Turmoil adds a twist to US foreign policy

THE TURMOIL on international markets is causing an unusual amount of introspection in Washington. President Clinton, perhaps the first to practise 'market diplomacy' in pursuit of foreign policy goals, is said to have ordered a review of US relations with Asia that are perceived to be destabilising factors.

The virtual meltdown of the bond market has prompted members of Congress to call for more protections for small investors. Arthur Levitt, chairman of the US Securities and Exchange Commission, also seized the opportunity to propose more aggressive supervision of mutual funds and others using derivative financial products. There has not been this much focus on Wall Street since the 1987 crash.

President Clinton's focus on global economic security as the cornerstone of US foreign policy makes him more sensitive than most US presidents to the reaction of international financial markets. But whether he will engage in 'stock market diplomacy' as suggested by the New York Times remains to be seen.

There is no indication that Mr Clinton has as yet taken foreign policy decisions based on likely market reaction.

The fact that he is pausing to review what many regard as a destabilising Asia policy in response to adverse market reaction is all to the good. But hands-on stock market diplomacy would lead to more White House interference with the Federal Reserve Board, which would not be to the good. There is no question, however, that the globalising of markets and the resulting spread of financial power are much greater checks on US policy.

The power of the markets, notably their impact on small investors, is cause for renewed concern among government regulators. Periodically, there are spasms of intense activity in Washington, whenever Wall Street appears to be getting out of hand. These usually result in legislation or other safeguards. The spotlight this time is on mutual funds because of the tidal wave of small investors who flooded in during the years of low interest rates. Last week members of Congress expressed their concern over two classes of investor: big institutional investors who lost millions in bond hedge funds, and small investors who withdrew savings from banks and put them into bond funds.

A Florida congressman told of a retired couple in Jacksonville who placed dollars 160,000 ( pounds 109,000), or more than 65 per cent of their savings, into a corporate bond fund that has sustained huge losses. In recent weeks there have been double- digit losses in established funds held by many fixed-income investors. Once the magnitude of these losses sinks in, it is feared that Congress will take draconian steps in a tense mid-term election year. Some big houses on Wall Street also sustained heavy losses, which would give Congress more ammunition. The biggest losers were US hedge funds, investment banks and commercial banks that were carrying large bond inventories when the trouble first began in Europe.

Until now Mr Levitt has been a relatively low-profile SEC chairman. In recent weeks he has been speaking out on the role and performance of mutual funds and most particularly about the responsibilies of their outside directors. As a former president of the American Stock Exchange Mr Levitt is not one to support the heavy-handed controls that many critics of derivative products have proposed. But his vision of the newly aggressive outside director as the 'front line' of investor protection may upset more than a few on Wall Street.

He outlined four areas needing more supervision: mutual fund investment in derivatives, portfolio liquidity, personal trading by fund managers, and the shareholder involvement of funds. He also proposed that outside directors analyse the performance and attendance records of their peers to make nominations less automatic.

Concerning derivatives, Mr Levitt said that outside directors must review pricing issues, trading strategies, accounting and internal controls to ensure that small investors are protected.

They should hold portfolio managers to liquidity standards geared to changing market conditions. And personal trading by managers, a grey area, should be regulated by a strict ethics code.

Shareholder activism, a relatively new role for mutual funds and other large institutional investors, should be pursued more aggressively. As big shareholders of companies, funds and their directors should play a more active role in anti-takover measures, proxy fights and executive compensation proposals.

Mr Levitt stopped short of supporting micro-management proposals of the sort now circulating in academia. But the greater role that he proposed for outside directors suggests the rise of a new breed of power brokers on Wall Street.