Understanding a crisis through differing glasses

by Chakravarthi Raghavan

GENEVA: Ten months after the Thai baht devaluation set off a financial crisis that swept through Asia, and whose aftermath does not still appear to be over, financial experts still seem to be groping for explanations and reasons that leave the ordinary public befuddled.

Most of those favouring the current orthodoxies argue that it is a crisis of Asia and its mores, or that it is a liquidity crisis and a balance-of-payments crisis, and that pragmatic policies of a few years of adjustment and hardship (by the people) would set things right.

While the IMF, other Western treasuries, and transnational investment and banking experts are busy trying to place the onus on the countries themselves, other voices, those that can no longer be dismissed as heterodox views, have been insisting that it is a financial crisis and a symptom of the deeper systemic crisis, as former Federal Reserve Chairman Paul Volcker was quoted as saying by an International Herald Tribune columnist on 5 May.

At the Asian Development Bank (AsDB) seminar at the end of April in Geneva, a paper by Mr. S.Ghon Rhee, AsDB resident scholar, presented a history of the crisis and data to show that in the period before the onslaught of the crisis, the affected economies (Indonesia, Thailand, South Korea, Malaysia and the Philippines) did not look much different from the economies that had fared better (Hong Kong, Singapore and Taiwan).

But Rhee's analysis, and that of the former Finance Minister of India, P. Chidambaram, who commended the Rhee paper, or of Thai opposition Senator (and former banker) Naronghchai Akrasanee, were of controlled dissent - putting the blame also on foreign banks pushing money and short-term flows, but not constituting a basic challenge to the establishment's orthodoxy: liberalization of financial sectors, capital account convertibility or opening up of an economy to all kinds of investments and providing foreign investors national treatment and full entry and exit rights.

Tarapore Committee

It was during Chidambaram's stewardship as India's Finance Minister that the Tarapore Committee (appointed by the Reserve Bank of India) advocated capital account convertibility and felt this Valhalla could be achieved within a reasonably short period of three to five years. And Chidambaram himself had spoken of the need for reforms and had made statements about current account convertibility and moving towards capital account convertibility. But the people of India have been spared the Asian trauma: no action was taken on the Tarapore Committee recommendations, partly because of some caution from the much-maligned bureaucracy, and the unstable government at the centre, and the subsequent Asian crisis.

Chidambaram asked at the AsDB, why there had been no warning of the impending crisis - in the AsDB 1997 outlook (which said most of the economies would strengthen their performance), or in the 1997 September Fund/Bank meetings at Hong Kong when neither the IMF nor the World Bank sensed a catastrophe was imminent.

He also spoke of the macroeconomic fundamentals of a country being no longer of avail when millions of players in the market expect a currency would depreciate or the real- estate bubble would burst. The other "villain", he said, appeared to be external capital inflows which can quickly turn into capital outflows.

Effects of crisis

A big global investment player at the AsDB seminar, Mr. Gerald Corrigan, Managing Director of Goldman Sachs & Co and former member of the New York Federal Reserve, sidestepped the finger-pointing for the crisis but addressed himself to the effects.

Once a foreign currency liquidity crisis strikes, a country's official reserves can be severely depleted in a matter of 30-90 days. And once severely depleted, even a near- optimal macro and structural policy response will not stop the bleeding in the short run. The only solutions lie in raising interest rates; suspending interest or principal payments on all foreign currency obligations; raising new foreign currency balances, directly or indirectly via restructuring of existing debts (he did not mention payment of commissions to those who arrange it); and raising new foreign currency balances from official sources.

Whether or not a country should seek IMF help, he said, was a complex issue, and the risks and balance of contagion and systemic risks must be weighed. Also, it is virtually impossible to see how a country can escape from a financial crisis without incurring substantial declines in economic activity. "Like it or not, that is the reality," said the Wall Street banker, who also claimed that private banks had lost money in the Mexican crisis.

But if the luminaries at the AsDB had attended the UNCTAD seminar two days later, they would have heard a different account of the nature of the crisis (and thus solutions and crisis management), and that carefully couched warnings had been advanced by other institutions (Bank for International Settlements, about the short-term lending and investment flows to the region; UNCTAD, about the dangers inherent in premature financial sector liberalization), but the markets and the operators had chosen to ignore them.

At the UNCTAD seminar, Yilmaz Akyuz, who heads the UNCTAD Macroeconomic and Development Policies Branch (which organized the seminar), did not waste too much time on the causes, arguing that it was not necessary to apportion blame or responsibility between domestic and external factors or between government policies and market behaviour.

"But a greater understanding of the causes and nature of the crisis could help us manage it better and identify measures needed to reduce the likelihood of the crisis and contain its adverse effects on the real economy," he said, going on to note that there seemed now to be more consensus on the underlying reasons for the capital inflows into the region than on reasons for the sudden exit. "Financial liberalization, interest rate differentials and exchange rate pegging, together with attraction caused by successful economic performance, are agreed to have been responsible for the massive inflows."

