Introduction

The financial crises of 1997 and 1998 have had a profound effect on East Asia's view of international financial and monetary arrangements, including the role of the International Monetary Fund (IMF) in international policy dialogue and financial cooperation. There has been a tectonic shift in the policy landscape of the region. While there are differences between and within countries, no longer is East Asia content to rely almost exclusively on global forums, mechanisms and institutions; it now wants to develop a complementary regional structure. The process of developing a regional economic and financial architecture may be in its early stages but the political and policy dynamics under way make it irreversible.

There are many elements to the expansion of regional arrangements – ranging from strengthened policy dialogue, greater financial cooperation, deeper economic and trade integration and even common currency arrangements. Much of the content of the evolving debate and policy on regional financial arrangements is tied directly to the region's discontent with the IMF and its concomitant, disillusion with the way the United States dealt with the financial crisis in East Asia. It is also motivated by a profound sense that deep economic and financial integration in East Asia can be of substantial benefit, both nationally and internationally, to countries in the region. At the same time, the European experience is seen as compelling.

Knowing the positions of hedge funds in financial markets is critical in evaluating the effect that they may have on the dynamics of financial markets. In the first place, knowing positions is necessary to evaluate how changes in positions affect financial prices. And knowing positions of hedge funds, as well as those of other market participants, is necessary to evaluate how hedge funds' positions affect the positions of other market players.

The problem is that data on market positions are proprietary information and are not publicly available: this creates a serious evidentiary problem. Analysts have tried to work around this by using various methods to infer hedge funds' positions in various markets. One method is to talk with a wide range of market participants and obtain market estimates of positions at particular points in time. But these data are anecdotal and are not available in times series format, and so they do not lend themselves to econometric analysis.

Brown, Goetzman and Park (1998) have suggested another way to get around the lack of data. They argued that positions can be inferred from the aggregate returns and net asset values of individual hedge funds. Returns and net asset values are more or less publicly available information.

Geographic proximity, ethnic and cultural links, and deep trade integration closely bind the economies and financial markets of Indonesia, Malaysia and Singapore together. In many respects, they are seen as a bloc despite the many substantial differences in their economic development, financial sophistication and regulatory framework. From the perspective of international investors, the circumstances of one affects perceptions of the other two, and this had an important bearing on financial market dynamics and positions in 1997 and 1998, intimately intertwining outcomes in the three countries' financial markets.

The experiences of Indonesia, Malaysia and Singapore in 1997 and 1998 also feature many of the extremes of the east Asian financial crisis. Indonesia, on the one hand, had the most tempestuous experience, with its currency at one stage losing 85 per cent of its value against the dollar and its financial and economic system routed. Singapore, on the other hand, had one of the most stable economies and financial systems of the region, and its asset markets experienced the least disruption and volatility. Indonesia, on the one hand, experienced substantial buying of its currency by macro hedge funds in late 1997 after the falls in regional currencies left many with the view that the initial depreciations had been overdone. Malaysia, on the other hand, experienced some of the most aggressive currency selling by highly leveraged institutions seen in the region, especially in 1998.

Economists have long been puzzled by substantial overshooting of asset prices from their perceived fundamental value. The sharp rise and subsequent crash of the UK stock market in October 1987, for example, provoked a fiurry of research examining the regularity of such events and trying to explain how they could occur. In elementary rational expectations models, movements in prices occur because market participants receive new information. But many movements in asset prices, even large and sustained ones, appear not to be explained by new information.

The literature on the microstructure of financial markets seeks to address some of these issues, and shows that movements in prices can occur for many reasons, including because of the trading mechanism itself, the types of trades made, and the strategies of different types of traders (O'Hara 1995). The aim of this chapter is not to summarise the already large and expanding literature on market microstructure but to selectively identify and set out some of the main models that are relevant to the issue of this book: how, as shown by the experiences of 1997 and 1998 in east Asian financial markets, large informed players can affect financial-market dynamics.

