Chapter 6: Financial Crises



Asian Crisis Notes

We first look at the events leading up to the Asian Crisis in S. Korea. Much of the following material was obtained from “South Korea: The Country that Invested its way into Trouble,” Thursday, January 15, 1998, Financial Times, by John Burton and Gerard Baker.

Early 1993 - Kim Young-sam became president - he was a populist politician and took office during a mild recession. He promised to boost growth. He did so by encouraging Korea’s giant diversified conglomerates, or Chaebol, to invest heavily in new factories. Korea enjoyed an investment-led economic boom in 1994-1995, but at a cost. The Chaebol, always heavily reliant on borrowing, now had huge debts - four times equity on average - and excess production capacity (they were too big!).

In 1996, overcapacity led to falling prices for the nation’s main export products. Prices for computer memory chips, Korea’s largest export, collapsed in a glutted global market. Earnings of chip makers fell by 90%. Cars, shipbuilding, steel and petrochemicals were also affected.

Short-term foreign borrowing by industrial groups rose rapidly as they struggled to service their long-term debts. Foreign loans were particularly attractive to the Chaebol since they carried lower interest rates than domestic loans, which reflected a capital shortage that resulted from Korea’s closed financial markets.

(note: prescriptions from the IMF included breaking up the Chaebol as well as opening up financial markets)

The corporate debt bomb was primed to explode.

January 1997 - Hanbo Steel collapsed under $ 6 billion in debts - the first conglomerate (Chaebol) to fall. Hanbo was a prime example of the Crony Capitalism that pervaded (saturated) S. Korea. Crony Capitalism is where politics and business are intertwined. Banks had been forced by the government to lend to the steel maker.

Politics played a big role here. President Kim forced through a labor law during a secret session of parliament in early January. The labor union went on strike for three weeks and Kim lost his authority (labor unions in S. Korea are very powerful). Given the loss of authority and the close connection of the government and banks, the banks felt strong enough to refuse to provide more loans to Hanbo.

Political scandals erupted and in March 1997, Kim appointed a new finance minister Mr. Kang (his 7th). Kang took over a ministry that was notorious for being opposed to economic reforms. Mr. Kang vowed to change the ministry from being opposed to economic reforms to being supportive of them (he was a firm believer in free market principles). Within days of Kang’s appointment, Sammi Steel, Korea’s big specialty steel maker was allowed to fail.

By now the wider Asian crisis was under way, sapping confidence in Korean companies as well the Korean currency (won). Kang’s commitment to free market reforms was put to the test in July 1997 when Korea’s third largest carmaker (Kia) ran out of cash and asked for emergency bank loans to avoid bankruptcy. At the same time, Korea’s largest liquor group, Jinro, became the third conglomerate to go bust in 1997. Given the financial troubles of the Chaebol, the international credit agencies began to downgrade the ratings for the banks with heavy exposure to the troubled Chaebol.

By October 1997, Kim was under intense pressure and intense criticism for refusing to bail out Kia. Politics are very relevant here as presidential elections were coming up in December, and Kim was by no means a “shoe-in” for reelection. So on October 22, 1997, Kim relented. After the banks refused to provide loans to Kia, Kim nationalized the carmaker.

Standard & Poor’s (a US credit rating agency) promptly downgraded Korea’s debt. By coincidence, this decision to nationalize Kia came at the same time as the speculative attack on the Hong Kong dollar and the crash of the Hong Kong Stock market.

The two events triggered an outflow of foreign capital as investors dumped their holdings of Korean equities and bonds (note - there is a debate on whether flows of foreign capital should be restricted - Greenspan, among many others, is against restricting the free flow of capital). Foreign banks began to refuse to roll over short-term loans to Korea. By early November (1997), the slide in the won was accelerating. Foreign currency reserves started the month at $30 billion and within two weeks, were slashed in half (the central bank pulled wons off of the market by purchasing them with foreign currency reserves, hoping to maintain its value relative to the US dollar).

Korean officials began scrambling to enlist direct US and Japanese support - hoping to avoid the strict conditions that the IMF would impose. The US Treasury quickly made it clear that their requests would be fruitless.

Korean officials then pursued commercial banks in hopes that they would agree to reschedule Korea’s massive foreign debt. For a few days, commercial bankers tossed around the idea and after a few days, it was clear that this strategy would fail as well. Korean officials feared that the news of negotiations would be interpreted as a moratorium on Korea’s debt. Capital would flow out of every emerging market (Korean banks were also exposed heavily to other emerging markets). The officials felt that it was best to let the IMF handle it.

On the night of Thursday, November 13, Mr. Kang, the finance minister, the central bank governor, and the president’s chief economic adviser decided that Korea had no choice but to call in the IMF. Mr. Camdessus (head of the IMF) was asked to come secretly to Seoul that weekend.

During the meeting with Mr. Camdessus, Mr. Kang proposed to announce the request for an IMF rescue the following Wednesday, November 19, 1997. The announcement would be linked to two reform packages:

1. Immediate new laws to improve the government’s financial supervision; give independence to the central bank on monetary policy; and require consolidated accounts from the Chaebol (increase transparency).

2. Widen access to Korea’s financial markets for foreign investors and ease trading limits on the won.

An indication of the change in policy came on Monday, November 17 when the won was allowed to drop below the psychological threshold of 1,000 to the US dollar as the central bank abandoned intervention in the foreign exchange market. But Kang’s plans quickly unraveled. The very next day, on Tuesday, November 18, the parliament refused to pass the financial reform laws. On the morning of the day scheduled for the IMF request announcement, Kang (the finance minister) was sacked!!

Kim figured that Kang was not the right man to negotiate with the IMF. Instead, Kim appointed Lim Chang-yuel, the trade and industry minister to replace Kang. Lim had a reputation as being a tough negotiator. He also served with the IMF in the late 1980s, which might help him get a “better deal” for Korea.

On the day of the originally proposed Kang announcement, Lim announced his own financial stabilization package. The daily trading ban for the won was widened to 10 per cent from 2.5 per cent (Kang wanted to widen it to 15 per cent). Lim also announced a 10 billion won government fund to liquidate bad bank loans (banks were hurting - the Chaebols were not paying their debts) and the government promised to merge “shaky” financial institutions (the IMF wanted Korea to let these shaky banks fail - very difficult (politically) to do in S. Korea given the Crony Capitalism).

