Financial Crisis in Asia: What It Can Teach Us
From a talk by Valpy Fitzgerald, director of the Finance and Trade Research Centre of Queen Elizabeth House, University of Oxford, with envío and with Masters students in Development from Central American University in Managua about this predictable as well as worrisome crisis.
THE ASIAN FINANCIAL CRISIS REFERRED TO AS "YELLOW FEVER," WHICH IS SPREADING throughout the world, forces us to ask ourselves what is causing the instability we are currently observing in international financial markets and what the consequences are. We also ask: what might be the consequences of all of this in Central America and in Nicaragua? Are there lessons that Nicaragua can learn from the Asian crisis?
To understand what happened in Asia it's very important to understand that the 1998 international financial system is totally different from the system in place in 1982, when the Latin American debt crisis erupted. Over the past ten or fifteen years drastic changes have occurred in the functioning of the international financial system, leading to a transformation that makes this animal totally different from the previous one.
The financial system is itself unstable today. The problems and the crises in Korea, Malaysia or Hong Kong did not emerge because of speculation or erroneous macroeconomic policies. They are the consequence of the way the system itself functions.
The first major change in the international financial system over the last ten years has been the transformation in the supply of funds from the North to the South. Today more funds are in circulation than ever before. The flow of private capital currently comes to some $200 billion a year, ten times more than in the 1980s. The growth of capital flow from industrialized countries to industrializing ones has been dizzying. This growth in the supply of funds in the First World is better understood as a growth in demand for financial shares in so-called Third World countries.
The capital flow has increased beyond measure. And the composition of it has gone through three fundamental changes. The major protagonist of the Latin American debt crisis in the 1980s was the international commercial banking system. First change: that protagonist has left the stage. Multinational banks are no longer in the business of loaning to developing countries as they were before. They got their fingers burned in the crisis of the last decade and decided to leave that game. The large banks have also gotten out of the mediation process in industrialized countries.
A bank's function has traditionally been to attract short-term savings, checking accounts and small liquid savings that it then transfers to long-term investments. Today, international banks—same as the banks in Nicaragua—are no longer dedicated to that task. Insofar as they are able, they are more interested in attracting long-term savings—pension plans, for example—to then offer short-term loans to the stock market. Thus, the bank's historical economic function, which was to transfer small savings to large long-term investors, has almost totally disappeared at the international level as a result of the financial liberalization process in the world economy.
The second big change in the composition of the increased money flows from North to South is the importance these flows have acquired in pension funds, which accumulate savings, or pensions, or pension deposits by citizens of developed countries. Today, that money—which is mostly invested in stocks or bonds—is the primary participant in European and US stock markets and has already begun seeking investments in underdeveloped countries. That money represents the lion's share of the short-term capital flow from the North to Latin America and Asia. The money flowing around the world is no longer the banks' money; now it is the pension capital of First World workers. In the United States and other countries, the retirement pension system has changed totally, from one of public or occupational pensions with guaranteed incomes or a system based on the capitalization of the funds of each pensioner to today's system of variable profit retirement pensions, with no guarantees. No US citizens today have a pension that guarantees a certain amount the year they retire. Everything received at that point will depend on what their income has earned in a fund. Those US citizens receive a monthly or quarterly report from their pension administrator, explaining how much the fund is worth at that time. One month it might be worth $100,000 and with a bit more savings $105,000, but if its stocks go up, its value could jump up to $150,000, and the person would be very happy because his or her pension savings are worth more.
Investment fund money seeks short-term investments with high liquidity and high risk, and with high returns. The reason these pension funds can seek high-risk investments is that they have very diversified portfolios. This means that the risk they run in one country is compensated for by the one they run in another, the risk of one investment with that of another, the risk in one sector with that in another.
When citizens from the North invest in a pension fund, their plan is to redeem it in 30 years, at retirement time. Those who invest in pension funds do not have the least idea of what the pension's value will be when they retire, because that depends on the profitability of the fund they chose. Since there are no guarantees, they will choose the pension fund with the highest return at the moment of investment. Pension funds compete among themselves to present the best short-term earnings. And that competition leads them to certain actions: they always seek quick profits with high-risk investments, but as soon as they smell any problems, they get out of the game as fast as possible.
The third great change in the capital flow around the world is the increasing popularity of direct foreign investment given the globalization of production. This means that a large part of the industrial processes are shifted from rich countries to poorer ones, triggering increased piece-work industries.
There has also been a great change in this foreign investment process in the past ten years: the bulk of direct foreign investment is no longer in the export or industrial sector, but in the service sector—hotels, restaurants, banks, etc. More and more investment is seeking the real estate sector. Since none of these sectors are tradables, this type of investment doesn't resolve anything when a country needs to increase export-generated income, because it doesn't generate more income.
