"IMF2" 2 March 98 Comments welcome: wade@rsage.org, or 212-750-6084, Veneroso 908-522-8815 or 603-430-8482 or lizsummit@aol.com.

Citation: Forthcoming, New Left Review, March-April 1998. Working Paper # 128, 2 March 1998, Russell Sage Foundation. Address: Russell Sage Foundation, 112 E 64th St., NYC 10021.
 
 

THE ASIAN CRISIS: THE HIGH DEBT MODEL VS. THE WALL STREET-TREASURY-IMF COMPLEX
 
 

Robert Wade and Frank Veneroso
 
 

How could the widely acknowledged real estate problems of Thailand’s banks in 1996 and 1997 have triggered such a far-reaching debt-and-development crisis? The devaluation of the Thai baht in July 1997 was followed by currency crises or financial instability in Indonesia, Malaysia, Philippines, Taiwan, Hong Kong, Korea, Estonia, Russia, Brazil, Australia and New Zealand. There were few signs of impending crisis, such as rising interest rates in the G-7 countries or a sudden suspension of capital flows to developing countries after the baht devaluation. On the contrary, bank lending to Asia rose to a record level in the third quarter of 1997. The Japanese government’s de facto credit rating agency, the Japan Center for International Finance, gave Korea one of its highest credit ratings for any developing country in June 1997. The IMF and the World Bank lavished praise upon the governments of the region through 1997, including on the Korean authorities as recently as September 1997.

What began as a debt crisis has become a fully-fledged development crisis. Throughout this most successful of developing regions living standards are falling as unemployment rises and the effects of huge devaluations work through into higher import prices. Many millions of poor people are at risk, and many millions of people who were confident of middle class status feel robbed of their lifetime savings and security. It is not a humanitarian tragedy on the scale of North Korea, but the loss of security and productivity is a tragedy nonetheless, almost as cruel as war. South Korea, Thailand and Indonesia are sliding into depressions comparable to those that gripped Europe and North America in the 1930s.

Financial crises—speculative bubbles followed by collapse—have recurred throughout the history of capitalism. In the early 1980s Latin America, another fast-growing developing region, suddenly went into debt-and-developoment crisis and stopped its rise up the world economic hierarchy. The Latin American crisis was due, said the consensus of analysts, to the combination of bad macroeconomic policies plus foreign borrowing by governments, that was wasteful and corrupt because done by governments rather than by private firms operating in competitive markets. But the Asian crisis has occured in the opposite conditions. In East and Southeast Asia today most debt is private debt. And prior to the crisis, the macroeconomic "fundamentals" looked fine. The countries in question have had low inflation, budget surpluses or only small deficits, and until recently stable or rising foreign exchange reserves. They have been growing fast. East and Southeast Asia accounted for a quarter of world output, but half of world growth over the 1990s and almost two thirds of world capital spending. Firms throughout the region make products that sell in the most demanding markets—if the exchange rate is right.

There is little agreement on why the magnitude of the crisis has been so large, what can be done to get out of it, who will gain and who will lose, and what changes need to be made in international regimes to reduce the likelihood of repeats. These matters should be the subject of an international debate as important as the Bretton Woods conference at the end of the Second World War.

According to the IMF, the solution has two thrusts: on the one hand, domestic austerity in order to restore the capacity to repay foreign debts; on the other, radical institutional reforms, including further financial liberalization. Many analysts have come forward to disagree. Indeed, a new "conventional wisdom" among the IMF ’s critics has emerged, which goes like this.

The crisis is a crisis of illiquidity more than of insolvency. Creditors have "run" on the currency and on domestic assets, leaving the borrowers unable to continue to finance their loans. It happened partly because of excessive financial deregulation, including, above all, allowing banks and firms to borrow abroad without any government controls or coordination. And international bankers, also largely unregulated, have been only too happy to provide Asian corporations with large amounts of short-term, unhedged dollar loans. Once some of them tried to call in their loans the crisis began to build upon itself as other lenders tried to call in loans and firms cut operating costs and sold assets, causing unemployment to rise and asset values to crash.

"Instead of dousing the fire the IMF in effect screamed fire in the theater", says Jeffrey Sachs. The Fund’s insistence on shuttering many banks despite the fact that systems of deposit insurance hardly exist led panicky depositors to withdraw their deposits even from sound banks, and hold cash instead. Its insistence on cutting demand and liquidity accelerated the bankruptcy or radical devaluation of the value of firms that were efficient and profitable, as well as those that were not. Its push for institutional reforms in finance, corporate governance and labor markets convinced lenders that the economies were fundamentally unsound.

The immediate goal must be to restore confidence, which requires overcoming the collective action problem in which no lender wants to refinance for fear that others will not. Demand and liquidity must be increased, not reduced, in order to keep firms turning over. The IMF should be concentrating its attention on organizing a determined refinancing effort and then in helping to erect the structure of financial regulation, especially at the border, that will help to minimize the risks of such a melt-down occurring again.

We agree with this line of argument as far as it goes. We go further, however, arguing that the long-term damage to Asian economies of the IMF’s prescriptions is likely to be even greater than the critics have recognized. The reason has to do with a neglected dimension of the crisis—the financial strucuture of East and Southeast Asian economies, that differs from the kind of case the IMF usually deals with. Because of this difference, a unit of IMF "austerity" and "financial liberalization" will have higher costs and smaller benefits in Asia than elsewhere. The slowness of the IMF’s bail out packages for Thailand, Indonesia and Korea to revive confidence, despite being the biggest in the organization’s history, reflects not only their imposition of impossibly ambitious institutional reforms but also their inappropriateness for Asian financial structures.