These announcements were in line with Kang’s plans but there was no request to the IMF! Since there was no request, the won dropped 10% the next day (November 20). Lim hastily called a news conference the next night and formally announced a Korean request for $20 billion in stand-by IMF loans. The following week, a team of IMF officials arrived to begin formal negotiations.

Back in Washington DC, the pace of negotiations was intense. The Thanksgiving holiday was one to remember for at least three senior members of the Clinton administration - as their families complained that their Thanksgiving Dinners were interrupted by lengthy conversations between the Treasury, the White House, and S. Korea.

Among other things, foreign policy issues were at stake. “This was happening in a country that faced a million enemy soldiers across its border,” said one US official. North Korea had problems of its own, but the US feared that N. Korea would take advantage of S. Korea’s susceptible position. With 37,000 US troops in S. Korea, the US interest in resolving the crisis was clear.

On the morning of Friday, November 28, 1997, Kim got a phone call from President Clinton that would drastically speed up the pace of the IMF negotiations with S. Korea. The US felt that S. Korea was close to defaulting in the first week in December. For 15 minutes, Clinton outlined the dire situation that Korea confronted and suggested a deadline of Monday, December 1, 1997 for the end of the IMF negotiations. He warned that S. Korea would be “severely punished” by the international financial community if a deal was not quickly reached. He promised US financial support as a second line of defense if an accord was reached.

Shaken, Kim ordered Lim to reach an IMF agreement by December 1. Frantic negotiations were conducted over that weekend - by Sunday night, Lim announced that an agreement had been reached.

The claim was premature. Mr. Camdessus, who was in Kuala Lumpar at the time, refused to approve the deal because S. Korea was still reluctant to close down insolvent financial institutions. He flew to Seoul to intervene directly. During a courtesy call to Kim, he insisted that the three presidential candidates (election was on December 18) must promise, in writing, to obey the proposed agreement.

Koreans felt that Camdessus’s demand was arrogant. After an initial refusal, Kim saved face by compromising the demand: the candidates would address their promise of support to Kim himself, rather than the IMF. Camdessus continued to discuss the problem of insolvent banks with the finance minister, Mr. Lim.

A scheduled luncheon in which Mr. Camdessus was to host Korean financial officials and ambassadors from Western nations that would contribute to the bail out went ahead on schedule. Mrs. Camdessus hosted the luncheon in her husband’s place. During the luncheon she (a former nurse) pointedly told the Korean officials that “the one thing that I learned from the medical profession was that it was not only the medicine that counted, but the way that the patient takes it.”

Mrs. Camdessus’s remark proved prophetic. A $55 billion IMF deal was signed that evening - and started unraveling almost immediately.

On December 8, 1997, a leading Korean newspaper revealed a confidential IMF document that said Korea’s short term foreign debt was more than $100 billion, nearly twice as big as previously thought. The same day, Lim announced that the government would take over Korea’s two weakest banks - instead of closing them as the IMF conditions called for. And Daewoo, one of the Chaebols, bought debt-laden Ssangyong Motors under a deal that forced Ssangyong’s creditor banks to share much of the financial burden.

Due to these events, foreign banks questioned S. Korea’s commitment to undertaking and then abiding by the IMF reforms. Overseas banks refused to roll over loans, foreign investors fled the Seoul bourse (Korean stock market), and the won “dropped like a stone.”

Critics of the IMF argued that the conditions it was imposing were too strict. Other critics complained that the US was contributing to a bailout that would save Western banks from facing up to the consequences of imprudent lending (the moral hazard problem).

Korean Politics

Kim Dae-jung, the veteran centre-left opposition leader, took advantage of the popular unhappiness over the IMF deal. His party proclaimed December 3 as “national economic humiliation day.” He criticized the IMF agreement as representing a “loss of economic sovereignty.” Promising to renegotiate the deal’s terms to avoid job losses, Mr. Kim received a bounce of support that made him the front-runner.

As foreign investors reacted to Mr. Kim’s (Dae-jung) lack of support of the IMF plan, Mr. Lee Hoi-chang, the government candidate, accused him of worsening the nation’s financial turmoil with “irresponsible” remarks. Mr. Kim retreated and sent a letter to Mr. Camdessus promising full compliance with the IMF’s terms. Kim Dae-jung won the presidential election by a narrow margin.

Shortly after the election, Kim sent Kim Ki-hwan, Korea’s roving ambassador for economic policy, to discuss a new financial aid package with the US.

The reason was that despite the initial inflow of IMF funds, Korea would exhaust its foreign currency reserves by the end of the month. The ambassador hoped to persuade the IMF, the US, and other lenders to speed up payment of the next installment of funds. The ambassador arrived in Washington DC on December 18 carrying a new set of proposals known as “IMF plus.”

In a meeting with Lawrence Summers, the deputy US Secretary of the Treasury, the ambassador admitted that Korea was days away from a debt moratorium. He promised that Korea would support tougher measures in return for aid.

Initially, the US was unenthusiastic - Robert Rubin (the US Secretary of the Treasury) was still confident that Korea would not need an accelerated payment program. The attitude did not last. At dinner that evening (December 18), Rubin, Greenspan and others worried that a Korean default would cause a banking crisis in Japan - Japan held $25 billion in Korean debt. They also worried about financial turmoil in other emerging markets where Korean banks were heavy investors. Something had to be done.

The shift in the US approach was followed by reassurance from Korea. The president stated that his top priority was to improve Korea’s economic competitiveness rather than protect job security.

On the same day (December 22) Moody’s investor service and Standard & Poor’s, the leading US credit agencies, reduced Korean state and corporate bonds to junk bond status (junk status is as low as it gets).

The final details of the “IMF plus” proposal were being negotiated with the finance ministry, including the rapid opening of financial markets to overseas investors. At the stroke of midnight on Christmas Eve, Lim announced that the IMF and eight country lenders had agreed to advance $10 billion to Korea to prevent a debt default. The worst seemed to be over.

Brief Chronology of the E. Asian Financial Crisis; June 19 through October 23, 1997 - The Meltdown

June 19 - Amnuay Viravan, staunchly against devaluing the baht, resigns as Thailand's finance minister. The Prime Minister, Chavalit Yongchaiyudh says: "We will never devalue the baht." The resignation has immediate financial impact in the Philippines, where the overnight (interest) rate rises to 15 percent.

