International Financial Markets after the U.S. Elections

Presentation to Douglas L. Derry, F.C.A.

Honoured guests, ladies and gentlemen: Before introducing our guest speaker, I have a very happy task to perform. This represents an annual event and it is the occasion on which the members of the club recognize the outstanding contributions of the immediate Past President.

Douglas Derry served us well thoughout the 1983-84 season, and it is a pleasure to thank him publicly for his services to the club. Not only did he have an outstanding year of interesting and informative speakers, crowned by the inspiring luncheon for Prime Minister Margaret Thatcher, but he also served the club in many quiet and less noticeable ways.

Not only did Douglas oversee the computerization of the membership lists, which is no mean task with over 2,400 members, but he convinced his partners at Price Waterhouse to assist us, with an essential refurbishing of our previously antiquated office.

The directors and past presidents held a dinner last Tuesday to recognize his welcome contributions to the club. Now it is my pleasure on behalf of all of you to present him with this scroll signed by Governor General Jeanne Sauve, Honorary President of the Empire Club, in recognition of his services.

Douglas Derry

Madam Chairman, Mr. Weatherstone, distinguished past presidents, ladies and gentlemen: Thank you Madam Chairman for your most kind remarks and for this scroll which I shall always treasure. The honour of having been president of this club is one that I value greatly, though I have to admit, there is an analogy that I recently heard which, when applied to the prospect of becoming president of this club seemed particularly appropriate. It compared the approaching new responsibility to that of a murderer awaiting his execution - as the day approached, it certainly focused the mind to the issue at hand!

But as much as it focuses one's attention to impending peril, it also makes one conscious of the inner workings of this club in a depth of detail that few others have the opportunity to gain. Our members are readily familiar with the quality and abilities of our weekly speakers, such as Mr. Weatherstone, and of course this is essential. But less obvious is the warm welcome that we all receive from the gentlemen at the door of the room each week who in such a genteel manner assist members and their guests to find a table; or the dignity of our reception room before the luncheons, where head table guests gather and have the opportunity to meet the speaker of the day; or the arranging of the head table itself which tests the ingenuity and organizational skills of those responsible.

It is all of these things, when taken together, that make this club Canada's pre-eminent speakers' forum, and I thank you for the privilege for serving as your president.

Honoured guests, ladies and gentlemen: It is probable that a majority of us here have, at some time in our lives, found ourselves agreeing with Ogden Nash, in his "Hymn to the Thing that Makes the Wolf Go":

O money, money, money.

I'm not necessarily one of those who think thee holy,

but I often stop to wonder how thou canst go out so fast, when thou comest in so slowly.

It just might be that our speaker today will give us a clue to this problem.

We are exceptionally fortunate to have Mr. Dennis Weatherstone to address us. We are fortunate for many reasons, including the fact that he has a profound knowledge of the vastly complex global banking world, and the lucidity to talk about it in plain language. When I say "fortunate" I refer to the fact that the so-called "House of Morgan" has a reputation for reserve, and aloofness. As one senior executive said: "We do not blow our horn terribly loudly or widely. We think it is just part of doing our job." Mr. Weatherstone is now Chairman of the Executive Committee, and a Director of JT Morgan and Company, and of its banking subsidiary, Morgan Guaranty Trust. He is rather unique at Morgan's for not graduating from one of America's ivy league universities.

He joined the London, England offices of this elite organization at the age of sixteen in 1947. By what must have been arduous night-time study, he graduated from London's Northwestern Polytechnic College with professional qualifications as a corporate secretary. He is now an Associate of the Institute of Chartered Secretaries and Administrators, and a Fellow of the Institute of Bankers. While still in London, he became Deputy General Manager of the London office at the age of twenty-nine, and a Vice President a few years later. In 1971 he was assigned to the Bank's headquarters in New York. A year later he became Senior Vice President. In 1980 he assumed the responsibilities of Chairman, along with a directorship.

There is no need for me to describe to this audience, the eminence and solid reputation of J.P Morgan and Company, nor of its banking subsidiary. It is enough just to recall that as recently as 1982, Fortune reported Morgan's core clientele to include the top 150 corporations of the world.

Ladies and gentlemen, Mr. Dennis Weatherstone.