THE ASIAN HIGH DEBT MODEL

In a western, including Latin American, financial system companies normally carry an amount of debt that is no bigger than and generally less than the value of their equity capital; and banks will not, or should not according to standard prudential limits, lend to companies with higher levels of debt. In East and Southeast Asia, and especially in Japan and Korea, corporate debt/equity ratios of the bigger firms are commonly two to one or more.

Why are corporate debt/equity ratios so much higher than in western systems? First, because savings are much higher. Gross domestic savings to GDP ratios in Asia are one third of GDP or more, compared to 15-20 percent in western systems. The savings are done in large part by households. Households hold their savings mostly in bank deposits, bank deposits being much less risky than equities in the noisy stockmarket environments of developing countries. Banks have to lend. When neither households nor government are significant net borrowers, the system is biassed towards borrowing by firms. (Lending or investing abroad is only a very partial alternative, given the amount of savings to be absorbed.)

Second, firms that aim to make an assault on major world industries (as especially in Japan, Korea, Taiwan) must get their hands on very large amounts of resources, which they can do only by borrowing. Neither equity markets nor corporate retained earnings are feasible alternatives for mobilizing resources on the scale required to compete in these export markets and continually upgrade.

High ratios of bank deposits and loan intermediation to GDP, and of corporate debt to equity, make the financial structure vulnerable to shocks that depress cash flows or the supply of bank or portfolio capital. The deeper the intermediation of debt (that is, the higher the ratio of bank deposits to GDP and the higher the ratio of corporate debt to equity), the more likely that any depressive shock will cause illiquidity, default, and bankruptcy. Debt-intensive strategies should be labelled, "This product can be harmful to your wealth".

Such a financial structure requires cooperation between banks and firms, and considerable government support. The trick is to buffer firms’ cash flow and supply of capital against "systemic" shocks, while not protecting firms from the consequences of bad judgement or malfeasance. Restrictions on the freedom of firms and banks to borrow abroad, and coordination of foreign borrowing by government, are a necessary part of this system.

Western commentators often dismiss the system as "crony capitalism", seeing only its corruption and favoritism. They miss the financial rationale for cooperative, long-term, reciprocal relations between firms, banks and government in a system which intermediates high savings into high corporate debt/equity ratios. (They also miss the crony capitalism US style, generated by the regime of electoral campaign finance.)

The need for state support allows the state to influence the decisions of banks and firms in line with a national industrial strategy; it can withhold support from banks and firms that operate against the national industrial strategy. The whole system can be disciplined by making investment incentives conditional on export performance or on reductions in the gap between the firm’s prices and international prices for the same products.

High household savings, plus high corporate debt/equity ratios, plus bank-firm-state collaboration, plus national industrial strategy, plus investment incentives conditional on international competitiveness, equals the "developmental state". For all the white elephants and corruption ( inevitable when a third of national income is being intermediated), the system that allows firms to borrow multiples of their equity has yielded a quantum leap up the world hierarchy in technology and scale, and rates of improvement in living conditions that surpass virtually all other countries’.

Notice the parallels with Keynesian theory, which identifies savings rates in excess of investment rates as a cause of depressions and insecurity and even higher savings rates. Keynesian theory, however, posits government deficit spending as the solution. We see in East Asia a model of private debt based on high corporate debt/equity ratios, which give rise to the need for government protection against periodic slippages that would otherwise lead to widespread bankruptcy.

IMPACT OF SHOCKS

The other side of the equation, however, is very high levels of corporate debt. It is likely that Korea’s corporate debt/GDP ratio is of the order of 30 to 50 percent higher than the US’s corresponding ratio. This represents a debt mountain that sits at the heart of the Korean problem. The mountain may be less high in other Asian countries, but it remains much higher than is normal in western systems.

To see the dangers of debt, compare systems with low and high corporate debt/equity ratios. Low corporate debt/equity systems, as are found in Latin America and North

America, are not able to invest as heavily as the others but are also less vulnerable to shocks. They can sustain a sharp rise in real interest rates for some time. Corporate gross profits before interest and taxes are more likely to be high enough relative to the higher interest charges that some degree of debt repayment out of cash flow remains possible. Therefore the tendency for real debt to grow as a result of higher real interest charges is less than when debt/equity ratios are high. If the interest rate rises to the point where the firm cannot repay any of the extra cost out of cash flow or reserves and therefore must recapitalize it (that is, add it to its stock of debt), the balance sheet still has room for a higher debt/equity ratio without threatening the firm’s viability by wiping out its equity.

The risk that an interest rate above the rate of gross profit has disastrous consequences increases with the debt/equity ratio. In higher debt/equity systems firms have to use more of their gross profits on interest charges. A significant rise in interest costs may not be able to be met out of profits, in which case it has to be recapitalized into debt. But the balance sheet may not have room for more debt without threatening the firm’s viability. A rise from 10 to 20 percent lifts a debt/equity ratio of 80:20 (or 4:1) to 88:12 in the first year (if the interest due is all recapitalized and if the corporation is just breaking even at the start). Replicated across many firms, the country’s overall debt to GDP ratio rises. If, in addition, the high real interest rate policy also depresses aggregate demand, it will further depress cash flow relative to interest charges, accelerating the indebtedness of the corporate sector. And all the worse if, as is true in Asia, a substantial share of the debt is foreign debt and the domestic currency is devalued, raising the fixed interest payments on the foreign debt in domestic currency.

A higher debt/equity ratio not only makes for higher borrower’s risk; the lender’s risk equally rises with the ratio- unless the IMF bails them out.

The box illustrates the contrast between high and low debt/equity systems with a simple example. It shows how a "Latin American" firm with low debt to equity is able to survive a devaluation, interest rate hike and austerity program much more easily than an "Asian" high debt to equity firm.

