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Address of Former Mexican Minister to Social Science Academy

5/19/2007 - 10:00 AM PST

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"Fairness and Unfairness of the Financial Markets"

VATICAN CITY, MAY 19, 2007 (Zenit) - Here is the address Luis Ernesto Derbez Bautista, former foreign minister of Mexico, gave at the plenary session of the Pontifical Academy of Social Sciences in Rome. The meetings were held from April 27 - May 1.

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When speaking of fairness in financial markets, one has to be aware of the many aspects this implies.

Because I framed my thoughts in terms of the capital markets of the world, I would like to start my presentation with the following quote that appeared in the March 31 issue of the magazine the Economist, as it referred to the current situation of the world's financial markets:

"The next wave of distress will be unlike the last in two respects. First, commercial banks no longer dominate the process. Non-banks such as hedge funds now make roughly half of all high-yielding leveraged loans and hold the lion's share in the secondary market. Secondly, borrowers' capital structures -- the various layers of debt and equity, each with different rights in the event of default -- are now more complex."

Fairness and unfairness of the financial markets

What does this mean? It means that globalization, and the appearance of new actors in the market has modified the rules in such a way that fairness in international flows of capital is difficult to evaluate. The explosion of financial instruments based on derivatives make it extremely difficult to understand even by experts in the field, why the access that many developing nations should have to required capital, either as foreign aid, or foreign direct investment, is not occurring.

Indeed, unlike the expectations that globalization of the markets brought in the last part of the past century, the many financial instruments now available to the world and the fact that speculation has taken hold of the markets, has led the world to a financial system with greater vulnerability to accidents than it ever was before. As a result, time and again we have observed that the possibility that through no fault of its own, a developing nation suddenly finds itself without access to capital in a very quick period of time occurs.

Today, as a result of this globalization process, we are facing two major financial risks which throw initial light on the unfairness of the current system to developing nations. The first one has to do with the proliferation of derivative instruments; the second with an excess appetite for dollar denominated debt to finance current account deficits in large nations. I would like to talk about both today, as I believe they are the source of the great inequality and unfairness in today's world that developing nations face when looking for financial support to their economic programs.

First, proliferation and profusion of financial instruments have increased the potential risks to the international financial system. The instability that they produce, translates into fewer opportunities for financing projects in developing nations. The nominal (face) value of derivative instruments amounts to multiples of global gross domestic product. Based on this massive number, it is easy to tell stories about how a financial crisis can occur, as a chain of interlocking derivative contracts unravels due to a failure to settle one contract, which is hedging another contract, which in turn is a hedge to something else. Pretty soon, as in stories in which the payments system grinds to a halt due to a relatively small payments failure, a small event can be made to have frightening consequences.

Scenarios involving the unraveling of a chain of derivative transactions may be unrealistic, because there are netting arrangements among most institutions which mean that it should generally be possible to offset obligations that have not been settled. Nevertheless, it may be equally possible that the risks that are passed on through derivative contracts may be inappropriately placed and not adequately recognized. For instance, when banks securitize or hedge a risk, the risk migrates to other places -- frequently, it is believed, to insurance companies. The concern is that the risks move from people who understand them to those who do not. If that is the case, the world may soon be facing a major financial collapse; one where poor and disadvantaged nations may end up with the worst part of the cost.

On the other hand, superfluous consumption in developed nations has created an excess demand for funds to finance their current account deficits. The ease with which a country as the United States of America manages to attract funds is remarkable, leading to question a system which provides large amounts to finance consumption, and few resources to finance projects in developing nations which could help them to reach higher levels of growth and ...

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