1. Introduction (excerpt)

    Since the outbreak of the Asian financial crisis in the summer of 1997, the rapid flow of private-sector capital into international financial markets and the role played by institutional investors have been drawing renewed attention. And unfamiliar words, such as "hedge funds," have started to appear frequently in newspapers along the argument that speculative activities by hedge funds and other institutional investors have played havoc with the economies of emerging countries, in particular with those of emerging countries in Asia. But the authorities of advanced countries and the IMF did not seem to have been fully aware of the implications of hedge fund activities. For example, an IMF report on hedge funds, which was worked out in May 1998, does not make thorough discussion on the dire impact of hedge fund activities with high leverages. It contains such sentences as "hedge fund capital is small relative to the resources at the command of other institutional investors" and "hedge funds have the flexibility (to cope with changes in the market.)… Thus, they can function as 'stabilization speculation.' "

    The international financial community as a whole began to deal with problems caused by hedge funds only after the Russian crisis in the summer of 1998 and the near collapse of Long Term Capital Management (LTCM) of the U.S. that followed. The problems have been taken up and discussed at the Summit of the Asia Pacific Economic Cooperation (APEC), which is composed of newly industrializing Asian countries, and the Asia Europe Meeting (ASEM) since the fall of 1998. They have been and will also be one of the major topics of discussion at such global economic and financial forums as the IMF, G-7 meetings of finance ministers and central bankers, and meetings of finance ministers on the occasion of G-7 summits. Japan has made proposals on the need to enhance transparency with regard to hedge fund activities in view of their impact on emerging market countries.

    Following the release of a report by the Basle Committee on Banking Supervision in January 1999, G-7 countries in cooperation with the Basle Committee and IOSCO established the Financial Stability Forum in April to promote discussions on banking supervision. In the private sector, the Counter Party Risk Management Policy Group, a group formed by financial institutions with global operations, published a report in June. Furthermore, in the United States, the President’s Working Group on Financial Markets (chaired by Treasury Secretary Robert Rubin) released a report on April 28.

2. What are hedge funds? (omission)

3. Legal status of hedge funds in the U.S. (omission)

    Generally speaking, the existence of investors, including hedge funds, who are willing to take risks provide the liquidity to the market and allows easier reallocation of market risks. Some argue that hedge funds, as willing risk takers, have played a role of a lubricant in the market just as "oil money" once did.

    Speculation performs a market stabilizing function when, for example, some one buys an asset when its price is low and sells it when the price is high in a situation where there is only actual demand. In this case, the speculator can make profits, but prices tend to be equalized since there would be additional demand when prices are low and there would be additional supply when prices are high. In this connection, the IMF report released last May gives a positive evaluation on the function of hedge funds; while a mutual fund that enjoys high returns may attract new investors and be bound by its prospectus to buy more of the recently appreciated asset and other institutional investors may be forced to cut their losses by their internal controls and to sell into a falling market, hedge funds are better able to ride out these fluctuations because their investors are locked in for substantial periods and thus hedge fund should stabilize the market.

    Contrary to the view just mentioned, others would argue that hedge funds sometimes have an extremely strong influence or monopolistically distorting power on a specific market due in some part to herd behavior (which will be described later), bringing about an equilibrium far removed from the economic fundamentals of a country, which would not have occurred but for their speculative activities. They argue that hedge funds fall into either one of the following models-"self-realizing monetary crisis model" (which maintains that a monetary crisis is not necessarily caused by the aggravation of economic fundamentals but rather it becomes actual crisis because investors make a speculative attack on a currency in anticipation of a devaluation of the currency) and "multiple equilibria model" (which maintains that although in an economic model there is only one equilibrium guided by initial conditions or exogenous variables, there could be more than one equilibrium in a market like a foreign exchange market, where a price forecast for the future often determines the price for the moment.) According to these arguments, in small economies adopting a fixed exchange rate regime, for example, a massive short-selling of the country's currency in expectation of a shift from the fixed exchange rate regime could cause a plunge in the value of the currency first on the futures market and then on the spot market and it could make it impossible to restore the original equilibrium, even though its policy management is sound.

