The Chastening

by Paul Blustein

  Quite apart from their anger over the lack of consultation, the Germans fumed that the IMF loan to Mexico was essentially going to bail out Wall Street. It was a point the Clinton administration could not deny. American investors and brokerage firms had bought tens of billions of dollars worth of short-term Mexican government bonds, called tesobonos, and the rescue package was providing Mexico with enough dollars to ensure that it could avoid defaulting on any of those bonds. Washington’s defense was that the alternative—allowing default—would have dealt an incalculable blow to U.S. interests and conceivably to the global economy in general. Mexico had become one of the shining stars of market-oriented reform in the developing world, and that model would be severely tarnished if the country became an international financial pariah. Moreover, administration officials argued, a Mexican default would risk causing other countries to succumb to crises, with ill effects all over the Western Hemisphere if not beyond. But in Tietmeyer’s view, the deal virtually invited investors and lenders to shower money on emerging markets as if the downside didn’t exist. “The generous involvement in Mexico must remain an exception,” he thundered.

  The German protests about moral hazard were a source of considerable contention within the IMF. The prevailing view was that Tietmeyer and his colleagues were overstating the problem. In the first place, as Camdessus repeatedly noted, many private investors were taking heavy losses on their emerging-market holdings. Moreover, there was little if any hard evidence that the Mexican bailout had caused excessive amounts of capital to flow into Asian countries such as Korea; the overwhelmingly dominant factor was that the region was booming.

  But perhaps the most compelling counterargument to the Germans was that appalling consequences were likely in store for millions of people if bailouts were not provided. Should the world turn its back on a country in distress for the sake of deterring reckless behavior in the future? Wasn’t that somehow analogous to denying medical treatment for a car-crash victim who has been driving too fast? At an IMF conference, the Fund’s chief economist Michael Mussa acknowledged that the Mexican bailout might have made investors and lenders a tad more cavalier. But he added, to laughter from the audience, “And if we hadn’t rescued 800 people from the Titanic, we would have taught everyone an even more valuable lesson about the dangers of ocean travel!”

  The Germans, like the Japanese, eventually fell in line with the U.S.-led consensus on how to handle the crisis, partly to avoid worsening the turmoil. But their concerns about moral hazard could not be dismissed lightly, and when the crisis spread to Russia, there would be no disputing that investors had placed large bets on the expectation of a bailout for a country deemed too strategically important to fail. Although Tietmeyer and his colleagues strongly supported the need for IMF programs, they inveighed against “Powell Doctrine” packages. Instead of providing massive amounts of taxpayer money, they argued, the international community should insist on “involving the private sector”—a code phrase for inducing banks and investors to accept part of the burden for resolving a crisis by reducing or stretching out their claims.

  The ultimate German taunt was that the Powell Doctrine was a fraud—that the flows of private capital moving across borders had grown so vast that they would almost always swamp the packages that the IMF, the World Bank, and the G-7 were capable of putting together. Sure, the $50 billion rescue for Mexico was large enough to assure all the holders of tesobonos, plus all the other foreign holders of Mexico’s short-term debt, that the country would have enough dollars to pay all its obligations. But Mexico would prove to be the only example of the official sector mobilizing truly overwhelming financial force to stem a crisis. In other cases, the markets would see that even large packages were insufficient to cover all possible capital outflows.

  By that logic, the only surefire crisis-beating strategy is to involve the people controlling those outflows, and make sure they are part of the solution rather than part of the problem. The logic, which Tietmeyer tirelessly propounded, would prove particularly compelling in Korea.

  7

  THE BOSUN’S MATE

  Within the IMF, staffers later recalled, one person saw more clearly than most that the rescue for Korea announced on December 3, 1997, wouldn’t work, and that a different strategy was required. That person was Michael Mussa, the Fund’s chief economist and head of its Research Department.