June 27 - The Thai central bank suspends operations of 16 cash-strapped finance companies and orders them to submit merger or consolidation plans.

June 30 - Thai Prime Minister Chavalit Yonchaiyudh assures the nation in a televised address "that there will be no devaluation of the baht."

July 2 - The Bank of Thailand announces a managed float of the baht and calls on the

International Monetary Fund for "technical assistance." The announcement effectively devalues the baht by about 15-20 percent. It ends at a record low of 28.80 to the dollar. This is the trigger for the East Asian crisis. In Manila, the Philippines central bank is forced to intervene heavily to defend the peso.

July 3 - The Philippine central bank raises the overnight lending rate to 24 percent from 15 percent.

July 8 - Malaysia's central bank - Bank Negara has to intervene aggressively to defend the ringgit. The intervention works and the currency hits a high of 2.5100/10 after a low of 2.5240/50.

July 11 - The Philippine central bank says in a statement it will allow the peso to move in a wider range against the dollar. The IMF backs the move and Managing Director Camdessus says he would recommend the IMF board approve the Philippines' request for an extension of its Extended Fund Facility (EFF). In Indonesia, the rupiah is starting to be affected. In a surprise move, Jakarta widens its rupiah

trading band to 12 from 8 percent.

July 14 - The IMF offers the Philippines almost $1.1 billion in financial support under fast-track regulations drawn up after the 1995 Mexican crisis. The Malaysian central bank abandons the defense of the ringgit.

July 17 - The Singapore monetary authority allows the depreciation of the S$. It falls to its lowest level since February 1995.

July 24 - Currency meltdown. The ringgit hits 38-month low of 2.6530 to the dollar. Malaysian Prime Minister Mahathir Mohamad launches bitter attack on "rogue speculators." The Hong Kong dollar remains steady, but Hong Kong later reveals US$1 billion was spent on intervention during a period of two hours on an unspecified day in July.

July 26 - Malaysian PM Mahathir names hedge fund manager George Soros as the man

responsible for the attack on the ringgit. He later brands Soros a "moron."

July 28 - Thailand calls in the IMF.

Aug. 5 - Thailand unveils austerity plan and complete revamp of finance sector as part of IMF suggested policies for a rescue package. Central bank suspends 48 finance firms.

Aug. 11 - The IMF unveils in Tokyo a rescue package for Thailand including loans totaling $16 billion from the IMF and Asian nations.

Aug. 13 - The Indonesian rupiah begins to come under severe pressure. It hits a historic low of 2,682 to the dollar before ending at 2,655. The central bank actively intervenes in its defense.

Aug. 14 - Indonesia abolishes its system of managing the exchange rate through the use of a band and allows it to float. The rupiah plunges to 2,755. Bank Indonesia tries mopping up liquidity with high interest rates.

Aug 15 - Speculators attack Hong Kong dollar; overnight interest rates up 150 basis points from previous day to 8%. Stock market sharply lower.

Aug. 16 - An unnamed Beijing source tells a local Hong Kong newspaper that China is prepared to use US$50 billion to defend the Hong Kong dollar.

Aug. 20 - IMF approves a $3.9 billion credit for Thailand. The package now totals $16.7

billion.

Aug. 23 - Malaysian PM Mahathir Mohamad blames US financier George Soros for leading attack on East Asian currencies: "All these countries have spent 40 years trying to build up their economies and a moron like Soros comes along."

Sept. 4 - Carnage in the Philippine peso continues. It falls to a record low of 32.43 to the dollar before central bank intervention helps it up slightly to end at 32.38. Malaysian Ringgit breaks through 3.0000 to the dollar barrier. Mahathir delays several multi-billion dollar construction projects.

Sept. 16 - Indonesia says it will postpone projects worth 39 trillion rupiah in an attempt to slash the budget shortfall.

Sept. 20 - Mahathir tells delegates to the IMF/World Bank annual conference in Hong Kong that currency trading is immoral and should be stopped.

Sept. 21 - Soros says "Dr. Mahathir is a menace to his own country."

Oct. 1 - Mahathir repeats his siren call for tighter regulation, or a total ban, on forex trading. The currency falls four percent in less than two hours to a low of 3.4080.

Oct. 6 - The Indonesian rupiah hits a low of 3,845.

Oct. 8 - Indonesia says it will ask the IMF for financial assistance.

Oct. 14 - Vietnam, bowing to months of pressure on its dong currency, doubles the permitted trading range to 10 percent on either side of the daily official rate. Devaluation of the Taiwan dollar.

Oct. 17 Friday - Malaysia presents a belt-tightening budget to try to stop the economy from sliding into recession.

Oct. 20-23 Monday - Thursday - The Hong Kong stock market suffers its heaviest drubbing ever, shedding nearly a quarter of its value in four days on fears over interest rates and pressures on the Hong Kong dollar. The fall, more severe than the 1987 crash, forces the Hang Seng index down 23.34 percent down to 10,426.30 at Thursday's close, after 13,601.01 the previous Friday. The devaluation of the Taiwan dollar the previous week, the latest in a string of Southeast Asian currency devaluations, created doubt about Hong Kong changing its long-standing peg to the U.S. dollar."I think the biggest thing to scare Hong Kong was the devaluation in Taiwan," said John Bender, vice president at HSBC James Capel. "[Taiwan] is a country with substantial foreign exchange reserves." In short, Taiwan is a lot like Hong Kong and Taiwan was unable to keep up the link. Taiwan's dollar has fared poorly since the devaluation, dropping about 5 percent, and is currently valued at 30.23 to the U.S. dollar. The Hong Kong dollar is at about 7.50 to the U.S. dollar.

Causes of the East Asian Crisis (also read pages 189 – 198 –Mishkin, Chapter 8 – Seventh Edition)

The causes of the Asian Crisis will be debated for some time. The following article is a good place to start (also see Greenspan’s prepared text “Lessons from the Global Crises” that follows the Russian Crisis notes).

Wall Street Journal, February 4 ,1998

Too Much Government Control

By CHARLES WOLF JR.

Asia's financial earthquake is the second biggest international surprise of the past decade. The first, and weightier, one was the demise of the Soviet Union. Like the 1991 Soviet shock, Asia's financial hemorrhaging has had many causes. The ensuing debate has largely focused on their relative importance.

