Harold Wilson once blamed the "gnomes of Zurich" for the sterling crises which dogged Britain in the 1960s. Mahathir Muhammad, Malaysia's prime minister, was expressing similar sentiments when he blamed his country's currency crisis on George Soros and other "Zionist" speculators. In both cases the statesmen were rightly mocked for brazenly trying to pass the buck. (Soros actually lost money in the Malaysian currency turmoil although, unlike one or two other hedge funds with heavy exposure to Asia, he did not lose his shirt).
Holding up politicians to ridicule is one thing-but absolving the financial markets of any responsibility for such crises is quite another. As the dust settles on the Asian crisis and attention shifts to Russia (and elsewhere), a number of erstwhile proponents of financial liberalisation are beginning to question the wisdom of the move towards a fully liberalised global capital market. With the costs of Asia's currency turmoil rising, Mahathir is not alone in wondering whether the errors committed by Asia's economic managers merited such harsh punishment. With globalisation still in its infancy, the likelihood of such crises recurring is high. Finding new structures to manage the recurrences is an urgent task.
It was left to the International Monetary Fund to impose the tough qualifying conditions for the bail out packages in Korea, Thailand and Indonesia, despite the fact that the IMF had been dolloping out praise to the managers of these economies shortly before the crisis unfolded. The IMF was not alone. Standard & Poor's and Moody's Investors Service, the gatekeepers of a country's ability to tap the capital markets, were also unaware of any serious flaws in the management of these economies. Similarly, in the period before the crisis broke, the international banks were lending hundreds of billions of dollars to the region on increasingly favourable terms. Nor can the west's army of mutual, insurance and pension fund managers claim any special foresight, having poured huge sums of money into Asian and other emerging markets. (The economist Paul Krugman recently described attending a conference of money market managers where contrarians were ridiculed and only those reciting conventional wisdom were given a respectful hearing. "Asian leaders who have been fulminating against the... speculators are wrong," wrote Krugman. "What I saw in that room was not a predatory pack of speculative wolves: it was an extremely dangerous flock of financial sheep.")
In the aftermath of the crisis, the experts have competed to expose the weaknesses of the "Asian model." Much like one of those spoof apologies in Private Eye, the global financial community has reversed its conventional wisdom: "In common with others we might have given the impression that the economies of Asia had developed a new and unprecedented route to riches which we called the Asian miracle. In fact, the economies of Asia are basket cases run by nepotistic crooks who deserve to be consigned to the economic doghouse until they have learnt some sense. We apologise for having misled our readers."
This shift in conventional wisdom misses the point. The economies of Thailand, Korea and Indonesia were in reasonably good shape prior to last year's crisis. They had low and declining inflation, several consecutive years of budget surpluses and high domestic savings ratios.
There were, however, some worrying signs, not least the presence of large and rapidly widening current account and trade deficits in Thailand and Malaysia and to a lesser extent in Indonesia and the Philippines. Attention began to focus on the steep decline in regional export growth and the emergence of asset price bubbles in the property sector. Several voices predicted that the region's pegged exchange rates would have to be devalued in order to kick-start export growth and relax the monetary vice which threatened to bankrupt many Thai companies. But no one anticipated the events which were to follow.
What ensued was the by now familiar domino effect of emerging market crises. Much like the Mexican "Tequila" crisis of late 1994-or the crisis triggered by the Mexican debt moratorium in 1982-the contagion quickly spread from one economy to another. The failure of the Thai authorities to stave off a speculative attack on the baht led to the collapse of the currency and stoked fears about the imminent bankruptcy of the Thai financial sector. Such fears became self-fulfilling, exacerbated by the fact that commitment to the dollar peg had been so complete that there had been no hedging of risk. The faster portfolio capital was withdrawn and domestic capital converted into dollars, the quicker the currency plummeted against the US dollar and the less likely it became that Thai banks would be able to afford to service their dollar borrowings. Nemesis became inevitable the moment financial markets realised it was a possibility. The scenario was repeated in Korea and Indonesia.
