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WILL ASIA BOUNCE BACK? (speech for Credit Suisse First Boston, Hong Kong, March 1998)
Let me begin my remarks with a disclaimer. Back in 1994, as many of you probably know, I published an article in Foreign Affairs with the deliberately provocative title "The myth of Asia's miracle". I said some things in that article that were extremely unfashionable at the time, and that were also calculated to make both Asians and their Western admirers more than a bit furious. One thing I did not do, however, was predict the current crisis. In fact, I went out of my way to avoid predicting any imminent crisis. At one point the editors of Foreign Affairs, for reasons not worth mentioning, wanted to change the title of my piece to "Asia's boom is over" - and I went ballistic. Of course the boom wasn't over - and I was afraid that any suggestion that growth in the region was about to come to a halt, as opposed to merely slowing down, would have cost me all my credibility. True, about a year later I began to worry about the possibility of some garden-variety currency crises in Southeast Asia, and even advised Citibank to limit their exposure - but even then, what I thought I saw coming was nothing like the catastrophe that materialized.
In short, I was 90 percent wrong about what was going to happen to Asia. However, everyone else was 150 percent wrong - they saw only the "miracle", and none of the risks. So while nobody predicted what actually happened, I guess in that sense I came closest - which is presumably why I'm here right now.
So what is going to happen to Asia now? Let me let you in on a secret: I don't really know. And I wouldn't be surprised if whatever I say now turns out to be 90 percent wrong all over again. But what isn't a secret, of course, is that nobody really knows what comes next. And if I can get it even 10 percent right, I am probably well ahead of the game.
So in a little while I will venture some predictions. But not just yet. First, we need to talk about how we got to this pass in the first place. So let me devote the first part of this talk to the question of how this thing can have happened - how a region whose growth rate was the envy of the world can have become an economic disaster area with so little warning.
Models of crisis
Anyone who claims to fully understand the economic disaster that has overtaken Asia proves, by that very certainty, that he doesn't know what he is talking about. (The guy who convinced Suharto that a currency board would solve all his problems is a case in point). The truth is that we have never seen anything quite like this. Of course the country doctors at the IMF and the US Treasury Department are obliged, by the nature of their position, to adopt a reassuring bedside manner as they prescribe their bitter economic medicine. But we all know that in reality they are pretending a confidence they do not at all feel, that even as they lay down the law to their clients they are groping frantically for models and metaphors to make sense of this thing. In fact, the best thing I can say about the people running the show in this case - who happen to be people I know rather well - is that they are smart enough, and also personally secure enough, to know and admit to themselves that they are making it up as they go along. In fact, some of them do something really unusual: they continue to come to academic and quasi-academic meetings, to listen to the give and take of outsiders who have the luxury of being able to engage in irresponsible speculation. (Whether they are prepared to act on what they hear is another matter).
As you might guess, I also spend a lot of time at those same academic and quasi-academic bull sessions - I mean seminars - so I have a pretty good overview of what the best and the brightest have to say about the Asian crisis. Let me give you a brief report.
Broadly speaking, I would say that there are two approaches to the Asian crisis that make at least some sense. (There are also other approaches, with substantial followings, that make no sense at all - like the idea that it is all a sinister plot by George Soros and Bob Rubin, or the idea that somehow this thing is the inevitable result of global overcapacity - but I won't discuss the nonsense ideas unless someone specifically asks about them).
One approach - which I would identify mainly with Harvard's Jeffrey Sachs - regards what happened to Asia as basically a modern, high-tech, multicultural version of a good old-fashioned financial panic.
What do the advocates of this view mean by a panic? They don't just mean that investors suddenly got cold feet, although of course they did. What they have in mind is a specific kind of self-reinforcing financial crisis whose logic economists actually understand quite well in principle (although predicting when one will start - or end - is another matter). So let me talk for a moment about the theory of the case.
The starting point for panic theory is the observation that there is always a tension between the desire for flexibility - the ability to spend whenever you feel like it - and the economic payoff to commitment, to sticking with long-term projects until they are finished. In a primitive economy there is no way to avoid this tradeoff - if you want to be able to leave for the desert on short notice, you settle for unleavened bread, and if you want ready cash, you keep gold coins under the mattress. But in a more sophisticated economy this dilemma can be finessed. My local bank is largely in the business of lending money at long term - say, 30-year mortgages - yet it offers depositors like me, who supply that money, the right to withdraw it any time they like.
What a financial intermediary (a bank or something more or less like a bank) does is to pool the money of a large number of people, and put most of that money into long-term investments that are "illiquid", hard to turn quickly into cash. Only a fairly small reserve is held in cash and other "liquid" assets. The reason this works is the law of averages: on any given day deposits and withdrawals more or less balance out, and there is enough cash on hand to take care of any difference. The individual depositor is free to pull his money out whenever he wants, yet that money can nonetheless be used to finance projects that require long-term commitment. It is a sort of magic trick that is fundamental to making a complex economy work.
