The simple truth is that governments are playing a far greater role in the global financial system than ever before. The sorry part is that they are acting badly by distorting markets and information. In short, they are acting just like governments

Economists and financial analysts use tools derived from studies of markets and market economies in the developed world to help predict the future direction of the world economies, but there has been a tectonic change. The rise of Asia, emerging economies and the financial crisis has changed the rules. The simple truth is that governments are playing a far greater role in the global financial system than ever before. The sad part is that they are acting badly by distorting markets and information. In short, they are acting just like governments.

For the past two decades, the Japanese government was the largest purchaser of US government bonds. Although in the long bond bull market the value of the bonds did go up, they did not go up in terms of yen as the dollar weakened. So either the Japanese government was among one of the worst investors on the planet or they were not trying to make a profit.

They were buying US Treasuries in an attempt to keep the yen low. A cheap yen acts as a subsidy to Japanese export industries. So the Japanese government happily lost money, taxpayers' money, in order to subsidise its export industry. The fact that it did not work never fazed the government, because in their eyes it worked perfectly. The Liberal Democratic Party stayed in power for almost 54 years.

Now China is the main buyer of US Treasuries for basically the same reason. They are trying to sterilise the renminbi in order to keep their export industries competitive. The losers in this process are the Chinese people who would benefit by a stronger currency. But they don't matter very much. The ruling Communist Party feels that its policies have been very effective in keeping them in power for over 60 years. So why change?

But it is not just Asian countries making political decisions to protect their export industries that are distorting markets. Now the American Federal Reserve is in on the act. The Fed is now the third largest buyer of US Treasury bills. Like the Asian countries, they are not acting like other market participants by trying to make a profit. In theory they are trying to fulfill their government mandate by trying to increase employment.

Not to be outdone, the European Union created the European financial stability facility to buy bonds of European countries like Ireland, Portugal and Greece. The Japanese and Chinese governments are exacerbating the issue by supporting the Euro to insure its survival as an alternative to the dollar, regardless of the cost. This is the problem.

All of these governments are not motivated by profit, so they could care less about price. Their massive buying power helps to distort the price signals from the bond market by artificially depressing yields. The yields are especially important because they are a direct indication of risk.
 
But it is not just currency manipulation or bailouts. Governments all over the world are interfering in markets as never before. Sovereign wealth funds are managing ever larger amounts of money, often not very wisely. Their political masters imagine that they have the abilities of George Soros, but often end up like the clients of Bernie Madoff. In the mean time, their decisions send capital where it ought not to be, overvaluing assets and confusing the reality of risk.

Market phobia also extends to state-owned companies. The collapse of Communism and the retreat of socialism were supposed to put an end to these taxpayer subsidised monoliths. They are not only alive and well, but they are growing. All of the world's largest oil firms are firmly in state hands. Large state-owned companies make up four of the top five companies and 32% of the top 50 companies.

China is supposed to have privatised great swaths of its economy to become a land of one billion capitalists, but the reverse is true. Over the past several years, a programme of renationalisation has been going on in China. This process has been exacerbated by the recession, when the capital available to private enterprises dried up. It is estimated that over 20% went under. Meanwhile, state-owned companies were flooded with capital as the state-owned banks opened their vaults to distribute 16.5 trillion renminbi ($2.5 trillion) in loans.

In the past, there were socialist countries like China, and the former Soviet Union, India and Africa, but their effect on the global economy was tiny. Things have changed. The impact and distortions inflicted on the world's markets will continue. They will often be dramatic, because the political motives of governments are far less predictable than the profit motives of business.  Worse, since governments are the law, there are no legal disincentives requiring any degree of transparency for their actions. So the rise of emerging markets will certainly change global markets, but most likely in ways that the markets and those who analyse them do not expect.    

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected])