Notes on the Capital Markets and a Modest Proposal

When assessing the uniqueness of the US economy, the flexibility of its labor markets is often cited as a critical factor. Businesses indeed have a largely free hand in hiring and firing workers. The unionization rate among the private sector continues to trend lower and dissent over tactics led to a split in organized labor about a year ago. There are no language barriers or other restrictions on the migration of workers between states, like there is in the euro-zone. Yet, many observers probably exaggerate the impact of this and the frequent downward pressure on real wages as a critical competitive element.

What is frequently under-appreciated is the flexibility of the US capital markets. There are two main ways that capital is distributed: bank and the markets. For various historical reasons that are well beyond the scope of this short note, the Anglo-American economies rely more on the markets, while Continental Europe, Japan, and most developing countries relay more on banks to distribute capital. For nearly every dollar that a US corporate will borrow from the banks, they will raise around $2 from the capital markets by issuing stocks and bonds. Much of Europe and Japan, in contrast, are almost the exact opposite.

Ask David Bowie about Flexible Capital Markets

The fact that what economists call the disintermediation process has gone further in the United States is important because economic activity is increasingly capital intensive. Bank-centric distribution of capital tends to be extremely conservative and largely a binary decision—you either get the loan or your don’t. In contrast the markets have capital for anyone, even companies that are bankrupt, and only the terms are dickered over.

Consider a guy who drops out of college in the mid-1980s to build computers in his garage. If he sought a loan from a bank, he would have been laughed out of the office. The capital markets had money for Michael Dell, though initially it was through credit cards, which itself could have been include in a new security backed by credit card receivables.

Consider David Bowie. He sells millions of dollars a year in CDs and videos. He goes to a bank and asks if he can get some of the money in advance. The bank manager would likely point him to the door. Yet the capital markets can and do provide Bowie is money. There are now Bowie bonds, for example, that are asset-backed (the revenue stream from his sales) securities.

Under-Development in Emerging Asia

One of the criticisms of developing countries in Asia is the under-development of their capital markets. At the very least this exacerbates the global imbalances; at worst it is a significant cause of the imbalances. The inability of the regional capital markets to absorb the vast savings and export earnings means that the capital must get exported. And with the deepest, more liquid and transparent markets, US and US dollar denominated instruments is the biggest recipient.

Just like the G8 and the IMF call on the US to boost its own savings to readdress its large current account deficit, they also urged Asia to develop its own bond market. The local currency bond market is growing but at a snail’s pace. Many corporations prefer to raise capital in the US and to a lesser extent European markets rather than pay the cost of operating in the less developed, less liquid, and frequently less transparent domestic markets.

Bank-centric capitalism can take care of the large investment grade companies. Sub-investment grade companies from developing Asia have flocked to the US and Europe to raise funds. Reports suggest that nearly 30 Asian companies have issued almost $10 bln of high-risk, high-yield bonds this year and about half of the companies had never previously sold debt to international investors. Industry benchmarks complied by Merrill Lynch indicate that Asian corporate bonds have returned 2.6% since the end of June compared with a 2% return on corporate bonds globally and completely recoups the ground lost in the spring rout of emerging markets.

Ask Willie Sutton Why He Robbed Banks

Legend has it that when asked once why he robbed banks, Willie Sutton quipped, that is where the money’s at. While Asia’s savings in excess of its ability to absorb it has been widely commented on, the excess savings in the Middle East is even greater, thanks to the flood of petrodollars.

A growing share of Asian trade is within the region. Developing Asia, including China, had an external surplus of about $155 bln last year and it is likely to be around that this year and next. The external surplus of the oil exporters is expected to be closer to $450 bln this year on top of the $347 bln last year. It was about $150 bln in 2000.

