The Chastening

by Paul Blustein

  Why did the IMF miscalculate so badly? The main reason is that Thailand had another major problem that set its crisis well apart from the garden-variety current account type—the disastrous condition of its financial system.

  The Fund was by no means oblivious to the existence of the banking system’s troubles. Shortly after the mission arrived in Bangkok in late July 1997, its members were shocked to learn of the extraordinary lengths to which the Thai authorities had been going to keep the system from collapsing. To compensate for the steady withdrawals of deposits from the finance companies and some of the weakest banks, the Bank of Thailand had secretly lent about $20 billion to those institutions, at below-market interest rates. Those loans, moreover, went well beyond the standard central bank practice of serving as lender of last resort to healthy financial institutions that are suffering runs by panicky depositors. Although a central bank is supposed to lend freely to banks that are temporarily short of cash, the Bank of Thailand was propping up insolvent institutions that were so loss-ridden that they weren’t genuinely viable as business concerns.

  The Fund insisted that Thailand must stop the secret bailouts and start shutting down insolvent finance companies. But that triggered another battle—this one within the Fund itself, pitting the mission in Bangkok against much of the top brass at headquarters. At one point, the dispute became so tense that Carl-Johan Lindgren, who headed the IMF’s financial-sector mission to Thailand, got calls in the middle of the night from colleagues in Washington, warning him that he was endangering his career because of the position he was taking.

  Lindgren, a Finnish national, contended that closing insolvent finance companies meant that the Thais also had to take drastic steps to protect the surviving financial institutions. Otherwise depositors would become worried that more institutions might be closed, and total panic might set in, toppling bank after bank. Accordingly, he supported a plan for the Thai government to guarantee the claims of all depositors and creditors in all banks and finance companies. But this idea outraged many top Fund officials back at headquarters, who saw a guarantee as a giveaway to rich investors who had gambled on high-yielding deposits in shaky financial institutions. It would be a classic case of “moral hazard,” they argued, in which people who had behaved recklessly would be saved from the consequences of their actions, thereby encouraging more recklessness in the future. But Lindgren persisted, asserting that although the guarantee might be costly, the cost of not issuing one would likely be much higher.

  The debate with headquarters “was awful,” said Anoop Singh, a deputy director of the Asia and Pacific Department, who as the number two member of the IMF mission was siding with Lindgren. “We had never worked this fast in any country. Deposits were flying out the doors of the banks. Over three nights, we were up in Bangkok, arguing with Washington.”

  Lindgren won. On August 5, the Thais suspended the operations of a total of fifty-eight finance companies, and a comprehensive guarantee was issued on deposits and liabilities of financial institutions. That decision now appears wise and farsighted, for the bank runs gradually abated.

  The Fund’s decision may have kept Thailand’s banking system from utter collapse, but the closure of the finance companies left many small and medium-sized businesses without their traditional sources of funding. As a result, the financial system’s woes crushed the country’s economy far more severely than the Fund anticipated. Furthermore, and perhaps the worst of the fallout, the IMF program for Thailand misfired in achieving one of its overriding aims, which was to halt the slide of the baht.

  “How does it feel to be a superpower?” Timothy Geithner, the U.S. Treasury’s assistant secretary for international affairs, whispered Jokingly to Eisuke Sakakibara, the Japanese vice minister of finance.

  The occasion was an August 11 conference in Tokyo of donor countries and organizations that were planning to back up the IMF in its rescue of Thailand. Negotiations between the Fund and the Thai authorities were almost finished, and the Fund was planning to lend Bangkok $4 billion. Although that amount was 500 percent of Thailand’s IMF quota, and thus considerably more than the country would qualify to receive under normal circumstances, by many standards it looked insufficient. It paled in comparison with the $50 billion package marshaled for Mexico in 1995, which included a $17 billion loan from the Fund and a $20 billion line of credit from the United States.

  Japan now was eager to show that it could take care of its Asian neighbors the same way Washington had helped its most important neighbor in Latin America. So Tokyo was matching the IMF’s loan with a $4 billion loan of its own, and other Asian nations were prepared to kick in another $6 billion. Including loans from the World Bank and the Asian Development Bank, the Thai package would total $17.2 billion.

