The Chastening

by Paul Blustein

  Now the markets could see more clearly than ever how close Korea was to running out of reserves and how vulnerable it was to a rush for the exits by its creditors. Some market participants had already drawn the conclusion that the rescue package was insufficient; they had peered through the hype of the $55 billion “headline” figure and noticed some squishy elements, such as the second line of defense and the World Bank’s pledge to lend “up to $10 billion.” The data in the IMF document enabled them to discern that Korea was not getting a sufficient injection of reserves compared with the hard-currency obligations of Korean firms. As Guillaume Lejoindre, director general of Credit Agricole Indosuez in Seoul, told Agence France Presse on December 12: “The calculation is simple. Korea is to receive $9 billion from the IMF and other multilateral institutions between now and the end of the year. The short term debt due at the same time is difficult to calculate precisely, but it is around $20 billion. The country still has $4 billion to $5 billion in reserves, but they can’t let it fall to nothing. The money isn’t there.”

  The Thompson Financial Services Company, the world’s largest bank credit rating agency, expressed similar sentiments, downgrading Korea’s sovereign risk rating on December 11 with a warning about the “increasing prospect of the recent IMF emergency package being insufficient to meet the country’s short-term financial obligations.”

  As such assessments proliferated, the panic among foreign banks deepened, and their willingness to roll over short-term loans to Korean borrowers virtually ceased. John Dodsworth got a close-up view of the process from the offices of the Bank of Korea, where he helped staff the IMF’s “drain watch.” A British citizen, Dodsworth had been sent by the IMF to India in June 1997 as the Fund’s resident representative, and he recalled his six months there as “interesting but quiet.” Around December 10, he got orders to fly to Seoul—not that he had ever worked on Korea or been there before. He arrived around December 15, missing a Christmas visit from his three children, and returned to India for only about five days. “I finally told my wife, ‘Pack up. We’re moving to Seoul,’” said Dodsworth, who was eventually named the Fund’s resident representative there.

  In the evenings at the Bank of Korea, Dodsworth and other members of the drain-watch team, which included American economists Gary Moser and Rob Kahn, looked on in dismay as the central bank scrambled to respond to the flood of requests for hard currency that were coming in from Korean commercial bank branches around the world. Usually these requests took the form of faxes, saying that the commercial bank making the request had an obligation coming due that a foreign creditor had refused to roll over. And usually the Bank of Korea would accede to the request by lending reserves, although in some cases, central bank officials would call in a top executive from the commercial bank to appear in person—in the middle of the night—to explain the request in more detail. “The second or third evening I was there, someone came in from a commercial bank, and all of a sudden a Bank of Korea employee started screaming at him,” Dodsworth recalled. “This guy had seen too many of these things, of people coming and asking for [reserves], and he Just snapped.”

  The IMF tried to maintain a brave face, insisting that the program was finally starting to work even as all market indicators continued to point toward disaster. At a briefing for reporters on December 16, a senior Fund official said that the Korean authorities—as well as the presidential candidates and the nation’s broader body politic—had finally recognized the seriousness of the situation and were demonstrating the sort of firm commitment to the program that was required:We had during the last few days a significant change in Korea. You had conflicting signals from Korea Just after the adoption of our program; you had the impression that the government was only half-heartedly committed to it, that after signing [letters promising to back the program] the candidates could have second thoughts. Now all of that is changed, for the candidates, and the government.

  We are impressed that not only is the government complying with the program but they go beyond it, and in the right direction. We asked for the suspension of nine merchant banks, and fourteen have been suspended so far. We asked for liberalization of financial operations, for foreigners to operate in the money market and bond market—all of that is speeded up.

  We are not going to change this program when the ink is not yet dry.

  But behind the scenes, despair was taking hold among top policymakers. Alarmed members of the Clinton administration’s foreign policy establishment were once again demanding that the United States take whatever actions were necessary to save Korea, including backing a new and bigger international bailout. But Rubin dug in his heels more firmly than ever. “What Bob said at that point was, ‘If you go with another package, and that one doesn’t work either, then you’re really in trouble,” recalled Daniel Tarullo, the president’s chief international economic policy adviser.

  Talk of the unthinkable—allowing a Korean default—was quietly spreading. At a meeting among senior Treasury and Fed officials over lunch in Rubin’s private dining room, Greenspan asked that the agencies’ staffs examine the possible consequences of a default more thoroughly than they had previously. He wanted to know how awful the impact would really be; for example, how much further would the won be likely to fall? The Fed chief had a strong libertarian streak, having once been a leading disciple of Ayn Rand, the philosopher whose “objectivist” theories disdain large government. So his question about the impact of default was no mere matter of wanting to be sure that the High Command was prepared for the worst. He considered government bailouts inherently distasteful and preferred to let debtors and creditors sort out their own problems. The failure by a major country to pay its obligations might be the best outcome for the financial system, he thought, because if lenders paid the price for having made irresponsible decisions, the moral-hazard problem would be obliterated and Justice would be served. The only question was, would the system destabilize completely?

