The Chastening

by Paul Blustein

  In New York, McDonough convened a second meeting of U.S. bank executives on the morning of December 24, with John Reed of Citicorp participating by speakerphone from Colorado. Once again, McDonough told the bankers the realities as he saw them: Either they reschedule the debt, or Korea goes into default. “They were sort of looking around,” the New York Fed president recalled, “and I said, ‘I bet it would be convenient if I Just go have a cup of coffee. Why don’t you guys talk.’ And when I came back, the best of all possible worlds had happened. They said, ‘Not only will we reschedule, but we think a public announcement that we’re supporting the policy would be a great idea.’”

  Some of the bankers present recalled a more contentious discussion, in which participants demanded to know why Wall Street investment banks weren’t being roped into the standstill, and others complained anew about being solicited at the eleventh hour.

  The plan was still touch-and-go. New York Fed officials informed the bankers that William Rhodes, vice chairman of Citicorp, was being asked to coordinate the effort by international banks to halt the run on Korea, but they acknowledged that Rhodes wasn’t in New York. “They said he was on an island somewhere, which tells you how completely screwed up all this was,” one banker said.

  In fact, Rhodes was on vacation in Barbados, but he was the obvious choice for the Job. During the debt crisis of the 1980s, he had headed or worked on committees of major banks in negotiations with Brazil, Mexico, Argentina, and numerous other countries, and he still maintained an extraordinary number of contacts in the executive ranks of financial institutions around the world. Rushing back from Barbados Just before Christmas, the sixty-two-year-old Rhodes spent the next several days on the phone cajoling his fellow bankers. In the process, Rhodes said, he gained a scary insight into how Japan’s financial weakness was threatening its neighbors:The pulling [of credit lines from Korea] was still going on at $1 billion a day. I called [Japanese Vice Finance Minister] Sakakibara, and he said he alone could not get Japanese banks to hold. So the first step was to get the major banks to stop pulling. Over the weekend of the twenty-seventh and twenty-eighth, I got all of them—either the president, chairman, or vice chairman of major Japanese banks. Some I knew, some I didn’t. I had to promise that I would get the European and U.S. banks to hold. Some of the banks, like Long Term Credit Bank, which was already in trouble, said, “It’s hard for us to do this.” I really had to put my name on the line. I finally got everyone to agree not to pull.

  This was a sign of the Japanese banking crisis. The world had changed. [Tasaku] Takagaki [the president of the Bank of Tokyo-Mitsubishi] told me, “Bill, this is not like the days when we worked together in the eighties.”

  In the end, thanks to a lot of luck—not to mention ruined Christmases—the world’s bankers behaved in much the same way as Mussa’s cousin John and the other sailors on the Lexington under the stern gaze of the 200-pound bosun’s mate. There is much more to the story, but in a nutshell, most of the banks—or enough of them, anyway—stopped panicking and rolled over their loans. To ensure that they did, and to protect against cheating, the IMF and the central banks of wealthy nations established a worldwide monitoring system, supervised by the Fund’s Matthew Fisher and the Fed’s Ted Truman. Crucially important to the operation was a mass of data that the IMF drain-watch team and Bank of Korea staffers in Seoul had painstakingly assembled, showing how much each Korean bank owed to foreign lenders, to which foreign institution the money was owed, and when the debt was coming due. Every business day, a report was sent from IMF headquarters to each major central bank in the G-7 and other wealthy nations, showing which of their country’s banks had rolled over loans and which hadn’t; each central bank also received a report of how the other countries were doing. Top finance ministry and central bank officials—in the United States, Rubin and his aides—had to call the CEOs of banks that were balking, to reiterate that a default could be catastrophic.

