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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.
Dr Hans F. Sennholz
www.sennholz.com
Dr. Sennholz is President of
The Foundation for Economic Education, Irvington-on-Hudson, New York and a
consultant, author and lecturer of Austrian Economics.
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