  Mussa could be counted on to relieve the tedium of IMF meetings with a savagely funny line (for example, his remark about Camdessus seeing the glass half-full even when there wasn’t any glass)—or, in some cases, with plain odd behavior. He once broke into song at a board meeting, regaling the bemused executive directors with a rendition of “My Wild Irish Rose.” After returning to work from a long absence due to a heart ailment, he was cheerfully blunt about its severity: “My condition is category three/four,” he told colleagues. “There is no category five.”

  Balding, bespectacled, and a lifelong bachelor, Mussa was born in 1944 and grew up in Long Beach, California. His father, a native of France whose education ended in the eighth grade, was a leader in the Screen Set Designers and Decorators Union. Mussa attended the University of California at Los Angeles and earned his M.A. and Ph.D. at the University of Chicago, where he later Joined the business school faculty. But he developed a yen for public policy after a stint as a member of the Council of Economic Advisers in the Reagan administration, and he Joined the IMF as chief economist in 1991. Economics, by the accounts of his friends and associates, was his life’s great passion, aside from his private collection of fine wine. Socially awkward, he tended to stand nervously sipping a drink at social gatherings, unless he was stimulated with a remark or question about economics—in which case he suddenly became the life of the party, using anecdotes and analogies to illustrate his points. He often used such story-telling devices to good effect in internal debate, and during the Korean crisis, he told this story about his cousin:On the eighth of December 1941, my cousin John volunteered to Join the U.S. Navy. He was then not quite old enough, and he lied about his age. He was assigned to the aircraft carrier Lexington.

  He was serving in the engine room, during the Battle of the Coral Sea, when they took two torpedoes from Japanese naval aircraft. The crew fought for at least eighteen hours to keep the Lex afloat. But ultimately the order came down to abandon ship. And John said that as they were climbing up the gangway out of the engine room, there was a 200-pound bosun’s mate standing on deck, pounding on the rail with a billy club, commanding, “One at a time! One at a time! One at a time!”

  Something like that bosun’s mate—something to restore order—was what Korea needed, Mussa reasoned as the country’s crisis unfolded. Foreign banks were clambering all over each other to abandon ship, so unless order was imposed on them, the country’s economy was doomed. Simply throwing together a large package of loans wouldn’t work. The amount of money the international community could reasonably muster for Korea wouldn’t suffice to reassure all the foreigners holding short-term Korean debt that they could get their money back. They would keep Jumping overboard in a panic unless prevented from doing so. Korea posed no worries about solvency—it had an economy churning out a half trillion dollars a year in goods and services, so full payment could be made eventually on the debts Koreans owed to foreigners, which totaled Just 30 percent of that half-trillion-dollar GDP. But the country was in quite a liquidity bind.

  At meetings in November 1997 with Fund staffers preparing to head to Seoul, Mussa suggested a plan in which Korea’s financial problems would be handled much as New York City’s were in 1975. That is, creditors holding short-term debt owed by Korean banks would be induced to exchange their claims for longer-term bonds. Foreign banks would be told to calm down, that they would eventually get their money back, but they couldn’t get it back right away, so they would simply have to wait over a longer period. They would become “involved” in resolving the crisis, as the Germans liked to put it. Instead of
being bailed out, they would be bailed in.

  In fact, something quite similar to this solution would ultimately be adopted, but only after the world’s eleventh-largest economy had come within a whisker of being forced to default. The final resolution of the Korean crisis is now viewed as a triumph for the High Command, and in a way it was. But the tumultuous series of events that preceded it is evidence for the tenuousness of the High Command’s grip on the global economy, and shows how close the Committee to Save the World came to being the Gang Who Couldn’t Shoot Straight.

