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June 25, 2006

Hedge Funds Curb the Business Cycle
by Hans F. Sennholz

A business cycle greatly affects individual income and wealth, which makes it an important consideration in economic action and behavior. Businessmen who base their investment decisions on correct cycle projections tend to be rather successful; others who misread the cycle or simply ignore it may face difficulties and disappointments. Some speculators who hope to profit from buying and selling investment contracts specialize in cycle observation and analysis. Their favorite media are hedge funds which are both, investment vehicles and cycle power.

Hedge funds are private investment partnerships or off-shore corporations in which the general partner has made a substantial personal investment and in which wealthy speculators like to join him. He requires his partners to be "sophisticated investors", that is, to have a net worth of at least $1 million or an annual income of $200,000. They all require minimum investments that vary from some $200,000 to $10 million and "lock-ups" of investor funds of one year or longer. The funds take both long and short positions, use leverage and derivatives, and invest in many markets. They take large risks in program trading, swaps and arbitrage, moving billions of dollars in and out of markets quickly. Their actions usually have significant impact on stock, bond, and futures markets.

The international volume of these funds is estimated at some $1.1 trillion which are supported by ready bank credit of at least double to triple this amount. Moreover, hedge fund managers are far more nimble and enterprising than those of traditional stock and bond funds, which makes them prominent market participants. Throughout the world they can be found in booming markets; their sudden departure forces central bankers to behold the market and readjust their interest rates. Their behavior has become a growing concern of central bankers and regulators who look upon hedge funds with fear and trepidation.

A favorite hedge-fund strategy is to borrow funds in low-interest markets, preferably in Japan where the central bank rate has been zero since 1995, and invest them at high rates of return in developing countries. Prices and profits tend to rise as more and more funds join the rush. But they may choose to scramble as soon as indications of the maladjustment become noticeable. They also may rush when interest rates in Japan and other low-rate markets rise again and thereby reduce the power of attraction of the developing countries.

Hedge fund managers are busy in the stock and currency markets of developing countries which, in recent years, have benefited greatly from the influx of large blocs of fund capital. It brought technical improvements and boom activity especially to India, Russia, Turkey, and Brazil. But these countries must always brace not only for sudden withdrawals in case of rising interest rates in the creditor countries but also for the appearance of frightening symptoms of a business cycle.

Hedge fund managers pay close attention to and brace for potential financial crises also in several other markets. They are busy in countries that appear to be maladjusted in their economic transactions with the rest of the world, that is, in their balances of payments. The monetary policies of a central bank greatly affect these transactions - inflationary policies tend to cause deficits in current accounts that cover the imports and exports of goods and services. Hedge fund managers keep an eye on the deficits and central-bank monetary policies. At the present, they seem to pay special attention to some Eastern European countries, such as Poland, Hungary, and the Czech Republic.

Finally, the managers never tire looking for opportunities in countries with large government budget deficits and feverish real estate markets that tend to emulate the deficits. They congregate in markets displaying signs of feverish activity and exuberance which, sooner or later, are bound to give way to sobering readjustments. At the present, they can be found in many markets in Australia, the United Kingdom, Canada, and the United States, patiently waiting for sudden changes and extraordinary profit opportunities. Their actions and reactions can move the markets; they may even curb the business cycle.

The important role played by hedge funds is buttressed also by a relatively new financial instrument, the so-called credit derivatives. They are instruments the value of which is based on the performance of an underlying financial asset, index, or other investment. An ordinary option is a derivative because its value is based on the performance of an underlying stock. Derivatives may be based also on the performance of interest rates, currency exchange rates, and various domestic and foreign indexes. They afford leverage and, when handled properly by the owner, yield large returns. They gained notoriety during the 1990s when some mutual funds, municipalities, and leading banks suffered staggering losses from unexpected movements in interest rates. They undoubtedly will make headlines again in coming market readjustments.

Derivatives allow banks to pass the credit risk of their debtors to hedge funds and other investors, which improves the strength and stability of the bank and makes bank failures less likely. According to some estimates, hedge funds now hold some 30 percent of all credit derivatives and some 80 percent of unpaid and overdue debt. Many controllers and regulators are dismayed and upset about this development as risky credit transactions tend to disappear from their sphere of authority into unregulated "black holes" of hedge funds. These funds nevertheless are the bêtes noires of the world of money and credit. Central bankers, controllers, and regulators have no power over them, which gives them the power to take advantage of every turn and shift of money and credit policy. Fund managers not only may foresee the consequences of central bank policies but also anticipate the turns of policy to be made by the officials. Furthermore, their actions may either counterbalance or exacerbate the effects of central-bank moves, depending on which path is more profitable. If they curb the mal-effects, they will be ignored. If they expose them, they will be vilified and used as scapegoats for the economic harm "they" caused. In either event, let us remember that hedge funds not only are supplying the world with capital when and where it is needed but also are moderating the harmful effects of the business cycle.

Hans F. Sennholz
www.sennholz.com

Copyright © 2002-2007 Hans F. Sennholz

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