THE CRISIS OF 1997-98

What made for the high-growth performance of Asian systems in the past has led to or at least amplified the present crisis. Over the 1990s western and Japanese banks and investment houses lent heavily to Asian companies. They assumed, contrary to all historical knowledge about growth rates, that fast growth (four times the OECD average) would continue, and consequently that exchange rates would remain stable. They also each ignored their own prudential limits on lending to companies with high debt/equity ratios, because everyone else was ignoring the limits and they each wanted to win business. International bankers have a powerful incentive to follow the herd, because the banker who does not make money where others are making it risks being seen as incompetent but does not suffer by making losses when everyone else is making losses too.

Meanwhile, Asian governments undertook radical financial deregulation, encouraged by the IMF, the OECD, and by western governments, banks and firms. They removed or loosened controls on companies’ foreign borrowings, abandonned coordination of borrowings and investments, and failed to strengthen bank supervision. By doing so they violated one of the stability conditions of the Asian high debt model, helping to set up the crisis.

The rush to capital liberalization in the early to mid 1990s without serious institutional support stands out as the single most irresponsible act in the whole crisis, for which the blame falls equally on national governments and international organizations. The Bank of Thailand, for example, undertook capital liberalization just as it and other relevant government regulatory agencies were overwhelmed with other complex issues and political strife. The subsequent capital inflows were entirely unmonitored, let alone controlled. In Korea key people were bribed by Japanese and western financial institutions, thanks to which they did something that was counter to the whole thrust of Korean development policy for decades past. Bribery aside, the government placed great emphasis on joining the OECD, and the OECD made financial openness a condition of membership. As part of the same set of reforms, the government abolished the Economic Planning Board, the main body for making economic strategy since the early 1960s, and made the Finance Ministry dominant.

Domestic corporate borrowers discovered that they could borrow abroad half as cheaply as they could borrow at home. Foreign debt escalated, most of it private and short-term (maturing in 12 months or less). In Korea, foreign debt incurred by its banks and the companies that borrowed from them exploded from very little in the early 1990s to roughly $160 billion by late 1997.

China’s devaluations of 1990 and 1994, together with its lower inflation and faster productivity growth, made the yuan the most undervalued major currency in the world, worsening the export competitiveness of other East and Southeast Asian economies. The appreciation of the US dollar against the yen after 1995 (the result of an agreement between the US Treasury and the Japanese Finance Ministry to help Japan export its way out of trouble and use the resulting surpluses to buy US Treasury bills, thereby allowing US interest rates to be kept at politically desirable levels and assisting the re-election of President Clinton) worsened their competiveness still further, because their own currencies were pegged to the dollar and rose with it. Thailand in 1996 experienced zero growth of exports, the slowest rate of growth of GDP in a decade, and a ballooning current account deficit. The Thai stock market lost a fifth of its value in the first nine months of 1996, and growth of direct foreign investment fell sharply. In Korea, manufacturing production started to fall in 1996, the current account went strongly negative in the same year, industrial bankruptcies occured.

Once foreign lenders began to worry about currency falls, they "discovered" their heavy exposure to companies with debt/equity ratios far above their prudential limits. More exactly, they discovered the possibility that others might make a similar "discovery", the aggregation of which would precipitate falls in the exchange rate—multipling the loan burden and the risks of default. Hence they have tried in every way to call in their loans and not make new ones. The Japanese banks that lent heavily to firms in East and Southeast Asia have been especially anxious to call in these loans as their domestic position deteriorated.

This is why the run has been so surprisingly big. International banks have slashed credit lines to all borrowers, including the export-oriented firms that should be benefitting from currency depreciation. Even the big Korean chaebol, with world-wide brand names, are finding it difficult to get even trade credit (letters of credit to cover the import of inputs into export production). In Latin America of the 1980s, where companies had much lower debt/equity ratios, foreign lenders found that companies continued to meet their test of prudence, even if countries did not. Latin American companies therefore did not suffer such a big withdrawal of bank credit, and the problem of refinancing the Latin American debt was solved more quickly than looks like happening in the Asian case—though the Latin American countries were far less creditworthy. As of this writing, the IMF, the United Nations and other international forecasters continue to chase the world economy downhill, at least for 1998.

IMF TO THE RESCUE?

The IMF is designed to provide bridging finance while a country gets its balance of payments in order. IMF programs normally seek to reduce current account deficits, keep inflation in check, and keep domestic demand constrained. Such objectives are set out in the opening lines of the IMF stand-by agreement with South Korea, dated December 5, 1997:

1. Objectives The program is intended to narrow the external current account deficit to below 1 percent of GDP in 1998 and 1999, contain inflation at or below 5 percent, and—hoping for an early return to confidence—limit the deceleration in real GDP growth to about 3 percent in 1998, followed by a recovery toward potential in 1999." From then on the IMF program for Korea goes well beyond standard IMF programs, calling for structural and institutional reforms even though they are not needed to resolve the current crisis. It requires major financial restructuring to make the financial system operate like a western one, though without actually saying so, including closing down or recapitalizing troubled financial institutions; letting foreign financial institutions freely buy up domestic ones; requiring banks to follow western ("Basle") prudential standards; requiring "international" (read "western") accounting standards to be followed and international accounting firms to be used for the auditing of financial institutions. It requires the government to undertake not to intervene in the lending decisions of commercial banks, and to eliminate all government-directed lending; and to give up measures to assist individual corporations avoid bankruptcy, including subsidized credit and tax privileges.

The Fund also requires wider opening of Korea’s capital account, to enable even freer inflow and outflow of capital, both portfolio capital and direct investment. All restrictions on foreign borrowings by corporations are to be eliminated. The trade regime, too, will be further liberalized, to remove trade-related subsidies and restrictive import licensing. Labor market institutions and legislation will be reformed "to facilitate redeployment of labor".

