Financial innovation has been critical to progress around the world. A well-functioning financial system, one that allows risk management, raising funds and so forth, is a mechanism by which scientific or technological ideas get turned into growth. It is not magic or an illusion, but simply put, when practical ideas get successfully implemented in a commercial manner, it forms the basis of real time innovation and its entrepreneurship. Anyone claiming that real economy and the financial system are two separate things is indulging in nothing but fiction. Financial innovation means creating new types of tools and financial contracts that allow people to eliminate unnecessary risk or to be more efficient and productive. For example, the main historical problem for banks is that their funding, mostly deposits, is short-term but their loans are long-term with fixed interest rates. If interest rates rise, a bank could be in trouble. However, the financial tool innovation of interest rate swaps, where the bank swaps its fixed-rate assets with a counterparty that has floating rate assets, solved this problem – something that had plagued the banks ever since they were first created.
An economic engineer looking for financial solutions, Robert C. Merton, Nobel Laureate in Economic Sciences - 1997, career demonstrates how research can transform the real world. The work he did along with colleagues Myron Scholes and Fisher Black, in the early 1970s on how to calculate the value of options and other derivatives was immediately useful to banks, traders, investors and other financial practitioners. Before this work, many useful financial products could not be made available because no one knew how to determine the costs and risks. Now his work is the foundation of a trillion-dollar industry. Merton & Scholes (M&S) Options Model was immediately adopted by Wall Street even before it was officially published and within two years from being a pure idea it was being used by nearly everyone in the markets. Texas Instruments (TI) created a special hand calculator with it for the people on the floor of the Chicago Board Options Exchange because they didn’t have computers at that time; weren’t allowed to have telephones and of course couldn’t possibly do it in their head. Without the M&S equations there would have been no TI calculator and without this calculator and onward technological advancements in the field, there was no way that markets could have reached their renewed level of trading the world is witnessing today. Ironically TI never gave any royalty to M&S, in fact even refused them a free calculator!
When one talks about globalization or linking the economies of the world, the underlying fabric is always a financial order that allows all financial systems to work together. No need to have a common currency – in fact one currency more often than not can be counterproductive to individual financial options of a country – or even a common financial system, but just a well-functioning economic system in the economy that blends well with the overall global economic system. This is where financial innovation plays a big role. If a country does not have its own home grown innovative financial solutions, it can’t really develop growth opportunities. It will invariably be depending on outside help and it is not good enough to say we will arrange financing from outside.
For example, high savings rates more often reflect a poor financial system than a culture of saving for the future. If you have a well functioning financial system, you don’t have to save personally for that one chance that your house burns down or something bad happens – Insurance, which is a financial product, allows people to be prepared for catastrophic events without having to set aside a huge portion of their wealth as a safety net.
So what would be Merton’s specific advice to Pakistan? One that he says is a fit for all developing economies, including those in South Asia. For starters, he feels that they need to create safety nets and a good way to do this – at least in the organized sector – would be for the pension fund institutions to sign contracts with large institutional investors such as the sovereign wealth funds of Norway or Singapore. The contract should say that, each year, the local funds pay the outsiders the total returns from their investments in the domestic stock markets. The outsiders pay the local funds the gains from the world index fund. No actual stocks change hands and capital controls can remain in place. This illustrates how financial innovation can solve a problem. Local pension funds increase their expected returns by diversifying their risks worldwide. International investors, in exchange, get more access to the returns of the respective South Asian markets. Such a win-win solution significantly increases the real wealth and reduces the risks of all parties.
However, for his proposals to work, Pakistan has to further open up its financial markets. One cannot freely connect with the world and truly reap the benefits of globalization by staying a closed economy. Pakistan’s strong, robust and ever developing middle class is approaching almost the same size or perhaps more than most developed European economies and not only will it need different cum better financial services but it will also require a better and a more connected financial system that allows it to maximize its potential. Pakistan’s need for genuinely new financial services can only be achieved by its commitment to, if need be, even leapfrog the best practices of the past in order to build a new innovative financial system tailored to meet its own specific needs and requirements in the years ahead.
The writer is an entrepreneur and economic analyst.