Fault Lines: How Hidden Fractures Still Threaten the World Economy
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When the government’s borrowing exceeds available domestic resources, and it does not have access to official government-to-government aid, it turns to foreign private lenders. Because governments command some credibility, and have some access to borrowing from multilateral institutions like the IMF, lenders are willing to finance them for a while. Knowing, however, the temptations that face an opportunistic government—to inflate away debt if denominated in the domestic currency or to pile on more and more debt on existing debt, thus eroding its value—foreign lenders take precautions. They demand repayment in foreign currency (which is not affected by the country’s ability to inflate or devalue its currency), and they shorten the terms of their loans in proportion to the country’s indebtedness, so that they can pull their loans at short notice.
Instead of controlling its spending, therefore, the populist government that has exhausted its ability to borrow domestically turns to foreign lenders to finance it. Thus the circumstances in which foreign loans are made are not propitious. Knowing this, foreign lenders demand protection, which the government can typically give only by eroding the rights of existing domestic creditors—for instance, the more the overindebted government borrows in foreign currency, the higher the inflation it will eventually have to generate to erode domestic-debt claims on it. Moreover, because foreign investors make short-term loans, any adverse political development may scare them into refusing to refinance the government. Even more problematic, a substantial improvement in opportunities in their home countries—such as a rise in interest rates—can cause foreign investors to pull their money out en masse.6
All these factors were at play in the Mexican crisis of 1994. The sexenio, or six-year administration, of President Carlos Salinas de Gortari was coming to an end. In the traditional fashion of the dominant party, the Partido Revolucionario Institucional (PRI), he launched a spending splurge to keep voters happy. Domestic savings dropped by 3.3 percent of GDP between 1991 and 1994, with much of it accounted for by an increase in government spending, leading to a current-account deficit that touched 7 percent of GDP in 2004. Even while the need for foreign financing mounted, political developments took a turn for the worse. In Chiapas, aggrieved peasants rose up in an armed rebellion against the government, and later in the year, the PRI’s presidential candidate, Donaldo Colosio, was assassinated. Moreover, the Federal Reserve of the United States raised interest rates throughout 1994, from 3 percent to 5.5 percent, giving investors the incentive to bring their money back to the United States.
As foreign investors became more worried about financing the Mexican current-account deficit, the government started converting its short-term peso-denominated debt into tesobonos—short-term bonds that were indexed to the dollar-peso exchange rate and would protect investors from a devaluation. But as political uncertainty increased, even this was not protection enough. Investors started selling out, converting their pesos into dollars, and departing the country. The central bank’s exchange reserves became depleted, and the new president, Ernesto Zedillo, had a full-blown crisis on his hands when he entered office. Eventually, an enormous loan was put together by the U.S. Treasury and the IMF to prevent Mexico from defaulting on its debts. Investors in the tesobonos were paid back, but the country went through a wrenching crisis, and those who held on to peso-denominated debt suffered heavy losses.
The 1994 Mexican crisis was a classic populist emerging-market crisis, driven by excessive government spending. The 1998 East Asian crisis was different, first because the crisis stemmed from excessive investment by countries that did save considerable amounts, and second because in many countries, the domestic private sector was centrally at fault. To understand what happened, we need to examine corporate investment in a producer-biased economy.
Corporate Investment and Managed Capitalism
I argue above that bank funds are costly in a producer-biased economy, despite the subsidies offered to favored borrowers. In these economies, new corporate investment is most easily financed by resources that are produced by the corporations themselves—funds generated by growth in sales and profitability. For existing corporations that are well connected to the banks, this practice saves on costly borrowing. For corporations that are young and do not have strong bank relationships—such as the fast-growing but underfunded private sector in China—it may be the only option. Therefore corporations typically invest substantially more only when they grow faster, with their saved profits financing investment. The producer-biased strategy facilitates this kind of growth because the surplus value generated by the economy is allocated directly to producers, enhancing their profits and their ability to invest, instead of winding its way circuitously through households and a financial system that is incapable of lending effectively.
This kind of resource allocation is beneficial in some respects. Profitable corporations, which presumably have better investment opportunities, have more resources to invest in their existing businesses: profitability therefore drives investment, improving on the politicized investment decisions the state or the banking system would otherwise make. The danger, of course, is that profitable firms continue doing more of the same until they build overcapacity and extinguish the profits. For small countries focused on exports, the world market is typically large enough to make this possibility remote. For a large country like China, overcapacity is a clear and present danger.