The IMF programs for the other Asian cases differ from case to case. But they too include the traditional IMF measures to improve the balance of payments, including high real interest rates; and they also go beyond the IMF’s mandate into areas of institutional reform, including capital account opening and financial sector and labor market deregulation.

In terms of the first set of objectives (to remove the current account deficits and achieve macroeconomic balance), we are already seeing, at current heavily depreciated exchange rates, big trade surpluses from several Asian countries. Korea ran a giant current account surplus of $3.7 billion dollars in December 1997, equivalent to something like 15 percent of Korean GDP when annualized at the post-devaluation exchange rate of 1,600 won to the US dollar. Thailand ran a current account surplus for the last several months of 1997. So did Malaysia. So far the surplus is due more to falls in imports than to rises in exports. But the majority of imports are capital goods and industrial materials and fuel rather than consumer goods, and their cutback hurts exports. Only truly heroic improvements in the trade balance could garner enough foreign exchange to cover interest payments falling due in the next several years.

The difficulties of doing so are compounded by the costs associated with the Fund’s second set of objectives, those to do with radical institutional reform, and in partcular with liberalizing the financial sector both domestically and externally. Radical financial liberalization will face very large "transitional" costs; and in any case, even if a "western" look-alike system is established it would not be stable given the high flow of savings. It would also sacrifice the developmental advantages of a high debt system.

The transitional difficulties relate to the implications of the existing debt. Before western prudential limits can be viable, before the financial system can be made to work like a western one, the debt mountain must be brought down. The IMF seems not to have thought through the consequences of doing this.

Historically, debt mountains have been reduced in one of four ways. One is inflation: the debt is vaporized by means of a domestic inflation that causes real interest rates to turn negative. The second is bankruptcy: existing creditors lose some of the value of their assets as the debt is written down, the new creditors reorganize the assets and (hopefully) make the company viable again at the lower level of debt. The third is repayment of the debt out of cash flow. The fourth is by debt-to-equity swaps.

All of these have social costs, but some more than others. A country that goes the bankruptcy route will suffer major social disruption and loss of output while "resources" (including people) are reallocated. The principal lenders are banks, which are always highly leveraged (have high debt/equity). When banks write down the debt of the companies to whom they have lent they lower their own asset base, and jeopardize their own ability to meet their principal and interest payment obligations on deposits. They may have to stop refinancing sound companies that then become insolvent, in turn transmitting insolvency pressures to their customers and suppliers. Asset prices may begin to collapse as foreclosing creditors sell at firesale prices, causing further problems for holders of existing assets who see their value knocked down. Fears of bank deposit failures increase the demand for currency relative to bank deposits. The banking system may undergo a multiple contraction of deposits and loans. Layoffs proliferate. Consumers cut back. The disinflationary impetus is reinforced.

The bankruptcy route has been an integral part of all great depressions. Irving Fisher observed that the central propagating mechanism of the Great Depression of the 1930s was the rising real value of dollar liabilities (a rising real interest rate). As the price level fell, the real value of the principal of the debt rose. Firms found themselves facing higher and higher levels of indebtedness and repayment obligations, and banks called their loans and refused to lend. The resulting bankruptcies deepened and propagated the deflationary dynamic just described.

The repayment-out-of-cash flow route is likely to be protracted (if the existing levels of debt and interest rates are not too high for it to be workable from the start). As firms use most of their return on assets to repay principal and interest, their investment falls. This route is associated with prolonged stagnation. It takes many years to pay down the debt to the point where western prudential standards can be met. Japan has tried to follow this route during the 1990s. We can see its costs in the very slow growth of the Japanese economy since the stock market and property market bubbles burst in 1990.

The inflation route also has social costs, but historically the costs have tended to be lower than those associated with the others. Provided the inflation is kept at 40 percent or less the social costs are small. This approach requires the price level to be rising fast enough to make real interest rates low or negative, and it requires a semi-closed capital account in order to check capital flight.

The IMF prescriptions preclude the inflation route. They call for high real interest rates (in order not only to curb demand but also to encourage a reversal of the capital outflow). And they emphatically call for the capital account to be opened wide.

Debt-to-equity swaps were used to help reduce the Latin American debt crisis of the 1980s. In the Asian context, where debt to equity ratios are much higher, it is not clear that they could be used on a scale sufficient to make a big difference. In any case, given the lack of equity resources now held by post-crisis Asian nationals, a significant reduction of debt by this method requires massive foreign ownership positions in Asian firms and banks. Vast swathes of the corporate sector would end up in foreign hands. Already we are seeing Japanese and American companies jumping from minority to majority owners of Southeast Asian firms in return for a writing down of the debt. And debt-to-equity swaps aside, the devaluations enable foreign companies to buy up Asian companies at fire-sale prices (or in the current Korean phrase, "IMF cold wave prices"). We are already seeing a political backlash against the sudden jump in foreign ownership. Korean and Southeast Asian editorialists have started to write about "The Second Opium War" and US/IMF imperialism.

If the debt claims were swaped for equity claims held by domestic banks, the banks would end up as huge equity holders, something that banks are not supposed to be. If the debt claims were transferred to the state and the state in return acquired a voting interest in the company, this would amount to nationalization¾ not something the IMF or the US Treasury wish to encourage. Morgan Bank has suggested government guarantees for private foreign borrowing, in the hope that this would allow foreign lenders to resume lending to highly indebted firms on the grounds that the guarantee makes the debt look like sovereign debt. But the debt mountain would remain.

If the IMF prescriptions for reshaping Asian financial systems into something more like the western model require, as a condition of viability, a run down of corporate debt, and if the inflation route is ruled out, then the social costs are likely to be huge and long-lasting—especially because of the sheer amount of corporate debt relative to GDP that has to be shrunk to western levels. Inflation is the only way to reduce such a debt mountain without years of stagnation, nationalist backlash, or chaos.