  In a sense, the international banks got away with murder. They had foolishly injected billions of dollars of short-term loans into a country with a shaky financial system, yet they were suffering no losses. On January 28, 1998, after an intense month of negotiations, the banks reached a broad agreement with Korean officials to reschedule $22 billion of short-term interbank debt owed by Korean banks. In exchange for the interbank loans they held, the foreign banks received equal amounts of bonds, fully guaranteed by the Korean government. Moreover, those bonds paid attractive yields—2.25 percent over the London Interbank Offered Rate (LIBOR) for one-year bonds, 2.50 percent over LIBOR for two-year bonds, and 2.75 percent over LIBOR for three-year bonds.

  The Korean people, of course, were not so fortunate, especially the 1.5 million who found themselves out of work in 1998. For a brief insight into the misery and heartbreak such a statistic entails, consider Hong Kwan Pyo, a former elevator company manager who, before the crisis, was a contented member of Korea’s middle class, enjoying vacations at ski resorts and living with his wife and nine-year-old son in a spacious three-bedroom apartment in suburban Seoul. Hong’s company went bankrupt when the economy crashed and builders halted construction projects. His wife and son moved in with her parents, and Hong, too humiliated to face his wife or his inlaws, became a homeless inhabitant of a park near Seoul’s main train station, selling magazines on the street and vowing that he would not see his family until he raised the $4,000 he needed to start a small outdoor food stand. “I will stay away until I am able to stand up with nobody’s help,” Hong told Mary Jordan of the Washington Post. But he admitted that the wait was painful—so much so that one day, he went to his son’s school and hid in the shadows Just to catch a glimpse of the boy. “I cried all the way back here,” he said.

  Since Hong had to suffer for his country’s economic excesses, why not the banks that helped fuel those excesses? The answer is that meting out Justice in the midst of the Korean crisis would have been hard to square with the goal of maintaining financial stability, as Rubin noted in a speech he delivered as the Korean crisis was abating in January 1998: “We would not give one nickel to help any creditor or investor ... [but] any action that would force investors and creditors involuntarily to take losses, however appropriate that might seem, would risk serious adverse consequences. It would cause banks to pull money out of the countries involved. It could reduce the ability of these countries to access new sources of private capital. And perhaps most tellingly, it would cause banks to pull back from other emerging markets.”

  Defenders of the outcome in Korea can reasonably ask how much worse the situation might have been—and how many more stories like Hong’s might have materialized, not only in Korea but elsewhere—if the country had defaulted, or if losses had been imposed on the banks. In the end, at least, Korea got what an IMF rescue is supposed to provide—a breathing space to set its economy right, and enough hard currency to keep its economy functioning— thanks to the fact that the banks had finally been stopped from draining the money out faster than the IMF could pour it in.

  Still, the question asked by the bankers at the New York Fed on December 22 remains: What took so long?

  Many criticisms have been raised about how the Korean crisis was handled. But perhaps the most significant one is whether the High Command should have sought a bail-in right from the start, instead of a bailout. If the banks had been concerted into a standstill much earlier, and reached a collective agreement to stop pulling credit lines when the crisis was Just beginning to unfold, a lot of unfavorable developments might have been avoided or minimized. Korea might have suffered a less severe crisis and, consequently, a milder slump. The IMF might have enhanced its image with a rescue that was successful from the get-go instead of damaging its credibility with a bailout that initially flopped. The Fund might also have avoided making demands for deep structural changes in the Korean economy that delved into sensitive political questions and went far beyond ensuring that Seoul could restore financial stability. The structur
al reforms Korea accepted were surely beneficial to its long-run health, and some were arguably necessary for the resolution of the crisis, to persuade the markets that the country would be a safe place to invest in for the foreseeable future. But they weren’t as helpful in crisis-fighting as the more direct approach—halting the panic among the banks.