  On the night of December 3, following Camdessus’s press conference in Seoul where he announced the completion of negotiations with the Korean authorities, exhausted IMF mission members began work on one final task—writing a report on the program for the Executive Board, which would meet at 9 A.M. on December 4 to approve it. Some went back to their rooms and crashed, and Neiss had to fly to Washington to attend the board meeting. But Wanda Tseng and a handful of hardy others stayed up for yet another allnighter (her fourth straight) at the Hilton. “I don’t know how I managed. And I don’t remember how I managed,” she said, adding that her miseries intensified when her computer froze during the night, requiring an assistant to scroll through the Letter of Intent and type it into her own computer.

  Computer malfunctions would be the least of the mission’s woes. Far more serious was the growing concern that the rescue plan, unveiled to such fanfare, was itself dangerously prone to failure.

  The $55 billion package of loans consisted of two distinct portions. The multilateral portion, totaling $35 billion, came from the two Bretton Wood institutions—$21 billion from the IMF and up to $10 billion from the World Bank—plus $4 billion from the Asian Development Bank. The remaining $20 billion, which was to come on a bilateral basis from governments of wealthy countries, was the second-line-of-defense money—funds that were available if the multilateral loans proved insufficient. This portion had been thrown together in great haste during the last days of the negotiations. “Some unfortunate finance minister from one country—I won’t tell you which one—was woken at 2 A.M. [to see if his country would agree to contribute],” one IMF official recalled. “The executive director for that country said, ‘I can’t wake him at such an hour.’ We said, ‘Do you want your country in or not? The minister will be pretty mad if you’re not in because you didn’t wake him up.’”

  The IMF economists at the Hilton compiled a chart showing that Korea would obtain enough hard currency to avoid default if it received all the loans in the package, including the IMF money (which was to be disbursed in tranches a few billion dollars at a time), plus the $20 billion second line of defense. But after they sent a draft of their report to Fund headquarters, their work started to unravel. Bijan Aghevli, home from Indonesia, called from Washington in his capacity as deputy director of the Asia and Pacific Department to say that the report needed to be changed because of its assumption that the $20 billion in the second line would be lent to Korea. Board members from the rich countries contributing the second line couldn’t vote for a program that so clearly assumed the money would be used, Aghevli explained.

  The mission members in Seoul were thunderstruck, for without the $20 billion, the projections in the report showed the Koreans falling short of the reserves they needed to meet all their obligations. This posed an urgent problem: The Executive Board was due to meet in a matter of hours to approve the plan; it was close to midnight in Washington, and the staff report was supposed to be delivered to board members’ homes at 5 A.M. Eastern Standard Time. Under IMF procedures, the board cannot approve a program that is “not financed”—that is, in which the projections show a likelihood of a country lacking the ability to pay its bills. “You will have to tell the Board that the program is not financed!” members of the Seoul team told Aghevli, who tried—with limited success—to calm them down.

  The problem over the second line of defense was, at bottom, a problem with one country—the United States. The Treasury Department was still nervous about drawing attacks from Congress for even suggesting that it would use its emergency cash fund for lending money directly to bail out a country, and it wanted numerous conditions imposed on the use of the money. To this day, the prevalent view among non-U.S. policymakers involved in the Korean rescue is that the Treasury never intended to permit disbursal of the second line. “It was a funny thing about the second line,” said one IMF executive director. “The line was ‘there’—but it wasn’t there.”

  Treasury officials would later insist that they were prepared to disburse U.S. funds to Korea if the situation had become sufficiently dire. But they also admitted that the second line was, as one of Rubin’s former aides put it, “an experiment in trying to make something look as real as possible without ultimately having to spend the money. It had a sort of Catch-22 quality to it: If you don’t need the money, you don’t get it. And if you do need it, then you probably haven’t met the conditions for disbursal.”

  Aghevli and the Seoul mission team concocted a makeshift solution to their problem as the clock ticked down. Essentially, they cooked the books. They didn’t fake the numbers, of course, but they changed the assumptions. To compensate for the loss of the $20 billion in second-line money, the report assumed that 80 percent of Korea’s foreign creditors would roll over their loans instead of demanding immediate repayment as they had recently been doing. With that assumption plugged in, the chart showed Korea able to pay its obligations. Never mind that few staffers thought the assumption had a high probability of being achieved in the near term; at least the numbers added up.