The much higher real interest rates required by the Fund will tip many high debt/equity firms into bankruptcy—and the resulting financial instability and unrest may cause net capital outflow instead of the inflow that the Fund expects. Meeting western standards for the adequacy of banks’ capital entails a rapid fall in banks’ debt/equity ratios and a sharp cut in their lending, causing more company bankruptcies. Opening up the financial sector to foreign banks will result in a large-scale takeover, because after the bankruptcies and liquidations foreign banks and companies will be the only ones with the capital for recapitalizing the domestic ones. But foreign banks may not lend to high debt/equity local companies, and may not participate in the kind of alliances between government, the banks, and companies that a high debt/equity financial structure requires. If Citibank buys up Korean banks and applies its normal prudential limits (by which lending to a company with a debt/equity ratio of 1:1 is getting risky), it will not lend to Daewoo with a debt/equity ratio of 5:1. The amount of restructuring of Daewoo before its debt/equity ratio comes close to 1:1 is hard to imagine.

It seems particularly unwise for the IMF to insist that companies receive even more freedom than before to borrow on international capital markets on their own account, without government coordination, when it was their uncoordinated borrowing that set up the crisis in the first place. This will make the country more, not less, vulnerable to capital flight.

The IMF approach is likely to generate big social costs long before there is any significant amount of debt reduction, all because of a short-term and unforeseeable run by mobile capital. It aims to dismantle the high debt system, its developmental advantages notwithstanding. And it wants to see a western-type financial system in its place that can only work with a huge reduction in levels of corporate debt. The Fund has not properly weighed the economic and social costs of doing this, nor even the question of whether it has any legitimate business in entering the field of structural and institutional reform. Eventually Asian economies will start to grow again, for their "fundamentals" are strong; but by then their fundamentals will not be as strong. There will be an inner source of instability created by the attempt to integrate the massive flow of household deposit savings with a financial structure based on western norms of prudent debt/equity ratios. And by then they will have a rather different pattern of ownership, with foreign firms and banks—in particular, US firms and banks—having much more control than before and receiving much more of the profits. They will have given up the developmental advantages of a high debt system based on government-bank-firm collaboration in return for somewhat lower risks of financial crashes.

Once the crisis is passed, some reneging on IMF agreements may occur. But by that time foreign banks and other financial institutions may be well established, making the high debt/equity system difficult to rebuild.

AN ALTERNATIVE PATH

The high savings of Asian households impart a bias towards high levels of corporate debt. Household saving rates may come down over the next several decades, as overall growth comes to be based more on internal demand than on exports. But saving rates much higher than in the west are likely to be a feature of these economies for many years to come, and the current crisis will only intensify households’ wish to save.

Households’ risk aversion precludes transfer of more than a small part of the savings through equity markets. Equity markets will of course develop over time as the infrastructure for a well-working stock market is gradually built up. But even in the most highly developed equity markets only a few percentage points of GDP or less are transferred. In the United States, where the equity market is a celebrated national institution, net savings transferred to the corporate sector through the equity channel have averaged less than 1 percent of GDP, and have often been negative over the past decade. Such small flows may be meaningful in a country like the US where household savings are only 4 percent of GDP, but are trivial where household savings are more like 20 percent of GDP. Moreover the current crisis has caused huge losses for most of the Asian households that have recently begun to participate in national stock markets. This makes it all the more likely that sizable development of equity markets is a dead issue in Asia for another decade at least. The Japanese experience is cautionary. Since the crash of 1990, over 90 percent of the mutual fund holdings accumulated over the 1980s have been redeemed.

Nor is a regime of internal corporate finance, through retained earnings, likely to work in a system where firms aim to make inroads in major world industries. Such a regime of "internal financing", where the ratio of equity to debt is high because of high rates of retained profits, is found in some developing countries. But internal financing tends to be associated with very unequal distributions of income and wealth, since wealth accumulation is concentrated among corporate owners who earn very high profit rates—often because of high rates of protection and subsidy, or because of monopoly positions. And the regime, though financially stable, is "blind", in the sense that accumulation tends to be confined to established firms, and may be remote from the discipline of either market competition or a national industrial strategy.

If Asia continues to save at anything close to current levels there is an inescapable problem of how to invest the savings productively. It is a fine irony, since Asia’s high savings have been instrumental in its fast growth and the object of envy from the rest of the world.

We argue that high savings and high corporate debt yield powerful advantages in terms of national development. The high levels of debt can be sustained under normal conditions provided that banks and firms have mutual understandings about the refinancing of the debt, and provided the government supports them. This in turn requires, above all, closing or semi-closing the capital account, so that mobile capital cannot go freely in and out. In such high saving societies foreign savings are not needed; it is already difficult enough to allocate domestic savings to efficient investments at the margin. These arrangements may stop well short of a developmental state a` la Japan, Korea and Taiwan, but they are well along in that direction, and far from the IMF’s model of a desirable financial system.

To resolve the crisis, inflation is the least costly way to reduce debt. Real interest rates have to be kept negative or at least very low, which would also reduce the pressure for bankruptcies and financial instability more generally. Household savers have been content with the low rates they have been getting, so there is no reason to raise the rate above the level of inflation. The government would let the exchange rate float, removing the impetus to raise interest rates in order to keep the currency stable. The IMF assumes that low real interest rates will lead to net capital flight and greater refinancing difficulties. It is not obvious that high real interest rates will not have an even worse effect on capital flight, because of the magnitude of bankruptcies and financial instability caused by high rates in the context of high debt/equity ratios. At the least, the trade-off has to be examined, as the IMF, reading from a script developed in low debt/equity situations, has not.

