OCTOBER 4, 1999 VOL. 154 NO. 13

T I M E   F I N A N C E
Shoring Up the House
The Asian financial crisis is showing signs of receding. So, what next?
By ADAM ZAGORIN

The Financial Tsunami that struck Asia in July 1997 was the most powerful economic blow since the Great Depression. In its wake, hundreds of billions of dollars were sucked out of emerging markets, from Thailand and Russia to Brazil, provoking widespread hardship and calls for a "new global financial architecture" to shelter the world from future disaster. Capitalism no longer seemed to be working; "globalism" as practiced before the meltdown seemed in sore need of repair.

So, what has happened since? Not much. As stock markets and growth rates around the world have begun to rebound smartly in the past few months, the urgency of reform has faded--in some views, to an alarming degree. "There is a danger that the crisis, having diminished, will cause a slowdown in preparations to prevent the next one," warns Canada's Finance Minister, Paul Martin. "So now it really becomes a question of leadership, of not allowing a welcome improvement in the world economy to lull us into a false sense of complacency."

The good news is that "architectural reform" will be Topic A at this week's annual meetings of the World Bank and the International Monetary Fund, when scores of finance ministers and central bankers converge on Washington. Debt relief for the world's neediest nations, the so-called heavily indebted poor countries, or HIPCs, will be one focus for the sessions and the subject of an important new initiative. And yes, there will also be much discussion, a great deal of it arcane, of ways to make the world economy safer--moderated capital flows, more transparent accounting standards, more effective regulation.

There will also be a lot of soul searching. What went wrong in the financial crisis? And what needs to be changed? Views on those important issues vary. As its contribution, the influential U.S. Council on Foreign Relations has just issued a report calling for the IMF to do less and commercial banks and wealthy investors to do more in bailing out troubled economies. The Institute of International Finance, a global association of 300 financial institutions, disagrees. It holds that the private sector should participate only on a case-by-case basis in bailouts, leaving the heavy lifting to national governments and the IMF. For some experts, the debate amounts to dithering.

Joseph Stiglitz, chief economist of the World Bank, is fond of pointing out that in the past quarter-century there have been 80 or more financial crises, everything from the cash squeeze caused by two Arab oil embargoes to the Latin debt debacle of the 1980s. "When there is a single accident on a highway, one suspects the driver's attention may have lapsed," he maintains. "But when there are dozens of accidents at the same bend in the same highway, one needs to re-examine the design of the road." Stiglitz blames the IMF and the U.S. Treasury for bad engineering in the way they foisted overheated capital flows and privatization on emerging markets, nearly all of which lack the financial institutions and regulatory apparatus to absorb an influx of private cash that in Asia alone reached nearly $500 billion between 1993 and 1997.

In short, agreement on the causes and remedies for global financial contagion is limited. As a result, the world is pursuing what the experts call "architectural reform" at a distinctly measured pace that is typical of the international financial system. The U.S., in particular, is eager to avoid what it deems to be hastily crafted solutions that might destabilize a growing but still fragile world economy. It's an approach to reform that looks more like a plumber fixing leaky pipes than an architect trying to devise a grandiose new world order. But until a broad international consensus does form, U.S. Treasury Secretary Lawrence H. Summers, like his predecessor, Robert Rubin, is likely to pursue a cautious, incremental strategy, which a U.S. Treasury official calls a financial version of the Hippocratic oath: "... at least, to do no harm."

The Summers-Rubin approach does seem to be working, at least for now. Little more than a year ago, as the world teetered on a financial precipice, the duo (Summers was then Rubin's deputy) worked closely with Federal Reserve Board Chairman Alan Greenspan to maintain the strength of the U.S. economy. Their efforts fueled a spending binge by American consumers, who snapped up exports not only from hard-hit emerging markets but also from recession-bound Japan as well as Europe, where growth had slowed. Wall Street stock markets surged, while the U.S. racked up record trade deficits. The trade imbalance is headed for more than $300 billion by year's end, far above last year's record $220 billion.

All that spending is at last helping to generate renewed growth in many parts of the world. The Asian Development Bank has announced that 14 developing countries in the region, after recording growth of just 1% in the final quarter of 1998, had a "substantial" 4.8% jump in gross domestic product in the first quarter of this year. An overall increase of 5.5% is anticipated for 1999. "In just a few short months, Asia has made great strides in recovering from the worst economic crisis in a generation," said Myoung-Ho Shin, an ADB official. "Industrial production and exports in most of the crisis-affected economies are on the rise, and in many cases capital outflows have reversed."

Not all countries in Asia have done equally well, of course. South Korea, Singapore, Taiwan, the Philippines and Thailand have turned in the strongest performances; Hong Kong and Indonesia, the weakest. South Korea's case is especially remarkable, with growth accelerating from 4.8% in the first quarter to 9.8% in the second. Hong Kong's is the only Asian economy that will probably shrink in 1999, largely because overvalued stock and property markets have collapsed along with consumer confidence.