Magic, however, has its risks. Normally financial intermediation is a wonderful thing; but now and then disaster strikes. Suppose that for some reason - maybe a groundless rumor - many of a bank's depositors begin to worry that their money isn't safe. They rush to pull their money out. But there isn't enough cash to satisfy all of them, and because the bank's other assets are illiquid, it cannot quickly sell them to raise more cash (or can do so only at fire-sale prices). So the bank goes bust, and the slowest-moving depositors lose their money. And those who rushed to pull their money out are proved right - the bank *wasn't* safe, after all. In short, financial intermediation always carries with it the risk of bank runs, of self-fulfilling panic.
A panic, when it occurs, can do far more than destroy a single bank. Like the Panic of 1873 - or the similar panics of 1893, of 1907, of 1920, and that mother of all bank runs, the 1931 crisis (which, much more than the 1929 stock crash, caused the Depression) - it can spread to engulf the whole economy. Nor is strong long-term economic performance any guarantee against such crises. As the list suggests, the United States was not only subject to panics, but unusually crisis-prone compared with other advanced countries, during the very years that it was establishing its economic and technological dominance.
Now what Jeff Sachs and some other people claim is that what happened to Asia is basically a modernized version of this old story, with a few new twists. True, only in Indonesia was there a straightforward traditional bank run. But the basic problem of a mismatch between short-run liabilities and long-term assets, with the attendant risk of self-fulfilling crisis, was there in all of the countries. The risk was made greater, of course, by the fact that so many of the liabilities were in dollars - so that when the crisis came, the countries were faced with the grim choice between raising interest rates to defend their currencies, which would bankrupt many firms directly, or allowing the currency to plunge, which would have the same effect indirectly by causing the domestic-currency value of debts to soar.
The important point to make here is that a panic need not be a punishment for your sins. In principle, at least, an economy can be "fundamentally sound" - it can be doing more or less everything right - and yet be subjected to a devastating run started by nothing more than a self-fulfilling rumor. And the position that Jeff Sachs and a few other people take, as I understand it, is that this is basically what happened to Asia. The economies were in fine shape - as good as Jeff said they were when he gave them high grades in the 1996 World Competitiveness Report - and then, out of nowhere, came a panic that undermined them.
OK, as you may have guessed, I don't buy that story, although I think it does contain an element of truth to it. The story I believe (I think - as I said, anyone who is sure that he understands everything here is kidding himself) does not deny that there is a strong element of panic in the Asian crisis - but argues that the preconditions for that panic were created by bad policies in the years running up to the crisis. The crisis, in short, was a punishment for Asian sins, even if the punishment was disproportionate to the crime.
What were these Asian sins? We hear a lot now about "crony capitalism". It's a good phrase, and it certainly captures the spirit of what went on in much of Asia. But I think that it is crucial to be more specific. Corruption and nepotism are nasty things, and in much of Asia they have flourished on an epic scale; but not every nasty thing you do can land you in a financial crisis. The specific sin that pushed Asia to the brink was the problem of moral hazard in lending - mainly domestic lending.
In a way this is the flip side of the problem of financial panic. One of the things that governments can do to prevent or limit panics is to provide guarantees for depositors and other lenders to financial intermediaries: once you know your money is safe, you have no incentive to join in a bank run. But guarantees create their own problems. Once a financial intermediary's liabilities are guaranteed by the government, its creditors have no incentive to police the riskiness of its investments - which means that the owners have an incentive to take excessive risks, on the principle of "heads I win, tails someone else loses". So if you want to have a financial system that is somewhat protected from panic, you have to also have an effective system of financial regulation - requiring intermediaries to invest safely, and requiring that their owners put enough of their own money at risk to disincline them to gamble with it (which we often forget is the real meaning of abstruse "capital requirements"). The point is that good banking does not come easily. It is a constant struggle to keep a financial system working properly, a struggle that requires clear thinking and honesty - both personal and intellectual - on the part of government officials.
Even countries with a history of probity often screw up their financial markets. The U.S. savings and loan debacle is familiar to all of us; but similar examples, from Japan to Sweden, can be found in many advanced countries.
The characteristic feature of developing Asia, however, was that they didn't even really try to face up to the dilemmas of financial management. Instead, what happened was that politically connected individuals or institutions - Thai finance companies, members of the Suharto family, chaebol-controlled banks - were widely perceived to be backed by implicit government guarantees, yet were not subject to any effective supervision. This non-system was an invitation to excessive risk-taking, and became especially dangerous after 1990 or so, as foreign capital began to be freely available. The result was a now-familiar litany of mistakes: heavy lending to speculative real estate ventures, over-ambitious corporate expansions supported by ludicrous leverage ratios, and so on. By the mid-90s, I believe, Asian financial markets were inflated by a major bubble that had to burst sooner or later.
