© Institute for International Economics
A. Financial excesses abound
- Excessively close tie of local currencies to the U.S. dollar (correlation 70%+ to U.S. dollar) coupled with excessive depreciation of the yen relative to the dollar (Y100/$1 Dec 1994 to Y130/$1 Dec 1997)-these two excesses undercut Asia's export-driven growth strategy.
- Excessive reliance on debt (especially short-term foreign currency debt) as opposed to equity finance (for example, in 1995, developing countries issued $11 billion of international equity, $57 billion of international bonds, and rolled over about $300 billion of external short term bank debt). As of June 1997, their collective bank loans totaled some $1,000 billion.
- Excessive connected lending abetted both by inadequate financial surveillance and by giving undue weight to making rising asset prices in making credit evaluations (throughout Asia, cash-on-cash returns on property investments were usually under 3% through most the 1990s, but appreciation often exceeded 10% annually.
B. Financial depressions endure
- After the onset of the Great Depression, in 1929, U.S. Treasury bill rates dropped to a fraction of 1% and remained there for a decade. Yet four years later, after the price level had dropped 25%, Baa bonds were yielding 7.8%; even in 1940, when the price level was still 20% below the 1929 level, Baa bonds were yielding 4.8%. Per capita GDP did not regain its 1929 level until 1940. Share prices dropped a maximum of 75% (reaching bottom in 1932) and did not regain their 1929 level until 1953.
- In the debt crisis of the 1980s (triggered by Mexico's default in 1982), spreads on the dollar paper of heavily indebted countries often reached 500 basis points. The spreads did not narrow to the 200 basis point range until the Brady plan of 1989. There was no growth in per capita GDP for a decade in Latin America. Mexican equity prices (measured by the dollar price of the Mexico Fund) dropped about 75% in dollar terms (reaching bottom in 1984) and did not recover their early 1980s levels until the early 1990s.
- In the Asian financial crisis (triggered by Thailand in July 1997), spreads on dollar paper of heavily indebted countries have soared to 1000 basis points or higher (after Russia devalued and defaulted). We do not know how long it will take for spreads to descend to a more normal range of 200 basis points. Measured by the Templeton Emerging Market Fund, equity prices dropped 60% in dollar terms from October 1997 to September 1998. Optimists expect GDP in emerging markets to begin recovering in late 1999; pessimists add two years to this horizon.
C. Asian action plan
- Continued U.S. and European growth (Greenspan is helping; Tietmeyer and Duisenberg are not);
- A strong yen and a stable yuan (Y135/$1 to Y120/$1 is a good start; at yuan8.3/$1, China is a source of stability);
- Within crisis Asia, prudent fiscal stimulus; prudent reduction of interest rates; and maintenance of competitive exchange rates;
- Re-capitalize and restructure the banking system (Japan has made a start; so has Indonesia);
- Additional bilateral and multilateral funds are needed, beyond the IMF packages (Japan's $30 billion is helpful; now is the time for aggressive new lending by the World Bank and the Asian Development Bank).
D. "Architecture" of the World Financial System
- The world financial system has become increasingly dollarized, in the sense that bank loans and bond issues are increasingly denominated in dollars. Yet the disciplines that attend dollar credits within the United States are ignored abroad or imperfectly observed. These same constitutional weaknesses will beset the euro-zone, the yen-zone, and the yuan-zone, as and when they emerge.
- Large banks and other financial institutions are not held to international accounting standards. In particular: (a) many loans are made to connected parties without serious credit evaluation; (b) non-performing loans are often concealed; (c) loan and equity portfolios items are not marked to market. Moreover, large corporations often issue dollar denominated debt without adhering to international accounting standards and without timely disclosure of their business affairs.
- Worse, central banks too often maintain exchange rate regimes that give implicit, but false, assurances that the local currency will maintain a close parity with the dollar (a central rate perhaps surrounded by a small band of +/-5%). Or they give false assurances that the local currency will depreciate at a predictable slow rate against the dollar (say 7% to 10% per year). These regimes invite dollar borrowing by financial institutions and corporations, and use of the dollar funds to acquire assets that pay off in terms of local currency.