Ten or fifteen years ago, the flow of capital had different origins and composition. Banks predominated, direct investments in exports and manufacturing were given privileges, and public flows abounded. The Inter-american Development Bank and bilateral government-to-government flows dominated the field. At that time, almost half of all funds to developing countries came from public funds. Today, public funds aren't even a fourth of all capital moving from North to South. All of these changes have rapidly led to a permanent instability in investments.
There have also been important changes in the countries in the South on the demand side of funds—or rather, the supply side of debits. One of these has been a generalized liberalization of financial markets in both Asia and Latin America, in the framework of intense banking competition.
This has led to two important transformations. The first is that the Latin American banks—and also the Asian banks to a certain degree—have moved from investing in industry and agriculture to investing in real estate and expanding consumer credit. The expansion of consumer credit is a phenomenon that has swept through the entire Third World. Obviously, credit is expanded among the middle class, not among poor consumers. One root of Mexico's 1994-95 crisis was the massive expansion of consumer credit. When it became necessary to reduce credit, the consumers couldn't pay their credit card debts. The crisis led to the first known social movement of credit card debtors.
Second transformation: the massive privatization of public enterprises has attracted large private investment flows to developing countries. But this investment is prioritized toward non-tradable sectors: communications, telephone, water, energy, gas, etc., all sectors that don't directly generate funds or improve problems of low exports.
Another change that has occurred in the South, and is beginning to appear in Nicaragua and the rest of Central America, is the expansion of the local public debt market. Because developing countries in the 1980s found their attempts to get loans from the international banking system for the public sector blocked, they began to issue local bonds with high interest rates. Today almost all developing countries have local public debt markets with variable interest rates.
Historically, all changes in the countries of the South have coincided with the investment interests in the North. The recent boom in the demand for short-term, high-risk and high-profit assets in the North coincided with the expansion of their supply in the South. There were changes and deregulation in both the North and the South and liberalization coincided with financial transformations in both areas, all of which fed the capital flow.
The crisis developed because the financial market that has developed in the heat of all these changes is itself unstable. Financial markets operate on a credit rationing system: the amount of credit demanded by businesses and consumers is always greater than the amount the banks have available, so the banks ration credit, only lending the amounts they are sure they will recover. But the market never follows a simple model as textbooks sometimes teach us, with one curve here, another there with a certain interest rate, and another here with the dollar amount, and here savings and here investment and the market equilibrium of capital is obtained with a determined interest rate and flow of funds... This isn't what is happening in reality in the capital or credit markets, at either the national or international level.
Today, long-term interest rates in real terms are dropping around the world and are actually converging. The interest rates paid in different countries do not really reflect risk. It is the same thing that happens when a banker charges a similar interest rate to many different clients and, to cover the risks, limits the amount to be loaned to certain clients.
Another problem of the current financial market is what is known as asymmetric information. Investors deal with large amounts of money, but have very little knowledge of the countries or the sectors of countries where they are investing, and they are unwilling to invest either the resources or the time necessary to acquire this information. I've spoken with young people who handle investment funds in the United States and England as well as with those who manage large bond trading operations at the international level, and they can barely find Mexico or Argentina on a map, let alone differentiate one country from another. Their information about what is happening in southern countries is minimal, and they obviously don't speak Spanish.
When an investor makes a decision in a market like this, everyone else follows suit, because it's more profitable to go with the market than completely out of sync with it. Computers reinforce this tendency—which is known as the lemming instinct. People only work eight hours, but markets operate 24 hours a day. Global financial system computers stay on all night and are programmed with instructions to automatically buy and sell stocks and bonds on the international securities markets: if it goes down more than two points, sell; if it goes up more than two, buy. It's no coincidence that one of the most serious moments in the "cracks" in Korea and Mexico happened at Christmastime, precisely when computer operators are on vacation and leave the computers on automatic for longer periods of time.
When the Mexican crisis exploded over Christmas 1994, many yuppies in charge of buying and selling stocks and bonds got the news while on vacation in Colorado. They were skiing down the mountainside when their cellular phones rang to let them know that the Mexican peso was dropping. Without even leaving the slopes, they sent the order: sell, sell, sell! and went on skiing. Today's market moves in unity and automatically.