The exposition in this chapter comprises three parts. The first looks at the literature on herding in financial markets, focusing on semi-rational herding models with noise traders and rational herding models due to information cascades and principal-agent concerns.

Given Australia's and New Zealand's deep trade integration with east Asia, the Australian dollar and the NZ dollar depreciated substantially as the east Asian financial crisis progressed and commodity prices fell. Australia and New Zealand have freely floating exchange rates and, in both cases, substantial currency depreciation was welcomed as an effective means to stabilise domestic income in the face of a large adverse foreign demand shock. But there was a strong view in both the official sector and in financial markets that the currency falls were overdone and that, in Australia, market conditions at times became seriously disorderly.

Highly leveraged institutions were important players in both currency markets and had large concentrated positions. At least in the case of Australia, these large concentrated positions were associated with two undesirable effects. One was explicit aggressive destabilising activity by some HLIs that was designed on specific occasions to move prices to the advantage of those institutions. The other was that the very size and concentration of hedge fund positions affected the willingness of other market participants to take alternative positions, resulting in additional instability in foreign-exchange markets and overshooting of the exchange rate on the downside. These have important implications for market integrity which are explored in the conclusion.

The chapter assesses the economic context for both countries together, but reviews and assesses the market dynamics and activities of HLIs for each country separately.

Hedge funds are private collective investment vehicles for the very rich and, more recently, entities like university endowments, pension funds and insurance companies. They are designed to make money – and the more of it the better – which they do by taking positions on perceived price discrepancies in financial markets, although they have widely varying appetites for risk. They are institutions that tightly guard their privacy, which, combined with the fact that they are largely exempt from regulation, means that very little is known about them. Along with other institutions that sometimes engage in activities similar to them – like the proprietary trading desks of banks and securities companies – they are also called ‘highly leveraged institutions’ (HLIs), although this term can be misleading since they vary substantially in their use of credit. They are managed by some of the brightest and most creative people in the finance industry.

My interest in hedge funds in emerging markets was sparked by my involvement in the Study Group on Market Dynamics, which reported to the Financial Stability Forum Working Group on Highly Leveraged Institutions, in 1999. At the time I was Chief Manager, International Markets and Relations, at the Reserve Bank of Australia, a position I left when I became Professor of Economics at the Australian National University in January 2000.

Much of the information used in this book was collected at that time, in visits to Auckland, Hong Kong, Johannesburg, Kuala Lumpur, New York, Singapore, Sydney and Wellington. A lot of important information was also gathered after that, in visits as an academic to Bangkok, Singapore and Tokyo and in subsequent conversations with market participants and oficials.

It is important to stress at the outset that I have not used confidential information collected while I was a central bank official or discussed official meetings in this book. I have consulted widely with officials from relevant national and international authorities about the material presented here, and I am confident that I have not breached any commercial or official confidence. This is not intended to implicate these people; not everyone I consulted necessarily agrees with my analysis and views.

Despite the turmoil of recent years, hedge funds, including the macro funds, are here to stay and are likely to increase their infiuence in financial markets in the years to come. This chapter examines the reasons why hedge funds will remain important to financial markets and institutions, and then explores what this means for policy.

The policy analysis is structured in four parts. Given the experiences with highly leveraged institutions in recent years and the continuing important role of HLIs in markets around the world, the policy discussion starts with an analysis of the case for policy action, and then sets out three core principles which should underpin such action. Four proposals are then analysed: greater transparency of HLI operations, including public disclosure of aggregate positions by institutional class; imposing margining on all swap and repurchase facilities; the introduction of a code of conduct for financial market participants; and possibly regulating electronic broking in foreign-exchange markets. The policy analysis concludes with an assessment of the merits of direct and indirect regulation of HLI activity, including a discussion on the direct measures taken by some countries in east Asia to limit offshore speculative activity.

The endpiece concludes the chapter and the book.