The government should push weak banks to merge with strong domestic ones. It should use its own strong balance sheet to support existing banks, not close them down or let them be bought by foreign banks. Many of these banks are bankrupt only by western standards and under transitory crisis conditions, not according to the rules of the developmental state in conditions of reasonably fast growth.

Hence the government should step in to reintroduce controls on capital movements, to create credit in order to cover the extra costs of foreign debt incurred by the devaluation (injecting equity into banks, directly buying loans from foreign creditors, and so on), thereby setting off a controlled inflation which will spred the ultimate costs among the whole population of savers and the consumers of imports. At the least, there has to be large-scale rescheduling of the debts of the private sector. Korea and Thailand are already getting some help of this kind, but need much more. Indonesia, facing a greater political crisis and a larger number and nationality of creditors among whom agreement is more difficult, has received virtually none, and is in a state of financial paralysis with sharply falling GDP. Short of large-scale rescheduling Indonesia will be one of the greatest and most uncessary economic tragedies of our time.

Why should not Korea, for one, not just declare a debt moratorium and set about exporting its way out of trouble, using internal financing drawn from its high domestic savings? The vast increase in the servicing and repayment costs of foreign loans due to the devaluation is a national disaster, the costs of which should be borne collectively. Let belts be tightened, to the extent of refusing any new reliance on external finance. In any case it would not take long for a Korea to be able to borrow again. The government might even put aside its anxiety to remain in the good books of the OECD and focus more on the region for a change, taking the lead in bringing in China and in organizing a debtors’ cartel with Thailand and Suharto’s successor in Indonesia to bargain for better terms from the Fund and western banks. Afterall, default is perfectly consistent with certain American values. Personal bankruptcies in the US rose last year from $30 billion to $40 billion. One can find in any newspaper advertisements saying "Personal bankruptcy may be a way out of your problems, call now: 212-BANKRUP".

The Japanese government, which for a time seemed to be moving towards the IMF approach (particularly in allowing the bankruptcy of even large banks and security houses), appears now to be changing course. The vice minister for international finance emphasised on national television recently that, "We should make clear to the public that we will not allow banks to fail. We should not let securities companies of considerable size fail either. The United States and the United Kingdom have not done it either. This is the global standard." He went on to say that it is up to politicians and bureaucrats to save the banks from failing and it is up to banks to prevent companies from failing.

The Ministry of Finance has announced a $ 98 billion fund for bailing out the Japanese financial sector. With this fund the government will inject capital into the banks, which are now paralyzed as they try to meet western capital adequacy standards in the face of declining asset values. The government may also use the fund to boost the stock market, which will raise asset values. It is dramatically expanding the monetary base, to increase economic growth and corporate returns to assets as well as to generate an inflationary reduction in debt. It may also ask financial institutions to buy domestic bonds, and perhaps to sell some foreign bonds. One hopes that the Japanese government will become more active in creating an organization of the most affected countries to coordinate their bargaining strategies, also involving China.

CAPITAL OPENING AND THE WALL STREET-TREASURY-IMF COMPLEX

Why is the Fund saying what it is saying? It has gone far beyond its traditional concern with balance-of-payments adjustments partly because it had already crossed the line in dealing with the former Soviet Union and Eastern Europe, and legitimized its expanded agenda in that context. Those countries clearly needed advice about the creation of basic market institutions, and the Fund was able to get its advice accepted because it brought vital financial rewards. In its next great intervention, in Asia, the Fund has continued to operate over this much wider jurisdiction, seeking to impose on Thailand, Indonesia and Korea institutional free-market reforms as comprehensive as those imposed on Russia—even though such reforms in the Asian case are not necessary to restart the flow of funds.

The legitimizing precedent of the former Soviet Union and Eastern Europe is one thing. But the deeper answer involves the interests of the owners and managers of international capital. The reforms sought by the Fund are connected in one way or another with further opening up Asian economies to international capital. Why is the Fund insisting on capital account opening in countries that are awash with domestic savings? Why has the Fund done so little by way of organizing debt rescheduling negotiations, preferring to administer bail out funds in return for structural and institutional reforms? James Tobin, the Nobel laureate in economics, observes that, "South Koreans and other Asian countries—like Mexico in 1994-95—are…victims of a flawed international exchange rate system that, under U.S. leadership, gives the mobility of capital priority over all other considerations". Jagdish Bhagwati, professor of economics at Columbia University and champion of free trade, takes the argument further. Asked why the IMF was seeking to open financial markets everywhere he replied, "Wall Streeet has become a very powerful influence in terms of seeking markets everywhere. Morgan Stanley and all these gigantic firms want to be able to get into other markets and essentially see capital account convertibility as what will enable them to operate everywhere. Just like in the old days there was this ‘military-industrial complex’, nowadays there is a ‘Wall St.-Treasury complex" because Secretaries of State like Rubin come from Wall Street.... So today, Wall Street views are very dominant in terms of the kind of world you want to see. They want the ability to take capital in and out freely. It also ties in to the IMF’s own desires, which is to act as a lender of last resort. They see themselves as the apex body which will manage this whole system. So the IMF finally gets a role for itself, which is underpinned by maintaining complete freedom on the capital account." Bhagwati goes on to observe that many countries have grown well without capital account convertibility, including China today and Japan and western Europe earlier. "In my judgement it is a lot of ideological humbug to say that without free portfolio capital mobility, somehow the world cannot function and growth rates will collapse."