  In fact, officials of the Clinton administration Treasury have drawn flak at economic conferences from a number of bankers who say they wish the standstill proposal had come around Thanksgiving, in conjunction with the first rescue attempt. Rubin, Summers, and their subordinates insist that such timing would have been terrible. In early December, they contend, the markets would have reacted with disbelief to the news that Korea was on the brink of default, and the banks would have either refused a request for a standstill or reacted to such a dramatic initiative with a bigger panic. Moreover, the December 18 election was crucial; only after the nation’s political future was clear, and Kim Dae Jung had delivered a ringing endorsement of economic reform, could the markets feel confident in Seoul’s commitment to tackle its fundamental weaknesses.

  Readers may or may not be persuaded by that argument. But its implications help illuminate how Korea’s rescue depended so heavily on luck, and how close the High Command came to standing by helplessly as a default ensued.

  Imagine what might have happened if a few events had gone differently. Suppose, for example, that the Korean election had been scheduled for a month later, mid-January instead of December 18. The country was on the verge of running out of reserves on New Year’s Eve based on the funds it had received in the first rescue, so it would have defaulted before it had the chance to elect new leadership and demonstrate its commitment to reform. If, as the Treasury argues, the change in the country’s political environment was so essential to the late-December rescue, it is a matter of great good fortune that the election came in time to arrange the bank standstill.

  What would have happened if the election had not been scheduled as early as it was? Bill McDonough’s response to the question was to raise his palms toward the ceiling, smile broadly and say, “God is good!”

  No doubt. But only those with extraordinary trust in Divine Providence would wish to depend on it for the safety of the global financial system. Indeed, back in Indonesia, Providence was about to bestow a much less favorable outcome.

  8

  DOWN THE TUBES

  President Clinton was in his office aboard Air Force One, flying back to Washington from a fund-raising dinner in New York, when the White House signal room operator put through a phone call to President Suharto shortly after 9:30 P.M. Eastern Standard Time on January 8, 1998. A handful of top U.S. officials listened in on the call anxiously, which reflected the serious concern the administration felt about the budding upheaval in Indonesia.

  Hard on the heels of the Korean crisis, Indonesian financial markets were registering the full force of the compounding blunders that had been committed by the IMF and the Suharto regime in the closing months of 1997. The rupiah had dropped below 6,000 per dollar on January 2, which put the value of the Indonesian currency 60 percent below its level of the previous summer. Four days later, when the IMF was reported—inaccurately, as it turned out—to disapprove of the Indonesian government’s new budget, the rupiah-dollar rate hit 7,600. On the day of Clinton’s call to Suharto, the exchange rate touched the incomprehensibly low level of 10,000, causing ordinary Indonesians to strip supermarkets and grocery stalls bare of rice, cooking oil, flour, sugar, instant noodles, and Just about every other conceivable commodity, as rumors flew that a ban on food imports and large-scale rationing would soon be imposed to save their nation’s free-falling currency.

  Washington had long eyed the Indonesian market as a potentially rich source of demand for U.S. products and services, but the country’s crisis threatened much more than Just the loss of a few billion dollars in exports. Indonesia has the world’s largest Muslim population, so the State Department, the Pentagon, and the National Security Council were worried about the political implications of what was happening there. The brand of Islam practiced by most Indonesians is moderate and tolerant, but if hard times were to give rise to a more fundamentalist regime, the country might turn hostile toward the United States, and in particular toward the U.S. military presence in Asia. A stable, strong, and unified Indonesia helped keep Southeast Asians at peace with one another and with China; a weak and fractured Indonesia might generate tensions that would draw China into a conflict. Suharto’s repressive mode of governing, which included Jailing dissidents and brutally quelling civil disturbances, was offensive on human rights grounds, but its avowedly secular nature had helped keep the peace in a nation of widely disparate ethnic groups—more than 300 of them, by some counts—that included Hindus, Christians, Buddhists, and animists.

  In the phone call between the two presidents on January 8, Suharto started by thanking Clinton for his attention to the crisis, not only in Indonesia but in Southeast Asia generally. Clinton replied that he had been watching the situation very carefully, and that he was appreciative of the role that Indonesia played in the region. But he said that Suharto’s reform plan, though initially receiving a positive reaction in the markets, was producing the opposite effect now because of the perception that the reforms would not be implemented.