    Furthermore, if there is a lack of transparency and no restrictions or supervision are in place on certain institutional investors like in the case of hedge funds, there is a greater possibility that trading partners (counter parties) of such investors will not be fully aware of the risks involved and the final risk-taking burden will shift to the trading partner or the whole system. The case of LTCM suggests such a possibility. The collapse of LTCM revealed that in an extremely competitive market environment 1) it was difficult for each trading partner to have a full picture of the business risks involved in LTCM, 2) there were trading incentives based on the need to know LTCM's investment strategy and there was excessive confidence in the risk management ability of the LTCM management and 3) the effective leverage was underestimated so that some financial institutions offered generous trading terms.

    When we consider the impact of hedge funds' behavior on financial markets, we have to pay attention not only to hedge funds' investment behavior per se, but also to the existence of financial institutions and investors who copy hedge funds' behavior. The influence of hedge funds on the market will become greater if they behave in anticipation that other investors would follow them. According to thoughts that investors tend to make investment decisions based on how they think other investors as a whole would behave rather than on their own judgment of economic fundamentals, we have to keep in mind that hedge funds could induce such “herd behavior," in the examination of the influence of hedge funds. It is generally said that since hedge funds' investment strategy is presumed to be based on a more sophisticated investment theory, other investors often conduct copycat trading.

    In order to explain that herd behavior is rational, the following three models are often cited. 1) According to the "profit externality model," the higher the number of investors that adopt similar behavior, the more profit they will earn. For example, as Maynard Keynes said in his "beauty contest theory," you can get greater return by investing on the basis of "many other investors think it a good investment" rather than on "this is a good investment." 2) According to the "principal-agent model," when information to evaluate the investment results of a fund manager is not sufficient, the evaluation is made by comparing with others. So the fund manager, out of his desire to uphold his reputation, would behave based on how the herd would behave. However, some argue that this model does not apply to hedge funds themselves because the rewards for a fund manager of a hedge fund are determined not in comparison with those of other institutional investors but on the sheer investment returns. 3) According to the "information cascade model," investors make the same investment decision as the investors who acted earlier, believing that those who acted earlier must have had better investment information and must have made the investment decision based on the information. When information spreads in a cascade fashion, the herd as a whole takes investment action in the same direction. In addition to these three models, some argue that the fact that many institutional investors adopt a similar investment decision model is the source of herd behavior.

    In view of the fact that hedge funds were most active in relatively small markets in Asia in the process of Asian financial crisis, their influence has to be evaluated in relation to the market size of emerging market countries. If a market is small, hedge funds can exert a greater influence through fluctuations in market prices. On the other hand, what is most important for hedge funds' investment strategy is liquidity of the market. If there is not enough liquidity, it is difficult to hedge risks for investments or liquidate positions just before a crisis occurs. Therefore, some people maintain that rather than a market that is too small, an open and highly liquid market is essential for hedge funds to be active players. It also has to be noted that if a hedge fund liquidates its position drastically in a low liquidity market, it would have far-reaching effects on the whole market.

5. Policy issues in advanced countries

    Some people argue that hedge funds should be carefully supervised and kept under control in advanced countries where hedge fund investors and fund managers reside and where there are a lot of financial institutions as trading partners. In general, financial markets and financial institutions should be kept under control for three reasons, that is 1) to protect investors, 2) to ensure the soundness and integrity of the market, and 3) to maintain the stability of the financial system. Every advanced country has regulations on such traditional financial institutions as banks, brokerage houses and insurance companies in this regard. However, advanced countries have few regulations, including disclosure requirements, on hedge funds, not even in the United States where most hedge funds have their bases in effect. If advanced countries supervise and control hedge funds in one way or another in respect of three purposes (as described above 1)-3) ), we can reduce the possibility of hedge funds' speculative activity causing a crisis in emerging market countries and thereby stabilize the international financial system.

    First, regarding investors protection, it is generally thought that tighter controls, including more information disclosure, on hedge funds to protect investors are not necessary because investors in hedge funds are a small number of high-income earners, have professional knowledge on investment, and because hedge funds are on a private subscription basis. Some argue that hedge funds are already providing investors with fairly detailed information in line with their business strategy of complying with investors' demands. If the degree of information disclosure to investors becomes one of the factors in choosing a hedge fund, information disclosure will make progress under the market mechanism. But others argue that the quality of information provided to investors varies depending on the importance of the investors. On this issue, there are two opinions. One of them is that it is not necessary to seek proper disclosure of information through tighter regulations since it is a matter just between a limited number of professional investors and hedge funds. The other is that further examination should be made to see if it is necessary to work out some measures to provide investors protection.

