Hot money and fixed exchange rates are a dangerous mixture. The one common thread that runs through all the Asian Tiger stories is exchange rate policies that linked their currencies in one way or another to the dollar. The Hong Kong dollar was rigidly fixed to the dollar through a currency board. The Thai baht was pegged to a basket of currencies, but the dollar comprised 80 percent of the composition of the basket. The economic miracle of the Asian tigers was partly attributable to this link to the dollar. As the dollar plunged against the yen in the early 1990s, the Asian tigers gained a substantial competitive advantage over the Japanese in trade. Not only did Japanese exporters lose their market shares to South Korea and other Southeast Asian countries, Japanese corporations began to move their production facilities to the Tigers to capitalize on the lower labor costs. The phenomenal economic growth rates achieved by the Tigers in the early 1990s were fueled by an export boom and a flood of foreign investment, both predicated on the continuing undervaluation of their currencies. The balance of payments surpluses, in turn, led to excessive monetary expansion that kept real rates of interest close to zero or even negative. World investors saw nothing but blue skies ahead and practically begged the Tigers to take their money. But those expectations were overly- optimistic. As Alan Greenspan explained in his unique prose, In retrospect it is clear that more investment monies flowed into those economies than could be profitably employed at reasonable risk.
The seeds of the current crisis were sown when the Bank of Japan launched its all out attack on the yen in the summer of 1995, engineering the largest intervention in the foreign exchange market ever attempted by a central bank. From its low of 80 yen in April, the greenback soared to over 130 yen in the next two years, and the underpinnings of the East Asian boom unraveled as the appreciation of the dollar eliminated the Tigers competitive edge. Their export booms screeched to a halt. Still, the inflow of foreign capital continued unabated. As export industries lost their attractiveness as an investment vehicle, foreign lenders simply financed a real estate boom instead. Property prices soared. The national bird of Thailand unofficially became the building crane. Visions of thousands of mainland Chinese flooding into Hong Kong in the wake of the handover and needing housing danced in the heads of developers. But the bubble could not last. When the cost of capital became so cheap and the price of land so expensive that constructing the worlds tallest building in the middle of a Malaysian jungle appeared to make economic sense, the end was near.
The news coming out of East Asia became especially troubling in early 1997. In South Korea, the chaebols were reeling from the overvalued won and a world-wide glut of Koreas key exports - memory chips, steel and petrochemicals. Hanbo Steel, the flagship company of Koreas fourteenth largest chaebol, collapsed under $6 billion of debt and a cloud of scandal that led all the way up to the president, Kim Young-sam. Thai mortgage lenders were going bankrupt as the Bangkok property market collapsed like a deck of cards. Suddenly, international bankers woke up to the risks inherent in investing in a financial bubble, and they wanted out. Unfortunately, foreign investors face two hurdles that make it difficult to repatriate their assets. First, in order to liquidate their assets, foreign investors must find a domestic buyer. As they try to unload their assets on reluctant buyers, asset prices drop. The extent of that loss depends on the liquidity of the market in which it is sold. Physical assets are extremely illiquid, making repatriation virtually impossible. Hot money, by definition, can be sold in extremely liquid markets. Even so, foreign investors face a second hurdle: they must convert the local currency back into dollars or yen. In the absence of intervention by the central bank, the attempt to buy dollars will cause the dollar price of the local currency to fall. This need to find a seller of dollars makes it costly for foreign investors to repatriate capital without the assistance of the central bank. Faced with a capital flight from the baht, for example, the Bank of Thailand (BOT) can prevent the dollar price of the baht from falling by selling some of its dollar reserves. But in doing so, the BOT becomes an accomplice in the capital flight. Its intervention in the foreign exchange market allows the hot money to leave the country at an artificially favorable exchange rate. If there had been no intervention, the baht would have fallen, convincing many investors who originally desired to get out of baht to change their minds.
Thailand first experienced an attack on the baht in May 1997. At the time, the BOT had $37 billion in international reserves, which was considered to be an awesome war chest at the time, but in four days it spent nearly $10 billion defending the bahts value. To prevent additional losses of reserves, the BOT raised overnight interest rates for offshore borrowers to an annualized rate of more than 1000 percent. Those who had sold the baht short lost tremendous sums of money on that particular go round. But the baht bears kept coming back, with attack after attack, each time leaving the BOT with fewer and fewer reserves. The BOT could have saved its reserves by raising domestic interest rates to whatever level was necessary to clear the foreign exchange market, but such a draconian monetary policy was politically unthinkable when property markets were collapsing and banks were failing. For a month or so the bank tried to have its cake and eat it too - the baht was not allowed to fall, but interest rates were not allowed to rise enough to prevent a continuing loss of foreign exchange reserves.