The primary cause of the Asian crisis, however, has been largely obscured: namely, the legacy of the so-called Japanese development model, and its perverse consequences. Subsequently relabeled the Asian development model as its variants were applied elsewhere in the region, this strategy of economic growth has been grandly extolled in the past two decades. Its strongest proponents included Eisuke Sakakibara, presently Japan's vice minister of finance, Malaysian Prime Minister Mahathir Mohamad, and such Western commentators as Karel van Wolferen, Chalmers Johnson, James Fallows and Clyde Prestowitz. What we are now seeing in Asia's financial turbulence are the

model's accumulated shortcomings.

This is not to deny the role of other proximate causes, including short-term borrowing by Asian banks and companies, and their long-term lending or investing; the failure of the money-center banks in Japan, the U.S. and Germany that provided the mounting short-term credit to exercise due diligence; and foreign investors' unrealistic assumptions that Asian currencies' pegs to the U.S. dollar would be maintained. But these proximate causes are traceable to or abetted by the primary cause: widespread insulation from

market forces.

The Asian development model began with a conceptual framework largely built by American and Japanese academic economists. Central to it is the phenomenon of "market failure": the predictable inability of market mechanisms to achieve maximum efficiency and to encourage growth when confronting "economies of scale" and "path dependence." These conditions may lead to monopolies in the advanced economies and the extinction of competition from late-starters in the development process. If the objectively based decisions of the marketplace are recognized to have such predictable shortcomings, the argument has run, then subjectively based decisions by government agencies or key individuals could improve upon market outcomes.

In the original version of the model, these subjective judgments were provided by Japan's Ministry of International Trade and Industry and Ministry of Finance, in collaboration with targeted export industries believed to be associated with economies of scale. MITI and the Ministry of Finance tagged these "winners" to receive preferred access to capital, as well as protection in domestic markets through the use of tariffs or nontariff barriers to limit foreign competition.

In the Korean variant of the model, the subjective judgments as to who and what would receive preferences--often the same industries targeted by Japan--were exercised by the president, the industrial conglomerates and these chaebols' associated banks. In the Indonesian variant, the subjective oracular sources have been President Suharto and his extended family and hangers-on, in conjunction with B.J. Habibie's self-styled technological community at the Ministry of Research and Technology.

To be sure, the Japanese model and its variants produced noteworthy accomplishments. Vast amounts of savings and investment were mobilized for and channeled to the anointed industries and firms. While substantial resources were wasted in the process--for example, MITI's blunders in the case of steel, shipbuilding and aircraft--the scale of resource commitments led to world-class performance in other cases--notably in cars, consumer electronics, telecommunications equipment and semiconductors in Japan, similar heavy-industrial development in Korea, and light-industry development in Indonesia.

But the negative effects of the Asian model were cumulatively enormous, including the following:

Wasted resources when non-market choice processes made mistaken decisions, such as

Indonesia's large investments in a national car and in a domestic aircraft industry. These

non-market failures account for the fact that Asia's economic growth has been mainly due to large inputs of capital and labor, with relatively limited improvement in productivity. Structural imbalances due to overemphasis on export industries and neglect of the domestic economy. As a result, domestic production has been shortchanged, and consumption standards held down in favor of aggressive pursuit of export markets. Excess capacity has been built up in export industries through the arbitrary processes of "picking winners." Failure to take adequate account of demand saturation while production continued to expand has contributed to currency depreciation, falling prices and sharply adverse changes in Asia's terms of trade. A sense of hubris among the favored industries, firms and individuals. When these entities confronted market tests that they could not meet, they and their foreign lenders expected to be bailed out with additional resources, often publicly funded or guaranteed. Whether the shortfall was in an old-line major banking house (Japan's Yamaichi Securities), or an established conglomerate (Korea's Halla group), or the start-up of questionable new ventures (Indonesia's Timor car), it was expected that some non-market (i.e., government) preference would make up the difference. The favoritism, exclusivity and corruption of the Asian model's back-channel and nontransparent decision making has had a corrosive effect on the societies and polities of the

region.

That market-mediated allocations of resources have shortcomings doesn't imply that the Asian model's subjectively mediated ones will not have still greater shortcomings. In fact, the legacy of the Japanese model and its Asian variants suggests that their associated shortcomings are enormously greater, because they tend to be protected and concealed. Lacking the corrective, mediating responses that market mechanisms and incentives provide, the shortcomings accumulate until a systemic breakdown occurs.

If this lesson is heeded, Asia's recovery can be rapid and enduring; if it is not, recovery is more likely to be slow and fitful--and ultimately far more painful.

Mr. Wolf is senior economic adviser and corporate fellow in international economics at

RAND.

Copyright: Wall Street Journal, 1998.

Notes on Wolf Article

The Japanese model does not rely on free market principles. By this I mean that the methods of allocating scarce resources are not based on the forces of supply and demand. Rather, the allocation problem is primarily determined by the government. In economic jargon, the allocation problem is determined by a Command and Control System. The government tries to pick “winning industries” and then proceeds to give them favorable treatment. Sooner or later, the inevitable mis-allocation of resources (shortcomings of the system) will build, especially since they tend to be “protected and concealed.”

Factors Relevant in causing Crisis

1. Short term borrowing in unhedged US dollars, Yen, and Marks - by unhedged, we mean that the East Asian borrowers did not protect (buy insurance, hedge) themselves from the currency risk associated with borrowing in a foreign currency. When these currencies devalued, the foreign currency-denominated loans (e.g., dollar loans) became drastically more expensive to service (pay off). Why was there no hedging against currency risk? The borrowers must have felt that the odds of their currency depreciating were rather low. Recall that all these currencies were pegged to the US dollar. In previous years, the Asian countries had little trouble maintaining their dollar peg (a dollar peg is similar to but not exactly like a fixed exchange rate with the dollar). In fact, if anything, there was often pressure for their currencies to appreciate. Why? Lots of foreign financial capital was flowing into these countries and therefore the demand for their currencies was high. Since the demand was high, their currencies would have pressure to appreciate as opposed to depreciate. Think about it. When investors started to flee - they dumped wons, rupiah, etc., on their markets. The increase in supply put a lot of downward pressure on their currencies. Before the fleeing, the opposite occurred (capital “in-flight” as opposed to capital flight).

