New York Times January 29, 1999

Crash Course: Just What's Driving the Crisis in Emerging Markets?

By LOUIS UCHITELLE

DAVOS, Switzerland -- Among the movers and shakers gathered here for the World Economic Forum, a striking metaphor is helping to frame the debate over the global financial crisis that began in Asia and has spread to several other developing countries. The debacle, some say, brings to mind a slick stretch of highway, scene of a half-dozen recent auto accidents. So is it careless driving or the highway that is the cause of the accidents?

Substitute freewheeling worldwide capital flows and unrestricted lending for the slippery, fast-moving highway. Make South Korea, Thailand, Indonesia, Russia and Brazil stand-ins for the drivers and their cars. The accidents are the panics and recessions -- the crackups -- that have devastated each of these countries. And the question now so widely debated is simple enough: Are the countries mostly to blame or the unrestricted capital flows, or both?

After the first accidents, the countries came in for almost all the blame. It was because of crony capitalism, bad banking and overleveraged real estate investments, many experts said. Fix the sloppy financial practices and also make enough bailout money available when a country gets into trouble -- basically the current strategy of the International Monetary Fund for Brazil -- and the accidents will be avoided or, at worst, will be mere fender benders.

But spectacular wrecks have occurred with alarming frequency and severity in the last 18 months, even in Brazil, and some who had mostly blamed the countries have begun to argue, here and in earlier interviews, that the system needs serious fixing, too.

The Clinton administration had placed most of the blame on the countries, and still does. But its view, like that of the IMF, is starting to reflect a more nuanced appraisal. "We have seen that countries need to pursue sounder policies and avoid lurching for short-term capital, as Mexico and Thailand did," said Lawrence Summers, the deputy treasury secretary. But in a phone interview this week from Washington, he also called for "more prudence on the part of the lenders."

And in the administration's most direct acknowledgment so far that it is not necessarily always committed to unrestricted capital flows, he added: "Where countries have controls that restrict short-term lending, we have not in general sought to dismantle them."

Some on Wall Street are similarly shifting ground. "It is appropriate to certainly consider fixing the system," said Stephen Roach, chief economist at Morgan Stanley Dean Witter. Morgan Stanley normally makes more money when capital flows freely and the firm can lend where and how it sees best.

But the recent string of crackups has given Roach second thoughts. "I am not completely convinced that restrictions on the system are necessary," he said, "but unstable capital flows have clearly been a precipitant of these crises."

At the top of many lists for fixing the system are proposals to limit the flow of short-term foreign loans to developing countries, loans that often contributed to more rapid growth but which piled up in huge amounts in Asia, Russia and Brazil. Then, at the first hint of trouble, much of the money fled, precipitating and worsening a full-scale financial collapse.

But other systemwide suggestions are winning favor as well: pursing flexible exchange rates, for example, to avoid sudden, frightening devaluations; introducing bankruptcy laws that let companies deep in foreign debt borrow and resume operations even before they pay off the old debts; and standstill provisions in lending agreements that would temporarily prevent a foreign lender from withdrawing loans from a South Korea or a Brazil in the midst of a crisis.

What they have in common is an effort to put more of the burden on international banks and other lenders to evaluate risks more carefully early on and suffer more of the consequences later if things go bad.

"The banks don't like this; they value liquidity of lending," said Barry Eichengreen, an international economist at the University of California at Berkeley. "But if they had a provision in their loan agreements that they cannot pull out their money right away when a crisis is developing, maybe they would not lend the money in the first place."

Some experts now favor rules that prevent not only foreign lenders but wealthy nationals -- Brazilians, for example -- from canceling their short-term loans and investments, then converting this money from local currencies into dollars and taking the dollars out of the country. Wealthy Brazilians, many of them already moving chunks of capital abroad, hold more than $150 billion in their government's debt and rushing this money out of the country would quickly exhaust Brazil's dollar reserves.

"My view is that basically all short-term debt constitutes potential capital flight," said Paul Krugman, an economist at the Massachusetts Institute of Technology. "Brazil is at risk not only from foreign lenders, but from anyone who can take money out of the country."