As is well appreciated, many oil-exporting nations are Moslem and have special prohibitions that have discouraged the development of their own domestic capital markets. The best known is the prohibition against paying and receiving interest. There are several other prohibitions that have impinged on the development of conventional capital markets. These include gambling, certain types of activities that have “excessive” risk, and investment in other activities that may themselves be prohibited like casinos, pork, tobacco and alcohol.

Moslem law as it has been interpreted prohibits not only a conventional bond market, but also, interest rate swaps, conventional derivatives, like futures and options, credit default swaps, and forward exchange transactions. However, this does not necessarily mean that Moslem countries are locked into a pre-development stage. On the contrary, going back to Middle Ages when Moslem merchants played important roles as middle men between Europe, Asia, and Africa, these prohibitions have not prevent entrepreneurial activity or the development of contracts and property rights.

That’s Sharia

In fact, under Moslem law or Sharia, a number of various financial instruments have been created. These financial instruments are called sukuk. Sharia recognizes as legitimate financial securities that derive the rate of return from the performance of real assets. Sukuk are best conceived as asset-backed certificates that carry ownership rights and risks. There are also special purpose vehicles that acquire a financial asset and then issue financial claims on that asset. The claims represent a proportionate beneficial ownership for a defined period. The Sharia appears to be flexible enough to change over time.

There are a wide array of Sharia-approved financial instruments that have been issued and duplicate many of the functions of conventional financial products. These include instruments with fixed and floating rate pay-offs, forwards, futures and swaps. Just as the surge in oil revenue in the 1970s was a catalyst for development, so too is the present deluge of petrodollars spurring further development. There are an estimated 240 financial institutions in 40 countries that are Sharia-compliant. Reuters estimates that the pool of assets managed by Islamic banks is between $250 and $400 bln

Over the past 3-years, an estimated $40 bln of sukuk have been sold. The issuers are largely corporations, including the US-based Gulf East Cameron Partners. A German state and the World Bank have issued in the sukuk market. Japan’s trade promotion and international development institution, the Japan Bank for International Cooperation, is reportedly working with Bank Negara, Malaysia’s central bank and Malaysian-based Islamic banks to issue a sukuk probably some time early next year.

If this does materialize, Japan will become the first G7 nation to issue a bond complying with Sharia. It will also be the first large non-Muslim state to do so. The UK’s Chancellor of the Exchequer Gordon Brown has said that he wants London to become the global center for Islamic finance. There is a clear trend among large non-Moslem banks to move into Islamic finance. In fact a London-based bank may have been the second most important sukuk manager last year, helping to raise more than $800 mln in seven separate issues.

It’s about US

It is in the US economic and geo-strategic interests for there to be deep and broad Islamic capital markets. They promote economic development and through economic development, foster stability. It helps integrate the region and its people into the world economy, giving them a greater stake in the world’s prosperity. Developed Islamic capital markets would also help avoid repeating the potential destabilizing imbalances in Asia. The United States should consider issuing a US dollar denominated Sharia-compliant financial instrument. It would signal respect for Islamic law and people and would recognize the limitations of military and political strategies. It would recognize the real battle, as always is for the hearts and minds of the people. A sukuk issued as a way to fund the US assistance in rebuilding Lebanon, for example, might be the way to start.

Just like one doesn’t have to be Jewish to eat and enjoy kosher pastrami, one doesn’t have to be Moslem to invest in sukuk. Conventional fund managers are beginning to embrace sukuk as a separate asset class that helps diversify the overall portfolio. Fund managers in the growing socially-responsible investment space may also be attracted to the high ethical standards that Sharia demands.

The US has traditionally been a leader in financial innovation. It is one of its critical comparative advantages. There is a relatively new and growing market, one in which our friends and competitors like Japan and the UK already sense the significance. The US needs to respond to this competitive challenge. A Middle East integrated in the world economy is in the US interest on a number of different levels. This is a golden opportunity for the US to exercise its leadership and show its prowess in utilizing its soft power. Is this not a way to marry Wilsonian idealism with the realism of Thucydides and Hans Morgenthau?