FINANCIAL TIMES - WEDNESDAY SEPTEMBER 16 1998
G7: Supporting a house of cards
The G7 must make some painful choices now if it is to halt the crisis in the world economy, writes Martin Wolf
The west is waking up. The statement issued on Monday by the finance ministers and central bank governors of the Group of Seven leading countries shows that. Happily, the important players in the economic drama - Robert Rubin at the US Treasury and Alan Greenspan at the Federal Reserve - are not embroiled in the presidential soap opera. The question is what they - and the rest of the G7 - should do.
Some westerners believe that the crisis in emerging markets should be treated as background noise, irritating perhaps but rather trivial. This attitude is stupid, short-sighted and immoral. It is stupid because a crisis embracing 40 per cent of the world economy inevitably damages the west. It is short-sighted because not just the fate of the afflicted economies, but the legitimacy of a capitalist world economy is at stake. It is immoral because the crisis is harming hundreds of millions of people.
Something needs to be done. But what? There are three immediate tasks: sustain the growth of demand in the US and western Europe; halt the spread of the emerging-market contagion; and help restore damaged countries to renewed health.
Start then with the first. In its statement, the G7 reached the unsurprising conclusion that "inflation is low or falling in many parts of the world". More important, "they emphasised their commitment to preserve or create conditions for sustainable domestic growth and financial stability in their own economies".
What might those words mean? To answer, the starting point must be Japan, the country that has failed to do so. Its economy shrank at an annual rate of 3.3 per cent in the third quarter and has yields on long-term bonds at below 1 per cent - a rate consistent only with the expectation of falling prices.
With its recent cut in the short-term interest rate, the Bank of Japan may be signalling an aggressive expansion of the monetary base. This is the worst possible policy, except for the only other one on offer, namely to do almost nothing. Washington would prefer the Japanese government to try a more aggressive fiscal expansion, but some fiscal stimulus has already been applied, to little effect, and little more is apparently going to happen. As for cleaning up a banking system with non-performing loans estimated at a staggering $1,000bn, that is bound to take some time. If the weaker yen were to reduce the capital of the banks, as some analysts argue, the scale of needed government finance would increase further.
Aggressive and open-ended monetary emission would indeed expand Japanese domestic demand. It would also weaken the yen, perhaps dramatically. In a deflationary domestic environment, the monetary expansion is justified. But for the rest of the world, the weakening of the yen would be a mixed blessing, at best.
The beneficial side of the policy would be the squeeze on inflation in the US and western Europe. This disinflationary impact would make it easier for Mr Greenspan and his European counterparts to cut interest rates without contravening their domestic mandates to low inflation. Unfortunately, a weakening yen would also increase pressure on a number of other currencies, notably the Korean won and the Taiwanese and Hong Kong dollars. It might also be an excuse for a Chinese devaluation.
This raises the second question, which is how to halt the contagion, particularly in Latin America. A glance at the chart shows that a number of Latin American countries are now running current account deficits as large as those of the afflicted Asian countries, before their collapse (see chart). In Mexico and Brazil, the ratios of short term debt to foreign exchange reserves are similar to those of adversely affected Asian economies.
With 45 per cent of Latin America's gross domestic product, Brazil is the keystone in the arch. It is crumbling; $12.7bn of capital has fled the country this month. The fiscal deficit has been 7.8 per cent of gross domestic product (GDP) over the past 12 months. Interest rates have been put up to 50 per cent, to support the currency. This is obviously unsustainable.
A case can be made for trying to hold the line until after the presidential election, due on October 4. After that, a big fiscal package might be introduced. Stopgap measures, including tighter exchange controls, and a standard IMF package might achieve this. But when risk premia on emerging market debt are as high as they are today, the only sure escape is for the G7 to act as a true lender of last resort. That would mean it would cease to provide modest sums in limited tranches, but would offer huge sums up front and almost unconditionally. For Brazil, a line of credit of $100bn would surely do the trick. Given the present panic, there is also a strong case for this. But it will not happen - at least not on that scale.