  The lighthearted comment by Geithner masked an underlying tension between the United States and Japan that would intensify in the coming weeks as the crisis unfolded. Washington wasn’t adding a penny to the Thai package, and Treasury officials weren’t enthusiastic about the support Japan and the other Asians were contributing, in part because they feared the IMF’s central role in crisis-fighting might be undermined. Although the U.S. State Department and National Security Council had argued that Washington should make a modest contribution for the purpose of shoring up its image as a leader in the region, Treasury Secretary Bob Rubin had prevailed in rejecting the idea. He was concerned about a backlash in Congress, which during the Mexican episode had harshly criticized the Treasury’s use of a special pool of money to extend credit to Mexico.

  Accordingly, Japan stepped into the void left by the absence of U.S. support, happily seizing the opportunity to demonstrate regional leadership. The Thais were appreciative, according to Sakakibara, who recalled Finance Minister Thanong telling him at the Tokyo conference: “What happened today will surely find mention in the history of Thailand.” Unfortunately, events a few days later deflated the high hopes the Asians had held at the Tokyo meeting.

  The IMF board approved the Thai program on August 20, and at a press briefing the next day, Camdessus said: “I strongly believe that, yes, we have seen the worst of the crisis, provided this program is implemented with perseverance which should match the boldness of the measures which have been adopted.... I have no reason to doubt it, and as a matter of fact, I have been reassured by the reaction of the markets today.” But within hours of his remarks, the baht was plummeting to an all-time low of about 34 to the dollar, and the Thai currency weakened even further in September, trading between 35 and 37 to the dollar. The reason for the bailout’s miserable debut was that the Bank of Thailand had finally disclosed its big secret—the $23 billion in swap commitments it had made back in May. Suddenly, market experts realized the full extent of the depletion in Thailand’s reserves, and they questioned whether the IMF-led rescue was sufficient to provide the hard currency the country needed to meet its pending foreign obligations. Referring to the newly disclosed swap commitments, Donald Hanna, the Asian regional economist at Goldman, Sachs and Co., told The Asian Wall Street Journal: “I think everybody was surprised. That’s a lot of money.”

  The Thais hadn’t made the revelation voluntarily. On the contrary, they were forced to do so as a condition of getting the IMF loan. In a series of phone calls to Fischer, Chaiyawat had raised strenuous objections, arguing that the disclosure would undermine confidence and provide valuable information to the hedge funds. But he had been forced to yield in the face of Fischer’s explanation that there was no way the loan could be made otherwise, because of the adamant position of Rubin and Summers, who were insisting that the Thais, having brought on the crisis with their untransparent policies, now needed to show they were coming clean.

  Many at the IMF, including some of its most highly placed officials, were sympathetic to the Thais’ position and disagreed with Treasury on the necessity of making the disclosure immediately. It would be better to wait for a few weeks, some argued—say, until October. After all, the
point of the whole package was to stop the panicky flight of capital, improve investor psychology, and restore confidence. Why subvert its purpose? “I do not dispute the general case for transparency in policymaking,” said Gregory Taylor, the executive director for Australia and several other countries, in a confidential statement delivered at the August 20 IMF board meeting that approved the Thai program. “The practical issue here, however, is that Thailand has to traverse an extremely delicate transition from the current unsustainable position to a more secure one. During this transition, it is vital that market confidence be maintained.... Publishing the figures [about the swap commitments] may well trigger a reassessment by the market.” But the United States was too powerful to be denied. “We felt we could not perpetuate a deception,” Summers said. “I have no regrets about this, nor have I heard any regrets from anyone in this [Treasury] building.”