It is still too early to calculate the cost of the crisis, but the IMF's estimates are being revised upwards monthly. The current consensus is that GDP in Thailand and Korea will shrink by between 2 per cent and 5 per cent in 1998 and that they will be lucky to escape negative growth in 1999. Owing to the political chaos unleashed by the crisis, Indonesia will be much worse affected, experiencing an economic contraction of 10 per cent or more this year and further shrinkage in 1999. Those such as Malaysia, which escaped the worst of the backlash, will see growth drastically reduced this year. Although such events have become commonplace in Latin America, a downturn on this scale is unprecedented in southeast and east Asia over the last 30 years. In fact, the contraction in Indonesia bears comparison with the damage visited on the economies of Europe and the US in the aftermath of the Wall Street crisis of 1929.
It seems almost surreal to recall that just 12 months ago, the IMF and others were expecting Indonesia to grow by about 8 per cent this year and were anticipating similar rates of growth across the rest of Asia. But to conclude that the IMF simply got it wrong is unsatisfactory. Nobody could have foreseen the speed with which the financial markets reversed sentiment towards Asia-for the simple reason that it took the financial markets themselves by surprise. What triggered the crisis was as much an arbitrary shift in market psychology as it was a fresh assessment of the region's economic prospects.
The turmoil has thrown up beneficial side effects, not least a move towards greater transparency and widespread questioning of much of the cronyism which passes for "Asian values." But it would be premature to suggest that the crisis has led to a decisive shift in favour of the capitalist "level playing field," when it could still create a backlash against global liberalisation. Nor is belief that the markets over-reacted inconsistent with the view that the economies in question were ripe for a correction given their rates of over-investment (especially in property) and the resulting over-valuation of domestic asset prices. Periodic emergence of such asset price bubbles is routine in even the most developed economies.
Financial markets tend to overshoot both on the economic upturn and on the downturn and in the process contribute to the creation of the bubbles which, having burst, cause such damage to the real economy. The banking sector usually gets sucked in too. Indeed, if it had not been for the poor regulation of international-and notably Japanese-banks, less money would have been lent to dubious Korean and Indonesian borrowers and the scale of the banking sector crisis would have been smaller. Banks such as Cr?dit Lyonnais and some equally shaky Japanese and Korean institutions attempted to compensate for their declining return on capital by lending to high-risk/high-return counterparts in Asia.
Joseph Stiglitz, chief economist of the World Bank, has suggested that financial crises are an inherent feature of a world dominated by liberalised financial markets. "Small open economies are like row-boats on a wild and open sea. Although we may not be able to predict when the boat will capsize, the chances of eventually being broadsided by a large wave are significant no matter how well the boat is steered."
But the unusual feature of this crisis, in the context of the IMF's traditional work, is that it was largely a private sector phenomenon. It was not governments incurring excessive debt which created the bubble, but local, private sector banks raising dollars in international financial markets and lending in their domestic currencies to local, private sector companies. And this throws the issues of supranational policy into relief: if the behaviour of financial markets is the problem-rather than the wayward monetary, fiscal and regulatory regimes of national governments-then is the IMF equipped to anticipate and deal with such crises?
judging by the content of the three Asian rescue packages (Korea, Thailand and Indonesia) it is clear that the IMF has not revised its generally positive view of the nature of international financial markets. Although there are important differences between the packages, they nevertheless overlap extensively.
The first aspect of the bail out conditions is that most of the burden of cost has been loaded on to the countries themselves. Apart from those who lost money on regional stock markets or bet the wrong way on currencies, most banks which lent money to the three economies will be repaid in full. In some cases, as with the rolling over of the short-term debt of the Korean banking sector to its international counterparts, creditors will receive a higher rate of interest than they had negotiated before the crisis. Most western and Japanese banks have subsequently made provisions against the possibility of future losses in Asia, but this is what they should have done in the first place. The overwhelming proportion of losses have been borne by the (Asian) borrowers while many of the (western and Japanese) lenders have been bailed out by the IMF.