Borrowers can hedge against foreign currency risk by buying future contracts, forward contracts and/or options. Suppose you are a borrower from S. Korea and you know that three months from now, you will owe Citigroup bank $1 million. Your income is denominated in wons. You can buy a forward contract that will guarantee you a dollar/won exchange rate three months from now, regardless of what happens to the actual dollar/won exchange rate. Thus, if your currency goes through the floor, you are protected since you have a guaranteed dollar/won exchange rate. Options are similar except that they are more flexible. You simply have the option to exercise your agreed upon dollar/won exchange rate (set by the option contract). In hindsight, the E. Asian banks and firms should have hedged (bought insurance on) their foreign-denominated debt.

2. Low returns in equity markets in Japan and Western Europe - Investors were seeking higher returns and East Asian equity markets offered them - they appeared to be a sure bet. There was a huge influx of “hot money” which made matters precarious. What eventually happened is that this hot money reversed direction - in fact, it went out faster than it went in. Central banks were scrambling for foreign reserves to intervene in hopes of maintaining their (currency) peg to the US dollar. Another relevant factor is that the equity markets in the East Asian countries were becoming inflated. The more money that came in, the higher the valuation in the respective equity markets. Given that many borrowers use their stock holdings (banks included!) as collateral on loans, when the value of their stock holdings plummeted, so did the value of their collateral. This is another factor that increased the likelihood of default (along with currency depreciation).

3. Low interest rates in the US and Japan made borrowing attractive to the East Asian borrowers. Simply put, it was or at least appeared to be, cheaper borrowing abroad than borrowing at home.

4. Japanese Model (See “Too Much Government Control” above)

A. Command and Control Elements

B. Preferential treatment to “chosen” export industries

i. Preferred access to financial capital

a. offered below market interest rates

b. direct subsidies

c. “unlimited” funding

ii. Protection

a. Tariffs

b. Quotas

C. Over capacity led to low export prices, pressure to devalue, firms defaulted on loans.

D. Inadequacies of Model

i. Favoritism

ii. Exclusivity

iii. corruption

iv. subjective decision making

Other factors relevant in causing crisis:

5. Exchange rates were pegged to the US dollar for too long.

From “Anatomy of a Currency Crisis,” by Jane Little

Investors seeking higher returns quickly spotted the Southeast Asian countries, which were gradually opening their capital markets to foreigners. These “tiger” economies were growing fast. By LDC standards, their inflation was moderate and their fiscal positions prudent. Moreover, currency risk must have seemed small since these countries had long pegged or nearly pegged their currencies to the U.S. dollar. Small, open economies sometimes choose to peg their exchange rates, at least for a time, to encourage trade and investment, to anchor domestic prices, and to signal their commitment to sound monetary policies. With these many attractions, Southeast Asia's miracle countries have experienced huge capital inflows in recent years.

But, with exchange rates fixed, capital inflows to purchase Thai securities or to expand

an Indonesian manufacturing plant required that their central banks buy dollars and

supply the needed baht or rupiahs, ballooning the money supply. Central bank efforts

to offset these flows, by selling government securities, say, raised domestic interest

rates and encouraged further inflows. With inflation even modestly above U.S. levels

and exchange rates fixed, these countries' products became relatively costly on world

markets. Several developments magnified their problem. The 1994 devaluation of the

yuan made China more competitive; the yen's slide against the U.S. dollar made

matters worse. Finally, Taiwan's entry into the chip market brought a glut in a major

regional industry. So when world trade slowed in 1995-96, one of the first signs of

trouble for the Asean-4 (Indonesia, Malaysia, the Philippines, and Thailand) was a

deterioration in their current account deficits.

Summary: If the Asian countries only would have devalued earlier, the export industries would have remained competitive and thus their income flow may have been sufficient to pay back their loans and therefore they may not have been “forced” to borrow abroad.

6. Lax banking regulations coupled with capital controls- Again, from “Anatomy of a Currency Crisis.”

Another yellow flag was the rapid expansion of domestic credit, abetted by lax banking

supervision and rapid deregulation. In Indonesia, state-owned banking gave way to a system where anyone with $1million or so could open a bank. Because capital controls continued to deter outflows of domestic capital, much of this new credit flowed into misguided real estate investments and industries already burdened with unneeded capacity. In Hong Kong, real estate prices quadrupled in five years, and Malaysia became home to the world's tallest and longest buildings. Throughout the area, newcomers to the auto industry -- national favorites, presidents' relatives, electronics companies, and others -- insisted on pushing their way onto the crowded field. So by late 1996, bank and non-bank borrowers in these countries had taken on large amounts of foreign debt, much of it short-term, denominated in unhedged dollars, and invested in iffy projects.

Summary: With lax banking regulations, domestic credit grew rapidly. Given “domestic” capital controls, this credit had to go somewhere within the country. This factor added to the over-capacity.

7. Lack of US support (as in Mexico’s case) as well as bailout being too small - it is argued that since the United States did not offer Thailand funds independent of the IMF, as the US did in the early 1995 Mexican bailout; Thailand felt abandoned. From article: US best experts …

For all this expertise and brilliance, though, they stumbled. The Mexican formula didn’t fit in Thailand. The biggest difference: Mexico shared a border with the largest and healthiest economy on the planet; the U.S. pulled Mexico out of recession. The biggest economy in Thailand’s neighborhood, Japan, weakened as the crisis unfolded, and has been impervious to U.S. pressure. But that wasn’t obvious in July 1997.

The Treasury pushed the IMF to make a big loan to Thailand, but didn’t offer any additional U.S. money, a sharp contrast to its decision to offer Mexico $20 billion in early 1995.

The reasons for Mr. Rubin’s tight-fistedness were straightforward. For Mexico, Mr. Rubin had tapped the Treasury’s Exchange Stabilization Fund, a kitty that he and the president controlled. Subsequently, an angry Congress slapped restrictions on its future use. Those restrictions were about to expire when Thailand hit. To avoid provoking Congress into extending the restrictions, the Treasury kept its wallet in its pocket. “It was important that we have the freedom to use the ESF when it was needed,” Mr. Rubin says. He argues that Thailand suffered more from the dithering of its politicians in the summer of 1997 than from inadequate U.S. aid.

