians). But sanctions are unlikely to bring about the internal changes that Russia needs, because those changes need to be accomplished by the Russian people.

For the West, the real issue should be shoring up security structures and being prepared for the long haul. NATO has taken an important step in reassuring its eastern members. This is not to say that Russia, having annexed Crimea and intimidated Ukraine, will seek to make similar trouble among former Sovietallies.” But historical memories die hard.

Poles are well aware that, 75 years ago this year, France and Britain were parties to security agreements that compelled them to declare war on Germany if it invaded Poland. In September 1939, when Germany invaded, both countries dutifully declared war, but neither fired a shot or helped Poland in any tangible way. Poland disappeared from the map of Europe for five years.

The Ukraine crisis is really a Russian crisis. Ukrainewhatever is eventually left of it – will increasingly become a Western country. Russia is showing no sign that it will follow suit.

Instead, Russian President Vladimir Putin seems to be settling in for a long diplomatic winter. The US needs to prepare for it, especially in shoring up partners and allies, and ensuring as best it can that Ukraine is Russia’s last victim, not its first.

Christopher R. Hill, former US Assistant Secretary of State for East Asia, was US Ambassador to Iraq, South Korea, Macedonia, and Poland, a US special envoy for Kosovo, a negotiator of the Dayton Peace Accords, and the chief US negotiator with North Korea from 2005-2009. He is currently Dean of the Korbel School of International Studies, University of Denver.

Putin’s Perilous Course

Jeffrey D. Sachs

APR 21, 2014
Newsart for Putin’s Perilous Course

NEW YORKThe dangers of the crisis in Ukraine cannot be exaggerated. Russian President Vladimir Putin is overtly and covertly inciting separatism in eastern Ukraine, and has declared Russia’s unilateral right to intervene there, in complete contravention of international law. Russia’s provocative policies are putting it on a collision course with the West.

Putin explained his point of view in a recent television appearance: Russia’s current international borders are provisional, determined by accidents of history, such as the transfer of Crimea from Russia to Ukraine in 1954, or the transfer of Russian territories to eastern Ukraine in the 1920’s. Putin claims that it is Russia’s right and duty to defend ethnic Russians in neighboring countries, especially in light of the arbitrariness of the existing borders.

If ethnic Russians call for a return to Russia, Putin asserts, then Russia must heed their call. Putin pointedly reminded listeners that eastern Ukraine was called Novorossiya” (New Russia) in Czarist times, clearly implying that it could be Novorossiya again.

Evidently, Putin believes that relentless pressure and claims over neighboring states, designed to undermine their sovereignty and force them to accede to Russian demands, will result in a stronger Russia, better able to confront the West. In the recent past, Russia sharply opposed American and NATO military intervention in Libya, Syria, and Serbia on the grounds that the West was violating those countries’ sovereignty. Now Putin claims the right to ignore neighboring countries’ sovereignty on the pretext that Russia is merely defending the rights of ethnic Russians abroad, up to and including their right to secede and join the Russian homeland.

Putin no doubt hopes to create facts on the ground – as in Crimeawithout provoking a severe Western reaction. Even without an invasion, Russia can use threats, displays of military power, secret operations, and heated rhetoric to destabilize its neighbors. That may be enough to achieve Russian foreign-policy aims, including its neighbors’ docility.

But Putin’s adventurism is likely to end very badly for Russia. Though the West is justifiably reticent to be drawn into any military confrontations with Russia beyond NATO’s boundaries, and is even reluctant to apply economic sanctions, Putin’s actions have triggered a strong and growing anti-Russian backlash in the US and Europe. The West’s response will intensify dramatically if Russia deploys forces across its borders, whatever the pretext; should Russia adopt subtler methods of political destabilization, Western pressure will build more gradually, but build it will.

Existing trade, investment, and financial relations between Russia and the West are already becoming severely frayed. New investment projects and joint ventures are being put on hold. Loans from Western investors to Russian entities are being called in. Russian banks and companies will face a growing credit squeeze.

In the short term, Russia has ample foreign-exchange reserves to offset capital outflows; but the reversal of capital flows will begin to bite within a matter of months. Following Russia’s forcible takeover of Crimea, it is almost unimaginable that normal economic relations between Russia and the West could survive Russian intervention, subversion, or annexation elsewhere in Ukraine.

In other words, if Cold War II sets in, as appears increasingly likely, Russia would be the long-term economic loser. The European Union can certainly survive without imports of Russian natural gas, even with a full cutoff. Russia’s gas exports to Europe constitute less than 10% of the EU’s primary energy consumption. Russia, on the other hand, would suffer a major loss of revenues.

Putin seems to believe that Russia can offset any worsening of economic relations with the West by strengthening its economic relations with China. But technologies and business are too globally intertwined to divide the world into economic blocs. China knows that its long-term economic prosperity depends on good economic relations with the US and Europe. Putin seems not to understand this point, or even the fact that the Soviet economy collapsed as a result of its isolation from technologically advanced economies.

Russia’s future economic strength depends on its ability to upgrade technologies in key sectors, including aviation, high-speed rail, automobiles, machinery, and heavy industry. That can be achieved only if Russian companies are more closely integrated into global production networks that knit them together with German, Japanese, American, and Chinese firms that rely on cutting-edge technology and advanced engineering.

Of course, matters could become much worse. A new cold war could all too easily turn hot. Many in the US are already calling for arming Ukraine as a deterrent to Russia. But, while military deterrence sometimes works, the West should emphasize trade and financial retaliation, rather than military responses to Russian provocations. Military responses could provoke disaster, such as turning Ukraine into a Syria-type battlefield, with untold thousands of deaths.

There can be no doubt that NATO will defend its own members if necessary. But Russia’s belligerency and appalling behavior should not permit Western hardliners to gain control of the policy debate. Hardline approaches brought expanded conflicts in Afghanistan, Iraq, Libya, and Syria, leading to plenty of deaths but not to meaningful political or economic solutions in the affected countries. War is not politics by other means. War is mayhem and suffering.

Putin is no doubt acting in Ukraine with domestic politics very much in mind, using his adventurism abroad to shore up his political base at home. The Russian economy is flagging, and the population is weary of repression, not to mention Russia’s pervasive corruption. Russia’s annexation of Crimea and threat to invade eastern Ukraine appear to be hugely popular. It remains a terrifying reality that politicians often perceive war to be an antidote to internal weakness.

Both Russia and the West have played fast and loose with international law in recent years. The West violated national sovereignty in Serbia, Afghanistan, Iraq, Libya, and Syria. Russia is now playing the same card with shocking brazenness in its own neighborhood, often justifying its actions by pointing to Western precedents.

But Russia’s true long-term interests lie in multilateralism, integration into the world economy, and the international rule of law. Putin’s current path is strewn with grave hazards. He is undermining Russia’s economic prospects, while confronting the world with a growing threat of war. Our only hope is that all sides return to the principles of international law, which they have forsaken for too long.

Jeffrey D. Sachs, Professor of Sustainable Development, Professor of Health Policy and Management, and Director of the Earth Institute at Columbia University, is also Special Adviser to the United Nations Secretary-General on the Millennium Development Goals. His books include The End of Poverty and Common Wealth.