China Daily European Weekly - - Last Word - By DAVID BLAIR david­blair@chi­na­di­aly.com.cn

No­bel-win­ning econ­o­mist Robert C. Mer­ton says fi­nan­cial in­no­va­tion is key to the fu­ture of Asia

Robert C. Mer­ton’s ca­reer demon­strates how sci­en­tific re­search can tran­sform the real world. The work he did, along with col­leagues My­ron Sc­holes and Fis­cher 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 or risks. Now his work is the foun­da­tion of a tril­lion-dol­lar in­dus­try.“With the op­tions model, we be­came well-known right af­ter writ­ing the mod­els down. Sc­holes and I took it to Wall Street be­fore it was even pub­lished. In two years, it went from be­ing a pure idea to be­ing used by ev­ery­body in the mar­kets,” he says in an in­ter­view with China Daily.

“Texas In­stru­ments cre­ated a spe­cial hand cal­cu­la­tor for the peo­ple on the floor of the Chicago Board Op­tions Ex­change be­cause they didn’t have com­put­ers at that time and weren’t al­lowed to have tele­phones. They couldn’t do it in their head. There was no way they could do this trad­ing without our equa­tions.

“Sc­holes called TI and asked for a roy­alty. They said no, it’s in the pub­lic do­main. We knew that, we put it in the pub­lic do­main. He asked if we could at least get a free cal­cu­la­tor and they said no,” Mer­ton re­calls.

“Fi­nan­cial in­no­va­tion has been enor­mously valu­able, and we’ve made great progress around the world,” he em­pha­sized in a re­cent speech to the Belt and Road EMBA Pro­gram for South­east Asia at the Peo­ple’s Bank of China School of Fi­nance at Ts­inghua Univer­sity.

“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’s not magic. Im­ple­men­ta­tion is a huge part of in­no­va­tion. Those who tell you the real econ­omy and the fi­nan­cial sys­tem are sep­a­rate — that’s a fic­tion,” he said in the speech.

Mer­ton, a long­time pro­fes­sor at Har­vard and MIT and win­ner of the 1997 No­bel Prize in Eco­nom­ics, sees his role as that of an en­gi­neer look­ing for so­lu­tions.

By fi­nan­cial in­no­va­tion, he 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, the bank could be in trou­ble. Mer­ton ex­plains that so-called in­ter­est rate swaps, in which the bank swaps its fixed-rate as­sets with a coun­ter­party that has float­ing rate as­sets, solved this prob­lem that had plagued banks since they were first cre­ated.

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.

“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 or some bad thing hap­pens,” he tells China Daily.

How­ever, not all fi­nan­cial in­no­va­tions are good. “I can’t dream of a way for bit­coin to suc­ceed,” he says.

Mer­ton says that he does not want to give spe­cific ad­vice to China or other coun­tries. But he does want to talk about things that are strate­gic and es­pe­cially wants peo­ple to un­der­stand the ben­e­fits of fi­nan­cial in­no­va­tion.

For ex­am­ple, in his speech to the Belt and Road EMBA stu­dents, Mer­ton made a plea for them to con­sider the role of fi­nance as an in­te­gral part of the Belt and Road Ini­tia­tive.

“When you are think­ing about the Belt and Road over­all, in­fra­struc­ture, roads and trans­porta­tion are im­por­tant. But don’t for­get the fi­nan­cial sys­tem. It may look in­tan­gi­ble, but it’s very real. A well-func­tion­ing fi­nan­cial sys­tem is cen­tral for global eco­nomic de­vel­op­ment. If you are go­ing to re­ally in­te­grate economies along the path of the Belt and Road, you need an in­te­grated fi­nan­cial sys­tem. You don’t have to have one cur­rency or one fi­nan­cial sys­tem. One cur­rency is not usu­ally a good idea. But, the fi­nan­cial sys­tems should work to­gether,” he said.