  Similar sentiments were voiced at the IMF’s board meeting on December 16 by Onno Wijnholds, the executive director representing Holland and several other countries. Wijnholds, who shared Greenspan’s desire to see the moral-hazard problem addressed more forcefully, said, “While not fit for publication, I would be interested in staff’s assessment of default.”

  In fact, the Fund staff had been contemplating that issue, in a top-secret document addressed to Stan Fischer that came to be known as the “Plan B” memo. Dated December 12 and drafted by Matthew Fisher, a British economist in the Policy Development and Review Department, the memo outlined several options for resolving the Korean crisis and explored their pros and cons. One option involved increasing the size of the bailout and speeding loan disbursements to Seoul faster than originally contemplated—which had the obvious disadvantage that the money might simply fly out of the country into the vaults of the foreign banks Just as the initial bailout money was already doing.

  A second option was default, in which the Korean government, recognizing that its reserves were insufficient to fulfill all obligations, unilaterally ordered Korean banks and companies to suspend making payments on their debts to foreigners and imposed controls on all outflows of capital except for trade-related transactions. Although this option was carefully considered as a possible least-bad choice, the disadvantage for Korea was that it would risk wrecking the country’s creditworthiness for the foreseeable future, and the disadvantage for the world as a whole was that it would risk sparking massive contagion, with the Electronic Herd bolting out of Latin America and every other emerging market Just as it had in Asia. The chances that this would happen were unknowable and unquantifiable, but as one Fund economist who was involved in the Plan B discussions said, “You could tell yourself a story that this could deliver the most severe shock to the world economy since the 1930s.”

  The third option involved using the IMF and the G-7 to perform the role of the 200-pound bosun’s mate on the USS Lexington. This was the “b
ail-in,” which was elegantly simple in theory but laden with practical complexities.

  The basic idea of the bail-in was that government officials in Washington, Tokyo, London, and other world capitals would use “moral suasion” to induce Korea’s foreign bank creditors to stop pulling their money out of the country. It was in the banks’ own interest, after all, to call a collective halt to their panic, roll over their loans, and accept a stretched-out payback of their claims, since default would be averted if everyone participated. But one obvious problem with this plan, which is also known as a “standstill,” was that it would require a high degree of government intervention and coordination. It wouldn’t work unless creditors could see they were all being treated more or less equally. Creditors might accept the argument that they had a collective self-interest in refraining from demanding immediate repayment, but the whole scheme would fall apart if the perception took hold that certain claimants were getting a better deal than others. Thus governments would have to ensure that the banks acted together.

  Camdessus and Fischer favored the idea of trying a bail-in, an option also supported by the Bundesbank’s Tietmeyer and his German government colleagues. In a G-7 deputies meeting at New York’s Kennedy Airport on November 26, the German deputy, Jürgen Stark, had argued for approaching the banks and admonished that a Mexican-style bailout should not be repeated in Korea, but he was rebuffed by the others.

  The idea of bailing in Korea’s bank creditors was also being bruited about within the U.S. government. The chief advocate, who initially proposed it before Thanksgiving, was the director of the Fed’s Division of International Finance, Edwin “Ted” Truman, a curmudgeonly former Yale professor. Truman, fifty-six, was a force to be reckoned with at the Fed, where he had worked since 1972. Much admired by Greenspan for his encyclopedic knowledge and experience in international financial issues, and by his subordinates for his devotion to public service, Truman was also saddled with a temper that sometimes got the better of him when he was confronted with lesser intellects who didn’t grasp the power of his logic with sufficient speed. The targets of his outbursts even included members of the Fed’s seven-person Board of Governors, who resented him for his reluctance to share information with them and acting as if his only fealty belonged to the chairman. Although not a physically imposing person—five feet, seven inches, balding, with thick glasses—Truman didn’t shy from raising his voice in board meetings to discourage lines of questioning he disliked. “Ted thought he was guardian of the gate,” said one former board member. “Governors were political types who came and went, and he was the protector of the institution, and he knew what was best.”

  Truman, perhaps better than any other senior U.S. policymaker, appreciated the art of twisting bankers’ arms to save countries from financial crises. He had been the top lieutenant on international matters for former Fed chief Paul Volcker during the Latin American debt crisis of the 1980s, which was first addressed with a strategy called “concerted lending.” When countries such as Mexico, Brazil, and Argentina had trouble paying the debts they owed to foreign banks, Volcker and Jacques de Larosiere, the IMF managing director at the time, would apply heavy pressure on the banks to provide new, longer-term loans, as would Volcker’s counterparts in other wealthy countries—provided, of course, that the debtor country reached agreement with the IMF on the conditions of a program to put its economy in order. The idea was to buy time for the countries to resume growth and make sure that the banks, which were being saved from default, bore a fair share of the burden involved in the rescue. Although Volcker never explicitly said he would use his powers as a bank regulator to exact retribution from a bank that refused to follow his moral suasion, the implication was not lost on bank executives.

  Korea was a nearly ideal candidate for a bail-in, Truman believed, because most all its foreign creditors were banks, which were easier to organize and more susceptible to government suasion than, say, mutual funds holding bonds. But the plan faced resistance from two very powerful men—Alan Greenspan and Bob Rubin.