  It is impossible to say whether allowing Bangkok to keep its secret a while longer might have made a significant difference to the success of the IMF’s program for Thailand. The program went even further off track in October and November 1997, with the baht plummeting to 56 per dollar in early 1998. The reasons were numerous; prime among them was the reluctance of Prime Minister Chavalit’s government to take tough action by closing sick finance companies. Only after Chavalit’s resignation in November 1997 did Thailand begin to demonstrate a genuine determination to clean up its financial system. And only after that determination became evident did the baht begin to recover, as investors perceived the government’s willingness to pursue IMF-mandated reforms. A logical conclusion—though it can’t be deduced with certainty—is that the baht would have weakened significantly regardless of the disclosure about the reserves.

  Still, within the IMF, many felt that the U.S. Treasury badly misread the likely reaction of the markets to the disclosure. In a 1999 report on the effectiveness of the rescues it launched in Asia, IMF staffers wrote that the disclosure “was intended as a step toward greater transparency ... but its timing weakened the impact on confidence that the announcement of the program could have had.”

  One of the IMF’s virtues is that it is not above issuing mea culpas as long as a decent interval has passed. The report Just cited is one example. In an effort to learn from its mistakes, the Fund studies its performance in handling problems and crises, and it often publishes the results. Its less than stellar Job in Thailand has come in for a fair share of self-criticism in IMF publications.

  Not that the IMF concedes, as some of its harshest critics allege, that it bears responsibility for all the misery that Thailand endured in 1997 and 1998. The country was surely destined to undergo a painful recession once its financial bubble had burst and billions of dollars in capital had fled the country. One can only imagine how much more pain Thailand would have suffered, and how much faster and further the baht would have fallen, if the Fund had not mobilized a sizable package of loans.

  But the IMF admits that its excessive demands for fiscal tightening exacerbated Thailand’s recession. In the 1999 report assessing the Fund’s performance in Asia, the authors, a group of staffers from the Policy Development and Review Department, took their colleagues to task for underestimating the weakness of the Thai economy, a mistake that was repeated in Indonesia and Korea. The report noted that even though most independent economists had also failed to foresee the severity of the downturns, the Fund couldn’t hide behind that excuse: “The fact that the IMF’s projections were close to the consensus is not very reassuring ... as the IMF should in principle have been able to anticipate events better than outside observers.” The report’s authors also wondered why the designers of the Fund’s Asia programs had failed to learn from what had happened in Mexico: “The experience of Mexico, where growth declined from four percent in 1994 to minus six percent in 1995, might have led one to predict a much sharper slowdown in growth than was initially projected in the Asian crisis countries.”

  As for the IMF’s crisis-prevention efforts, another report, authored by a panel of independent experts, leveled perhaps the most damning criticism—that instead of encouraging the Thais and other emerging markets to welcome foreign capital, the Fund should have been raising red flags about the risks. Citing the IMF staff’s confidential recommendations to the Thai government in 1996, the panel faulted these because the staff “failed to caution on the dangers associated with the then prevailing system, which tended to encourage short-term foreign borrowing.” The panel summed up the issue as it applied in Asia in general: “On the issue of capital account liberalization ... the Fund’s advice certainly did not help prevent the crisis.”

  The poor initial results of the Thai rescue cast a shadow over the Fund’s prowess at halting crises at a time when more trouble was brewing. The Fund and the rest of the High Command would soon have bigger fish to fry—though few could envision it at the time.

  After working until dawn one night in mid-August dictating a report to Washington on the program they had Just agreed upon with the Thais, Hubert Neiss and Anoop Singh held a small celebration. “I went out and bought a little silver box for one of the secretaries, who had stayed up an entire night with no sleep,” Singh said. “The box was inscribed ‘Thai SBA [stand-by agreement], August 14, 1997.’ Hubert opened a bottle of champagne. We did that partly to thank her, but in the back of our minds was that this was a unique event. And we would not have to repeat it.”

  4

  MALIGNANCY

  On October 8, 1997, less than two months after approval of the Thai rescue, an IMF mission was dispatched to negotiate a program, including a substantial loan, for Indonesia. Jakarta was seeking the Fund’s assistance because the Indonesian rupiah, which had initially held firm following the floating of the baht in July, was starting to drop sharply. This time, though, the nature of the IMF’s support was supposed to be different from the sort that Thailand had received. The watchword for the Jakarta-bound mission was “precautionary.”