    Ensuring the soundness and integrity of the market is an important policy objective. If such things as market manipulation by a big player, circulation of rumors, water sales and insider trading become rampant, the market would lose its integrity and would eventually lose its function to effectively allocate resources. Market rules to cope with these problems are already in place in advanced countries' securities markets. But we have to keep in mind that excessive restrictions will disrupt free transactions and efficiency of the market. It should also be noted that manipulation of transactions on exchange markets and of derivative trading on OTC markets are difficult to recognize because they are negotiated transactions and extremely varied demand and supply are offset in these markets. Since these transactions are not made on the exchanges, it is difficult for supervisors to constantly keep a close watch and take timely measures. However, in the United States, it is legally required to report to authorities if an exchange transaction is unusually large. Some point out that if such a rule is properly applied, it could hold artificial market disturbance in check to a certain extent.

    Maintaining the stability of the financial system is also an important policy objective for every country from the standpoint of maintaining the settlement system, which is the fundamental infrastructure for economic activity, and of protecting depositors. A hedge fund per se does not have settlement-system or deposit-accepting functions. But if a hedge fund incurs a huge loss, it would cause deterioration of assets at creditor financial institutions and this would worsen market sentiment and cause a flight to liquidity, leading to a sharp decline in liquidity. Depending on the degree of the decline, it could cause anxiety about the financial system as a whole. The collapse of LTCM is a good case in point. From the standpoint of maintaining a stable financial system, strengthening regulations on financial institutions (e.g. large-lot loan regulations and raising lending risk weights under capital adequacy rules) would help protect the financial system from the risks of hedge funds. The Basle Committee report proposes tightening these restrictions, while at the same time calling for financial institutions' thorough risk management on transactions with hedge funds. It is expected that these steps, if implemented, would help to indirectly curb hedge funds' risk-taking behavior.

    Hedge funds are generally viewed as "speculators" who make highly risky investments. But as described earlier, there are views that they make cool-headed investment judgments consistent with economic rationality; their behavior provides liquidity to the financial market and prevents the market from moving in only one direction; their behavior greatly helps to establish an efficient, transparent and undistorted market. (In this last sense, some commentators described hedge funds as "yield curve police.") In any case, in order to reduce destabilizing factors to be caused by international investors like hedge funds, every country should strive to establish and maintain an undistorted, highly liquid and transparent market as much as possible.

    On the other hand, if some measures are really needed to cope with problems posed by hedge funds, there are two approaches. One is a "direct approach," which calls on hedge funds to disclose their information and report to authorities and/or imposes regulations on their establishment and management. The other is an "indirect approach," which calls on those financial institutions having a business or lending relationship with hedge funds to enhance the risk management and/or imposes regulations on such operations. Yet other approaches would include strengthening the market rules by obligating every market participant to disclose and report large-lot transactions, tightening rules on leverage of OTC and negotiated transactions and supervise large-lot transactions from the standpoint of maintaining a fair market. It is noteworthy that the President's Working Group in its report called for introducing and reinforcing reporting and disclosure obligations of hedge funds, in addition to thoroughly implementing the "indirect approach."

    In either case, costs and benefits should be fully compared in working out measures to cope with risks that would be brought about by hedge fund operations. In particular, it is important to be aware of the technical or legal difficulties with regard to how to define coverage of regulations, how to prevent regulation-evading behaviors once the coverage of regulations defined and how to have the regulations observed effectively. If some kinds of restrictions on hedge funds are really necessary, it is pointed out that we should study and explore a system through international cooperation by establishing a realistic and practical standard.