Catalyst of crisis

But what triggered the crisis? There are two explanations, he said. One view singles out financial panic and contagion, explaining the crisis in terms of a typical boom/bust phenomenon (a view that Robert McCauley of the Bank for International Settlements later seemed to favour). The other view is of a crisis triggered by bad fundamentals, bad investments due to government interventions in investment and credit allocation, lack of effective supervision, inappropriate corporate governance and lack of transparency, as a result of which borrowers not only wasted money but hid it from creditors.

Even more, said an expert at the UNCTAD seminar, the commercial and investment banks that now mediate such transactions, and that should be depended on to assess market risks, no longer do so because they use derivatives to package all such operations and deliver high-risk investments or loans to emerging economies as investment-grade instruments to investors of developed countries, while collecting commissions and fees for such operations, but bearing no risks themselves.

"Capital flows," said Prof Jan Kregel of the University of Bologna and the Johns Hopkins University Centre at Bologna, "require both a borrower and a lender, but they are usually arranged by an intermediary..."

During the 1990s, apart from the fall in returns on investments in developed countries that led to a search for higher returns in emerging markets, the global investment banks were seeking alternative sources of revenue to help them emerge from their difficulties in the US in the 1980s.

"One of the ways they could do so was by earning fees and commission income by arranging structured derivative packages which allowed emerging market borrowers access to funds at low interest rates prevailing in developed country markets, while offering to developed country investors assets earning high emerging market interest rates. A popular means of arranging lending was by means of equity swaps in which high-yielding debt issued by emerging market firms or banks was repackaged into investment trust vehicles which could be sold to institutional investors in developed countries as if they were investment-grade assets..."

Another UNCTAD document, for a commodity meeting in the first week of May, shows how a leading oil TNC financed the operation of a subsidiary in Nigeria, using the commodity as a collateral - "the case of Mobil Producing Nigeria Unlimited", as the document headlines a box within.

Mobil Producing Nigeria (MPN), it said, holds a 40% interest in a joint venture with the Nigerian National Petroleum Corporation engaged in offshore production of hydrocarbons. For a new project, that is, the Oso Natural Gas Liquids (NGL) project, it needed to raise $330 million.

"But Nigeria is unrated, and the US parent company was unwilling to provide a guarantee on MPN's lending. MPN would normally not have been able to borrow money at a rate better than that paid by the Nigerian government. To overcome this problem, an investment bank structured a so-called 'asset- backed securities issue'. The future production of NGL and crude oil of the project was sold to an international buyer, who assigned the future proceeds of this sale to an offshore trust. This trust then issued 'trust certificates' that were sold to institutional investors, primarily in the USA. The issue was strongly oversubscribed (over $1 billion was offered) and the interest rate paid by MPN on this 7-8 year loan (much longer than would have been normally available for a country like Nigeria) was 4% lower than what it otherwise could have been expected to pay. This improvement in credit rating (and thus in credit conditions) is quite normal for collateralized finance. In dozens of cases, enterprises have been able to obtain large credits on conditions better than those available for their country."

History lesson

In opening the seminar on 1 May, UNCTAD Secretary-General Rubens Ricupero quoted English author G.K. Chesterton for the view that "History teaches us, history teaches us nothing." Ricupero went on to note that the debt crisis of the 1980s had not been sufficient to prevent the Mexican crisis of 1994, and that the Mexican crisis had not been able to forestall the 'Asian' crisis of 1997.

The collapse of the Asian emerging economies in 1997 was not like the free fall of the Mexican peso and the collapse of the Mexican Bolsa (stock market) which produced a tequila effect that spread to the whole of Latin America, but did not create a sell-off in global financial markets, Prof. Kregel later said in his presentation.

The Asian crisis was not a balance-of-payments (BOP) crisis like the one in Mexico but a financial and asset market crisis, and it broke at the weakest link in the Asian economies, that is, the recently liberalized and deregulated private domestic banking system (in Thailand).

The crisis, Kregel said, could best be explained as a case of "market failure" of two different types:

  • Firstly, a failure of competitive international capital markets to produce the optimal allocation of capital, with funds continuing to flow into Asian financial institutions after it was clear that financial instability was widespread.

  • Secondly, it is a failure of privatized free-market "banking systems, (that) were not up to the task of effectively absorbing and channelling to productive use large foreign capital inflows as well as the large amount of domestic savings (in) these economies... Such weakness led to the misallocation of resources."

(Third World Economics No. 184/185, 1-31 May 1998)

Chakravarthi Raghavan is the Chief Editor of the South-North Development Monitor (SUNS) from which the above article first appeared.