When the strain of maintaining the overvalued baht became too great, on July 2, 1997, the BOT gave up and allowed the baht to float. The baht immediately fell some forty percent against the dollar unleashing a domino-like chain reaction of competitive devaluations. In short order, the Philippine peso, the Malaysian ringget, and the Indonesian rupiah followed suit. Only the Hong Kong dollar and the Taiwan dollar remained linked to the greenback. With their enormous reserves (Hong Kong held foreign exchange reserves of $86 billion and Taiwan, $87.6 billion), the media proclaimed them invulnerable to speculative attack. But Taipei eventually decided it would not waste its reserves defending what had become an uncompetitive exchange rate and threw in the towel on October 18, allowing the Taiwan dollar to float.
On Red Thursday, October 23, just five days after the floating of the Taiwan dollar, there was an attack on the Hong Kong dollar. Unlike the other Southeast Asian countries whose currencies had fallen to the speculators, Hong Kong does not have a true central bank. Instead, it has the Hong Kong Monetary Authority - a currency board - that prints money when foreign-exchange reserves increase and reduces the supply of the local currency when they are spent. Its sole function is to supply or buy back its own currency at a fixed exchange rate 7. 8 Hong Kong dollars to the greenback. As speculators tried to buy U.S. dollars with their Hong Kong dollars, the Hong Kong Monetary Authority was required to sell its dollar reserves causing an equivalent fall in the supply of Hong Kong dollars. Local banks had to scramble for remaining reserves, bidding overnight rates up to 300 percent before they fell back and finished the day at 150 percent. But the loss of foreign-exchange reserves was contained because the currency board mechanism automatically brakes capital outflows with skyrocketing interest rates. While central banks can, and usually do, use open-market operations or lending through the discount window to replace bank reserves lost by the sale of foreign-exchange, thus sterilizing capital outflows, Hong Kongs Monetary Authority cannot. Currency boards, the first cousins of the classic gold standard, are intentionally set up as a sort of doomsday device. There is no way foreign investors can repatriate their funds without creating a liquidity crisis.
With its enormous reserves, Hong Kong can maintain its currencys link to the dollar, but it will require a huge economic sacrifice. The economic cost of maintaining the current exchange rate will be high interest rates, deflation, and periodic financial crises as speculators test Hong Kongs resolve. Property values will tumble, and Hong Kongs economy will suffer from an uncompetitive manufacturing sector. But Hong Kong is basically a service economy; the economic fate of its manufacturing sector does not matter as much to policy makers as it would in Malaysia, the Philippines, or Taiwan.
The last of the Tigers to fall was the most important - South Korea - the eleventh largest industrial power in the world. On November 18, the Central Bank of Korea abandoned its defense of the won and let it float. In less than a month it lost half its value. With the fall of the won, the domino effect of competitive devaluations of the Tiger currencies had run its course. Only the Hong Kong dollar remains pegged to the greenback.
Now the Tigers faced a debt crisis. For years the Asian Tigers had not only been borrowing hundreds of billions of dollars from abroad, they had borrowed in dollars or yen to take advantage of the lower interest rates charged on foreign-exchange denominated debt. Convinced that their currencies would continue to be fixed to the dollar, they didnt seriously consider the currency risk involved in such commitments. Now the plummeting value of their currencies increased the burden of those debts in local terms. Even prudently run companies suddenly found they could not repay their debts. Countries that borrow in foreign currencies experience very cruel periods of adjustment following a devaluation. While the currency devaluation improves the ability of the country to export, producing the current account surpluses that are necessary to pay off the countrys foreign indebtedness, at the same time it increases the outstanding burden of those debts. In the race to avoid bankruptcy, they have to run faster to stay in the same place.
Not only has the currency depreciation nearly doubled the burden of the Tigers external debt in local currencies, a large portion of that debt is coming due, and foreign banks are refusing to roll it over. That is a huge potential demand for dollars looming over the foreign exchange market. If the Tigers are to prevent default on that debt, their currencies must plunge much further, or else they must find access to dollars from other sources, i.e. IMF bailouts. The temporary liquidity crisis caused by the flight of these maturing short-term funds could result in an overshoot of exchange rates where local currencies may fall far below their long-run equilibrium values. In theory, the IMF could make everyone better off by cushioning the short-run overshoot with bailouts. But this argument raises a fundamental question: why wont speculators with the same knowledge of the presumed overshoot as the elites at the International Monetary Fund essentially replicate the optimal intervention strategy of IMF bailouts? If the overshoot exists, there are opportunities for speculators to make excess returns by selling dollars. This argument for a bailout must be predicated on the implicit assumption that the IMF has better knowledge of the future than the foreign exchange market has, a dubious assumption considering the currency crisis took the IMF completely by surprise.