This chapter sets out definitions of hedge funds in terms of their legal structure and in terms of the strategies they pursue. It reviews evidence on the number and size of hedge funds, as well as their performance as investment vehicles.

The term ‘hedge fund’ was first coined in 1949 to describe a private investment partnership set up by Alfred Winslow Jones which ‘hedged’ the risk in its operations by buying what it perceived to be undervalued stocks and ‘short selling’ (Box 1) what it perceived to be overvalued stocks, with the combination varying over time as Jones' assessment of market conditions changed.

Policymakers, practitioners and academics alike hold diverse and strong views about the role of speculators in the east Asian financial crisis, and about the role of hedge funds and proprietary trading desks in particular. The views range along a spectrum, where the two ends are that speculators played no independent role in the crisis and that speculators were the causes of the crisis, turning what should have been a modest adjustment of the baht into a fully fledged regional crisis with serious economic and social consequences.

While there is a lack of uniformity in views within countries and regions, it is probably fair to say that most of the critics of the role of hedge funds and other HLIs are based in east Asia and Europe, rather than in the United States where most of the hedge funds and proprietary trading desks are located and where the links with government, the financial markets and academia are strongest.

The controversy about hedge funds has led to two major international studies on their role in financial markets. The first was the IMF study, Hedge Funds and Financial Market Dynamics, led by Barry Eichengreen and Donald Mathieson, which was published in May 1998. The study examined many features of hedge funds and other highly leveraged institutions, including their role in east Asian financial markets in 1997.

Hong Kong experienced some of the most dramatic action of all the financial markets in east Asia in 1997 and 1998, with short-term market interest rates rising on occasion to several hundred per cent, the stock market falling 60 per cent, the market subject to highly aggressive trading tactics by a range of participants, and talk of attacks on the currency peg, all culminating in an unprecedented $15 billion intervention by the authorities in the stock market in August 1998.

The gyrations in Hong Kong's financial markets were the consequence of a series of aggressive speculative attacks in late 1997 and 1998. These attacks appear to have been much more than simply market participants positioning to take advantage of expected changes in asset prices at a time of domestic and regional uncertainty. Rather, in a number of instances it appears that speculators – especially highly leveraged institutions, and some macro hedge funds in particular – had large positions and tried to force prices in equity, interest-rate and exchangerate markets to move in a direction that put their positions in profit, but which also tended to force prices in these markets to overshoot. In some instances, highly leveraged players appear to have tried to take advantage of the negative correlation that developed between interest rates and stock prices to engineer stock-price falls by pushing on interest-rate markets.

An important decision in the design of macroeconomic policies in any country is the choice of currency and monetary regime. Not surprisingly, there is an enormous literature on currency and monetary regimes. This chapter sets out a policy menu for East Timor based on this literature, constructed in a way that suits the country's characteristics and needs.

There are two basic decisions to be made in choosing a currency and monetary regime. The first is whether to have a fixed or a flexible exchange rate. The decision to fix or float depends on weighing the advantages of one against the other, and assessing which works in practice. The second decision concerns the detail of the arrangements.

The chapter is structured in the following way. The following section looks at the first decision: whether to fix or to float the exchange rate, and what this means for monetary policy. The third section assesses different types of fixed exchange rate regimes, namely the standard peg, currency board and ‘dollar-ization’. The fourth section looks at which countries would be suitable pegging partners for East Timor. The chapter concludes by offering an assessment.

FIX OR FLOAT?

The first decision in selecting a currency and monetary regime is whether to fix or to float the currency. For a small economy like East Timor, there are two main issues to consider in making this choice.

Which Regime Is More Stabilizing?

The first is to assess the relative merits of having a fixed or flexible exchange rate. This decision ultimately turns on whether an independent exchange rate provides a country with a means to stabilize its economy as the external economic circumstances it faces change. If being able to change the exchange rate helps stabilize the economy, then having a more flexible regime is, in principle, helpful and preferable.