Corporations mitigate such problems by diversifying. South Korea’s chaebols—conglomerates with businesses in areas as diverse as construction and electronics—or India’s family-owned conglomerates, like the Tatas or the Birlas, essentially try to replicate the role of the financial system by creating an internal capital market within the conglomerate. Although the loss of corporate focus in conglomerates has often been found to be a problem in developed countries, resulting in storied corporations like ITT or Litton Industries being broken up, conglomerates have proved very valuable in developing countries because the alternative—relying on the financial system for funds—is so inferior.7
Of course, if corporations want to grow really fast, internal funds may not be enough. Also, new entrants into emerging industries need financing. Fast-growing young industries may therefore move to borrowing from domestic banks. And if domestic savings are not enough, they have to borrow from foreign investors. This is what corporations in East Asian countries did in the early 1990s.
Investing Too Much and the 1998 East Asian Crisis
We are already familiar with the export-led growth path followed by the East Asian economies. Having enjoyed a period of rapid growth, these economies started increasing their investment, financed with sizeable capital inflows from abroad in the early 1990s. Investment as a fraction of GDP, averaged across Korea, Malaysia, and Thailand, increased from an already high level of 29 percent in 1988 to an extraordinarily high 42 percent in 1996.
Yet these economies simply did not have the capacity to undertake this level of investment effectively. Ambitious corporations dreamed of silicon-wafer fabrication facilities, petrochemical complexes, and integrated steel plants. A $1.2 billion semiconductor plant started in Thailand in December 1995 as a joint venture between Texas Instruments and the Alphatec group was typical.8 The fabrication facility was state-of-the-art, intended to produce 16- and 64-megabit dynamic random-access memory chips, with the output to be purchased by Texas Instruments. The eventual aim was to build a 4,000-acre high-tech park, called Alpha Technopolis, to rival Taiwan’s famous Hsinchu Science-Based Industrial Park. The vision was grand, perhaps overly so.
After their initial role in directing credit and creating strong national champions, East Asian governments withdrew from the business of allocating credit, a task that had become much more difficult as businesses moved up the ladder of development into more complicated technologies. The task of credit allocation then devolved to domestic banks.
Domestic banks historically had overcome the impediments to lending—such as the difficulties of en
forcing repayment—by developing near-incestuous, long-term relationships with firms. Regular visits and meetings with clients gave them access to information that was not public, as did cross-shareholdings and membership on the companies’ boards. Furthermore, given the difficulty that outsiders had in accessing such information, the banks had a hold over their borrowers. Borrowers repaid for fear that their bank would cut them off from further funds and no one else would step up to lend.
Such relationships carried costs. Banks could not lend easily outside their existing circle of relationships, and they risked supporting client firms long after they should have been closed down. Outsiders had little idea of what was really going on in firms. Corporate practices were not transparent; nor were cash flows within or between the extensive corporate pyramids and cross-holdings. It was difficult to assess the extent to which a corporation was close to banks or the government and the extent of implicit or explicit support it could count on. Furthermore, the relative priority of other investors in claims to corporate assets in case of liquidation was uncertain, and the absence of a clear, effectively implemented bankruptcy code further reduced investor confidence.
As corporations invested at a faster rate than could be financed by domestic savings, they had to turn to foreign capital. But foreign investors, many of whom were banks, did not know much about domestic corporations and had little confidence that they would be able to enforce their rights in court. Unlike domestic banks, which enjoyed close relationships with firms, foreigners were not willing to lend long term and leave themselves exposed to potential malfeasance by corporations.
Instead, foreign creditors lent short term, in foreign currency, and often not to the corporation directly but to the domestic bank, which then lent to the corporations. Lending to the domestic bank effectively placed the government on the hook. Unless it was willing to see its banks fail, the betting was that the government, which was in fine health, would bail out a distressed bank, and hence its foreign lenders. Other foreign investors came in through the equity markets as portfolio investors, confident that they could sell and depart at the first sign of trouble.
The loans that domestic corporations took from their relationship banks were also typically denominated in foreign currency. Banks wanted to offload currency risk onto firms. The firms were willing to bear this risk because loans denominated in foreign currencies had lower interest rates, and the domestic currency had been relatively stable against foreign currencies.
The problem, therefore, was that managed capitalism was not equipped to deal with a plentiful supply of arm’s-length money from outside. When money was scarce and the government directed lending, large projects were scrutinized carefully by the government before it directed certain banks to finance them. Although those close to the government benefited excessively from this privileged access to finance, there was at least a layer of oversight. Moreover, corporations had been careful because defaults against their traditional lenders could mean a permanent cutoff of funding. But now, with money plentifully supplied by foreign investors who themselves exercised little scrutiny because they thought they were well protected, competition to make loans heated up, and domestic corporations’ fear of being cut off by domestic banks became remote. Corporations became less careful, and domestic banks, flooded with money that had to be lent, did not compensate by increasing their own diligence.
The East Asian crisis was thus largely a result of corporate overinvestment, in commercial real estate as well as manufacturing. And although the well-connected elite and investors stood to benefit if things went well, ultimately the risks of an economic collapse were borne by the government and hence by current and future generations of domestic taxpayers. Foreign borrowing was essentially a way for the country’s private sector to socialize the risk of systemwide default.