  The episode may have amounted to little more than a bureaucratic snafu. In a sense, the report had to assume that the rollover rate for the bank loans would rise sharply; the whole point of the IMF’s plan was to restore confidence. But the last-minute number crunching did not augur well for the rescue the IMF board would approve that morning. In effect, the board was endorsing a program in which key Fund staffers had very little faith. In their report, the mission team inserted an unmistakable caveat about the bailout’s chances for success: “It is difficult to estimate with any certainty the likely development in capital flows over the program period, given the uncertainty surrounding the rolling over of private sector short-term debt.” Translated from Fund-ese, this meant staffers feared the IMF’s money would end up being used to pay off foreign banks that were unwilling to keep their money in Korea.

  Stan Fischer was subdued but guardedly optimistic when he faced the press in Washington on Friday, December 5. “The early reactions have been promising,” he said, noting that in the two days since the completion of the negotiations, the won had appreciated about 2.5 percent, and the Korean stock market had rebounded by 15 percent. “While these immediate reactions are welcome, they will be sustained only if the Korean economic program is rigorously implemented and is seen to be rigorously implemented by the markets.”

  This would be the public position of the IMF and the Treasury: We’ve done our part. The Korean program is solid, and the rest is up to the Koreans themselves. If they fail to demonstrate sufficient commitment to IMF-mandated reforms, the markets will punish them accordingly. So the following week, when the bottom fell out, official fingers in Washington quickly pointed at Seoul.

  Beginning December 8 and continuing for five days, the won plummeted by the 10 percent limit each day, ending up at 1,712 per dollar on December 12, and markets around the world went into a tizzy. The Koreans were blamed for demonstrating an obvious lack of enthusiasm for revamping their economic system. The chief evidence that Korea still “didn’t get it” was the reaction of presidential candidate Kim Dae Jung, who held a slight lead in the polls for the December 18 election. The day after the rescue was announced, Kim—despite having Joined his rivals in signing a pledge to support the program—said that if elected he would renegotiate the terms, and soon thereafter his campaign took out ads in major newspapers attacking the deal. Washington’s frustration
deepened when the Finance Ministry disclosed on December 9 that it would invest $1 billion in two large ailing commercial banks and take control over them rather than shut them down. “It was one of a series of dubious decisions that have been surrounded with a lot of ill-thought-out pronouncements,” an unidentified American official told The New York Times. The Treasury publicly rejected Korean pleas for a speedup of disbursements from the international rescue package, with Rubin stating pointedly: “I think they’ve got a strong program with the IMF and I think the key is for them to implement that program and implement it effectively.”

  The Koreans’ actions were unhelpful, and the political uncertainty over the looming December 18 election surely increased the difficulty of regaining financial confidence. But what really hurt market sentiment was growing evidence that the bailout, large as it was, didn’t provide Seoul with sufficient hard currency to deal with the potential near-term outflow of capital. The precipitous downturn in the won had begun when Chosun Ilbo, a leading Korean daily, published a leaked version of the December 3 IMF staff report, which laid bare how low Korea’s reserves had fallen, and how high the country’s short-term debt was. Particularly shocking was one table showing that usable reserves had shrunk to $6 billion on December 2, and another indicating that the foreign debt falling due over the coming year was as high as $116 billion, instead of the $65 billion officially reported, once the data included debts owed by the overseas branches and subsidiaries of Korean companies. This information became public only because of a leak to the press; unlike the Thais, the Koreans were not forced to disclose it by the IMF or the Treasury or anyone else. But the impact was devastating to confidence in much the same way as the impact on Thailand when Bangkok revealed in August 1997 how much it had spent on forward commitments to defend the baht.