The Chastening

by Paul Blustein

  The lights dimmed in Toronto’s Roy Thompson Hall on July 18, 1996, at one of the largest shareholder meetings in the world. As 8,000 owners of Templeton mutual funds watched, some via closedcircuit TV in other cities, a bagpiper led Templeton’s thirty-two global analysts, plus its managers and directors, into the hall.

  Characteristically, Mark Mobius, head of the emerging-markets division for the Templeton funds, was on the road and had to be beamed into the meeting via satellite to make his presentation, in which he thanked investors for maintaining faith through some trying times in the funds he managed. A minor celebrity because of his distinctively shaved head and appearance in TV commercials, Mobius had cultivated an image as one of the most peripatetic people on earth, a sort of stateless financial adventurer whose private Jet was the closest thing to home. Born on Long Island but a citizen of Germany, he prided himself on maintaining a 250-day-a-year travel schedule that entailed keeping residences in Singapore, Hong Kong, Shanghai, and Washington, D.C., and left no time for a family. That’s what was required, after all, to get a close look at the hundreds of companies in the dozens of countries he visited annually in his relentless worldwide quest for promising investments. And it paid off: As Mobius loved to tell audiences and reporters, when his first emerging-markets fund had started in 1987, it managed Just $87 million, and it could invest in only a handful of countries, including Hong Kong, Singapore, Mexico, and Brazil. Ten years later, the amount of money he managed in emerging markets had risen more than one-hundredfold, the number of countries targeted for investment had increased to over forty, and his funds boasted some of the best returns in the industry.

  Mobius was not only a successful investment practitioner, but he also was an effective proselytizer for the view that investors in the world’s wealthy countries ought to be placing their chips on the high-rolling arenas of Asia, Latin America, Eastern Europe, and the former Soviet Union. In a 1996 book, he spelled out the case: The value of all stocks in low- and middle-income countries, he noted, constituted only about 10 percent of the total value of the world’s stock markets. But that ratio was increasing sharply, and the trend was bound to continue for the indefinite future, because economic growth in these emerging markets would far outstrip growth in the industrialized nations of the United States, Japan, Western Europe, and Canada.

  For starters, the emerging markets had more people—4.6 billion, compared with 795 million in advanced industrial nations—and about three times as much land, too. “It’s not hard to see what potential exists in mobilizing 85 percent of the world’s population to work towards economic expansion, utilizing 77 percent of the world’s land,” Mobius wrote. Although he acknowledged that investing in developing countries carried obvious risks, he emphasized that a variety of factors were working to help the emerging markets close the wealth gap with the industrialized world. Many lower-income countries had embarked on a “virtuous cycle of development,” in which a more well-to-do populace was becoming better educated and more literate; this in turn led to lower birthrates and higher Job aspirations, which in turn generated more wealth, more literacy, and so on.

  By spring 1995, enthusiasm for emerging markets had spread so widely that nearly 1,000 mutual funds were active in them, and the number of funds specializing in them had risen 38 percent over the previous year. Some offered middle-class investors the chance to take a flyer in particular regions of the world (the Vontobel Eastern European Equity Fund, the Ivy South America Fund); others focused on individual countries (the Argentina Fund, the Pakistan Investment Fund). And mutual funds were only part of a broader rush to emerging markets in the first six years of the 1990s by financial institutions of all sorts, including banks, brokerage firms, pension funds, and insurance companies.

  The chief draw was Asia, where the biggest providers of foreign capital weren’t portfolio managers like Mobius but banks, which were lending primarily to private borrowers. The dominant players in Asia were Japanese banks such as Sumitomo, Sakura, Mitsubishi, FuJi, and the Bank of Tokyo. Carmen Reinhart, an economist formerly in the IMF’s Capital Markets Division, traveled to Tokyo in early 1995 and offered this perspective:I visited a whole bunch of Japanese banks. The economy had been in a slump, and domestic demand for loans was nonexistent. So the banks were looking overseas, where you had all these vibrant markets. Between 1995 and 1997, their lending to the [East Asian] region Just skyrocketed. It made a lot of sense—these economies were labeled as the miracle economies. This was right after the Mexican crisis, and of course the Mexican crisis was seen as something that could happen in Latin America—but could never happen here.