The actual bursting of the bubble itself involved a sort of circular process: once it became clear that governments were going to have to spend a lot of money bailing out the existing creditors of financial institutions, it became unlikely that money would be spent to bail out any new creditors - so the money dried up, causing credit crunches and currency crises that undermined still more intermediaries, and so on.
It is at this point that the panic story has its place. In a perfect world the end of the moral hazard bubble would have been a positive thing: the bad financial institutions would have been closed - the ministers' nephews and presidents' sons would have had their creditors paid off, and been told to find something else to do with their time - but good financial institutions would have survived intact, and new ones been created to fill any gaps. In the real world the bursting of the bubble was the signal for a general panic - after all, who knew where the process would stop? And so what were probably overvalued exchange rates and were certainly excessive asset prices have become massively undervalued; the real economies have gone into a tailspin, not only because collapsing wealth and high interest rates have depressed demand, but because the implosion of trade credit has disrupted supply. I think the Asian economies had a crisis coming; they had in effect earned it; but Jeff Sachs nonetheless has a point: the depth of the crisis is far greater than their errors alone justify.
But did it have to be this bad? Let me turn next to the question of crisis management.
Did the IMF make it worse?
When events turn out as badly as they have in Asia, one naturally wonders whether the supposed rescue team actually did its job right - in fact, whether they didn't make the situation worse. Second-guessing the IMF has become something of a popular sport in certain circles; but it is also serious business.
Let me dispose quickly of what I do not believe is a serious objection to IMF policies. Some people have argued that the IMF should not have told countries to raise interest rates, or at least not as much. And higher interest rates have certainly made the domestic situation more difficult. But those who argue for lower interest rates in isolation seem to have a strange view of interest rates as being disconnected from everything else. After all, suppose that your exchange rate is plunging. Once you have run out of foreign exchange reserves, raising interest rates is the only way you have to support the currency. Now you might argue that it is better to just let the currency drop - in fact, there are a lot of cases where I would argue precisely that. But Korea, or worse yet Indonesia, are not like Britain in 1992, where a policy of benign neglect to the exchange rate meant a 15 percent devaluation and an extra point or so of inflation; when we are talking about free fall in the exchange rate and the risk of hyperinflation, even very high interest rates may be the preferred alternative. (I have heard some people propose what amounts to a sort of foreign exchange-interest rate Laffer curve: if you cut interest rates this will strengthen the economy, and the currency will actually rise. This is as silly as it sounds).
The real critique of the IMF, the one we should worry about, is the accusation that it failed to understand the panic element in the Asian crisis, and that it concentrated on disciplining countries when it should have concentrated instead on reassuring markets.
Now there is no question that the Fund, like almost everyone, underestimated the depth of and risks involved in the Asian crisis. And there is also no question that the intial instincts of the Fund were to grab standard programs off the shelf - to demand fiscal austerity, for example, from countries that did not have budget problems. But while the intellectual quality of the Fund's assessments may be questioned with hindsight, the important issue is what the Fund could have done differently (or for that matter could do differently now).
Let me offer a sort of caricature of the anti-IMF position - although it comes surprisingly close to what quite a few real people have said. According to this view, what the Fund should have done in Asia was to treat the crisis as a pure panic, completely unjustified by fundamentals. It should therefore have acted as a pure lender of last resort - making credit lines available to Asian nations with no questions asked. And instead of adopting its usual stance of criticizing country policies and imposing conditions, the IMF should have acted as a booster: Michel Camdessus and Larry Summers should have tried to look happy as they toured Asian capitals, and should have declared at each stop that the real economies were in excellent shape.
Like I said, this is a caricature - but aside from the bit about Camdessus looking happy, it is very close to what Jeffrey Sachs and other IMF critics seem to be demanding.
I think the problems are obvious. First of all, the IMF has limited resources. It simply is not set up as a full-scale lender of last resort; it cannot offer an open-ended credit line to liquidity-constrained countries in the same way that the Federal Reserve can for liquidity-constrained banks.
This limit on resources means, in turn, that the strategy of no-strings lending might - no let, me say very probably would - have failed: Indonesia and Korea would have run through their credit lines in a few weeks, the same way they had run through their own foreign exchange reserves. And then what?
Which brings us to the even bigger problem: it simply wasn't true that the crisis was a pure panic. There were serious flaws in the economies, especially in the financial systems, so that some banks and companies would have been insolvent even in the best of economic environments. Remember that Thai finance companies starting failing well before July's devaluation; remember also that eight of the 30 biggest chaebol were either bankrupt or close to it well before the won collapsed.
Now what a lender of last resort is supposed to do is to lend to solvent institutions that are short of cash; it is not supposed to lend to the insolvent. Even with unlimited resources, then, the IMF would have been engaged in a questionable activity if it had lent freely to Asia.