Second, all three Asian economies have been required to implement serious budgetary cuts in spite of the fact that they already had fiscal surpluses. The reason for this, and for high interest rates, was to stabilise foreign exchange rates against the US dollar, which would then enable governments to service their dollar-denominated liabilities and thus regain access to the capital markets. Again, the onus is on the borrower to make the full adjustment.
Third, the Asian governments were required to accelerate liberalisation of their financial markets and to remove any substantial capital controls which remained (extensive in the case of Korea). The implication appears to be that the distortions which arose from the existence of such controls helped to spark the crisis in the first place.
Finally, the three countries are required to improve their prudential capabilities, including better bank supervision, more transparent publication of financial data and improved monitoring of external borrowings. It would be wrong to criticise such measures. The more data which can be made public, the less likely there will be a dramatic turn in sentiment.
However, taken as a whole, the IMF conditions amount to a one-sided diagnosis of the crisis. The subtext of the IMF's actions in Asia is that the financial markets were acting on the best information available which, because of the opaque way Asia's economies were run, happened to be misleading. By ensuring that in future such information was readily available, Asia's governments could prevent the recurrence of such crises. The markets, in other words, have been absolved of any blame.
This is not only wrong; it will also help to ensure that such crises do recur in future. Moral hazard exists when lenders know that they will be fully repaid even if the borrower goes bankrupt. This encourages them to chase higher returns by lending to less creditworthy borrowers. The existence of implicit government guarantees on Thai and Korean companies and banks is one example of moral hazard; another is the IMF bail out of international loans to Korea and Thailand. To the extent that the institutional bias of supranational policy is to place the burden of recovery on the users rather than the suppliers of capital, this will only exacerbate the market's tendency to overshoot.
The IMF's view of liberalised financial markets is also unsatisfactory because it fails to take into account significant modifications to mainstream economic thinking in the aftermath of both the Mexican and Asian crises. Among those who have questioned the market's judgements are Joseph Stiglitz and Jeffrey Sachs, director of the Harvard Institute for International Development.
Stiglitz has suggested that the emphasis on improving the flow of information was unlikely to prove a complete solution. "The returns to better information are great," he wrote. "But we should not delude ourselves into thinking that this alone can resolve all the problems. Much existing information seems not to be fully incorporated into market assessments so there is no guarantee markets will respond perfectly to perfect information." Many others, notably Alan Greenspan, chairman of the US Federal Reserve (who has referred to the "irrational exuberance" of the US equity markets), appear to be questioning the stability of financial markets. Indeed, there has recently been a shift in the mainstream view of how markets work. That is the easy part. The difficult part is to propose credible solutions.
as a starting point we should define what we mean by global capital markets. It is a dreary clich? that "billions of dollars cross the world at the flick of a switch." Like most clich?s, this is an exaggeration. Not even George Soros can move billions so quickly. Nevertheless, markets do have the power to transfer money across borders at great speed and, when acting in unison, this gives them enormous power.
But without the existence of these stock, bond, derivative and foreign exchange markets, it would be difficult for countries to continue to trade goods and services with each other. A British company exporting 70 per cent of its output to Germany needs to hedge its exchange rate exposure in the futures market. A Philippine company seeking to expand in Asia must either raise dollars through the stock market or borrow directly from the bond markets or from a bank. Any company or bank conducting business outside of its domestic currency zone must have access to international capital. The notion that financial markets are simply casinos dominated by speculators is false. Without financial markets the real economy would achieve a fraction of its true potential and the international trading system would become a shadow of itself.
Yet, as a result of technology, cross-border flows dwarf the flow of goods and services. The London foreign exchange market turns over more than one trillion dollars a day-more than the combined annual flow of trade between the US and the EU. Such huge disparities, as Keynes noted, mean that the financial tail often wags the economic dog. Given the growth in cross-border flows, this is likely to become more troublesome.
