Chapter 28 The Inevitable Perils of a Precocious Giant
- International Monetary Fund
- Published Date:
- January 2001
In his classic of French literature, Francois Rabelais described the adventures of a picaresque father, Gargantua, and his son, Pantaguel. Both are robust and powerful giants. Because of their size, they went into the world at very young ages and were treated by others as adults. Sometimes their precociousness served them well; at other times, not. Sometimes the people with whom they came into contact were poorly served because of their failure to reflect on the giants’ lack of maturity. The current problems of Asia are, in my mind, akin to the problems of Gargantua and Pantaguel. The West has confused economic size and power with legal and financial sophistication. Worse yet, the West appears surprised at the results of its confusion.
East Asia has become an economic giant but yet it is still a legal and financial adolescent. Like Gargantua and Pantaguel, it lacks the sophistication of a mature adult. For the sake of convenience, somewhat unfairly, I will treat Malaysia, Indonesia, Thailand, South Korea, Taiwan, and the Philippines as if they were a monolithic entity and call them the “East Asian Giants.” While this treatment may be unfair in that it fails to recognize the considerable differences among these countries, for the purpose of my analysis, it is effectively accurate.
The so-called East Asian miracle of sustained high levels of economic growth and modest inflation was built on the four pillars of hard work, high savings rates, emphasis on education, and budgetary surpluses. These four pillars are cornerstones of capitalism. The economic Achilles’ heel of the Asian giants is that their growth, while prodigious, was not to be unending. Growth driven by input factors always peaks while the more illusive “productivity gains” are hard to achieve in economies relying upon low labor costs for comparative advantage. Thus, embedded in the miracle of sustained growth, is the root of the Asian crisis.
The parentage of the Asian crisis is in some dispute. As is often the case with disasters, finger-pointing and blame-shifting are widespread. The only one of the usual suspects not rounded up in this crisis is the “macroeconomic policy-induced crisis.” This form of crisis occurs when a central bank prints money to cover the budget deficits while trying to maintain pegged exchange rates. Usually, interest rates soar and the economy falters. The central bank finally begins to run low on the reserves necessary to hold the pegged price. The speculators come in, start shorting and there is a currency crash. Ultimately, the exchange rates float at a rate lower than the previously pegged rate. Net to net, it was a waste of money to the central bank and a windfall to the speculators.
The other usual suspects: (a) financial panic, (b) bubble collapse, (c) moral hazard crisis, and (d) disorderly workout procedures, all seem to own a meaningful piece of the responsibility in the East Asian crisis. Financial panic occurs when any set of investors attempt, usually for reasons not grounded in fundamental economics, to “get out” at the same time. In theory, financial panics could occur at any time. In practice, they seem to occur after there has been an asset bubble. Financial panic is usually the end game of “greater fool” investing, in which all the players realize prices are too dear but pay them anyway, thus creating an asset bubble. The reason they continue to play the game while knowing, or at least suspecting, they are paying too much is because thus far they have been able to pass the “bad penny” to a greater fool at a higher price. Then some event—the longer the game, the more trivial the event—spooks the players and they all run for the exits.
The trigger event in the Asian crisis is now alleged to be a modest slowing in the Thai economy. Given the input-driven nature of the growth and the lack of total production factor gains, this slowing was inevitable. The response of Japanese and other banks was to decline renewal of credits to the Asian Giants. The result was dramatic: a reversal of capital flow from plus $89 billion in 1996 to minus $12 billion in 1997. The largest change in capital flows came from net selling in the giants’ stock markets ($23 billion swing) and the reduction in credit to the giants’ banks ($76 billion swing).
However, in my view, the real music stopper was the recognition by Japanese financial authorities that Japanese banks had best circle the wagons around the Japanese economy and financial institutions. Given the problems at home, protecting the prosperity of others in their sphere of influence was no longer feasible or politically acceptable for Japan.
U.S. and U.K. portfolio managers, like most stock investors, were quite familiar with psychologically induced volatility and were quick to push the panic button. Equity portfolio managers punish missteps as small as missing a quarterly earning estimate by two cents with merciless abandonment. The slowing of the whole Thai economy seemed like an obvious and excellent reason to panic—before everyone else did.
It is well to remember that the portfolio managers had sold emerging markets investing to their best institutional clients as desirable co-variance reduction through global diversification. While I know co-variance reduction is a sound idea and widely accepted, it is a slim reed on which to hold at the apparent onset of a monsoon. Portfolio management is a business in which failure in relative performance is neither taken lightly nor forgiven quickly. I think the lessons to be learned from an asset bubble-financial panics scenario is that foreign investors, particularly if they themselves have uncertain footing on the slippery slope of seeking marginal risk adjusted returns, are likely, after a long run of profits, to hit the panic button at the first hint of a severe downturn.
The “moral hazard crisis” was more a domestic problem than an international one. In the U.S. savings and loan scandal, the assets of federally insured depositors were imprudently risked by dewey-eyed or villainous executives of mutual savings and loan associations in which the executives had no significant economic investment. In the East Asian crisis, most of the depository institutions had such high debt equity ratios that the owner/fiduciary aspects of managerial decision-making had been marginalized. It takes both fear and greed to make capitalism work; it is unwise to eliminate fear and to rely solely upon greed. The risk/reward analysis of bankers tolerating very high gearing ratios, both for themselves and for their clients, reflected fearlessness.
