Desai - Financial crisis, contagion, and containment : from Asia to Argentina

FINANCIAL CRISIS, CONTAGION, AND CONTAINMENT

FINANCIAL CRISIS, CONTAGION, AND CONTAINMENT

FROM ASIA TO ARGENTINA

Padma Desai

PRINCETON UNIVERSITY PRESS PRINCETON AND OXFORD

Copyright 2003 by Princeton University Press

Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540

In the United Kingdom: Princeton University Press, 3 Market Place, Woodstock, Oxfordshire OX20 1SY

All Rights Reserved

Library of Congress Cataloging-in-Publication Data

Desai, Padma.

Financial crisis, contagion, and containment : from Asia to
Argentina / Padma Desai.

p. cm.

Includes bibliographical references and index.

ISBN 0-691-11392-0 (alk. paper)

1. Financial crises. 2. Economic stabilization. I. Title.
HB3722 .D47 2003

332'.042dc21 2002031745

British Library Cataloging-in-Publication Data is available

This book has been composed in Sabon

Printed on acid-free paper.

www.pupress.princeton.edu

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

For
TN

chrya h prva-rpam, antevsy utt a ra-rpam, vidy sa m dhi h

(Taittirya Upani s ad, 1.3.3)

Contents

Preface

THE BORROWING BINGE of the eighties and the nineties was a pervasive phenomenon in the global economy. Japanese businesses borrowed heavily and invested unwisely in the eighties. U.S. households went overboard in stretching their finances in the second half of the nineties. Businesses, banks, and several governments in emerging market economies accumulated unsustainable foreign debt obligations.

There was however a difference in the process in the developed group at the center and the vulnerable economies at the periphery of the international financial system. Borrowers in the developed market economies managed their debt burden, by source and duration, of their free will. Their policy makers undertook homegrown measures for battling the consequences of the resulting economic booms. By contrast, the emerging market economies analyzed in this book invited financial and currency crises in their economies from destabilizing foreign capital flows. These flows resulted from a premature opening of their financial systems in an environment of hothouse pressure that emanated from private and institutional lenders in the U.S.-led developed center. From Asia in 1997 to Argentina in 2002, these countries struggled with the consequences of externally imposed financial crises and International Monetary Fund (IMF)-led policy prescriptions that they did not own.

I adopt this comparative center-periphery framework in the book for tracing the origins and spread of financial crises. I also employ it for arguing that emerging market economies with weak institutions and political maneuverability cannot be expected to grow crisis-free in a world of unrestricted capital mobility and floating exchange rates which are the latest magic bullets uncovered by the IMF. Even the U.S., eurozone, and Japan, advanced market systems with institutional capabilities and open economy adaptability face problems, which I analyze, in implementing successful policies in pursuit of stable growth.

The book also provides simple analytical models grounded in step-by-step empirical evidence in the crisis-swept countries for isolating the impact of volatile short-term capital flows in initiating financial crises and spreading them across countries. My policy judgments flow from relevant facts and unfolding events rather than from esoteric conceptualizing or random stone throwing. I also keep away from an all-embracing treatment of globalization issues and focus on financial crises with an eye on the IMF, its dubious record in rescuing crisis-ridden economies, and its unfolding policy agenda with uncertain promise for preempting future crises. The IMF, I feel, is neither good nor bad; it is simply incorrigible.

I would like to thank Manmohan Agarwal for commenting on a draft, Emil Czechowski for designing the maps and charts, tracking data sources, and providing creative research input on Argentina and Turkey, Bikas Joshi for locating the chronology and the cartoons relating to the Asian financial crisis, and Nyree Hartman and Nelly Nyambi for providing information on Brazil. The book has grown over the years from my continuing association with students at Columbia University and interaction with participants from the world of business and finance at conferences around the world. I have written it in the hope of convincing students and non-students alike that financial globalization is a complex process and can be destructive. A sensible approach with alternative possibilities, which I suggest, is in order so that lenders from the developed countries at the center of the world economy and borrowers at its periphery can benefit from the collective gains of global capital flows.

Padma Desai
New York, 2002

FINANCIAL CRISIS, CONTAGION, AND CONTAINMENT

Introduction

THE GLOBAL ECONOMY experienced extraordinary changes in the nineties that affected the economic prospects of both developed and less developed countries when the decade ended.

One of its alarming features was the widespread and massive borrowing in both groups. In the U.S., the government budget deficit was being energetically brought down during the Clinton administration, but American households and businesses borrowed freely during the unprecedented economic boom of the second half of the decade. Japanese corporate and financial sectors borrowed heavily and invested unwisely in land and real estate, burdening Japanese banks with a mountain of nonperforming loans when the unsustainable expansion of the eighties ended. In that regard, investors in the European Monetary Union (EMU), latecomers on the scene with its formation in 1998, were an exception. They took advantage of the expanded bond market defined in the single currency euro and invested in U.S. industry and financial activities.

Countries of the less developed group did not lag behind as borrowers. In the East Asian cluster of Indonesia, Malaysia, Philippines, South Korea, and Thailand analyzed in this book, government finances were in balance but businesses and banks borrowed on short term in foreign currency and invested long term in dubious domestic assets. Governments in Russia, Brazil, Argentina, and Turkey accumulated a significant foreign debt burden without concern or ability to meet their repayment obligations via export earnings.

A major difference in the borrowing activities of the two groups arose from the decision-making process. Borrowers, public and private, in the three dominating zonesthe U.S., the eurozone, and Japan included in this bookwere free agents unencumbered by external pressures in their decisions to borrow and pay up their debts. By contrast, the economies in the second group analyzed here invited financial and currency crises from the borrowing binge facilitated by a premature opening up of their capital markets to free entry of short-term, speculative funds. Preferences of developed country lenders, private and institutional, played a role in the hasty liberalization of their economies financial and capital account transactions involving foreign exchange.

A difference in the policy responses between the two sets of countries was also apparent when the debt-led expansion came to a halt. It ended in Japan in 1990 and in the U.S. in mid-2000. The East Asian economies were swept in a capital-outflow led financial and currency crisis that began in Thailand in mid-1997. Currencies tumbled at varying rates in Russia in August 1998, Brazil in January 1999, Turkey in early 2001, and Argentina in December 2001. Policy decisions to promote stable growth in Japan (marked by failure) and the U.S. (significantly on track despite the negative impact of the terrorist attacks of September 11, 2001) were domestically driven. By contrast, the crisis-ridden economies lost their decision-making initiatives under International Monetary Fund (IMF) bailouts, which consisted of extreme monetary and fiscal discipline and unrealistic triple-policy arrangements of floating exchange rates, free capital mobility, and a presumed monetary policy autonomy. The IMF sought to resolve an externally imposed crisis by subjecting these recession-prone economies to severe contractionary regimens, which would have been unthinkable in a developed economy in the midst of an economic downturn. None of these countries were adequately prepared for achieving post-crisis stable growth by implementing independent monetary policy in the midst of unrestricted capital flows and freely floating exchange rates. These triple-policy arrangements, preferred by the IMF, were more suited to the developed economies with flexible markets, robust institutions, and adequate supervision of their banking and financial sectors.