Bhagwati’s "Wall St-Treasury complex" has helped over the past year to push the process of amending the IMF’s articles of agreement to require member governments to remove capital controls and adopt full capital account convertibility. The extended Wall St-Treasury-IMF complex has likewise worked to promote the World Trade Organization’s agreement on liberalizing financial services being hammered out in 1996-97. Many developing country governments, including prominently several Asian ones, opposed the WTO’s efforts to liberalize financial services. In response, "Executives of groups including Barclays, Germany’s Dresdner Bank, Societe Generale of France and Chubb insurance, Citicorp, and Ford Financial Services of the US, … agreed discreetly to impress on finance ministers around the world the benefits of a WTO deal". Then came the financial crisis that richoceted around the region from one country to another. By December 1997 the Asian leaders agreed to drop their objections, and on 12 December 1997, more than 70 countries signed the agreement that commits them to open banking, insurance and securities markets to foreign firms. By then the Asian holdouts (including Thailand and Malaysia) saw no choice: either they signed or their receipt of IMF bail-out funds would be complicated. Meanwhile the OECD has been pushing ahead quickly with the negotiation of the Multilateral Agreement on Investment, that liberalizes all direct foreign investment restrictions, requiring signatory governments to grant equal treatment to foreign as to domestic companies. It will preclude many of the policies of the developmental state.

These events—the revision of the IMF’s articles of agreement, the WTO’s financial services agreement, and the OECD’s Multilateral Agreement on Investment—are the expression of a Big Push push from international organizations, backed by governments and corporations in the rich countries, to institute a world-wide regime of capital mobility that allows easy entry and exit from any particular place. If the agreements are ratified and enforced, they will ratchet up the power and legitimacy of the owners and managers of capital in the world at large. Yet for all their implications for sovereignty, democracy, and social stability they are being negotiated with scarcely any public debate. They have been protected from public concern partly because the champions of the wider movement towards free capital movement and lifting of government regulations have managed to harness to their cause the most self-justifying of slogans, "stopping corruption". Capital freedom, we are invited to believe, checks corruption (as in Asia’s "crony capitalism"), and is therefore self-evidently a good thing. The next step will be an international agreement to deregulate labor markets, intended to make them more "flexible" (code-speak for freedom to hire and fire) while stopping short of open migration. This would further consolidate the global governance of capital.

There is always a fine line to be trod between an interest-based theory and a conspiracy theory (for all that everyone accepts the former and hardly anyone accepts the latter). It is difficult to know to what extent and at what point some events in the Asian crisis were deliberately encouraged by those who stood to gain from the sudden loss of resources by Asian governments and from the opportunities to gain control of Asian companies at knock-down prices. Certainly the role of the US Treasury in stiffening the IMF’s insistence on radical financial opening in Korea is documented. The Treasury made it clear that Korean financial opening was a condition of US contributions to the bail-out, on the understanding that financial opening would benefit US firms that would in turn give political support for US contributions.

Financial crises have always caused transfers of ownership and power to those who keep their own assets intact and who are in a position to create credit, and the Asian crisis is no exception. Whatever their degree of intentionality and their methods of concerting strategy, there is no doubt that western and Japanese corporations and the multilateral economic and financial institutions are the big winners. The transfer to foreign owners has begun, as we noted. "If something was worth $1bn yesterday, and now it’s only worth $50m, it’s quite exciting", according to the head of a UK-based investment bank. The combination of massive devaluations, IMF-pushed financial liberalization, and IMF-facilitated recovery may even precipitate the biggest peacetime transfer of assets from domestic to foreign owners in the past fifty years anywhere in the world, dwarfing the transfers from domestic to US owners that occured in Latin America in the 1980s or in Mexico after 1994. One recalls the statement attributed to Andrew Mellon, "In a depression, assets return to their rightful owners".

The crisis has also been good for the multilateral economic institutions, including the IMF, the World Bank, and the WTO. The ability of the IMF and the Bank to provide refinancing and to link refinancing to governmental acceptance of WTO rules gives all three organizations leverage with which to cajole Asian governments to reshape their domestic economies in line with western models. For them the crisis is a short-run blessing not even in disguise. On the other hand, both they and the incoming foreign firms may eventually suffer from the mounting political backlash. As Henry Kissinger recently warned, "Even [Asian] friends whom I respect for their moderate views argue that Asia is confronting an American campaign to stifle Asian competition." "It is critical that at the end of this crisis", he went on to say, "when Asia will reemerge as a dynamic part of the world, America be perceived as a friend that gave constructive advice and assistance in the common interest, not as a bully determined to impose bitter social and economic medicine to serve largely American interests".

How long will it be before the affected countries regain 1996 levels of output and wealth? Korea escaped the debt trap of the 1980s in the space of a couple of years because it was able to resume fast export growth, while Latin American countries could not export fast enough to escape inflation and balance of payments problems and languished for more than a decade. Which case shows the future of the Asian debtors today? Korea was able to resume fast export growth partly because the Latin Americans were out of the market. Today, every Asian country is seeking to export its way out of trouble at the same time. How long the crisis lasts depends partly on how successful they are, which depends on the growth of the Japanese, US and European markets and their access to them. It also depends on the extent to which international lenders cooperate among themselves and the borrowers to reschedule the loans. This in turn requires the IMF to give up its demands for fundamental restructuring, and concentrate on organizing debt relief. If Asia resumes fast growth within the next two years and if in the meantime the US goes into recession as the stock market and currency bubbles burst, we may again look to Asian models, as we did in the 1980s, for lessons on how to improve the parlous performance of American capitalism.