- Worse still, the IMF is not a lender of last resort. Instead, it is a combination of reform bully and credit consolidator. When Continental Illinois and the Republic Bank of Texas failed in the 1980s, the Federal Reserve fired the managers and saved the depositors, thereby averting a bank run. The Fed did not use its leverage to reform public procurement in Chicago or the tax system in Texas. Compare this record to the IMF's bungled closure of 16 banks in Indonesia in November 1997. Salvador Dali would love this "architecture"! But it would be too streamlined for Antoni Gaudi!
E. Compare the Architecture of the World Trade and Tax Systems
- When the GATT was created, in 1947, it had 23 members (including China and Cuba, but China subsequently withdrew). The rules were very slender-basically a framework for future liberalization, not actual commitments to liberalize. Now it has 133 members. The original 23 members (excluding China) today account for only 40% of world trade. The rules of the original GATT, and the rules of the original GATT would have left them free to keep tariffs at about 40% ad valorem, to maintain numerous quotas, and to impose emergency protection almost at will. However, in the five decades since 1947, membership of the GATT (now the WTO) has expanded to 133 countries (China, Russia and the oil states of the Middle East being the important exceptions). The GATT members have slashed tariffs and nearly eliminated quotas; they have extended the trading rules to cover services and intellectual property; and they have created a working dispute settlement mechanism.
- In 1946, there were a handful of international tax treaties between industrial countries (the United States, for example, only had treaties with France, Sweden and the United Kingdom) the rules for adjusting taxes on imports and exports were not well settled. The opportunities for double taxation were rife. Only with the development of international tax rules under the auspices of the OECD, the GATT and the UN, and the negotiation of more than a 1000 bilateral tax treaties, was it possible for multinational corporations to operate in relative tax peace, if not tax bliss.
F. New Financial Architecture Needed!
- Between 1970 and 1998, world trade, at current values, expanded by a factor of 19, from $290 billion to $5,600 billion.
- Between 1970 and 1998, the stock of world foreign direct investment, at historical cost, expanded by a factor of 16, from $160 billion to about $2,500 billion.
- Meanwhile, between 1970 and 1998, cross-border interbank claims on developing countries expanded by a factor over 30, from under $30 billion to about $1,000 billion. Over the same period, outstanding international bond issues by developing countries expanded from a negligible level to about $600 billion.
- Yet, between 1970 and 1998, IMF quotas (a measure of its lending capacity) rose from $29 billion to $270 billion, a factor under 10, and an absolute amount less than 1% of world GDP and less than 5% of world trade. Meanwhile, the IMF's capability to enforce financial discipline on national central banks or large private financial institutions diminshed (because of the growing role of private finance).
- In short, there has been a huge growth of international trade and finance, most of it denominated in dollars, with little improvement in the institutional architecture.
- The concept is easy; the practice is hard (the IMF publication, Toward a Framework for Financial Stability, January 1998, is no more than a handbook of good intentions). Several things need to be done:
- Central banks: should declare their exchange rate and reserve targets; disclose daily all public sector foreign exchange reserves and liabilities; commit the central bank and the public sector not to engage in off-book or derivative transactions.
- Large private financial institutions: should disclose monthly all non-performing assets; mark-to-market of assets and liabilities at least monthly; maintain BIS capital adequacy standards; submit to periodic audit and disclosure of risks by major accounting firms (especially maturity risk, currency risk, credit risk).
- Large corporations: should publish quarterly accounts according to international accounting principles; make timely disclosure of material events.
- Create Independent Surveillance Department (ISD) within the Bank, officers appointed for a term of years, with power to approve auditors for those national central banks and major financial institutions and private corporations that wish to be eligible for IMF emergency support. Based on audit results, the central banks, financial institutions, and corporations would be periodically trated.
- In a financial emergency, IMF resources would be disbursed only at steep penalty rates to central banks that either do not disclose their position, or receive less than an AAA rating, one year prior to the crisis. The schedule of penalty rates would be determined by the ISD.
- Finally, in an emergency package, creditor banks would incur a loss on interbank and nonbank loans made to less than AAA graded borrowers. Again, the penalty schedule would be determined by the ISD.