  Not far behind the Japanese banks were the Europeans; American banks were less exposed in Asia, but they were a force as well.

  In all the emerging markets combined—not Just Asia—the net inflows of private capital, which totaled Just $42 billion in 1990, soared to $329 billion by 1996. But the overall numbers tell only part of the story.

  Long-term flows from multinational companies putting money directly into building factories, R&D facilities, warehouses, retail stores, and the like rose rapidly but steadily, year by year, reaching $92 billion in 1996. Much more fickle were portfolio investors—stock and bond buyers, in particular. Their flows to emerging markets, which totaled $32 billion in 1991, rocketed to $118 billion in 1993—a year of unbridled euphoria when the Hong Kong stock market gained 124 percent—but then collapsed to $53 billion in 1995 following the Mexican peso crisis, before rising again to nearly $112 billion in 1996. Fortunately, another variety of financial player, commercial banks, was fickle in a countervailing way: The banks were increasing their lending to emerging markets when the portfolio investors were retreating. The net result was that in 1996 and early 1997, optimism toward emerging markets prevailed among investors of all breeds.

  The allure of the frontier was only part of the motivation driving the financial institutions and investment firms. Another major factor was the desire to “chase yield” overseas. In the early 1990s, interest rates were trending downward in the United States and Japan, in particular, and with yields on U.S. Treasury bonds dipping below 6 percent at some points, financial institutions couldn’t resist the temptation to seek double-digit returns in places like Malaysia, Brazil, or Turkey.

  It wasn’t Just that money managers in the West and Japan were prowling for higher yields abroad with the money they already had. Around 1992, many international commercial and investment banks began using a specialized technique of borrowing low-cost money in their home markets for the specific purpose of investing it for a short while in higher-yielding emerging-market securities. This was called the “carry trade,” and it worked in a variety of ways. In one typical version, an international bank would borrow yen for three months in Japan, where the annualized rate for such borrowings by banks was a mere 0.5 percent in late 1996. By converting the proceeds into, say, Thai baht and putting the money in Thai bank time deposits or corporate promissory notes or government bills, the bank could earn annualized profits of 15 to 23 percent on its borrowed money during that period. To be sure, not every carry-trade transaction was nearly so lucrative, and not all international banks were comfortable borrowing yen for such transactions; a bank wanting to borrow dollars in New York for three months had to pay annualized interest of between 5 and 6 percent in 1996. But the carry trade became hugely popular in Asia, and it was especially appealing in countries like Thailand, which had fixed-rate currencies that made the deal seem almost risk-free.

  Getting carried away is a hoary tradition in “emerging markets”—a term first coined in 1981 when Antoine Van Agtmael, a former World Bank official planning to start a “Third World Equity Fund,” realized he needed a catchier name. In the early 1820s, excitement in Britain over the liberation of South America from Spanish colonial rule led to a fevered run-up in the bonds of countries such as Chile and Colombia, and South American gold mining shares enjoyed an even crazier surge, based partly on outlandish claims
by their promoters. But by 1826, every South American state except Brazil defaulted, and gold mining shares crashed. One prominent booster, the future prime minister Benjamin Disraeli, was burdened with such crushing debts that he suffered a nervous breakdown.

  Later in the nineteenth century, the United States became the favorite emerging market of financiers in London and on the European continent, who gobbled up the bonds of American states and railroads. Despite defaults that wiped out fortunes in the 1850s, 1870s, and 1890s, European investors also poured vast sums into Canada, Australia, and Russia. By the dawn of the twentieth century, the United States was providing more capital to the rest of the world than it was drawing in, and in the 1920s another emerging-market bubble arose, as “investment trusts” (precursors to emerging-markets funds) successfully lured thousands of ordinary Americans to pool their money for the purchase of Latin American bonds and other foreign securities.