Come what may, the great lesson of the Asian crisis is that the desirability of free movements of short-term capital has to be put in doubt. We have tended to lump together trade liberalization with capital liberalization, and discuss them as though what applies to one also applies, more or less, to the other. Bhagwati’s point is their effects are fundamentally different. He argues for trade liberalization without capital account liberalization. Significantly, Martin Wolf of The Financial Times largely agrees. The question from the Asian crisis, he says, "is what to do about capital account liberalisation, which the IMF is strongly promoting in all its programmes….The evidence now seems clear that any substantial net draft on foreign savings creates huge risks….almost any large-scale international borrowing, even by non-banks, threatens economic stability if it becomes big enough to threaten the currency….At the least, there is an overwhelming case for permanent prudential regulation of foreign borrowing, particularly short-term borrowing, by commercial banks. ….Unregulated flows of short-term international capital are a licence to rack up losses at the expense of taxpayers." And a senior economic advisor at the World Bank, Pieter Bottelier, argues that "The world needs to understand more fully what the consequences are of unlimited international freedom of capital movements between countries that have vastly unequal levels of economic development and vastly different standards for monitoring their financial systems." He raises the question of whether to equip the World Bank and the IMF with better monitoring tools or perhaps even the power to impose sanctions to protect the system. When influential voices at the World Bank and The Financial Times, joined by academic champions of free trade, begin to line up on the side of reopening the question of capital opening, the idea of a new Bretton Woods conference is not quite as far-fetched as it seems.

In the end we come back to the mysteries of finance and financiers. In good times we tend to think of them as like engine oil, necessary to make the engine work but not part of the engine and not the fuel that turns the engine over. The analogy misleads, however, because the structures of financial intermediation are as much part of the "engine" as the stocks of human resources, capital, technology and organizations. The contrast between the development performance of Latin America and East and Southeast Asia shows how some financial structures can help the economy to grow faster than others. The contrast in their debt crises shows how the same Asian high performance financial structures can respond to shocks in ways that make the economy not just grind to a halt, but go haywire. As the Cambridge economist A.C. Pigou said with the Great Depression in mind, finance, far from being merely "the garment draped around the body of economic life", can take on the appearance of "an active and evil genius". For just this reason John Maynard Keynes famously proposed, "Ideas, knowledge, art, hospitality, travel—these are things which should of their nature be international. But let goods be homespun whenever it is reasonably and conveniently possible; and above all, let finance be primarily national." But we now have in place a powerful phallanx of international organizations and multinational corporations devoted to maximizing the freedom of financial capital around the world. The question is what institutional muscle can be brought to bear by those convinced that such untrammeled freedom is even more dangerous for human welfare today than it has been in the past.

BOX SHOCKS AND DEBT

Compare the balance sheets of a "Latin American" firm and an "Asian" firm, the Latin American firm representing the kind of economy that the IMF is used to dealing with. The Latin American firm has, on the liabilities side, equity of 80 pesos and debt (in the form of bank loans, etc.) of 20 pesos, giving it a debt/equity ratio of 1/4. Assume the rate of interest on its debt is 10 percent. Assume the gross return on its assets is 12 percent. Its gross profit is then 12 pesos (12 percent of assets of 100 pesos).

Suppose that one quarter of its debt is borrowed from abroad, in US dollars. Its dollar debt is then equivalent to 5 pesos, its domestic debt is 15 pesos. Suppose now that the currency is devalued by half (from 800 pesos to the US dollar to 1,600). The firm’s dollar debt doubles, to 10 pesos, raising its total debt to 25 pesos. On this debt it must pay 2.5 pesos by way of interest charges. It can easily pay this out of its gross return on assets of 12.

Suppose further that, in line with an IMF program, the rate of interest on the firm’s peso debt doubles from 10 percent to 20 percent. The interest cost of the peso debt rises from 1.5 pesos to 3 pesos (20 percent of 15 pesos). The interest cost on the dollar debt continues to be 0.5 pesos. The total interest cost is now 3.5. This too can be covered out of the gross return on assets of 12 pesos.

Suppose also that because of the IMF austerity program the return on assets falls from 12 percent to 8 percent, or 8 pesos. Again, the firm can still easily cover its interest charges.

In short, in the face of a 100 percent devaluation, a doubling of interest rates on domestic debt, and a 50 percent fall in the rate of return on assets the "Latin American" firm, with its low debt/equity ratio, remains viable. It continues to be able to meet the fixed payment obligations represented by its interest charges out of its return on assets.

Compare now the "Asian" firm. The key difference lies in its debt/equity ratio. Big firms in Korea normally have debt/equity ratios of 4/1 or more. Let us assume that our Asian firm has 20 won of equity and 80 won of debt, giving a debt/equity ratio of 4/1. Assume an interest rate of 10 percent; so the firm has interest costs of 8 won. Assume a return on assets of 12 percent, or 12 won.

Suppose, as in the Latin American case, one quarter of the debt is foreign, amounting to the dollar equivalent of 20 won, with 60 won in domestic debt. If the currency is devalued by half, the won value of the foreign debt doubles to 40 won. Total debt (domestic plus foreign) is now 100 won. The devaluation thus wipes out the firm’s equity (the difference between its assets and its debts). Using Western prudential standards the firm is in crisis. It is either thrown into bankruptcy, or the lenders agree to restructure the firm’s balance sheet, involving writing down the firm’s debt (such as accepting an interest rate well below the market rate) by sufficient to restore some positive equity.

If, also, thanks to an IMF program, the interest rate on the domestic debt rises from 10 percent to 20 percent the firm’s interest charges on its domestic debt rise from 6 won to 12 won. Together with the interest charge on foreign debt (equal to 10 percent of 40 won), total interest charges now amount to 16 won, compared to pre-interest profits of 12. The firm is even more unviable, its gross returns are even less than its interest charges.

If also the return on assets falls (because of an austerity program) from 12 percent to 8 percent the situation is worse. Gross profit is now 8, interest costs are 16. The deficit is minus 8. The firm has no equity and runs at a big loss. The loss must be recapitalized: that is, the interest payments due but unpayable must be added to the principle of the loan, raising the company’s debt/equity ratio still further, compounding its vulnerabilities.

When this happens across many firms, the debt/GDP ratio of the corporate sector rises and the country’s refinancing difficulties multiply.

END

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