Dennis Weatherstone

I am delighted to be here to address you today, even on so formidable a topic as "International Financial Markets after the U.S. Elections". Let me begin by stating the obvious: if the outcome of the recent U.S. presidential election had been different, there would have been a lot more to say about the international markets "afterward" - at least in terms of cause and effect. As things turned out, financial markets after the elections have to contend with the same policymakers in Washington as they did before. No new wrenches have been thrown into the works: we have simply got the same old wrenches to deal with. Not that these do not involve uncertainties and challenges of their own, which I will return to in a few minutes, but the U.S. election as an event will not figure significantly in my remarks.

Nevertheless, I think it is fair to say that international financial markets after the U.S. elections will change dramatically - not, as I mentioned, because of the election itself, but because of market forces and government policies that have been building for a long time. These forces have already had enormous effects on international markets. The momentum of change is continuing to build, and if anything I expect it to accelerate. Today more than ever, you have to be fast on your feet to succeed in the financial markets. To give you some perspective on why this is true, I would like to talk for a few minutes - and necessarily in broad terms - about what is commonly called the convergence of world financial markets. What is driving this phenomenon? And where is it likely to lead?

At the most basic level, the convergence or integration of world financial markets means that the walls between different countries' markets are tumbling down. And increasingly the walls between sectors of financial markets are crumbling, too. In large part this process of integration is being carried out in the Euromarket - a borderless, globe-spanning financial laboratory whose size now exceeds $2 trillion. It is useful to recall that the Euromarket got started as an alternative to domestic markets that were cluttered with rules and regulations. The lesson of history here is that markets are thoroughly pragmatic: they have a knack for finding efficient ways to do business that make bureaucracy irrelevant.

As the Euromarket expanded, serving first governments and official institutions and then increasingly multinational corporations, a common ground was established on which users and providers of funds, as well as financial intermediaries from around the globe, could meet in a free competitive environment. International investors' preferences could be tested, and borrowers and issuers of securities could compare a multitude of financing alternatives, limited only by the ingenuity - some might say the cheekiness - of their bankers and financial advisers.. As a result, demand could and did develop for financing in a variety of instruments and currencies.

It is fascinating to see how that demand has shifted over time and changed the face of world markets. Once upon a time, financing in the capital markets meant issuing long-term, fixed-rate bonds. Financing from your bank came in the form of short-term advances and medium-term, floating-rate loans. Today, the credit and capital markets often cannot be told apart. In effect what has happened is that all the component parts of financing can be put together in practically infinite combinations - fixed or floating rates, maturities, currency denominations, tax features, and whether or not a piece of paper is involved.

... A swap ... is simply a way to exchange one kind of interest obligation or one currency for another ...

The explosion of financing involving interest rate and currency swaps is a perfect example of this trend. A swap, as financial executives in the audience know, is simply a way to exchange one kind of interest obligation or one currency for another. Using swaps, a company can tap the market that offers a comparative cost advantage even though the firm's immediate need may be for a different instrument or currency from the one which that market provides. In effect, the swap mechanism has made all of the world's financial markets accessible to borrowers and investors at just about any time.

We arranged one of the earliest transactions involving long-date swaps about five years ago for a Canadian company that needed fixed-rate financing in Canadian dollars. By first issuing U.S. dollar bonds in the Euromarket and then swapping them into Canadian dollars, the company was able to raise money at a lower cost than it would have incurred by issuing bonds here at home. Since that deal almost $75 billion of swaps have been transacted. And that is just one example of how demand for different kinds of financing has either blossomed or died. Another, and one that dramatizes how financial intermediaries must adapt in order to survive, is the shift away from syndicated loans as a major source of international financing.

From a peak of more than $133 billion in the volume of Eurocurrency bank credits in 1981, only $74 billion of such credits were arranged last year. In part the peak reflects credits arranged in 1981 to finance a spate of corporate mergers in the United States, and a portion of the decline can be attributed to a reduction in lending to developing country borrowers. But it is nevertheless clear that the world is turning increasingly toward the capital markets to raise money. Innovations have stretched the capital markets' capacity to accommodate preferences for fixed or floating rates or for various currencies, and recently for maturities that have no maturity - the perpetual deal. New instruments have both lowered the cost of borrowing and proved highly attractive to many investors. In the first quarter of this year, for example, the volume of floating rate notes issued surpassed for the first time the amount of announced syndicated bank credits.

