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Why the record-breaking falls

  • Robert Peston
  • 27 Oct 08, 10:57 AM

Today's fall in stock markets across the world puts us on track to set new records for monthly declines in share prices.

So far this month, share prices in the US and Europe have fallen on average by more than a quarter, those in Asia by a bit more.

Falling sharesUnless there's a sudden bounce, the cumulative monthly falls in October for most major markets will be as big as has been by anyone alive.

In the case of the US, the monthly drop is likely to be the biggest for 70 years. For other markets, where serious measurement of stock-market movements is a younger pursuit, the drops are as bad as any seen since records began some 40 years go.

Why the rout?

Well three things are going on.

First, we're seeing the end of the carry trade, the investment of cheap, low-interest loans raised in yen and dollars for investment in higher yielding financial markets, such as those of the emerging economies, Iceland and - to an extent - the UK.

Investors are liquidating assets everywhere from South Korea, to Argentina, to Hungary, and holding the proceeds in the Japanese and US currencies.

And since so much of the carry trade came out of Japan, the yen has surged to an astonishing extent.

Sterling has been punished, in part because when the carry trade was booming, the UK received a disproportionate amount of this hot money, because our interest rates were always a bit higher than the developed economy norm.

A second phenomenon is the one I described in my note of earlier this morning ("Hungary, Goldman and Regulators"), namely that the conversion of Morgan Stanley and Goldman Sachs into banks is sucking the juice out of hedge funds.

That's forcing those hedge funds to dump assets such as shares, corporate bonds and commodities - which in turn is precipitating further asset sales , as the fall in their prices causes lenders to demand that those who've invested on credit (such as hedge funds) put up more collateral.

Finally, the global economic slowdown has prompted a re-evaluation and re-pricing of risk, in the jargon.

Or, to translate, investors have in the course of 14 months gone from the mad conviction that busts had been abolished to the fear that everything's going bust.

Neither view was rational. But reason doesn't hold much sway at market peaks, when the prevailing emotion is greed, and troughs - when it's sauve qui peut.

Goldman, Hungary and Regulators

  • Robert Peston
  • 27 Oct 08, 06:59 AM

The , the ambulance service for the global economy, announced late last night that Hungary would be receiving an "exceptional level" of - without specifying how many billions of dollars in loans that would be.

Man counts his cash in UkraineEarlier it had said that it had agreed to provide $16.5bn in standby loans for Ukraine.

It's a fair bet Hungary will be receiving rather more than that, because its dependence on loans from overseas banks and financial institutions is greater than Ukraine's.

Official figures that are out of date and are therefore an understatement show that Hungary has borrowed well over $100bn from abroad, equivalent to more than its entire annual economic output.

Ukraine's foreign debt is about half that.

So Ukraine is less exposed than Hungary to the global trend of capital being withdrawn from economies perceived - rightly or wrongly - as weak.

Although Ukraine has a special problem of its own, namely its dependence on steel manufacture: there has been a serious worsening in Ukraine's trade balance caused by the slump in steel prices, which in turn has been caused by the worldwide economic slowdown.

Ukraine and Hungary are trapped in the vice of the last phase of deleveraging, or the reduction in credit being provided by banks and other investors, and the decline in the real economy.

As for this most recent phase of the withdrawal of credit, which has caused financial crises for a series of emerging economies in eastern Europe, Asia and South America (see "Now there are runs on countries") and also global falls in share prices, it was in a way wholly foreseeable.

It was caused, to a large extent, by an exceptional and unprecedented shrinkage in the prime brokerage industry, which in turn led to a serious reduction in the volume of credit extended to hedge funds, which in turn forced hedge funds to sell assets, especially those perceived as higher risk.

This contraction in loans provide through prime brokers was the inevitable consequence of the collapse of Lehman, but also - far more importantly - of the recent conversion into banks of Morgan Stanley and Goldman Sachs.

Morgan Stanley and Goldman are - by far - the biggest prime brokers, with Morgan Stanley the number one.

But as banks, they're prevented by regulators from lending as much relative to their capital resources as they had been as securities firms.

So the US authorities should have known - and presumably did know - that by allowing Morgan Stanley and Goldman to become banks they were in effect forcing a serious contraction in the hedge-fund industry, which in turn would lead to sales of all manner of assets held by hedge funds and precipitate turmoil throughout the financial economy.

Which, as if you needed telling, only goes to show that regulatory intervention carried out with the best of intentions can have consequences that - in the short term at least - can be very painful.

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