Do not forget the lessons of Asia
We are back to the capital markets crises which were a feature of the business cycle before the 1929 crash
Monday 09 August 1999
The good news is that some have been growing like a rocket. Most impressively, South Korea posted industrial production up 21.8 per cent over the year to May and Thai industrial production was up 7.2 per cent.
Even Indonesian and Russian production is edging up, despite their respective political uncertainties, while the first glimmers of recovery are now visible in Brazil.
The bad news is that this growth is following unusually sharp falls in output: the recessions in the three Asian crisis economies were greater than the falls in the Western economies during the Great Depression of 1929-31. Indonesian national output dropped 14 per cent last year, putting the world's third most populous country under enormous social stress.
Even as the recovery begins, it is worth trying to ensure that this never happens again. That, however, may prove difficult. The various official groups which have been set to work on the lessons of the crisis - the Willard group, the Group of 10 industrial countries deputies and so forth - are coming to no more radical conclusions than they did after the Mexican crisis in 1994-95. That is politically understandable, given that the developed world runs the world's financial institutions and was relatively untouched by the crisis, but it is a mistake.
The 1997-99 crisis may be the first of many in the same mould. We are back to the capital markets crises which were such a feature of the classical business cycle up until the great crash in 1929.
What was new about the Asian crises was that there was no public sector profligacy in the way that there had been, arguably, in the 1982-4 Latin American crises. Public spending was under control. Budget deficits were negligible. Public sector debt was small and declining as share of GDP.
The problem was excessive private sector expansion, funded by short-term foreign lending (with a maturity typically less than a year). Those flows could therefore reverse quickly should investor sentiment change: not only would the on-going needs of the economy fail to be met, but the country had to find liquidity to meet capital outflows as well. Imports had to be slashed, and domestic demand and output collapsed.
The volatile funding of these emerging markets looked very much like that of banks: reliant on short term deposits which they were turning into long-term, illiquid investments. Like banks, they were also vulnerable to a depositor panic. If depositors believed that other depositors would try to get their money out, the rational course of action was to withdraw their own deposits first.
The Asian crisis was like a good, old-fashioned nineteenth century bank run. The solution to the problem of bank depositor panics was the "lender of last resort".
Ultimately, the central bank would agree to provide cash to meet depositor withdrawals so long as it was convinced that the bank was solvent - its assets outstripped its liabilities - but merely illiquid - it could not turn the assets into cash quickly.
For countries, the nearest institution fulfilling such a role is the International Monetary Fund.
The ideal IMF operation was its support of the UK in 1976: the very announcement that it was going to extend funds to the Labour government turned market confidence. The private funds came flooding back, and Britain never needed to draw on the IMF's facilities.
Since then, the IMF's magic has waned, not least because the size of its resources has dwindled by comparison with international trade let alone the vast international capital flows.
And in the case of Russia last summer, the markets simply did not believe that the IMF was pledging enough resources to provide investors with their cash if they wanted to get out. And therefore it remained rational for those investors to get out before everybody else tried to do so. The IMF's programme failed in record time.
There is no reason in principle why the IMF could not discipline the markets as it used to: the IMF has the right to issue its own currency, the Special Drawing Right. In principle, it could be just like a central bank in its relations with commercial banks: able to print money to staunch any panic.
In practice, politics gets in the way. The industrial countries have never been happy to have a rival source of hard money creation, and the United States Congress has been reluctant to vote increased resources for the IMF because of the problem of "moral hazard".
This is familiar to people in the insurance markets: if you insure a building against loss, it is more likely to suffer a fire or a theft because people become less careful.
This phenomenon is less significant in the case of the emerging markets, because so many investors had their fingers burned. But it certainly exists.
The institutions that did better out of Asia were the Western and Japanese commercial banks, whose short term loans were rolled over at longer maturities and higher interest rates.
One approach would be the gradual introduction into bond and inter-bank lending documentation of clauses that allowed a standstill during which creditors and debtors could negotiate some rescheduling, rather as a liquidator of a private company can call a creditor standstill to see what can be salvaged. This is in the interests not merely of the employees and shareholders, but also of the creditors because they stand a better chance of getting something back from an orderly work-out than from a panic.The best way to implement the change would be for the G7 themselves to set an example with their own practices.
Will it happen? I hope so, but I doubt it. In the past, major changes in the international financial architecture have only occurred in the wake of a systemic crisis which threatened the leading players. In the absence of wider changes, the emerging markets would be wise to mind their own backs.
Openness to world competition, opportunity and investment brings enormous advantages: look at Korea's growth from a level of income per head like Sudan's in the early sixties to Greece's or Portugal's today.
But it is sensible to encourage long-term capital - such as foreign direct investment which brings with it plant, equipment and know-how - and discourage the more volatile cash which can pour into Treasury bills or local banks.
The right economic model is Chile, which was the only Latin American country in the 1982 crisis which got into trouble because of private sector borrowing and therefore learned the lesson of 1997-98 15 years early. It imposed an encaje - an interest-free deposit equal to the foreign investment - that had to be placed with the central bank for a given period of months (usually three).
This was effectively a penal tax on short term money, and an insignificant tax on long term investment. As a result of deterring volatile short term money, Chile has been able to weather the storm relatively well despite the fall in the price of copper (which accounts for more than 40 per cent of exports).
In short, beware of foreigners bearing gifts.
Not all money is as committed as foreign direct investment. The successful emerging markets over the next 10 years are likely to be those that are open to trade and investment - but avoid the perils of short-term speculative flows.
Christopher Huhne, a Liberal Democrat member of the European Parliament's economic and monetary affairs committee, was the founder of the country risk team at Fitch IBCA, the international rating agency, where he is vice-chairman
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