    If it is necessary to impose certain obligations or discipline the behavior of hedge funds, we need to study which country should have legislative and legal power over them, in view of the international nature of hedge funds. As to legislative jurisdiction, there are four basic ideas in international law. They are 1) territorial principle (A country has legislative jurisdiction over any act done within its territory.), 2) nationality principle (A country has legislative jurisdiction over any act done by its citizen or by a company established under the country's laws, regardless of where the act has been done.), 3) national interest principle (A country has legislative jurisdiction over any act that may have a grave impact on the country's national interest, such as national security and stability of the economic system, regardless of who did the act and where.), 4) universality principle (A country has legislative jurisdiction over any act which runs counter to the universal interest of the whole world, regardless of who did the act and where it was done and regardless of whether the act had a direct impact on the country.) The problem is how to employ these ideas. Take, for example, the most popular idea of the territorial principle. It could be argued that legislative jurisdiction rests with the country in which the transactions took place, with the country on which law the establishment of the actor is based, with the country where the actor's management headquarters is located, with the country to which the nationality of the person in charge of investment belongs or in which such person lives, or with the country in which investors or ultimate beneficiaries from investment activities reside. As to the execution of laws, it would be most effective to carry out execution first in the United States, where most hedge funds have their bases in effect.

    Given the fact that funds move freely and instantly from one country to another, hedge funds would detect loopholes with high possibility even if regulations have been put in place. So, it is pointed out that it would be necessary for those countries with major financial markets to take a concerted approach to the problem within the framework of their shared objectives of maintaining the transparency and stability of the markets. It would also be necessary for industrialized countries to seek the cooperation of "offshore centers" where many institutions have established and urge such countries and regions not to take steps that may be detrimental to the effectiveness of their regulations. It is, therefore, important to promote close international cooperation in order to cope with the problems among G-7 and other advanced countries as well as among countries with major money centers. The Financial Stability Forum as described in Chapter 1 would be a good place to coordinate.

6. Policy issues in emerging countries

    For an emerging country whose market size is small compared with the amount of funds hedge funds and other institutional investors can mobilize or the positions that such investors can build, it is much more vital than for advanced countries to take preventive measures against a huge, abrupt shift of capital and promote the stability of its own currency and financial market. First of all, it would be important to take a sound macroeconomic policy and strengthen the financial supervisory system by thoroughly implementing prudential rules for financial institutions. But at the same time, emerging countries should explore the possibility of introducing regulations in accordance with the situations in each country from the standpoint of stabilizing the financial system and keeping the market integrity in the same manner as discussed above regarding advanced countries. They should also address the following problems unique to them: 1) how to proceed with the liberalization of capital transactions, 2) establishment of an appropriate exchange rate regime, and 3) capital controls in response to crises.

    As will be described below, Japan has been taking a realistic, and practical approach to the promotion of capital liberalization and roles to be played by capital controls. It is true that the free flow of capital has helped to increase the productivity and economic development of emerging and other capital-receiving countries and has brought about higher returns to the investors. But in theory as well as in the actual financial world, there is no assurance that leaving everything to the market would bring about the most efficient allocation of resources, or more simply put, the optimal economic outcome. As a textbook on microeconomic theory describes, for the market to bring about the most efficient allocation of resources, the following preconditions have to be met: that there is no asymmetry in information held by market participants, that there do not exist any economic externality and that objects to be traded do not have the characteristics of public goods. However, in a financial market, asymmetry in information has often been observed as was described in the herd behavior section and a financial system has to a certain extent the characteristics of public goods because the public "collectively" use it. It is, therefore, necessary to regulate domestic finance from the several standpoints discussed in chapter 5. In the area of international finance as well, it is important to pay attention to several caveats regarding the idea of the free flow of international capital, which is different from the case of goods (trading). Moreover, it goes without saying that the market mechanism does not perform its full function when various market infrastructures (such as a proper accounting system and legal framework) are not properly organized.

    It was once a dominant international view that the liberalization of capital transactions should be promoted as broadly and speedily as possible. But now an international consensus is that the liberalization should be proceeded in a well-sequenced manner assuring whether certain preconditions are in place. There would be preconditions to promote the liberalization of capital transactions: 1) a market economy system is firmly established (in particular in countries whose economies are in transition), 2) liberalization of trade is in progress, and 3) the economy is mature in general and has been integrated into the world economy to a certain extent. It is also necessary 4) to have a strong financial sector and a highly efficient supervisory system. Regarding the last precondition, it is essential, for example, to monitor the risks involved in exposure to foreign currency-denominated loans and maturity mismatches through appropriate implementation of prudential regulations. Some also suggest that the liberalization of the more stable long-term direct investment should precede that of short-term capital transaction. Japan has advocated the necessity of the well-sequenced liberalization of capital transactions.