What seemed reasonable in Mr. Rubin’s office played poorly in Bangkok and elsewhere in Asia. Thailand felt abandoned, and other Asian governments— as well as some players in financial markets—wondered if the U.S. would come to their aid if necessary.

8. Lack of transparency in banks; firm’s balance sheets. Many foreign investors had no clue how bad things were. When they found out - take your money and run in herds! This key IMF condition (increased transparency) should help us to avoid this herding behavior from occurring in the future.

9. The moral hazard problem - Milton Friedman among others are convinced that the very existence of the IMF was primarily responsible for the East Asian crisis. From the WSJ’s editorial page,

October 13, 1998, Friedman writes:

Indeed, Congress and the Clinton administration spent much of the last week's budget negotiations fine-tuning the details of the U.S.'s latest $18 billion IMF subvention package. Such talk is on a par with the advice to the inebriate that the cure for a hangover is the hair of the dog that bit him.

And

The Mexican bailout helped fuel the East Asian crisis that erupted two years later. It encouraged individuals and financial institutions to lend to and invest in the East Asian countries, drawn by high domestic interest rates and returns on investment, and reassured about currency risk by the belief that the IMF would bail them out if the unexpected happened and the exchange pegs broke. This effect has come to be called "moral hazard," though I regard that as something of a libel. If someone offers you a gift, is it immoral for you to accept it? Similarly, it's hard to blame private lenders for accepting the IMF's implicit offer of insurance against currency risk. However, I do blame the IMF for offering the gift. And I blame the U.S. and other countries that are members of the IMF for allowing taxpayer money to be used to subsidize private banks and other financial institutions.

Criticisms of the IMF

The following list captures most of the opponents’ view regarding the IMF:

1. IMF policies are conducted in secrecy - consider the following quotes from Jeffrey Sachs, “IMF is a power unto itself” Financial Times, Thursday, December 11, 1997.

Jeffrey Sachs was the head of the Harvard Institute for International Development at that time.

“It is time that the world take a serious look at the International Monetary Fund. In the past three months, this small, secretive institution has dictated economic conditions to 350m people in Indonesia, South Korea, the Philippines, and Thailand. It has put on the line more than $100bn of taxpayers’ money in loans.”

While it pays lip service to “transparency”, the IMF offers virtually no substantive public documentation of its decisions, except for a few pages in press releases that are shorn of the technical details needed for a serious professional evaluation of its programmes. Remarkably, the international community accepts this state of affairs as normal.

The world waits to see what the Fund will demand of country X, assuming that the IMF has chosen the best course of action. The world accepts as normal the idea that crucial details of IMF programmes should remain confidential, even though these “details” affect the well-being of millions. Staff at the Fund, meanwhile, are unaccountable for their decisions.

The people most affected by these policies have little knowledge or input. In Korea, the IMF insisted that all presidential candidates immediately “endorse” an agreement they had no part in drafting or negotiating - and no time to understand.

The situation is out of hand. However useful the IMF may be to the world community, it defies logic to believe that the small group of 1,000 economists on 19th Street in Washington should dictate the economic conditions of life to 75 developing countries with around 1.4bn people.

These people constitute 57 per cent of the developing world outside China and India (which are not under IMF programmes). Since perhaps half of the IMF’s professional time is devoted to these countries - with the rest tied up in surveillance of advanced countries, management, research, and other tasks - about 500 staff cover the 75 countries. That is an average of about seven economists per country.

One might suspect that seven staffers would not be enough to get a very sophisticated view of what is happening. That suspicion would be right. The IMF threw together a draconian programme for Korea in just a few days, without deep knowledge of the country’s financial system and without any subtlety as to how to approach the problems.

Consider what the Fund said about Korea just three months ago in its 1997 annual report. “Directors welcomed Korea’s continued impressive macroeconomic performance [and] praised the authorities for their enviable fiscal record.” Three months ago there was not a hint of alarm, only a call for further financial sector reform - incidentally without mentioning the chaebol (conglomerates), or the issue of foreign ownership of banks, or banking supervision that now figure so prominently in the IMF’s Korea programme.

In the same report, the IMF had this to say about Thailand, at that moment on the edge of the financial abyss. “Directors strongly praised Thailand’s remarkable economic performance and the authorities’ consistent record of sound macroeconomic policies.”

With a straight face, Michel Camdessus, the IMF managing director, now blames Asian governments for the deep failures of macroeconomic and financial policies that the IMF has discovered. It would have been more useful instead, for the IMF to ponder why the situation looked so much better three months ago, for therein lies a basic truth about the situation in Asia.

2. There is a serious moral hazard problem - The argument is that big international banks downplayed the downside risk of the loans they made to Asian countries since if there was a crisis, they would eventually be bailed out by the IMF. Again from Jeffrey Sachs:

“These bailout operations, if handled incorrectly, could end up helping a few dozen international banks to escape losses for risky loans by forcing Asian governments to cover the losses on private transactions that have gone bad. Yet the IMF decisions have been taken without any public debate, comment, or scrutiny.”

It is very difficult to eliminate the moral hazard problem. Jeffrey A. Frankel - member of the Council of Economic Advisors writes (from “The Asian Model, The Miracle, The Crisis and The Fund” delivered at the U.S. International Trade Commission, April 16,1998):

Today’s financial markets are like superhighways. They get you where you want to go fast. By this I mean that they are useful: they help countries finance investment and therefore growth, and they smooth and diversify away fluctuations. But accidents do occur, and they tend to be big ones – bigger than they used to be when people were not able to drive so fast. The lesson is not that superhighways are bad. But drivers need to drive carefully, society needs speed limits or speed bumps, and cars need air bags. ……

Everyone has now learned about moral hazard, the principle that bailing out investors and borrowers reduces their incentive to be more careful next time. The moral hazard point is a correct one, and it enters into the East Asian developments in a number of ways. But there is a danger of exaggerating it. It is a standard principle of economics that actions in one area can generate partly offsetting reactions in another. That is not in itself a reason not to take action. In our highway example, there is research demonstrating that drivers react to seat belts and airbags by driving faster and less safely than they used to. But that is not a reason to dispense with air bags. If it were, that logic would say that to discourage dangerous driving, we should put a spike in the steering wheel (as Michael Mussa of the IMF says).