Despite the rapid growth in private pension, insurance and mutual funds over the past ten years, the existence of large pools of privately managed funds is still mostly confined to the economies of the US, Britain and Japan. Given the strict budgetary constraints which will prevail in "euroland" after monetary union next January, it is a near certainty that France, Germany and the others will eventually embrace an Anglo-Saxon style approach towards the provision of pensions and social insurance. The combination of budgetary rigour, demographic trends in Europe and the existence of massive unfunded state pension liabilities (as a result of the "pay-as-you-go" taxpayer-funded systems) suggest that such reforms are likely to take place sooner rather than later. The resulting growth in privately managed portfolio funds in continental Europe will ultimately overshadow what we have witnessed in Britain, the US and Japan over the last two decades.
Any proposal to reform the global financial system must take into account the fact that international financial markets are still in their infancy. The recent growth in cross-border capital flows is likely to continue. Considering the volume of such flows, it is reasonable to bet that there will be more "Tequila," Asian and Russian crises around the corner.
However, given the differences between the Latin American and Asian crises, it will be impossible to predict where or when the next crisis will strike. Instead of fighting the last battle, as it did after the Mexico crisis and is arguably doing now after Asia, the IMF should be devising generic solutions to cope with the full spectrum of potential crises. This would entail acceptance that such crises are an integral condition of the existence of liberalised capital markets. It should also include the premise that it is possible to reduce the frequency and severity of such crises if enough international political will can be marshalled.
The development of a global capital market is too important to be left solely to the markets. Its potential to influence the performance of emerging and developed economies alike and to frustrate the goals of democratically elected governments is undisputed. Countries should accept that no single government is bigger than the markets. But is there the necessary political will to regulate the markets? And what type of institutional framework would it require? The current system of loose cooperation between the separate national regulatory systems and between various ad hoc global agencies such as the IMF and the Bank for International Settlements is inadequate.
Most of the world's economies accepted this fact in the case of the international trading system when they signed the Uruguay Round treaty in 1995 which brought the World Trade Organisation into existence. Although the full extent of its remit is still unclear, the WTO stands as a symbol of the merits of pooling national sovereignty in the interests of enhanced international stability and prosperity. The same logic-albeit with different means-should be applied to the international capital markets. Acceptance that the effective regulation of global capital markets would entail some sacrifice of national sovereignty would parallel what sovereignty governments have already ceded to the markets.
Any solution would have to involve explicit negotiation between sovereign states, culminating in an international treaty. The basis of such a treaty would be to create a global capital markets authority (perhaps called "Woof"-the World Organisation of Finance) with powers to regulate the international markets and enforce minimum standards of commercial disclosure by both borrowers and lenders. It would also entail the creation of an international financial court to settle disputes between parties in cases involving cross-border financial transactions above a certain value. The global authority would also have the sole mandate to deal with sovereign default crises and to impose an equitable distribution of costs between lenders and borrowers.
Many of the powers bestowed on the global agency would overlap with some of the existing powers of the IMF and the BIS and, on a national level, the Securities and Exchange Commission in the US and its counterparts in Europe and elsewhere. It would, in particular, clash with the remit of the IMF, which is the de facto policeman of the world's capital flows and arbiter of sovereign liquidity crises. Any final settlement would therefore involve either a significant dilution of the IMF's powers or, perhaps more realistically, the creation of a much more explicitly empowered IMF.