  It took the Great Depression to put a serious damper on such activity. When the Federal Reserve started raising U.S. interest rates in 1928, American money that had been previously invested abroad switched back to Treasury bills. Governments that had become dependent on American capital desperately scrambled for cash but were forced to suspend payment on their debts, led by Bolivia in 1931, followed soon thereafter by much of Latin America, countries in southern Europe, and finally in 1933 by Germany.

  This catastrophe was one reason for White’s and Keynes’s determination to restrict international flows of private capital when they designed the Bretton Woods system of fixed currency rates. But with the breakdown of Bretton Woods in the early 1970s, rich countries began dismantling their controls on capital movements, and some developing nations followed a few years later, though others hung back.

  The case for free movement of capital is based on a logical foundation. Poor countries need funds to develop, and rich countries tend to have a surfeit of savings; so why deprive the less fortunate of financial resources? Moreover, when investors are restricted from putting their capital into an investment overseas that offers more attractive returns than they can get at home, the world’s overall resources are presumably being used less efficiently than they might.

  But as the trend toward ending capital controls accelerated in the 1990s, some experts began to grow uneasy. Among their number was a small group of policymakers within the Clinton administration. Up to that point, U.S. policy had been to enthusiastically support the liberalization of the rules governing capital movements and to exhort the IMF to encourage the trend as well. But in the early years of the first Clinton term, economists at the Council of Economic Advisers (CEA) questioned whether the Treasury Department was committing a blunder by continuing the policy. “There was a considerable, though one-sided, debate,” said Alan Blinder, a CEA member. “Treasury on one side, CEA on the other. You can see this wasn’t a fair fight.”

  To Blinder and fellow CEA member Joseph Stiglitz, Treasury was acting as Wall Street’s handmaiden and taking insufficient account of the risks involved in exposing developing countries to the ebbs and flows of global money markets. Blinder and Stiglitz did not object to direct investment by multinational corporations overseas; along with the overwhelming majority of economists across the political spectrum, they believed the building of factories and other business operations in low-wage developing countries was generally positive for living standards. Their problem lay with financial flows, especially short-term flows, which are susceptible to sudden reversals. In those days, Blinder recalled, “everything in the administration was about Job creation,” and Treasury wanted to prevent countries from maintaining barriers to one of the America’s most competitive industries—banking and finance. Blinder and Stiglitz hotly disputed Treasury assertions that, besides providing benefits for U.S. firms, lowering obstacles to foreign financial institutions would confer benefits on emerging markets as well. “It was argued, correctly, that there were benefits from financial inflows into these countries. But there was also the danger of outflow,” Blinder said, adding: “It was dangerous to put this fancy finance into these countries with underdeveloped financial systems.”

  The CEA’s chief antagonist was Larry Summers, then Treasury undersecretary for international affairs. Though only in his late thirties, Summers was already emerging as a major force within the administration—partly because of the clout his agency possessed but also because of his raw brainpower.

  Summers had grown up in a family notable for its distinctions in economics. Two of his uncles, Paul Samuelson and Kenneth Arrow, were Nobel prizewinners in the field, and both his parents were economists at the University of Pennsylvania. In the family’s suburban Philadelphia home, control over the TV set was determined by an auction process that his father, Robert, devised to demonstrate how markets worked. Young Larry showed promise early at living up to the family tradition. At age eleven, he developed a mathematical formula aimed at determining how accurately a baseball team’s standing on July 4 could predict its chances for winning the pennant. He entered MIT at sixteen, and in 1983, one year after getting his Ph.D. in economics from Harvard, the twenty-eight-year-old Summers became one of the youngest individuals in the university’s history to be awarded a full professorship. Ten years later, after having published over 100 articles in academic Journals, many of them focused on unemployment and taxation issues, he won the John Bates Clark medal for the most talented economist under forty. But he found the policy arena too alluring to pass up, and in 1988 he served as an economic adviser to Democratic presidential candidate Michael Dukakis, battling the more left-leaning campaign officials who favored heavy taxes and interventionist industrial policy schemes. In a sign of the respect he enjoyed among conservatives, the Bush administration sanctioned his appointment in 1990 to become chief economist of the World Bank.