Perhaps some of these measures would make the highway safer for ordinary drivers. But before the dangerous stretch of road is rebuilt in hopes of preventing future accidents, the smashed cars of the last 18 months have to be repaired and put back in operation. There is little agreement on how to do that. Rather there are two diametrically opposite, so far unyielding, approaches.

The current practice, carried out at the insistence of the Clinton administration and the IMF, is to require countries in trouble to adopt policies intended to limit devaluations of a country's currency and restore the confidence of international lenders. If currencies plunge too far, the argument goes, then foreign loans become much harder to repay and inflation sets in as imports shoot up in price.

"The mainstream view would still be that the key solutions to crises remain policy adjustments within the countries themselves," said William Cline, chief economist at the Institute for International Finance, which represents lenders. "Once you restore confidence in a country's financial system, then you can get its economy growing again."

The chief tools in this approach are sharply higher interest rates and cutbacks in public spending. But the high rates and spending cutbacks invariably produce recessions.

The Clinton administration argues that once confidence in a financial system is restored, interest rates can then come down, as they have in South Korea and Thailand, and nations can begin the long climb out of recession. But even Thailand and South Korea are still on the side of the road, their economies spinning their wheels rather than moving forward again.

"It is too facile to say, 'Look at Korea and Thailand, they are turning around,"' said Dani Rodrik, a Harvard economist. "Their economies have taken bigger hits than either country has experienced in the last 30 years."

Like the East Asian countries, Brazil, the latest victim of a financial panic, is hewing to policies that are plunging that country into recession. And as the hobbling of giant Brazil slows economic activity everywhere in Latin America, the odds rise that even the United States and Europe could be caught in the spreading global crisis.

That would not happen so much because of recession in Latin America, but because some new blow -- a major bankruptcy, for example, or a sharp decline in American stock prices -- undermines confidence in an American financial system still nervous about Asia and Brazil.

The contrasting view is argued most vehemently by Jeffrey Sachs of Harvard, who insists that high interest rates and austerity measures are bringing disaster to many emerging markets. He would keep interest rates down to encourage economic activity and let exchange rates find their own level. A growing economy is more likely to restore investor confidence, he says, than a recessionary one burdened by high interest rates.

"The Treasury and the IMF have driven a large part of the developing world into recession," said Sachs, who directs Harvard's Institute for International Development. "And the Brazil case makes absolutely clear that the first step is not to defend overvalued currencies. The punishing cost of this is overwhelmingly high. This is a lesson that the IMF and the Treasury have continued to ignore. I don't understand why."

For all the disagreement over how to repair the damaged East Asian and Latin economies, much of the debate centers not on the present, but on how to avoid financial crises in the future. And here the proposals increasingly involve a mixture of fixing the system and fixing the countries -- repairing the highway and making the drivers more cautious and skilled.

On the country side, several proposals have been made to set up a super central bank that would make huge amounts of money available to bail out a country in the event of a crisis. George Soros, the speculator and philanthropist, has offered one version, and another comes from Stanley Fischer, the IMF's first deputy managing director. But to qualify for such bailouts in the future, the countries would have to strengthen their banking and financial systems.

"You would shore up the international system by providing a more meaningful lender of last resort," said C. Fred Bergsten, director of the Institute for International Economics.

Those who focus mostly on the system would require, among other things, that banks put aside extra money in a reserve fund if they lent into emerging countries heavily burdened with foreign debt. "Putting aside money in that fashion reduces the profitability of a loan, which in turn makes lenders more cautious," said Ricardo French-Davis, a Chilean economist who works in Santiago with the U.N. Economic Commission for Latin America.

Krugman of MIT goes further in blaming the system and in arguing that the need to fix structural problems in individual countries should not stand in the way of broader macro-economic measures, particularly those designed to stimulate growth in hard times.

In the current issue of Foreign Affairs, he writes that over the last 25 years, much of the global economy has returned in many ways to a "pre-Depression free-market capitalism," with its virtues but also its vices -- the main vice being a vulnerability to spectacular crackups.

"It is hard to avoid concluding that sooner or later we will have to turn the clock at least part of the way back," he writes. "To limit capital flows for countries that are unsuitable for either currency unions or free floating; to reregulate financial markets to some extent; and to seek low, but not too low, inflation rather than price stability. We must heed the lessons of Depression economics, lest we be forced to relearn them the hard way."

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