“The places along the road that don’t have good fi­nan­cial sys­tems are go­ing to be log­jams. If a coun­try does not have it’s own fi­nan­cial sys­tem, it can’t re­ally develop growth op­por­tu­ni­ties. It’s not good enough to say we’ll pro­vide fi­nanc­ing from out­side,” he said.

Mer­ton re­fuses to give ad­vice or an­swer ques­tions out­side his spe­cial­iza­tion.

Im­me­di­ately af­ter find­ing out that he had won a No­bel Prize, he re­ceived ad­vice from Paul Sa­muel­son, who was a very fa­mous econ­o­mist and one of the ear­li­est win­ners of the No­bel for eco­nom­ics.

“Sa­muel­son, who was my men­tor, took me aside and said that the No­bel Prize is not for the re­nais­sance man of eco­nom­ics, it is for a very spe­cific thing. Now, they will think you not only know ev­ery­thing about eco­nom­ics, they will think you know ev­ery­thing. They will ask you med­i­cal ques­tions,” Mer­ton re­calls.

In his speech at the PBC School of Fi­nance, Mer­ton pre­sented his re­search on the costs to Chi­nese inves- tors of not be­ing able to in­vest world­wide. A cen­tral tenet of fi­nance science is that the op­ti­mal trade­off be­tween risk and re­turn for an in­vestor is an in­dex of all the as­sets in the world. Us­ing data from 1993 to 2015, he cal­cu­lates that the ex­pected re­turn to a China-only port­fo­lio would be three per­cent­age points less than that of a world port­fo­lio.

That may not sound like much, but over 24 years, roughly a gen­er­a­tion, a pen­sion fund would lose out on half its po­ten­tial value by not in­vest­ing world­wide. That’s a huge prob­lem for an ag­ing so­ci­ety, he said.

Not want­ing to present a prob­lem without sug­gest­ing a so­lu­tion, Mer­ton pro­posed a fi­nan­cial prod­uct that he calls a “to­tal re­turn swap”.

He pro­posed that China’s pen­sion funds sign con­tracts with large in­sti­tu­tional in­vestors such as the sov­er­eign wealth funds of Nor­way or Sin­ga­pore. The con­tract would say that, each year, the Chi­nese funds pay the out­siders the to­tal re­turns from their in­vest­ments in the Chi­nese stock mar­kets. The out­siders pay the Chi­nese 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. Chi­nese pen­sion funds in­crease their ex­pected re­turns by di­ver­si­fy­ing their risks world­wide. In­ter­na­tional in­vestors, in ex­change, get more ac­cess to the re­turns of the Chi­nese mar­kets. Such a win-win so­lu­tion sig­nif­i­cantly in­creases the real wealth and re­duces the risks of all par­ties, he says.

Mer­ton says that in fall 2012 he made a com­mit­ment to him­self to “re­turn, and re­turn, and re­turn,” to Asia. Last year, he spent more than 15 weeks in the re­gion.

Ex­plain­ing that Asian gov­ern­ments are look­ing se­ri­ously for so­lu­tions, Mer­ton says: “I don’t mind go­ing to Europe as a va­ca­tion, but go­ing there as a pol­icy ad­viser is a night­mare. They don’t even like aca­demics. The US has been do­ing it for a long time and is a lit­tle bet­ter.

“China has to be open,” he adds. “You can­not do Belt and Road and stay a closed econ­omy. You can­not be a world leader and have a re­serve cur­rency if there are cap­i­tal con­trols.”

“China’s mid­dle class is ap­proach­ing the same size as the en­tire pop­u­la­tion of the United States. They will need far dif­fer­ent fi­nan­cial ser­vices. When you get things done is when there is need for such change.”

He says that China’s need for new fi­nan­cial ser­vices, and its com­mit­ment to the Belt and Road, gives it a chance to leapfrog even the best prac­tices of the past to build an in­no­va­tive new fi­nan­cial sys­tem.

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