3. The IMF charges below market interest rates to risky borrowers (UNFAIR!).

From “An Unreformed IMF Doesn’t Deserve a Dime” By JIM SAXTON

“ Subsidized interest rates encourage economic inefficiency and exacerbate the moral hazard problem. The standard interest rate charged by the IMF for its bailout loans, currently under 4.5%, simultaneously encourages unsound lending practices and promotes high-risk investments.”

And from “The IMF’s Big Wealth Transfer” By DAVID SACKS and PETER THIEL

“And this is what is taking place. Recent IMF packages to South Korea, Thailand and Indonesia involve interest rates ranging from 4.6% to 4.8% on dollar-denominated debt with a maturity of three years. Even the U.S. government has to pay substantially more (about 5.5%) for debt of that term. What this means is that, even if there were no risk of default at all, American taxpayers would still be losing money, because the rates at which they are lending dollars are lower than the rates at which they are borrowing dollars.”

And:

“Curiously, the U.S. government lends money through the IMF at far lower rates of interest than it charges to most domestic loans to Americans. In the case of loans guaranteed by the Small Business Administration, for example, the prevailing interest rate hovers around 10.75%; university students must pay about 9% on college loans; and veterans must pay about 7% on federally guaranteed mortgage loans. All of these borrowers are safer credit risks than East Asian governments.”

One of the conditions for the US $18 billion contribution to the IMF is to push the interest rate charged by the IMF to 3 percentage points above the “market rate.”

4. The fund is costly to the U.S. taxpayer. (From article, “The IMF’s Big Wealth Transfer” by David Sacks and Peter Thiel, WSJ 3/13/98 )

(Repeated from above) And this is what is taking place. Recent IMF packages to South Korea, Thailand and Indonesia involve interest rates ranging from 4.6% to 4.8% on dollar-denominated debt with a maturity of three years. Even the U.S. government has to pay substantially more (about 5.5%) for debt of that term. What this means is that, even if there were no risk of default at all, American taxpayers would still be losing money, because the rates at which they are lending dollars are lower than the rates at which they are borrowing dollars.

5. The IMF Imposes inappropriate policy prescriptions (From Article, “An Unreformed IMF Doesn’t Deserve a Dime,” by Jim Saxton, WSJ, 9/22/1998). The IMF frequently imposes inappropriate conditions on countries that request its assistance—undermining rather than helping the target economies. In Indonesia, for instance, the IMF called for the end of food and fuel subsidies at a time when millions of people could no longer afford the necessities of life. These conditions sparked riots and violence that caused long- term damage to the prospect of economic recovery.

More generally, the common prescription is higher interest rates and government budget cuts: from article “Missteps of the U.S.’s Best Experts May Have Fostered Economic Crisis,” by David Wessel and Bob Davis, WSJ, 9/24/1998.

But even early supporters of the Treasury-backed IMF approach are uneasy. Mr. Greenspan told Congress last week he thought the IMF had “misread the depth of some of the really fundamental problems that were involved in the crisis that evolved.” He added: “I think their actions were somewhat misguided in the early stages.”

In pushing for budget cuts, the IMF was misled by its own optimistic assumptions. Incorrectly forecasting only mild downturns in Asia, the IMF demanded that governments reduce spending to offset the expense of restructuring banks. That pulled money out of economies that, in retrospect, needed more, not less, government spending; it was like siphoning gasoline out of a truck already low on fuel.

Mr. Rubin now concedes it was an error. “I think they may have been somewhat more stringent than they should have been.” But he and Mr. Fischer say the IMF called for easier government budgets as the crisis intensified.

The human cost was greatest in Indonesia, where the IMF insisted on curtailment of fuel and cooking-oil subsidies. It reasoned that the subsidies required to keep prices from rising were growing rapidly as the falling rupiah pushed up import costs, threatening hyperinflation. Indonesia dithered for months, but in May it abruptly cut subsidies and pushed up gasoline prices by 71%, bus fares by 67% and kerosene and cooking oil by 25%. That sparked riots in which hundreds died, and eventually led to Mr. Suharto’s resignation.

Few issues are as hotly debated as the currency devaluations that accompanied the problems in Thailand, Indonesia and Korea. To the IMF and Treasury, devaluations are a consequence, not a cause, of failed economic policies. When Mexico or Thailand or Korea ran out of dollars to support their currencies against the assault of the merciless markets, they had no choice but to let the currencies go down. But in each case, the devaluations were far deeper than Washington anticipated.

To a set of conservatives who are influential with congressional Republicans, devaluations are a cause of the problem. They blame the IMF for encouraging such moves, saying that countries, such as Argentina, that firmly and credibly declare they won’t devalue are more likely to withstand market attacks.

The Interest-Rate Cure

Neither the Treasury nor the IMF expresses misgivings about advising high interest rates, even to countries that are as bad off as Thailand, Indonesia and Korea. Tight money is the classic prescription for countries that need to support a weak currency, since higher rates generally draw domestic and foreign investors.

But at the World Bank, chief economist Joseph Stiglitz is honing a critique, presented in detail at a recent Brookings Institution seminar, that high interest rates in Asia did more harm to highly leveraged businesses than good in terms of boosting exchange rates.

And Jeffrey Sachs, the Harvard economist who worked closely with the IMF in Eastern Europe and now counsels developing countries to look elsewhere for advice, argues that high rates spooked investors. “The IMF and the U.S. thought the orthodox approach would calm markets and the high-profile approach would instill confidence, and they didn’t,” he says. “They set off a first-class financial panic.”

The IMF Proponents Response to the Criticisms

1. IMF policies are conducted in secrecy - The secrecy is very likely going to dissipate. One argument, probably a weak argument, is that it is possible that the IMF can prescribe the correct reforms before the international community needs to know. This line of reasoning relies on the idea that investor and speculator reactions to “news” tend to be excessive and destabilizing (herding behavior).

1. There is a serious moral hazard problem - Proponents of the IMF do not deny the existence of the moral hazard problem, but they do suggest that the moral hazard problem is often exaggerated. Stanley Fischer writes (“The Asian Crisis: A View from the IMF”, 1998):

Of course, not everyone agrees with the international community's approach of trying to cushion the effects of such crises. Some say that it would be better simply to let the chips fall where they may, arguing that to come to the assistance of countries in crisis will only encourage more reckless behavior on the part of borrowers and lenders. I do not share the view that we should step aside in these cases. To begin with, the notion that the availability of IMF programs encourages reckless behavior by countries is far-fetched: no country would deliberately court such a crisis even if it thought international assistance would be forthcoming. The economic, financial, social, and political pain is simply too great; nor do countries show any great desire to enter IMF programs unless they absolutely have to.