    Given the current huge and drastic movement of capital in the world economy, what kind of exchange rate regime an emerging country should decide to choose is very important. Of course, what would be the most suitable exchange rate regime for a country varies depending on the country's economic size, the composition of its trading partners, the composition of its major trading items, the degree of capital liberalization and its inflation experience. But the Asian crisis has taught us that pegging a country's currency to any one particular currency is highly risky. Generally speaking, an emerging market country can flexibly cope with exchange fluctuations by pegging its currency with, or referring to, a basket of currencies of some advanced countries with which it has the closest interdependent relationship in terms of trade and investment. In any case, there is no simple formula. Therefore, it should be stressed here that it is important for every emerging country to choose a suitable exchange rate regime on a case by case basis and implement an appropriate macroeconomic policy consistent with the adopted exchange regime.

    An inflow of capital into a country has so far simply been regarded as merely a reflection of confidence in the country's potential and its policy. But it is necessary for emerging market countries in particular to monitor the size and content of capital inflow and adopt the appropriate macroeconomic policy to cope with it. It is essential to be aware that the direction of short-term capital may change suddenly from an inflow to an outflow and that holding foreign currency-denominated debts contains foreign exchange risk. During the Asian crisis, the amount of capital that once flew in and then flew out of Asian countries in one year amounted to more than 10% of the combined gross domestic product of the countries involved. Therefore, there may be arguments for making best use of market friendly controls on capital inflow in a way that would not distort the market. Such capital controls would include higher reserve ratios for deposits received from nonresidents and stricter prudent regulations on borrowing from abroad and securities issuance by residents (in particular, by financial institutions).

    Implementing controls on capital outflow at a time of crisis would inevitably have long-term adverse effects on investment in the country. And in view of the fact that financial transactions are complicated and highly developed now, it is not easy to effectively control capital outflow and employing discretionary or arbitrary restrictions for a long time would deteriorate the efficiency of the national economy. Having said these, however, implementing such controls may be justified in exceptional cases such as when the country is facing a massive outflow of capital due to the contagion of a crisis in another country despite the fact that the country's policy is basically sound, when there is a need to prevent IMF loans from being used for the rescue of investors abroad, and when the country prevents the flight of residents' capital. Of course, these controls should not be viewed as a norm but as exceptional measures. It is also important that such restrictions are carefully designed so that they would not have adverse effects on the inflow of stable and useful investments such as direct investment involving the transfer of technology or management know-how.

    In international field, most arguments are cautious about controls on capital outflow due to the many problems involved, including possible adverse effects on capital inflow, difficulty in ensuring effectiveness and the interests of investors in advanced countries. However, it is noteworthy that there has emerged a fresh argument that capital and exchange controls are necessary in exceptional cases from the standpoint of promoting "private involvement in the prevention and settlement of crises." The recent string of crises in Asia is characteristic in that the private sector was both the main creditors and debtors and that the crises were caused when they became unable to maintain the massive inflow of capital. We should not tolerate the use of IMF and other public funds to help private creditors and investors withdraw their funds, from the standpoint of fairness and efficiency (from the viewpoint of moral hazard that similar incidents may occur in the future), since they invested in emerging countries seeking for high returns, knowing the risky nature of their investment. It is now increasingly called for that, as preconditions for assistance from the IMF, private banks should maintain a certain level of lending and that debtors, including bond holders, should restructure their debts. In an extension of this argument, some propose that in order to give time for debt restructuring, temporary capital and exchange control should be considered to suspend payments of public debts or curb debt repayments by the private sector.

    We should study controls on capital inflow and outflow from a realistic perspective, including in what cases restrictions would be justified and what restrictions would be appropriate to each emerging country as a way of crisis management, taking into consideration cost and benefit of such measures. Reflecting strong requests from the Japanese Government among others, the IMF will continue its comprehensive analysis and study of restrictions implemented so far by each country, which is expected to come up with useful outcome.

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