Other emerging markets are also doing much better than expected even a few months ago. Brazil's economy will contract only about 1% in 1999, despite an earlier forecast of 3.7% shrinkage. Russia's output will decline 2% rather than a widely anticipated 7%.

The trouble is that the recovery remains fragile. Most of the improvement has come not from much needed economic reforms but from government pump priming. Result: in Asia each of the five nations hit hardest by the crisis is expected to run a budget deficit equivalent to more than 5% of GDP by the year 2000.

There are, to be sure, some promising signs. Nearly all the Asian countries have taken some incremental steps toward changing the structure of their economies, primarily in the downsizing by troubled companies. Thailand, Indonesia, Singapore, Hong Kong and China have conducted limited bank reforms, while South Korea has taken action against its chaebols, or cartels.

But for every encouraging note, there is a discordant one. South Korea's campaign to open its banking sector to foreign ownership and transparent business practices looks as if it may be stalled, according to the Goldman Sachs investment firm. In Indonesia the situation is, if anything, more precarious. Plagued by domestic turmoil and violence in East Timor, the country faces a major corruption scandal involving the alleged transfer of $80 million from the privately owned Bank of Bali to the country's ruling Golkar Party. In Thailand, where 1999 growth is expected to hit 3% after a contraction of more than 9% last year, bank reform remains a major problem. After the government passed new bankruptcy and foreclosure laws and authorized a huge fiscal-stimulus package, it turns out that nearly 50% of all loans are still considered "nonperforming."

Lagging reform in separate emerging markets is compounded by lack of international agreement on how to deal with the riptides of financial contagion. Following the lead of German Bundesbank president Hans Tietmeyer, a body called the Financial Stability Forum was established at the Basel headquarters of the Bank for International Settlements. It brings together national regulators and other senior financial officials to discuss key architecture issues. Three working groups have formed, including one looking at options for regulating hedge funds, the multibillion-dollar pools of investment capital that were deeply involved in speculating on collapsing emerging-market currencies during the financial crisis. The group has already attracted attention by inviting participation from a number of countries, like Malaysia, that are eager to be included in deliberations sponsored by the G-7. That meshes with efforts by the U.S., Canada and other G-7 members to form a group of "systemically significant nations" whose agreement will be essential in creating an international consensus on reform of the global economy. But so far, no hard proposals have been put into practice.

Many countries are pushing for a new set of minimally acceptable practices to help financial-market participants better manage risk. If private investors had known of Asia's peril earlier in the last crisis, they could have limited their exposure gradually instead of pulling out all at once. At least that is the argument in favor of developing more rigorous and transparent accounting and disclosure standards and upgrading corporate governance and regulation of the financial sector. An independent group of experts headed by John Crow, former governor of the Bank of Canada, warns that even when countries report their true financial condition, governments often fail to heed warnings that might fend off economic turmoil.

One area where a broad international consensus has formed involves more flexible exchange rates. After the billions of dollars spent trying to control foreign-exchange markets during the 1997-98 crisis, there is little enthusiasm for defending currencies pegged at what often prove to be unrealistic levels. The IMF alone blew almost $5 billion trying to save Russia's overvalued ruble in July 1998, only to see it fall victim to an inevitable devaluation. To make matters worse, such interventions also foster a "moral hazard," creating the impression among speculators that it is possible to dabble in national currencies with relative impunity.

Most countries now accept that allowing a freer flow of money across their borders is key to attracting foreign investment and maintaining a healthy financial sector. But the question is, How much freer? Malaysia faced widespread condemnation for imposing capital controls in the middle of the crisis, but the IMF recently conceded that this strategy produced benefits. In fact, Malaysia used a breathing space offered by the imposition of controls to successfully float $1 billion in international bonds last May, and foreign buyers did not move to sell them when the controls were lifted in September. Together with well-known examples like Chile, which has for years regulated inflows of short-term capital, Malaysia by its behavior has changed the terms of the debate.

The past 18 months have seen not just a remarkable, if partial recovery from the financial crisis but also a major expansion of the IMF's role. In the fiscal year ending April 30, the 182-member lending organization disbursed a record $30 billion to hard-pressed countries, and $4 billion more has been handed out since then. The fund's uncommitted reserves stand at $76 billion, more than double the level of a year ago.

That said, the money may be needed because, as the World Bank's Stiglitz notes, "the global economy is certainly weaker now than it was before the onset of financial turmoil in 1997." Rising interest rates threaten a cooling of America's long expansion; much of Latin America is still in recession; and a growing list of countries, including Ecuador, Russia and Pakistan, are in or close to default on tens of billions of dollars owed to private lenders.

Despite these threats, movement toward a new global financial architecture is likely to proceed at a measured pace. "It would be amazing if a real plan of action took less than five years to develop," notes Barry Eichengreen, an expert on the international financial system at the University of California at Berkeley. It would be equally amazing if another financial crisis did not occur before then.