A World Too Tightly Wired

April 12 2007 by Robert Lawrence Kuhn


That a drop in the Shanghai Stock Market could trigger a worldwide sell-off exposes, I now believe, a deeper and more insidious problem. It’s suddenly clear. All the efficiencies and luxuries of a tightly wired world have come at a price. The price is fragility, and we are vulnerable.

Here’s the scary part: Nothing fundamentally bad or even unexpected caused the stock drop in Shanghai. The market had more than doubled in value over the past year; there were rumors of a possible capital gains tax; Chinese officials were cautioning about irrational exuberance; lockups of shares owned by state-owned enterprises were expiring; people were returning from their annual Spring Festival vacations; and some decided to take their profits. The correction put hardly a dent in Shanghai‘s stock market gains; furthermore, it was virtually planned by the government. Yet the impact on established exchanges around the globe was astounding. Even with their huge depths of liquidities-the market capitalization of the New York Stock Exchange is 20 times that of Shanghai‘s-the established exchanges were pummeled.

Take what happened as a warning and get prepared for worse. This column is not a happy one.

I write from London where the confluence of three strands of my sometimes schizophrenic life has made me reflect on these matters.  First, as an investment banker, I am talking to European CEOs about China. Every company, I tell them, has a China strategy, whether it knows it or not. China will figure in the futures of most large companies, whether as supplier, customer, competitor or, in many cases, as all three. Even those companies with strong home markets will need China, in one way or another, to secure those home markets. An economically powerful China changes all the rules.

Second, as editor in chief of a just-published book, China‘s Banking and Financial Markets: The Internal Research Report of the Chinese Government, I find myself in the eye of the stock storm. The topic is front-page news, and journalists want to understand what China‘s financial markets are all about. My initial reaction to press questions was to dismiss the putative problem as artificial, naïve or silly. But as I continued to explain the banality of the Shanghai market correction and the inappropriateness of the worldwide swoon in response, I began to sense that we do have a real problem on our hands, and it is precisely this exaggerated reaction. Chaos theory in action, I speculated, where a small perturbation somewhere gets unpredictably amplified so that it causes far-reaching consequences elsewhere. To apply the classic metaphor, consider the Shanghai Stock Market as the butterfly which flaps its wings in China and by so doing triggers a cascading series of events that causes storm clouds to gather in New York.

Third, I am in the U.K. as creator and host of the PBS TV series Closer To Truth, taping interviews with leading scientists and philosophers in Oxford, Cambridge and London. When I was with Sir Martin Rees, the Astronomer Royal and president of the Royal Society, in addition to discussing the origin of the universe and multiple universes, we also considered Rees’ Jeremiahic book, Our Final Hour: A Scientist’s Warning: How Terror, Error, and Environmental Disaster Threaten Humankind’s Future In This Century-On Earth and Beyond. Rees enumerates all manner of mechanisms, from genetically engineered viruses and self-replicating nano-robots to global warming and determined terrorists, which can destroy our species. Making his point with a wager he’d prefer not win, Rees has famously bet $1,000 that a biological event will kill one million people by 2020. He states: “In this increasingly interconnected world where individuals have more power than ever before at their fingertips, society should worry more about some kind of massive calamity, however improbable.”

Why are We Vulnerable?

So we are vulnerable, our financial markets even more so. Consider three underlying causes.

Competitive Pressure for Returns. The increasingly fierce competition among investment funds, especially hedge funds and private equity, to generate above-average returns-the holy grail of investment managers-threatens to distort portfolio theory and warp relationships between risk and return. At the margin, more units of increased risk must be assumed in order to generate a single unit of increased return, so that inordinate risks are taken. High risk is doubly encouraged since managers of these funds are betting other people’s money, and while they are incentivized to receive a generous percentage of profits they may make, they are not punished by absorbing any of the losses they may incur.

Financial Interconnectivity. World financial systems have become so ecologically interconnected that any perturbation can shake the entire system. Financial institutions are like mountain climbers inextricably attached by belts; while in most circumstances such linkage provides safety, under some conditions it can pull them all down together.

Instant and Pervasive Communications. Conflicts exist among religions, ethnicities and contiguous states; and isolated individuals, consumed by misguided mission or media-massaged hate, can cause great damage. Television and the Internet personalize problems, feeding frustrations and heating emotions to the point of combustion. Indeed, with intense competition among news organizations, the sensational, the lurid and the horrid is often emphasized, even exaggerated. There is no time for digestion of news, for absorption, consideration and amelioration of events, for hotheaded feelings to dissipate. Reaction must be instant and instant reaction facilitates runaway reaction.

What Can Be Done?

Astute business executives should consider the following precautions and preparations.

Develop Redundancies. Think redundant. Get redundant. Do not be dependent on any one thing: not on one location, not on one product, not on one person, not on one system. For example, even if China is your low-cost producer, it may make sense to maintain a secondary source in a different region, even if the cost is higher.

Mitigate Risks. Do not take on too much debt and do not place bets that are too large. Deleverage your balance sheet; while this reduces returns under most market conditions, it makes the enterprise much more robust under extreme conditions.

Scenario Planning. Take simulation seriously. Require your enterprise to run, and to keep current, detailed scenarios of strategy and operations under different hypothetical external conditions, including those resulting from capital market disruptions. Even though reality will not conform precisely to any one of your firm’s specific scenarios, the fact that you have prepared the scenarios and thought carefully about each will enable you and your team to react more intelligently and with less panic to any real exigency.

Disaster Planning. Review your disaster plan on a regular basis; keep it current by embedding recent corporate changes. In most companies, managing the disaster plan is not a career-enhancing task, but CEOs can make sure it is taken seriously by giving those people responsible proper recognition and reward.

What I am advocating may not sound very exciting and in normal times may reduce profitability and constrain enterprise value. But when unexpected events cause markets to shudder, your company will be rewarded for its relative strength. I say “when,” not “if,” because I am no longer sanguine about our collective future. I tell myself that people of every generation have thought their times to have been special and that, though tragedies have happened, in the end things always seemed to have worked out well. I do not think that this pattern is any longer reliable or predictive. The world is now wired too tightly; there is no slack in the system, no give for sudden movement. And sudden movements, I fear, will come.

Robert Lawrence Kuhn, an international investment banker and corporate strategist, is senior adviser at Citigroup where he focuses on China. He is editor in chief of a new book, China‘s Banking and Financial Markets: The Internal Report of the Chinese Government. His articles describing and explaining investment banking, which advise business executives on how to optimize investment banking products and services, To learn about it kindly click on following links.