In times of crisis, the only defense available to an investor of this type—which means most investors today—is to move the portfolio, rapidly changing the composition of its investments. Today's investors always seek liquidity, and when any negative information is received, they rapidly get out of the market. This is a totally different defense than the traditional banker uses. If a banker has money problems in a certain country, he or she pressures the government of that country to pay up, by going through the Monetary Fund or the US Embassy or directly through the bank branch in the country. But that's not what today's investors do. They cut their losses by getting out of that market. The dynamic has changed radically: the long negotiations we used to have with international bankers in Nicaragua in the 1980s no longer take place. Today everything gets resolved in five minutes.
These radical changes have also taken place in the United States and in Europe, but they don't cause as much instability in the North as in the South because in the North there are three institutions to guarantee financial stability. The first is the institution we call the market maker. Within the New York or London or Tokyo market, there are large enterprises always willing to buy and sell stocks at a price that is maintained within a determined band, established publicly. Market-makers buy or sell in these markets or in other financial centers, wherever. They "make markets" because other buyers and sellers of stocks know that they can always trade what they want to at a reasonable price and, even if they suffer a slight loss at crisis moments, they won't lose everything. This isn't true for the peasant who comes from Ticuantepe to sell pineapples in the Oriental Market in Managua and finds that it's flooded with pineapples and the vendors don't want more at any price. The existence of market makers, which operate like "wholesale financiers," guarantees that this won't happen to someone who wants to sell stocks in, say, the New York market. Market makers like Solomon Brothers, Merrill Lynch or Goldman Sachs are a sort of oligopoly, and act as stabilizing forces in the market. They also permanently offer vast information about market ups and downs.
The second institution that guarantees stability in the North is the prudential regulator, which in the United States is called the Security and Exchange Commission—in Nicaragua this would be something like the Superintendent of Banks. The role of this institution is to guarantee that investors don't take too many risks with their depositors' funds. This is necessary because the demand for funds always exceeds supply in the financial market, especially today, and there is no equilibrium. There are always more people who want to borrow money at a certain interest rate than there is money to lend. Thus, the point of equilibrium isn't determined by demand, but by supply. The person loaning the money has more power than the one asking for the loan. To stabilize the domestic financial market in the United States, regulations are placed on people lending money, not on people borrowing. Investors, pension funds, banks are all regulated. If a bank is lending to businesses, public financial authorities don't inspect the businesses, but they do inspect the bank. It's curious: at the international level, the situation is reversed. The IMF never inspects those who loan money, only those who request loans.
The third stabilizing institution in the North is the lender of last resort. When the national financial market lacks liquidity, when panic occurs due to a shortage of money, it is the Central Bank's responsibility to supply enough currency to stabilize the market. It provides it basically by buying financial titles in the market and thus injecting more currency into the market. In other words, it offers liquid shares and acquires non-liquid ones, thus increasing market liquidity.
These three institutions are very important for the smooth functioning of a financial system because they prevent national crises. Regrettably, none of the three exist at the international level. The global financial market has no market makers, prudential regulators or lenders of last resort. And the IMF and the Group of Seven are totally inadequate institutions to take on any of these three roles.
All of this helps us to better understand the nature of Asia's financial crisis. It began as much in the industrialized countries that invested in Asia as in Asia itself. The massive expansion of short-term capital in search of high profits brought an excess of funds to the Asian markets. When a lot of funds enter a market, the prices of financial shares begin to rise in that market. And when share prices begin to rise, new funds come in. This is a cumulative process, known as "bubble." Prices rise, more and more funds enter, but since traders in London or New York have minimum information about the country in question, all they see is that Thailand's stock market is rising, inflating like a bubble. That's the only information they have; none of them is investigating anything about what's happening in the country. One of the sources of information that they could use would be large banks like Merrill Lynch or Goldman Sachs. But, when there's a new issue of private or public debt in Poland, Thailand or Mexico, traders use those huge banks to sell their bonds, and the banks then go to pension funds to sell them its Polish, Mexican or Thai bonds. In the current system, the large banks have ceased being a source of independent information, because their objective is to sell more and more bonds.
In 1997 this financial reality came together with a worrisome over-evaluation of the US and European stock markets, largely due to merger fever, particularly among large telecommunications companies and some other sectors. On top of this, the Japanese yen, the US dollar and the German mark—that is, the Euro—were very unstable. That created a sort of triangle that forced the dollar up, although everyone knows that the increase in the dollar is artificial and is waiting for it to fall. If to this unstable currency market situation we add the uncertainties in 1997 about the transfer of Hong Kong to China or about the future of the European Monetary Union, it was logical that the financial market would be enormously uncertain.
Uncertain but appealing. When I speak with those who invest in Asian markets and ask them why they don't leave those markets if they are so unstable, they always respond: "We know there will be problems in Asia, but we don't know when. So, if the crisis will begin on Monday, I'll stay there till Friday. But if the crisis won't start until next month..." The temptation to remain in these markets is great because of the high yield.