Meanwhile, the volume of international bond issues has also shot up. In 1981, for example, $53 billion of bonds were launched. In contrast, volume was nearly $86 billion in the first ten months of 1984 alone. Viewed from another interesting statistical vantage, the volume of Eurocurrency credits issued during the first ten months of this year was only seven per cent greater than the volume of new international bond issues. Just three years ago in 1981, syndicated credit volume was two and a half times that of international bonds.

Commercial banks have had to be fast on their feet, as I suggested earlier, to make up for declining international loan business by getting more involved in the capital markets. Their adaptation is just one example of what is happening everywhere. The constant comparison of financing and investment opportunities worldwide, the innovations and shifts in preference that result, and the capital flows associated with them-all have created pressure for change in financial markets, with a bias toward breaking down conventional barriers and streamlining market operations. Let me highlight some recent developments along these lines in London and Tokyo to illustrate this process.

... The City of London's financial institutions evolved in a world centred around the pound sterling ...

The City of London's financial institutions evolved in a world centred around the pound sterling that has now all but disappeared. The old system that accommodated broker and jobber, clearer and merchant bank in well-appointed niches could not stand up to the international competition that rushed in, especially after the United Kingdom abandoned foreign exchange controls in 1979. As international securities markets have begun to rival domestic markets in profit-making importance at the London houses, competitive pressures have forced a revolution of the old order. In the process, of course, U.K. domestic markets are also being streamlined.

So in London today we have a familiar scenario shaping up. Fixed commissions on the London Stock Exchange are giving way to negotiated commissions. The small firms that the old system supported are combining with U.K. merchant or clearing banks, or foreign partners, to create world-class, well-capitalized competitors for securities business. The development of more active international equity markets is a widely expected consequence of this realignment - in fact, two Canadian companies, Alcan Aluminum and Bell Canada Enterprises, launched deals last year that were characterized as among the first truly international equity issues, sold simultaneously in Canada, Europe, and the United States. At the same time, the London market restructuring will accommodate the Bank of England's revamping of the British gilt or government securities market along North American lines.

... Interest rates ... increasingly are being determined by market forces ...

On the other side of the globe, equally profound changes are taking place in the Japanese capital market - not as quickly as in London, but spurred nonetheless by international capital market developments and by the yen's growing importance as an international currency. Interest rates, for one thing, increasingly are being determined by market forces, rather than set artificially. Earlier this year, the Japanese Ministry of Finance took steps toward opening up the Euroyen market, and is now tackling, among other things, the deregulation of Euroyen bond issues by foreigners. The beginnings of a yen bankers acceptance market are evident. As in London, these measures will also have the effect of liberalizing domestic financial markets.

Taken altogether, the changes I have outlined mean an erosion of barriers to the ready flow of capital around the world. But do not mistake me: I am not yet ready to announce the millenium, because significant obstacles to the development of efficient global financial markets remain. The legally segmented financial systems embodied in the Glass-Steagall Act in the United States, the "four pillars" here in Canada, and similar structures in Japan and elsewhere are the subject for another speech. You must have guessed by now, though, that to my mind they seem counter-productive in converging financial markets. If demand for financing shifts between the credit markets and the capital markets, and if the distinctions between those markets are disappearing anyway, why shouldn't financial institutions diversify their activities to adapt to a changing world?

As you know, many banks pursue securities activities in the Euromarket from which they are barred at home - with happy consequences for their bottom lines. Experience shows that changes like this, which are taking place wherever financial institutions are free to adapt to competitive pressures, do make for more efficient markets. It is going to take a while for regulatory systems in many countries to deregulate, but in my view it is just a matter of time before they too reflect the reality of market integration that I have been discussing today.

I know that the Ontario Securities Commission next week will launch hearings on the capitalization and scope of the securities industry, and we will be watching their progress with keen interest. I might mention that in the financial markets of the future, we expect strong capitalization to become increasingly critical to individual institutions' success and to the stability of the international financial system. The need for increased capital clearly has been a driving force behind the merger of securities firms in the United States, Canada, and more recently in London. The emergence of a strong international securities industry should be one important legacy of the convergence of markets spurred by global competition.