And finally we come to the most crucial point of all: not only does the IMF have limited financial capital, it has limited political capital. Suppose that it lent $100 billion or so, no questions asked, and then lost a significant part of that - to countries where a substantial fraction of the money went to banks controlled by the president's son, or to conglomerates that had given the now-imprisoned former president a few hundred million dollars in bribes. And now imagine trying to explain that to Senator D'Amato.
Many people have argued that the IMF's current insistence on major structural reforms is a mistake, that it involves going beyond the Fund's mandate. The answer, I think, is that given what U.S. Treasury officials refer to privately as the "rathole" problem - that is, the risk that the money will simply disappear into corrupt, politically connected institutions, and that Senator D'Amato will notice - the Fund must either confront crony capitalism or stay out of the picture altogether. Perhaps the latter would have been better - but somehow that doesn't come through clearly in the critiques.
Someday, perhaps, we will have a truly global lender of last resort which does not have to answer to narrow-minded and know-nothing national constituencies, which has the resources to deal with even the largest financial run, and which can lose a few billion dollars now and then without destroying itself as an institution. And it would be a safer world if we did. But we don't.
Every few weeks since July something has happened in Asia that completely surprised everyone. So forecasting is a highly risky exercise. Still, I guess I have to try.
There are, it seems to me, three basic scenarios for what might happen to Asian economies starting from here. Call them Mexico 95, Mexico 82, and the fall of civilization.
Mexico 95 is the scenario everyone hoped for and expected at the start of the crisis: after a short sharp shock, there would be a reversal of market sentiment; capital would come flodding back in, and it would be time for some 8 percent growth.
Mexico 82 is a drearier scenario. Investors, having been burned and remaining skeptical about deeper structural problems, stop fleeing but take a long time to return in force. The countries find themselves engaged in a series of reschedulings, perhaps incur scattered arrears, and go through a sustained period of sub-par growth.
Finally, there is the disaster scenario: as the economic consequences of the crisis strike home, political unrest runs out of control, leading to a vicious circle of capital flight and domestic violence. Businesses end up torched, and businessmen become boat people.
The truth is that all of these are still viable scenarios. It is still, just, possible that after a few months of financial stability (in Korea in particular) mutual fund managers will start to worry more about missing the boat on Asia's recovery than about getting caught in its collapse, and that a steep, Latin-America-1997-style recovery will commence. On the other hand, it is all too possible that Indonesia, in particular, will tear itself apart.
But since one must make a choice, I would put my money on the middle scenario - or to be more precise, on a sort of higher-end version of that scenario. That is, I predict (OK, guess) that there will be an extended workout, in which countries will be obliged to keep negotiating with their creditors for delays in repayment, but that the situation will gradually improve. I don't think Asia is headed for a Latin-America-in-the-80s (or Japan in the 90s!) "lost decade" of zero growth; more like a lost two or three years.
Where does that prediction come from? The big reason that I don't believe in the dramatic recovery scenario - the V-shaped crisis - is the same reason that I don't believe that the crisis was a pure panic. Asian economies did indeed have big structural problems, especially in their financial sectors. Money will not come in freely, and economic growth will not revive fully, until those problems have been cleared up, and are seen to have been cleared up.
On the other hand, even though I am generally known as the guy who didn't believe in the Asian miracle, I never said that Asian economies were paper tigers. The huge growth in productive capacity over the past generation may not have been miraculous, but that doesn't mean it was a fake: these economies are not Potemkin villages, facades with nothing behind them. So the potential for fairly high growth is still there. Remember that earlier in this talk I pointed out that there is no relationship between good long-run economic performance and vulnerability to crises - that the United States before World War II was both the most productive and the most panic-prone of advanced nations. Well, that cuts both ways: Asia's economic momentum didn't save it from crisis, but its crisis does not mean that it has lost its economic potential.
Why don't I believe in the total-collapse scenario? Basically because you don't make dire predictions like that unless you really know something; and what do I know about the state of mind of the average Indonesian?
And now the big question: what does all this say about investment decisions? To me the answer seems obvious: buy.
The reason is not that, as Jeff Sachs unfortunately titled a recent essay in Foreign Affairs, "Asia's future is bright". The truth is that its future is quite murky. But what Asia really is, is CHEAP. Throughout the region, assets are valued (in dollars) at anywhere from 25 percent down to 10 percent of what they were worth before the crisis. Now even if you think there was a serious bubble in 1996; even if you think that the future growth of these economies will be half what it was in the first half of this decade; in fact, even if you think there is, say, one chance in 20 that by this time next year 5 million ethnic Chinese Indonesians will be trying to sail to Australia - investing at those prices is a good bet.
How confident am I about this? Hey - I'm 10 percent sure.
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