  Greenspan had his libertarian reasons for objecting; as the nation’s chief bank regulator, he was loath to take any action that smacked of using his powers to coerce private-sector institutions, which were supposed to be accountable to their shareholders. More important, the Fed and Treasury chiefs were dubious that the bail-in would work, and they were fearful that if it did, it might produce catastrophic side effects. They knew the markets had changed a great deal since the 1980s, when banks were virtually the only conduits for private international capital flows. They were unsure whether the banks that had lent to Korea would bow to the exhortations of government officials, and they reasoned that the banks might react to being concerted in Korea by withdrawing en masse from other emerging markets. “The main question was, would doing this cause more dominoes to fall?” said Truman, who recalled that Brazil and Russia were most frequently mentioned as countries from which foreign banks might flee.

  In other words, the High Command might be damned it if did and damned if it didn’t. A unilateral stoppage of payments by Korea would surely risk contagion, but so might an effort to prevent default that involved bailing in the banks. Meanwhile, Korea’s reserves were dwindling lower by the day.

  At the Jefferson Hotel, where Rubin lived, the top policymakers in the Treasury and Fed gathered for dinner on Thursday, December 18, the day of the Korean election. The idea of bailing in the banks, participants recalled, was not even discussed much. The main option before the group was whether to increase the size and speed of the bailout, which would involve accelerating the IMF disbursements, inducing the World Bank to lend faster, and disbursing the second line of defense. Summers and Lipton made the case for this approach, but others argued that extra bailout money would do little more than ensure that more frightened bankers got their loans repaid.

  Rubin mostly listened and asked questions, his skepticism evident. As usual, he was weighing the idea probabilistically, in terms of whether it would substantially improve the odds of a favorable outcome. “The Jefferson dinner was the classic Rubin decisionmaking paradigm,” Geithner recalled. “Rubin’s view was, he’s totally happy to take the risk if it’s a prudent risk. If $5 billion of U.S. money is going to make the difference between success and failure in Brazil or Korea, he would invest the money; a serious country should be willing and able to make that kind of investment. But the key question is what the probability is that it will increase your chances of success.”

  The dinner meeting broke up in a bit of disarray as Geithner and Truman, who carried pocket electronic devices that could transmit financial newswires, began catching some of the early reports from Seoul about the pending electoral victory of Kim Dae Jung. The president-elect’s initial comments did not inspire confidence and were causing renewed turbulence in the markets. The won, which had rallied earlier in the week, was falling again, to about 1,630 per dollar. The outlook was bleaker than ever. As Summers recalled: “That dinner sort of ended with everyone agreeing that default’s a terrible alternative; pouring more money into Korea so the banks can take more money out is an untenable alternative; so let’s all wrack our brains and see what we can come up with.”

  Kim Ki Hwan had been waiting patiently for several days to travel from Seoul to Washington. Now, on December 19, he was arriving in the U.S. capital on a mission that he desperately hoped would save his country’s economy.

  Kim was not a government official, exactly, though he bore the title “ambassador-at-large for economic affairs.” Fluent in English and distinguished-looking with wavy silver hair and glasses, Kim was a lawyer who had been recruited by the Ministry of Finance and Economy earlier in the year to help represent the government’s interests overseas. He was traveling to Washington at the behest of Finance Minister Lim, with whom he had dined a few days before, to plead with the Treasury for a new rescue plan.

  Instead of leaving for Washington immediately after the dinner with Lim, he had delib
erately arranged an appointment with Summers for Friday, December 19, because the Korean presidential election was scheduled for the eighteenth. He wanted to know the identity of the next president before making his pitch. “The Korean government had lost so much credibility, I felt making any request in the name of the existing government would not be enough,” Kim recalled. “That’s why I decided to visit right after the election. So I got on a plane right after voting. I didn’t know who had won. When the plane landed at Kennedy Airport, that’s when I learned who would be our next president. I had a person from the ministry make a call to the Korean consulate in New York. He said, ‘It’s going to be DJ!’”

  The victory of “DJ”—the affectionate nickname for Kim Dae Jung, which helped differentiate him from the current president, Kim Young Sam—was a development for which Kim Ki Hwan was not fully prepared. Before leaving Seoul, he had met with the rulingparty camp, but he had not had a chance to meet with DJ’s people. And although Kim Ki Hwan felt fairly sure he could speak on DJ’s behalf, he couldn’t be entirely certain. DJ, after all, was a populist, a man who had become famous worldwide for his struggle to rid South Korea of military dictatorship. In 1971, while running against President Park Chung Hee, DJ had been permanently injured when a truck “accidentally” ran his campaign vehicle off the road; a couple of years later, he was kidnapped from a Tokyo hotel by Korean security agents and nearly murdered. Put on trial for allegedly fomenting riots, he was sentenced to death, spent years in prison, and was eventually exiled to the United States. Following the overthrow of military rule in 1987, he had resisted Joining the ruling party, and he maintained close ties with Korea’s militant trade unions.