A few governments contributed to the problem. For instance, the Vision 2020 plan set out by Malaysia’s prime minister Mahathir Mohamad included the Bakun Dam (then Asia’s largest hydropower dam), the Petronas Towers (one of the world’s tallest buildings), a supermodern airport, and a new national administrative capital near Kuala Lumpur, appropriately called Putrajaya (City of Kings).9 Mahathir’s vision was certainly of pharaonic proportions: when I passed through Kuala Lumpur recently, the huge airport still looked impressive, well-maintained, and state-of-the-art—though it was largely bereft of planes and passengers. But generally, government excess was not the central problem (as it had been in previous developing-country crises, like that of Mexico in 1994). The fault lay with private excess funded by easy and hence dangerous foreign money.
The classic ingredients for a bust were in place: excessive investment financed with short-term debt, with the additional risk of a foreign-currency mismatch. All that was needed was the final trigger. This came from two related sources.
First, the overambitious investments themselves went sour. By early 1997, Alphatec had collapsed under its debts while its memory-chip plant was still under construction. Alphatec itself was only a small family-owned business with very limited experience in the semiconductor industry, and this lack of experience showed. Construction was plagued with delays: the plant was being built on land so marshy that concrete pilings had to be driven down to stabilize the buildings, at great cost. There was no clean water or power, both critical for chip manufacture, so Alphatec had to build the necessary facilities, adding further to costs. And even before high-tech plants like Alphatec’s were completed, investors became concerned about their viability and started pulling out.
The second trigger was the depreciation of the Japanese yen against the dollar, starting in 1995. This made Japanese exports far more competitive than exports from East Asia, where currencies were linked more closely to the dollar. Rather than sourcing from Thailand, with its uncertain quality and small pool of scientists and engineers, importers around the world now preferred to return to tried and tested Japan. East Asian exports started faltering, corporate profitability plummeted, and investment projects started closing down.
Foreign investors started pulling out their money. Speculators joined the frenzy as they saw countries trying to defend exchange rates that were now distinctly overvalued. And as the countries used up their foreign exchange reserves in this defense, the likelihood of a devaluation became a certainty. The devaluation bankrupted first the many firms who had borrowed in foreign currencies and then the domestic banks that had lent to them. For even as these banks found that their borrowers could not repay, they had to repay their own foreign lenders. The East Asian miracle turned into a bust of gigantic proportions.
The East Asian banks turned to their governments, and the governments appealed to the IMF to give them the foreign currency that they needed to pay back foreign lenders and preserve their banks. Fund money came with conditions attached: actions that countries had to take—some before getting a loan, others after—to qualify as borrowers in good standing. Some conditions were relatively standard: after all, any lender, especially a lender who lends when no one else is willing, needs to put in place covenants to ensure that the borrower will repay. But others were onerous.
The East Asian governments believed the Fund overreached in two ways. First, it stipulated conditions that suggested it simply did not understand that it was dealing with a different client from its usual ones. By and large these were not governments, like Mexico’s, that had overspent themselves into trouble. Rather, the domestic private sector had run amok with investment, with foreign lenders lacking discipline because of the implicit guarantees that they correctly surmised governments would honor. The immediate need was to restore financial stability, perhaps infuse some government stimulus to compensate for the sharp decline in economic activity, and then, with confidence restored, sort out the mess over time.
This was indeed what Western governments did in their own economies in 2008–2010, and what the IMF eventually turned to doing. But proud East Asian government officials were initially treated
as derelicts who did not understand how to run clean governments. Overnight, managed capitalism was labeled crony capitalism, and there were certainly enough examples of cronyism to allow the Western financial press to go to town. Some of the initial policy advice from the Fund, the World Bank, and Western governments seemed to be focused on punishing the cronies, instead of recognizing that the system was so interconnected that many innocent people would suffer in the process. Empathy was missing, perhaps because managed capitalism seemed so alien to the outsiders who were now calling the shots.
The second way the Fund overreached was in setting conditions, often dictated by its major shareholders such as the United States, that attempted to reform the East Asian countries according to Western notions of governance. For instance, Indonesia was asked to undertake 140 or so actions in 1998, including disbanding the clove monopoly, strengthening reforestation programs, and introducing a microcredit scheme. To the cynic—and cynics were sometimes correct—these moves were really intended to open up large protected segments of the country to Western firms and advocacy groups. Although some of these measures may have benefited the country in the long run, these were decisions for the people themselves to take, not for foreign officials to require when the country was flat on its back. The unfortunate photo of the IMF managing director, Michel Camdessus, with his arms crossed and towering over a seemingly cowed President Suharto of Indonesia as he signed the IMF agreement suggested an image of the conqueror accepting the unconditional surrender of the defeated.10 Although the true circumstances were more benign, the photo compounded the sense that this was a new form of financial colonialism.