The most important objective of the new body would be to resolve sovereign bankruptcy crises in such a way as to minimise the chances of repeating the mistakes committed by both the markets and the countries in question. As now, the body would have the power to impose conditions on governments in exchange for bail outs, but these powers would be carefully circumscribed and any attached conditions would be made available to the public (which is currently not the case). Its most effective weapon would be the power to ensure that the international banking and financial community bore a more equitable share of the costs in the event of a sovereign bail out, by accepting a proportionate share of the losses. The body might also have the powers-in extremis-to declare a temporary moratorium on the debt repayments of the affected sovereign country while negotiations took place: this would enable the affected country to devise a workable debt payment schedule without being distracted by the immediate threat of bankruptcy. And it could also have the power to impose a temporary suspension of currency convertibility. This would enable it and the affected government to devise a recovery programme in the absence of speculative attack by the markets; and to set a reasonable exchange rate at which the debt would be serviced once the suspension was lifted. Such a facility would be designed to reduce the need for the type of draconian fiscal and monetary conditions we have witnessed on recent IMF bail outs in Korea and Thailand.
But the logic and force of the argument for change may take us further than this. If we are to take seriously the proposition that the core of the problem lies in the functioning of financial markets themselves, this may require a shift from the kind of remit the IMF has at present-the ex-post imposition of settlements on a case by case basis-to a system of ex-ante market regulation. In order to avoid the problem of moral hazard, and to pre-empt future problems, the new body should be able to regulate the operation of the markets themselves. Various proposals have been made for ways in which this might be achieved, including the so-called Tobin tax (named after economist James Tobin)-a levy on foreign exchange transactions, designed to discourage the flow of "hot money." For completeness we should also consider the possibility that individual countries should have old-fashioned capital controls (as Chile does). If you cannot pacify the sea, then Stiglitz's boats should be put into harbour.
None of these ideas-including the establishment of "Woof"-are new. But those who have proposed them have been too readily dismissed by critics on both right and left. Objections range from the doctrinal (any attempt to regulate global markets would create distortions) to the practical (the body would lack powers to regulate offshore financial centres and would be toothless).
Critics on the right, including a number of US Republican congressmen, have gone so far as to lobby for the abolition of the IMF and other supranational bodies, or at the very least to deprive them of US financial backing. In their view, the IMF distorts natural market outcomes when it intervenes to protect a country from bankruptcy. They also believe that the US taxpayer is a net contributor to the IMF, when in fact every dollar committed by the US to the IMF is repaid. (Such notions are difficult to disabuse because of widespread misconceptions in the US about the nature of the IMF and other international agencies.)
Equally, the IMF has an army of critics on the left in both the US and Europe. Many are vocal opponents of liberalised international markets in general. Such critics have argued for the imposition of transaction taxes to choke off short-term capital flows. But such taxes would also increase the cost of capital for those countries which could least afford it. Set too high, the tax would kill off cross-border flows. Set too low, it would do little to deter speculation in the event of a crisis. But at whatever rate it was set, the tax would simply result in more capital going through offshore banking centres such as the Cayman Islands-and would be self-defeating.
Despite these conundrums of reform, several leading supporters of the prevailing orthodoxy have begun to question some aspects of the international financial system. Robert Rubin, US Treasury Secretary, proposed a set of policies at the last IMF/ World Bank meeting, aiming to increase transparency, find ways to encourage countries to put in place strong financial systems, and create better burden-sharing between debtors and creditors. Others, surely, will also raise their voices as the full social and economic consequences of the financial crisis in Asia unfold. Supporters of establishing a global regulatory authority will be told that it will be impossible to reach international agreement on such a matter and-even if it was-there would always be the danger of such a treaty overreaching itself and killing the goose which lays the golden egg. Or, alternatively, establishment of a new authority would simply duplicate powers already in existence.
Neither can be lightly dismissed. But there is a third, more plausible scenario: the world as it stands is dangerously vulnerable to financial instability and is likely to become more so in the years ahead. Such a world (and especially the developing world) will become increasingly accustomed to the type of financial shocks it has recently witnessed as the globalisation of financial markets intensifies. Such crises will become more-not less-profound as the pool of capital under private management grows in Europe and elsewhere. And such a world will have to get used to the social and political instability which these crises leave in their wake. The status quo is a dangerous gamble because it contains the potential seeds of its own destruction. But the focus of policy debate at the very highest level may, at last, be shifting from the "whether" to the "how" of regulating financial markets.