So far the IMF has committed almost $120 billion to Asian bailouts: $17 billion to Thailand, $43 billion to Indonesia, and $57 billion to South Korea. These rescue packages have been rationalized as liquidity infusions to prevent temporary currency crises. Actually the long-run macroeconomic effects of these bailouts are insignificant, but they are of enormous importance to the parties involved in negotiations over who gets paid in the liquidation of insolvent banks and corporations. If foreign banks were not counting on the IMF to bail them out, they would be left to their own devices in reaching a compromise with their borrowers - one that would most likely entail a partial default or at least a conversion of short- term loans into longer maturities. Default is not an unthinkable solution to the debt crisis. After all, these loans had risk written all over them. The international bankers were receiving a lucrative interest rate premium on these loans before the crisis even began. Bringing the IMF to the table, with its offers of loans, greatly improves the bargaining position of the international banks. But extending IMF loans to Asia, so that American and Japanese banks can be repaid in full, only promotes moral hazard and sows the seeds of the next financial crisis. IMF bailouts must not come to be regarded as entitlements - a form of financial socialism that collectivizes the perils of insolvency for the worlds largest banks. If Citicorp, Bank of America, and Goldman Sachs are allowed to privatize the high rates of return on risky loans to foreign countries but socialize any losses, financial crises will only increase in frequency and intensity.
At the heart of any financial crisis is a dispute over the management of an economys productive assets. All of the Asian Tigers are bankrupt: they have wasted both their nations savings and the funds they obtained from abroad on unprofitable investments. They have created a capital stock that is now uneconomic. Insolvent banks and firms do to the economy what arteriosclerosis does to the heart: they kill it by choking off its supply of life sustaining blood. It is critical that the capital stock be placed in the hands of new owners who can make a profit. If this does not happen quickly, productive assets will fall into disuse, accelerating the contraction of employment and production. Often all it takes to make an asset profitable is a new owner who buys the asset for less than the previous owner did, thus reducing debt-service costs. Bankruptcy sounds hard-hearted, but it is essential to recovery because it restores incentives to use assets productively. Recent history affords ample evidence of the destructive behavior of zombie savings and loans that devoured their own good assets and destroyed many of their healthy competitors before they were eventually liquidated.
IMF bailouts also come with conditions. IMF demands that the recipient country permit foreign ownership of businesses and financial institutions and open domestic markets to foreign competition are necessary to the recapitalization process, but the tough love fiscal and monetary policies imposed as a condition of the bailouts are a mistake. The IMF was created in 1946 to provide emergency loans to those countries fixing their exchange rates to the dollar under the Bretton Woods Agreement. The Bretton Woods System broke down in 1971, but the IMF continues to survive as an institution and behave as though its mission was unchanged. During the Bretton Woods era, most balance-of- payments problems were caused by excessive government spending financed by monetary expansion. The resulting inflation would price the countrys goods out of world markets and create persistent trade deficits that would eventually deplete the countrys foreign-exchange reserves. In such a situation the IMF could understandably demand that, in exchange for a bailout, the recipient county should curtail money growth, cut spending, and raise taxes. But this situation does not exist in Asia today. Until the eve of the crisis, the IMF was praising Thailand and South Korea for their fiscal prudence.
There is a real danger that the IMF bailouts will be perceived by the recipient countries as a conspiracy to bail out foreign creditors while imposing austerity policies on local workers and small entrepreneurs who had no part in causing the crisis. Such a perception could easily provoke a nationalistic backlash. American corporations are gathering like vultures to snap up Korean companies at rock-bottom prices. We have to be careful not to appear that we are using the crisis to recolonize Korea. For now, most Asians blame their governments and banks for their problems, but the IMFs reform and austerity programs could easily ignite a virulent form of anti-Americanism. There is something offensive in the way Wall Street always seems to prosper from the mistakes of others but always avoids paying for its own.
The only way these Asian economies can get out of this mess is to run trade surpluses for the foreseeable future. Of the major industrial economies, only the United States is buoyant enough to absorb those exports. We cannot insist that the Tigers not default on their debt obligations and then prevent them from servicing that debt with trade surpluses. But the onslaught of cheap Asian imports will not be pleasant for many American industries. Not only will cheap Asian products flood U.S. markets, our sales to the hard-hit region will dry up as well. The U.S. trade deficit reached a nine-year high in 1997, but the real impact of the devaluations and collapsed demand in Asia still lies ahead. The U.S. trade deficit will easily double over the next two years, but the rising deficit need not jeopardize the ongoing economic boom in the United States. After all, the unemployment rate has fallen about a percentage point since 1995 despite a doubling of the trade deficit. This was the period during which Mexico worked its way out of its debt crisis thanks to free access to American markets. So far there is no sign that the Asia crisis will endanger the U.S. expansion; in fact, by reducing inflationary pressures, it may well extend its life. But, if the economy turns down, all our economic woes will be blamed on the trade deficit. 1998 is an election year, and it is a time honored political tradition to curry favor with blue-collar America by starting a trade war. Pat Buchanan and Richard Gephardt are waiting in the wings to become the great orators of such a campaign. That scenario would be the worst possible outcome for this crisis.
Mac Williams
Cosmos Mariner
Destination Unknown
© March 23, 1998