To understand the crisis one has to understand that the composition of investment portfolios is very different from what it was when the 1980s' debt crisis took place. Basically, the problem then was the public debt, and now it's private debt. The origin of the 1994 Mexican financial crisis was private debt. The crisis in Thailand has been over private debt, as has the Indonesian crisis. These are debts contracted by real estate agencies or corporations or foreign private banks. These weren't cases of governments with huge international loans. The bank loans of the 1980s crisis can always be calmly renegotiated. Not now. Now we are dealing with liquid participation, with stocks and bonds, short-term capital, and the lender, instead of negotiating, just bails out quick!
At the moment the crisis reached the height of its bubble and the first investors began to flee the Asian markets, prices began dropping. And when the price of shares begins to drop, all investors begin to abandon ship. Each one who goes depresses the price more and more. Each one accelerates the exit, because the last to go is the one who will lose all the money.
To understand this, it's important to know that those who operate in this type of market make incredible profits, based on commissions on successful operations. In the current financial market, it is totally normal for young men under 25 years old, employed by large London-based businesses dedicated to these kinds of investments to receive Christmas bonuses of up to a million pounds. They earn one and a half million dollars a year! These young men tremble when they see their disproportionate earnings in danger and this leads them to erratic investment activity. Naturally, their bosses earn double or more what their subordinates do and they choose not to question the erratic nature of the activities...
The entrance of massive short-term capital into the countries in the South leads to an expansion of consumer credit and thus a boom in consumption as happened in Mexico. It also leads to expanded credit to the real estate and service sectors. The problem begins when that liquid money escapes. If people get credit to buy a car, they can't pay the credit right back because they can't turn around and sell the car immediately. If the credit was to build a shopping mall or a new home, and the bank loses the deposit, the bank can't recover the credit, because the asset against which the construction credit was loaned is not saleable in the short run. Securities are harder to sell in a financial crisis. When there's a financial contraction, those with credit card debts find it harder to pay them. It's harder to find buyers for houses during a financial decline. In the crisis, an asset that had a certain value one day might have half that value the next day. It is in this asymmetry of liquidity that the crisis expresses itself, not in interest rates.
With the Asian crisis, the IMF, and behind it US citizens, found themselves facing a very serious problem: the collapse in the value of Asian shares could have a very negative impact on the value of pension funds in the United States. The US government was politically afraid of the popular reaction to the drop in the value of pension funds. And that fear was what led it to rapidly authorize a financial operation to back the value of assets in Asian countries.
The operation was intended to provide liquidity to these countries, obviously only temporarily. After a period, they will once again request long-term loans to replace the liquidity they were given in the emergency. No one in the international financial system was prepared for this type of rescue operation, oriented to a short-term solution, which involved pulling together funds from wherever possible.
The IMF and the US government mobilized an enormous volume of funds to Asia: almost $100 billion. The sum appears in its true dimensions when one takes into account that the total amount of official annual aid to the Third World is only $35 billion. Thus, the operation to rescue the Asian economy has required mobilizing three times more money than all the support for Third World development. We can also compare it with private investment data: the net private investment flow to all developing countries in 1997 was some $200 billion. The IMF and the US government mobilized half of this quantity in just a few weeks to support the Asian rescue operation.
One disturbing question is why the IMF and private investors didn't predict the Asian crisis. The response has a lot to do with the fact that this type of crisis is private, not public. Many of the indicators used in adjustment programs to determine whether an economy is stable or not—public debt in relation to GDP, fiscal deficit, inflation rate—are completely useless when the crisis takes place in the private sector and not the public sector. This is one of the great limitations of IMF policies in cases like Asia, because the IMF only acts on fiscal spending restriction and monetary stability, which is totally inadequate to respond to crises like Asia.
The failure to predict the crisis raises a very serious question. Why did Standard and Poors or Moodys or other experts not predict it? We still don't know the answer to that. There were people who announced that something like this was going to happen. I include myself among them, but I didn't bet a dollar of my savings, by which I mean that I wasn't so sure myself. With the Latin American experience, however, what was happening became very obvious by observing the level of private sector debt. There are still no instruments to control the massive flows of short-term private investment. Nor are there mechanisms to impede them. The only mechanism that has been used thus far is that of last resort lenders. In cases like that, this lender is the Monetary Fund, which lends to governments so that they can then make loans to national banks which can then make loans to private businesses. This circle of loans is generating a new foreign public debt.