  Clinton praised Suharto for showing courageous leadership in the past and said it was vital that he demonstrate similar leadership on economic reform now. The U.S. president urged Suharto to work with Michel Camdessus, who was due to arrive in Jakarta the following week to finalize a new IMF program for Indonesia. Clinton added that he was dispatching Larry Summers to Jakarta immediately to meet with the Indonesian president and his economic team.

  Suharto responded with a long, somewhat discursive interpretation of his country’s troubles, including a complaint that foreign speculators were to blame for torpedoing the rupiah. Although the Indonesian people would accept sacrifice if they could be sure the result would be positive, he said, he was reluctant to adopt austerity measures, such as cutting fuel subsidies, when citizens could not understand the reasons.

  Clinton said he understood how speculation can get going in one direction. But the only thing Suharto could do, he added, was to change market psychology by embracing reform. Closing a bank and then permitting it to reopen didn’t help, Clinton observed.

  Suharto said he absolutely agreed with the need to restore confidence. He tried to Justify the favoritism shown his son Bambang concerning the closing of Bank Andromeda, stating that one bank among those shuttered had been allowed to reopen because it filed a successful lawsuit. As Indonesia’s president, he said, he was obliged to respect the court’s decision.

  The phone call from Clinton would be quickly followed by similar calls from other world leaders, including German Chancellor Helmut Kohl and Japanese Prime Minister Ryutaro Hashimoto, and private meetings with Camdessus and Stan Fischer. The dominant message was that Suharto could lead his country out of its mess, but doing so would require demonstrating a renewed commitment to IMF discipline and structural reforms of the KKN-riddled economy. That included taking actions that would leave no doubt about Suharto’s willingness to change his ways and eliminate the most egregious practices that were enriching his children and cronies. Many of Suharto’s interlocutors, if not all, were anticipating a highly positive impact if he followed their advice.

  On January 15, 1998, Suharto would make a dramatic gesture toward acceding to the IMF proposal. He would sign a “strengthened” IMF program containing promises to eliminate or curb virtually all of the most prominent examples of KKN. The front pages of newspapers the world over would splash photos the next day of Camdessus with arms folded, standing over Suharto as the president, seated at a table, put his name to the Letter of Intent.

  This program would fare even worse than the first, and once again, Washington would fault Suharto’s evident distaste for reform. “It’s not that he tried the p
rogram and the program has failed; he’s not tried the program,” a senior Treasury official said heatedly in February. But the January 15 program would go down in flames before Suharto had any chance to undermine it, and its failure would come as a stunner to the IMF, underscoring the weakness of the grasp that the Fund had on the forces buffeting Indonesia’s economy.

  For Indonesia, the news that Clinton had called Suharto offered a ray of hope that the international community would somehow rally together to lift the country from the morass into which it was rapidly sinking. The rupiah began to recover as word spread that the IMF had begun intense work on a new program. A team led by Bijan Aghevli was Joined in Jakarta by Fischer on January 11, and Camdessus was on the way. By January 14, the Indonesian currency would rise to 7,300 per dollar—still weak compared with precrisis levels but moving in the right direction.

  Summers’s meeting with Suharto, which took place on January 13, was not promising. For much of the session, the elderly president lectured the American wunderkind on his country’s economic accomplishments. To colleagues, Summers Joked later that if the conversation had been a baseball game, they would have had difficulty getting out of the first inning, “because it was always Suharto’s turn at bat.”

  But reaching agreement on the structural reform package proved astonishingly easy for the IMF, especially considering that the Fund wasn’t offering Indonesia any new financial support. Aghevli and other top staffers spent an entire night hammering out many of the measures with the technocrats and other reformers in the government, and Fischer met a couple of times with Suharto to obtain his assent on most of the items, leaving a couple of sticking points for Camdessus, who arrived on January 14.