One concern I should mention at this juncture is the need for recognition that there are certain hazards associated with getting involved in unfamiliar business or financial territory. Prudent institutions will put a high priority on understanding and managing the risks associated with innovative financing instruments, which combine features of different markets, as well as the risks associated with new lines of business, whether insurance, futures, or, for that matter, banking.

No financial activity is riskless; banking by its nature involves taking risk. The trick is to recognize the risks and to balance them prudently. Some observers stress the need to strictly regulate increased risks of all kinds. In my experience, however, finely tuned internal controls are the most effective tools for monitoring risk. External regulation has a role to play, but it must go hand in hand with strong internal controls to keep financial institutions and the financial system safe. I would like to switch gears at this point and talk for the few remaining minutes about the outlook for the U.S. dollar and U.S. interest rates. During the 1970s, U.S. economic policy resulted, among other things, in very low or negative real - inflation-adjusted - interest rates. By 1980, inflation was running at a rate of more than thirteen per cent. All of us, I imagine, recall the flight from the dollar that occurred as investors lost confidence that dollar investments would generate real returns.

Today, in contrast, inflation is low - around four per cent - and real interest rates substantial - about six per cent. Foreign investors obviously are attracted by high U.S. interest rates which reflect, it is interesting to note, U.S. tax policy. Residents of the United States I.~ust pay tax on interest income and may deduct interest expense: this means in effect that interest rates are lower for them than for foreigners, and the dollar benefits accordingly.

But there is a more fundamental reason for dollar strength, which has persisted even in the face of large current account and budget deficits, usually considered negative for a currency. The reason is , in a word, confidence - hard to win, easy to lose.

Let us look at it from the market's viewpoint. The U.S. economy has enjoyed a sustained recovery, improved productivity, reduced unemployment, and low inflation, along with a stable political environment. The basic strength and promise of the U.S. economy, compared with other potential investment environments, is the real source of the dollar's strength. Labour mobility and labour's understanding of the need for improvements in competitiveness and profitability are key elements in this picture. The exchange market compares this attitude in the United States with that prevailing in labour markets elsewhere, and its views are reflected in the exchange rate.

All is not rosy on the horizon, however. With the presidential election over, the markets will be looking for the government to take credible steps to reduce the budget deficit. If they do not come, or at least appear to be coming, that hard-won confidence in the U.S. economy could drain away, taking with it capital inflows from abroad. These have helped finance the budget and current account deficits, as well as kept interest rates from being driven even higher. A drain of confidence could also pull down the dollar, possibly in a disorderly fashion.

It is critically important that our domestic fiscal policy recognize this and respond soon. A precipitous decline in the dollar, reflecting a vote of no confidence in U.S. fiscal resolve, could send dollar interest rates skyrocketing, trigger renewed inflation, abort recovery here and in other OECD countries, and deal a severe blow to the export performance of developing countries. This admittedly is a scare scenario. I paint it only to emphasize how important it is - not only for the United States, but for the rest of the world - for the United States to tackle the deficit. The fact that the exchange market is not currently sending out warning signals is no reason for complacency.

Although the Reagan administration has promised action through further budget cuts and growth, prudence dictates some contingency planning for tax increases, too. Obviously, if a major objective is to free more savings for private investment, changes that would encourage saving rather than consumption would be the best route. For the time being, however, the hottest item on the agenda is the modified flat tax proposal, and we are told not to expect it to generate revenues. We will see.

So where does this leave us in trying to see what is ahead for interest rates and the U.S. dollar? If the markets detect at least an attempt to bring the deficit down, I think interest rates could ease a shade further - or at least consolidate their recent sharp declines at the short end of the market. Such rate levels would likely coincide with an economy that remains sluggish over the next few months - two to three per cent growth. The dollar should hold its strength for a while longer under these conditions. It is, however, a vulnerable strength, and the dollar is likely to scare us all from time to time when tested by bad news.

In spite of the dilemmas and vulnerabilities, I remain basically optimistic. Perhaps it is because U.S. problems at least are identifiable and compared with many other countries' difficulties seem more manageable. At the end of the day - and my remarks - the 1985 soft landing scenario of four per cent growth and four per cent inflation for the United States looks like a pretty good deal. I am prepared to buy it, warts and all.

The appreciation of the audience was expressed by Douglas Derry, Immediate Past President of the Club.