The ESAF-type stabilization policies being implemented by the IMF in Indonesia, Thailand, Korea and all over are totally inadequate for these countries in cases of crisis, because they assume more public spending cuts, which depress the economy even more. Also because they assume interest rate increases, which overvalue the currency even more. And because—and this seems to me to be the most erroneous error—they pressure for more liberalization and more deregulation of the financial system.
The most appropriate policy for a crisis of this type would be to impose more controls on the movement of capital, but the policy the IMF proposes is exactly the opposite: deregulate and liberalize the financial markets more. The IMF is currently putting strong pressure on all Asian countries to eliminate the few controls they still have on the financial system. The reason is all too obvious: the US financial companies are extremely interested in penetrating the Korean and Japanese markets. In the midst of the crisis, the United States wants at all cost to prevent a joint Asian decision to close their capital markets so they can control them. The United States wants to keep these markets open.
What are the consequences of all these international changes and crises for Central America? Central America has the luck—if we want to call it that—of not having received short-term investment portfolio funds as much as Brazil, Argentina or Mexico. The "yellow fever" has not affected us as much.
But the Asian crisis will affect us. The availability of short-term funds for the region will drop, because US investors are nervous, though there is no prediction of an important rise in US interest rates. Apart from this, there is no reason for the flow of direct investment from the United States to Central America not to keep growing, nor is there any reason why the investment flow among Central American countries should stop. Basically three factors generate that flow and they haven't varied with the crisis.
The first of those factors is the return of much of the capital that fled Central America in the 1980s and early 1990s. The second is the wave of privatizations, which is attracting huge capital. The third is the movement of certain parts of production processes—above all labor intensive ones—to Central American countries because of the low wages that can be paid throughout the region. None of these three tendencies is affected by the Asian crisis.
Changes will be noted in Central America in the flow of direct investment from Japan, Korea or Taiwan. These investors will withdraw because of their serious financial problems. Their retreat will intensify US investments as well as investment among Central Americans.
Major changes can be expected in flows of official international cooperation because, with the crisis and rescue operations, the IMF has tended to take on enormous, historically unprecedented loans. And it knows it will have to take on a new rescue operation in 1998, in the face of the collapse of Russia's financial system, with an even greater injection of funds. This means that the availability of IMF funds for Enhanced Structural Adjustment Facilities (ESAF) and other programs for developing countries will be severely limited.
Japan will also reduce its special funds for foreign cooperation throughout Central America. And it is very probable that funds from Europe will also shrink, since Europe will be more involved in the Russian case and will also move more of its cooperation efforts to Africa, which is suffering a chain of emergencies.
The most regrettable of all is that there are no indications that, as a consequence of these changes and crises, the IMF plans to change its ESAF designs. One would expect the IMF to learn from these experiences and change the modality of its structural adjustments, but there is no sign of this. There are actually signs that the IMF may become stricter about debt pardons because this would cause greater uneasiness and uncertainty among investors.
The Asian crisis requires us to rethink current policies about financial deregulation in the Central American region. The current rush to deregulate, to liberalize financial markets, to expand consumer credit at any cost and in any way, to permit the banks to abandon industrial and agricultural investment and move into real estate and consumer credit, can be very dangerous. In Central America today there is a tendency toward short-term liquid savings as well as a tendency for Central American businesses to take on debts outside of Nicaragua because interest rates there are lower than local market rates. These are great risks.
The greatest risk is the current tendency, very marked in Latin America and especially in Nicaragua, to overvalue the national currency. It is evident that the córdoba is overvalued as an anti-inflationary tactic. What the ESAF agreement signed by the Liberal government proposes—stopping the sliding devaluations and supporting an overvalued exchange rate with more foreign debt or more international cooperation—will obviously have the effect of depressing exports and promoting a level of imports almost double that of exports.
On this path, the crisis will soon be knocking at the door in Nicaragua and Central America. All of these factors were present in the Asian and Mexican cracks. And although they have not yet reached the same level that they did in Mexico, Korea or Thailand, the weakness of our economies will make it more difficult to bear the effects of a crisis of this type.
It is urgent that not only the government's macroeconomic policies, but also our countries' financial strategy be cautiously rethought. An inadequate investment strategy, not only because it is unstable but because of the support being taken away from long-term agricultural investment and shifted to non tradable sectors, will impede the generation of exports needed to maintain a stable currency.
The "yellow fever" has affected all of us. It has left us two signals in Central America: there won't be many changes in private investment and there will be substantial restrictions in foreign aid. But above all, the Asian fever leaves us with a warning: Central America's financial systems, which have less serious symptoms but ones similar to those that caused the crisis, ought to learn something from this traumatic experience.