The failure to have comprehensive bank supervisory and inspection procedures, as well as an established procedure for closing insolvent banks, added to the Asian giants’ problems in the creation of the crisis and equally as important, in its resolution. When the IMF seemingly unwisely determined that the Asian giants should raise interest rates and reduce government spending, the increased rates only further spooked the panic stricken foreign banks and further inflamed the currency speculators. The foreign banks’ response was to more aggressively reduce credit exposures, and the currency traders’ response was adding to their short position. Regrettably, there was no systematic way to deal with the resulting increase in the number of insolvent banks. It is clear that the workout procedures were not well suited to the circumstances.
Was this all predictable? No, but I think it was inevitable. Given that … “in the long run we all are dead” … predictions without, dates, aren’t very helpful. It seems reasonably clear from my analysis of the economic and financial market data that the timing of the crisis was not predictable by conventional analytical means—until it was well underway. Rating agencies have been pilloried for not predicting the crisis. I think this criticism is quite unfair. The criticism arises from a misunderstanding of the role of investors’ due diligence versus the role of rating agencies. Rating agencies should not attempt to predict panics lest their prophecies become self-fulfilling. I believe they did a reasonable job of alerting the investor to the potential for panic. For rating agencies to do more than suggest the potential for panic is inappropriate and unwise. Predicting the panic would only have accelerated, and possibly exacerbated, the crisis.
That not one investment banks’ public research reports even alluded to the potential for the panic is a little more interesting. While I have no evidence, my personal experience in investment banking causes me to wonder if the desire of the investment bankers for positive relations with sovereign and corporate debt issuers might not have effectively suppressed the research department’s willingness to speculate about the possibility of a panic. This sometimes happens in the U.S. with respect to potentially negative reports on corporate clients. In any event, the bottom line is that the crisis seemingly came as a great surprise.
Nevertheless, these fundamental problems might have been solved without a panic-induced crisis. There is no question that the panic arose in part from the reaction to slowing growth by the foreign lenders and investors. Periods of slowing growth are understandable and predictable. However, there are additional problems inherent to the East Asian Giants that made the panic inevitable, if not predictable. These problems are the lack of transparency, disclosure and hardnosed analysis.
The quality of bank’s credit analysis is importantly a function of the quality of accounting procedures. The internal and external accounting procedures prevalent in both the government and corporate sectors in East Asia were significantly less rigorous than the norms in North America or Western Europe. Quarterly reporting, independence and adherence to some version of GAAP are not the general practices in East Asia. As a result, bankers will admit that the quality of bank credit analysis in East Asia was far below world standards. In East Asia, bank lending was viewed as more reputational than analytic. While knowing the customer is probably the most important ingredient in good credit decisions, the absence of a stream of reliable financial data is unsettling in times of unrest. An additional problem in emerging market investing is that Western debt and equity investors appear to have “bought” overall economic scenario stories buttressed by financial ratings. This is not what Graham & Dodd had in mind when they wrote “Security Analysis.” This kind of surface analysis tends to minimize the confidence of the investors in periods of extreme price volatility.
The history of U.S. and world capitalism reflects continuous progress toward the recognition of the value of transparency in markets, disclosure of financial results and avoidance of commercial bribery and cronyism. Initially, executives tended to resist disclosure. The legal power of securities laws and exchange listing standards were required to obtain grudging acceptance. In the early phase, disclosure was viewed by corporate executives as revealing privileged information not appropriate for the public investors, and worse yet, helpful to competitors. In the U.S., the recognition that business executives and politicians should avoid the temptation of bribery, reciprocity and cronyism has required thirty or forty years of criminal convictions. In the U.S., we are nearing the end of the first phase and beginning a new phase in which executives accept the reality that full disclosure and arms-length dealings are good business. They are good business because they reduce borrowing costs, increase price earnings ratios and, most importantly, reduce the likelihood of investor panic. The East Asian giants are still in the less mature phase in which accurate and complete disclosure and puritanical aversion to corruption are not the norm. Until this paradigm shift occurs, there will be periodic panics because there will be disheartening revelations and ugly surprises.
A cultural revolution will be required to cause the paradigm shift to full disclosure, arm’s length dealings, and market transparency. Thus, we now must focus on what should be done to avoid future panics and to ameliorate the one they have. I have six recommendations, which I believe would help.
1. Establish banking and securities laws with significant power of inspection and supervision by an independent agency of the government with the capability and willingness to impose harsh remedial sanctions as well as to recommend criminal prosecution with severe sentences for those convicted.
2. Convert a significant portion of the bonds and short-term debt in the corporate sector into equity.
3. Implore Western portfolio managers to abandon the “greater fool” theory of investing and to engage in detailed financial analyzes of all emerging market investments.
4. Implore bankers to insist on receiving a stream of reliable financial data from borrowers as a required part of the credit process.
5. Set up industrial banks or other forms of venture capital funds with long investment horizons, without daily pricing and not permitting regular redemption. These institutions should take on the job of making long-term, arms-length equity investments in productive enterprises.
6. Establish a legal framework for equitable and procedurally efficient bankruptcy proceedings, lien enforcement, and asset securitization.
When most or all of these measures are adopted, the precocious Asian Giants may have the maturity to participate in global capital markets without the periodic need for remediation and resuscitation. Remember, just because a young person is large and strong does not mean he has the experience and wisdom to react prudently to adversity. Treating such persons as mature is, at the very least, negligent entrustment and, depending on the circumstances, possibly a crime. The West must resist the temptation to over-invest and overburden the fragile infrastructure of the young Asian giants until they have developed the maturity to cope with the procedural, disclosure and transparency demands of the global capital markets.