  Leading the mission was Bijan Aghevli, age fifty-two, deputy director of the Asia and Pacific Department. A native of Iran who came to the United States by himself at eighteen, graduated from Colorado State University, and earned a Ph.D. from Brown University, Aghevli had thick, swept-back hair and would be nicknamed “Radovan Karadzic” by Indonesian Journalists because of his passing resemblance to the leader of the Bosnian Serbs. Jovial and charming at times, willful and arrogant at others, he had spent his entire career at the IMF (except for a two-year teaching stint at the London School of Economics), earning a steady stream of promotions on the strength of his keen intellect.

  Aghevli had not been to Indonesia for years, and the mission he led was organized in considerable haste. Instead of the usual procedure, in which a team going into the field drafts a briefing paper and circulates it around the Fund for several weeks before finalizing its marching orders, Aghevli’s mission had to throw its plan together in about three days, almost immediately after the Indonesian government signaled that it wanted a program; the Fund wanted to respond promptly to the Indonesians’ request.

  The lack of preparation didn’t seem to be a major problem, in view of the precautionary character of the program that the IMF envisioned. As far as the Fund was concerned, the purpose of coming to Indonesia’s aid was to convince financial market players that they were wrong to bet against the country, and that the fall in the rupiah was grossly excessive. Unlike Thailand, Indonesia had a comfortably large $20 billion in hard-currency reserves. In both public and private comments, IMF officials went out of their way to praise Indonesia’s fundamental strengths and to suggest that the government of President Suharto needed to take only a few more steps beyond what it had already done, which included cutting spending on expensive infrastructure projects. “We’re in a strange situation where it’s not entirely clear why the markets have been so disturbed lately, and we see ourselves as supporting what the Indonesians want to do,” a senior IMF official said at the time. “I think of this as sort
of giving a seal of approval to their policies, and maybe providing them with some extra resources to show the markets that their policies really make sense.”

  Accordingly, the mission left Washington with the expectation of negotiating a program with the Suharto government that would contain relatively modest reforms. Part of the Fund’s thinking was that it wanted to score a success to counteract the black eye it was getting in Thailand. “The desire was, let’s have a show of [financial] force up front, for a responsible regime,” recalled Michael Mussa, who was the IMF’s chief economist. “Indonesia didn’t have a particularly big current account deficit. It was Just a question of confidence. And there was a lot of political support for the regime. The U.S. had been a strong supporter, and the Germans and Japanese too. So there was a lot of sentiment for the idea that we should stop the crisis at Indonesia. There was also the perception that the program in Thailand wasn’t working. The impact on confidence had been negative. We said, we didn’t want to do that again.”

  All the more stupefying, therefore, was the disintegration that would befall the Indonesian economy over the next several months, amid a highly charged showdown in which the IMF was demanding that Suharto dismantle long-criticized monopolies and subsidies benefiting his children and cronies. The rupiah would sink to the rate of 15,000 per dollar in January 1998, 85 percent below the summer 1997 level of 2,400 per dollar. As the rupiah fell, so would the fortunes of this country of 200 million people—the fourth most populous on earth—whose quarter-century record of solid growth and rising living standards had been one of the developing world’s most impressive success stories. Economic output would shrink by more than 14 percent in 1998, a rate of contraction that ranks among the most catastrophic suffered by any country in a single year since the Great Depression of the 1930s. Among Indonesian men who were working in 1997, 15 percent would lose their Jobs by mid-1998, and millions of Indonesians would slip back into the poverty they thought they had escaped forever, as median daily wages fell by about 30 percent (adjusted for inflation) in rural areas and 40 percent in urban areas. The economic slump would fuel social unrest that would force Suharto to resign in May 1998, amid bloodshed that would claim over 1,000 lives. The departure of his autocratic regime would pave the way for Indonesia’s first truly democratic election in decades and the flowering of free expression. But by mid-2001, the economy was continuing to sputter and the political scene remained chaotic, with violent ethnic and religious strife flaring in parts of the Indonesian archipelago.