  With his shirt often untucked, his schedule often a shambles, and his sharp wit often aimed at his own foibles, Summers could be endearing, and his Treasury colleagues fondly recounted “Larry stories” about his misplaced passports and missed planes. But his least lovable trait was his inability to conceal a high regard for his own intellect. Early on in his Treasury career, Summers became the target of numerous complaints about rolling his eyes and belittling the arguments of others during interagency meetings and even in negotiating sessions on Capitol Hill. His skill at interpersonal relations improved substantially in his later years at Treasury, but his contempt for what he viewed as substandard work sometimes boiled over in paper-flinging tirades that appalled colleagues, and his brittle ego was exposed one evening in 1994 at a press briefing in Tokyo when a U.S. embassy official announced that the remarks by the undersecretary should be attributed to an administration official. “Senior administration official,” Summers instantly corrected him.

  Summers had originally been in line to become CEA chairman, but his bid was blocked by environmentalists outraged over a memo he had signed while at the World Bank concerning pollution in developing countries. (Although the memo was written by another World Bank staffer, Summers took the heat for having signed it.) Ironically, the episode redounded to his benefit because he ended up accepting the Treasury undersecretaryship, a Job with less prestige but plenty of responsibility for formulating specific areas of policy, unlike the CEA, a tiny agency that was little more than a bully pulpit for its members. Hence arose Blinder’s lament about the lopsidedness of the clash with Summers over liberalizing international capital flows.

  Summers’s version of the debate with Blinder and Stiglitz was that he, at least, didn’t favor a U.S. policy of prodding developing countries into allowing the inflow of more foreign money. Rather, he wanted those countries to grant greater access in their domestic markets to competition from foreign banks and financial institutions. Many Asian nations, in particular, made it hard for the likes of Chase Manhattan or Bank of America to compete directly against local banks for deposits and customers. Lifting such restrictions to allow foreign competition, Summers and other
s argued, would force these countries’ financial systems to become more efficient and less corrupt; a local Thai bank would be less inclined to make shaky loans to friends of influential politicians if it had to compete with Citibank for access to deposits.

  Summers acknowledged that some of his subordinates at Treasury might have aggressively advocated the department’s traditional line, which was to broadly favor dismantling controls on international capital flows. But his own line was different, he contended: “There are enormous advantages for the U.S., and these countries, in having foreign participation in their domestic financial systems. So as a trade issue, we saw [removing barriers to competition] as something that should be very aggressively pushed. But it is possible for a country to have foreign participation in its financial system and still have capital controls. It is possible to have no capital controls and no foreign participation in the domestic financial system. The question of capital controls is a separate question from the question of foreign participation in financial services.”

  Blinder retorted that although Summers was technically correct, and that he agreed with Summers’s point about competition, “our view was that the line was very blurry in practice” between pressing developing countries to allow competition from foreign financial institutions and pressing them to open up to hot foreign money.

  Other former administration officials said ruefully that in retrospect, the Treasury and the IMF should have been far more vocal in warning developing countries against the risks of welcoming foreign funds before their banking systems had matured to the point that the money could be prudently lent. Even when such caveats were stated, the admonitions were muted. “I think what everybody felt—and I mean everybody, not Just the government but all the financial markets, virtually all public policy thinkers—was to see the conceptual value and importance of these capital flows, and to also see the potential dangers,” said W. Bowman Cutter, a White House economic adviser during the first Clinton term. “But the tendency was to overestimate the first and underestimate the second.”