On the side of the lenders, despite the constant talk of bailouts, most investors have made substantial losses in the crisis. With stock markets and exchange rates plunging, foreign equity investors have lost nearly three-quarters of the value of their equity holdings in some Asian markets. Many firms and financial institutions in these countries will go bankrupt, and their foreign and domestic lenders will share in the losses. International banks are also sharing in the cost of the crisis. Some lenders may be forced to write down their claims, especially against corporate borrowers. In addition, foreign commercial banks are having to roll over their loans at a time when they would not normally choose to do so. And although some banks may benefit from higher interest rates on their rollovers than they would otherwise receive, the fourth quarter earnings reports that became available indicate that, overall, the Asian crisis has indeed been costly for foreign commercial banks.

3. The IMF charges below market interest rates to risky borrowers. - Again, this will certainly change - the proposal is to charge 3% higher than the “market rate.” People will still argue that the 3% premium is not enough to reflect the associated default risks with the loans. As far as the IMF reaction is concerned, I imagine they would argue that these affected countries are so bad off that it is reasonable to give them a break (humanitarian). Charging low rates will also increase the probability of payback. Naturally, the higher the rate that the IMF charges borrowers, the higher the chance of default. Perhaps the IMF is worried about its credibility as well as (losing) its power. Think about it - if there are a lot of IMF deadbeat debtors, society will want to know what’s going on within the IMF. Once the IMF loses its secrecy, the loss of (exclusive) power and influence is likely to follow.

4. The Fund is costly to the US taxpayer - proponents of the IMF would argue that the IMF costs the US taxpayer nothing. The idea is that the IMF operates like a credit union - we simply contribute funds and earn interest on these funds. Since the interest rate we get on these IMF loans is comparable to the market rate, funds to the IMF cost the US taxpayer nothing.

5. The IMF imposes inappropriate policy prescriptions - A proponent would simply admit that the IMF does the best it can. It is a very complicated and complex macroeconomic world out there and we are still learning. If it weren’t for the IMF, things would have been much worse.

Lessons of Currency Crisis - From Anatomy of a Currency Crisis - By Jane Little. What are the lessons of this currency crisis? Two are well known but bear repeating. A second pair may be more controversial.

1. Developing countries should adopt flexible exchange rate regimes as soon as strains start to become evident. Markets can be extremely strict disciplinarians once participants notice something amiss. Since investors tend to move in herds and momentum traders abound, markets sometimes overshoot. Delay can thus result in excessive devaluations, unwarranted output losses, and setbacks in the fight against inflation that can take years to overcome.

2. LDCs must make their financial markets more transparent by providing more data and by using generally accepted accounting standards -- of course. But data are always subject to interpretation; thus, they are a necessary but not a sufficient condition for avoiding future crises.

3. Multilateral rescue/reform packages must be multilateral and clearly credible. The E. Asian turmoil was less well contained relative to the peso crisis of 1994-95. The Asian governments' resistance/inability to reform contributed enormously to this outcome. But the West's hands-off attitude may also have played a role.

When the international community decides to provide a rescue package, it does so to curb contagion, as lender of last resort. True, moral hazard is an important issue; the international community should not encourage reckless future behavior by limiting today's losses too quickly or too generously. But at some point, the need to stop accumulating credit contraction takes precedence. In contrast to Mexico's $48 billion package, which far exceeded that country's dollar-denominated Tesobono liabilities, the $17 billion Thai rescue package was probably too small, given the central bank's $23 billion liability for dollars sold forward. In the end, a successful containment effort requires a financially and politically credible commitment from world policy makers -- borrowers and lenders alike.

4. In future, policy makers may want to look more carefully at global asset prices and the reasons for their behavior. Of late, policy makers worldwide have been well satisfied with the benign trends in consumer prices. If asset prices seemed high, that was a supervisory issue, not an issue for monetary policy. But with hindsight, the global asset price inflation seen in Asian real estate prices and in equity prices elsewhere may have been a significant symptom of excess world liquidity.

Brazil's President Cardoso described the currency crisis as "a ball that dropped on us from Asia." He went on, "We are good at soccer, and we plan to send the ball back so it falls on somebody else, or preferably in the middle of the Atlantic." We may all view the crisis as a ball that dropped on us, but the crisis did not grow in a vacuum. These problems reflect the many mistakes of individual developing nations and individual investors. They also reflect the tight fiscal and relatively loose monetary policies of the major industrialized countries. In times of crisis, policy makers usually feel compelled to step forward to halt an asset-price collapse. Perhaps they also have a stake in curbing excessive updrafts. The question is, how?

Asian Crisis Terms – make sure you know how these terms played a role in the Asian crisis.

1. Chaebol

2. Crony Capitalism

3. Japanese Model

4. IMF

5. Moral Hazard

6. Excess Capacity – Glut

7. Capital Flight – capital inflows to US

8. Asian Monetary Fund

9. Exchange Stabilization Fund

10. Hubris

11. Credibility

12. Secrecy

13. Corruption

14. Transparency

15. Credit Agencies – Credit Ranking

16. Economies of Scale

17. Favoritism

18. Exclusivity

19. Unhedged Foreign Debt

20. Interest Rate Differential

21. Currency Pegs

22. Command and Control

23. Lax Banking Regulations

24. Capital Controls

25. Below Market Interest Rates

26. Defending Currency

27. Trading ban/range

Essay Questions

1. Milton Friedman suggests that the IMF caused the Asian currency crisis. Explain.

2. Explain how the “Japanese Model” helped cause the problems in East Asia.

3. Explain why most of the East Asian countries were reluctant to bring in the IMF.

4. Some argue that if the Asian countries would have only let their currencies depreciate earlier, the crisis may not have occurred. Explain.

5. Explain why East Asian banks and firms had such heavy debt with foreign, international banks.

6. Explain how the Asian crisis affected the performance of the U.S. economy and comment on the longer-term influence of the Asian crisis on the U.S. economy.

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