The sanest alternative is to float the real before both the reserves and the government's credibility burn away. This would be an unhappy outcome. Yet in conditions that, for emerging markets, increasingly rival the early 1930s, it looks like the least bad option. Without massive external support or exceptionally strong fundamentals, fixed exchange rates cannot survive in present conditions.
This leads to the third immediate question: how to bring about recovery in the most afflicted economies. Afflicted they are. The swing in Thailand's current account between 1996 and 1998 is now expected to be more than 20 per cent of GDP, from a deficit of 8 per cent to a surplus of over 12 per cent. In South Korea, the adjustment is expected to be close to 16 per cent of GDP and in Indonesia more than 14 per cent. Given this brutal consequence of last year's capital flight, it cannot be surprising that they are all in depression.
What can be done to help them escape? The short answer is that the chief priorities are an easy monetary policy and elimination of the overhang of internal and external debt. Progress has been made on both fronts, particularly by South Korea and Thailand.
Korea's overnight interest rate fell from 22.1 per cent in March to 8.6 per cent at the end of last month. Thailand was able to lower its inter-bank rate from 24.5 per cent to 14 per cent. The exchange rate is being stabilised, quite naturally, by huge improvements in the external balance and structural reforms. South Korea's foreign exchange reserves grew by $18bn, to $45bn, between February and August alone.
Unfortunately, merely lowering interest rates will not push the economy into a strong recovery, because the debt overhang must be eliminated if banks are to lend and companies to invest. South Korean and Thai banks are estimated by Deutsche Bank to have non-performing loans equal to over 40 per cent of GDP. In both countries the dead weight of domestic debt is substantially more onerous than the external burden.
Encouraging these countries to sort out the internal debt overhang is an essential part of the cure. Thailand has made substantial progress already. But it is equally important to speed up negotiations over the external burden. The G7 has harsh words for countries that "embrace unilateral action on debt as a substitute for reform and co-operation." (They mean Russia). The question, however, is what they are doing to help eliminate unpayable external debt, not least that owed by the private sector. Debt-equity swaps, debt buy-backs and all the other techniques employed in Latin America during the 1980s need to be brought into play now.
Where then does that leave the heterodox recommendation by Paul Krugman of the Massachusetts Institute of Technology that afflicted countries should impose short-term controls on capital outflow? The immediate answer is that such a policy does little to eliminate debt overhangs or promote policy reforms. But it might permit a country to run a looser monetary policy, without risking a collapse in the exchange rate. This could help - or so at least Mahathir Mohammed, prime minister of Malaysia, believes.
The chief objection is that the policy is likely to turn into a semi-permanent attempt to avoid resolving underlying difficulties rather than a temporary means to facilitate recovery. If so, there will be still greater difficulties further down the road.
Malaysia avoided accumulating much short term debt, which is why it has avoided the unwelcome embrace of the IMF. But its overhang of unpayable domestic debt is estimated at over 30 per cent of GDP. What will happen if an already insolvent financial system is not just encouraged, but forced, to expand domestic lending? The answer is that it will lend still more to politically well connected borrowers. The already overwhelming burden of bad debt is then likely to grow rapidly. In a country that already has a ratio of domestic credit to GDP of 1.7 - among the highest in the world - the final outcome is likely to be a serious inflation.
In short, for emerging markets, tight controls on capital outflow could do more harm than good. If they are to be avoided, greater help from rich industrial countries will almost certainly be needed. For the latter, five conclusions stand out:
If Japan does not adopt alternative measures, massive monetary expansion and yen weakening seem inevitable and probably, on balance, desirable. If Japan does do this, it will at least force easier monetary policy on the US and Europe. It will also trigger a further general devaluation of the emerging market currencies against the US dollar, the euro and the pound. If the G7 wants to halt the contagion, it will have to act as a true lender of last resort, on a vast scale, starting with Brazil; and, finally: If counterproductive exchange controls are to be avoided and easier monetary policy encouraged, urgent attention must be paid to elimination of unpayable domestic and external debt.
The choices are painful. But the G7 must make them now.