|Thursday, March 12, 1998|
|8:15 am - 8:25 am THU 3/12|
|Opening Remarks - Richard Riordan|
|I'd like to congratulate the Milken Institute for putting on this extremely important conference, putting together the best brains in the world to study problems and solutions that are the most important financially in the world today. I particularly want to thank them for picking Los Angeles, and I hope all of you have a chance to look at our city. We've been described as a bunch of suburbs in search of a city, and if you travel around these suburbs, you will see a tremendous cultural center. We have more music groups here than any city in the world; our museums compare internationally, and, of course, we have great beaches, great mountains. You can go skiing in the morning and surfing in the afternoon.
But in the next few days, we will all learn more about the turmoil in the financial institutions in Asia. And I think what you will learn is that the problems and the solutions are different in each country in Asia. And just before I go into my pitch on Los Angeles, I'd like to tell you a little bit of what I learned over there. I know it's a fraction of what Mike Milken knows, because I talked to him about it two days ago. But first of all, one big question you have to ask is the rule of law. What is the rule of law in each of the countries? You'll find that it differs by country. Also, what is the will of government to admit mistakes, or as I put in my speeches to Keidanren and other major groups in Asia, is the courage. I use courage rather than face saving. The courage to admit mistakes, to admit that loans are worth less than 100 percent, to have the courage to realize the you increase the value-added tax too high, and a variety of other things. And also to have the courage to seek outside help from people who have had experience in restructuring companies.
And they were intrigued. There are two concepts I had which are somewhat unrelated but to me are important. One is a concept of what I call ownership. Ownership is putting power and accountability together in the same place. Government does a great job of diffusing power and accountability. And that's why we do so badly. And learning power and accountability has helped me in turning Los Angeles around, putting them together over various projects, over the airport, the port, and other entities. And this is a concept that they were very interested in. They asked me a lot of questions. The other concept is, if your company is making money before debt service there is no reason that company should close its doors, if you seek the right help. If you give backing on the loss so that investments are made, you can be sure that you will be protected on those investments if you reduce the value of loans, to make that happen. Now, I'm not an expert, and you'll learn more, but my brief experience over there would indicate that Korea is farther ahead of the other countries as far as setting up something similar to the RTC, to make all this happen. So enough of that. You'll learn much more from the experts in the next few days.
Los Angeles, when I took over as Mayor, was at a low point. It had been through the worst recession in its history, really the only one. It had been through fires, floods and then the riot of '92, where we had lost our confidence. Ironically, the Northridge earthquake turned us around. It was the worst natural disaster in the history of America. And in no time, Angelenos got together, helped neighbors, rebuilt their businesses, rebuilt bridges, and within six months we were much farther ahead than San Francisco and Miami were after five, six, seven years from Loma Prieto and Hurricane Andrew. This gave us confidence that we could do almost anything. And a lot has happened.
I had, when I became, four major goals. The first goal was to have a safe city, because from a safe city, all else follows. And we've come a long way there. Major crime in most parts of the city is down 50 percent or more, in the last 4-1/2 years. The second thing was to make Los Angeles a friendly city, a city that was no longer the enemy of business.
For example, in the film industry, by far our best and most important industry, before I was mayor, you had to go back to City Hall four or five times to get a permit to produce one film on the streets of L.A. Today we've merged the the county and city zone permitting process and you can get a permit seven days a week, 24 hours a day, by fax. All you have to do is sign an agreement that you will follow the codes of conduct in the neighborhood.
Also, I worked to have an efficient city where we could pay for everything. And we have actually increased services in the city while reducing the cost of government dramatically. A lot of this happened because if I have one expertise, it's networking. And I have brought in the best minds, not only in L.A., but in the world, to help me solve problems. People like Eli Broad, who has pretty single handedly raised $200 million to the new Disney concert hall; Bruce Kerits, who raised $16 million to computerize the police department; and many, many others. Over 30 different task forces operating. And then I have long walks on the beach with Mike Milken, who has a list of about 30 things he things can be done to improve Los Angeles. I tell him: Mike, why don't you run for mayor?
The other goal was to organize neighborhoods.
Government will always fail you if you're relying on the government. I will go throughout the city, and people will ask, what are you going to do about the cracks in the sidewalk, the graffiti on the walls, the illegal dumping, prostitutes on street corners, and my answer is always, "Nothing." Because government will always fail if you're expecting somebody in City Hall to solve all these problems. The way to solve them is for you as communities, as neighborhoods, to organize, to have a strong commitment to solving these problems, and to demand that government be you partner, your employee, your resource, in solving these problems. And all over L.A., literally thousands of these neighborhood organizations have sprung up. And if I had to say why is crime down so much, sure it's because we have a great new chief of police, we have a great mayor, but most of all [laughter], most of all, it's because the neighborhoods have gotten together and organized, and said, we are fed up, we are not going to tolerate this any longer.
The last goal is education. Now, education is not directly under my jurisdiction, but it's been my passion for many years. As Don mentioned, I formed, about 8 years ago, a group called LEARN, which is a reform movement. But let me tell you about education in L.A., some facts that drive me nuts. A 6 year old in the inner city of L.A., and this is true of any place in the country, has a 12 percent chance to read and write at the 8th grade level by the time this child's 18 years old. What does this mean? It means that this child and most of these children at not likely to have access to the middle class, are not likely to be productive adults, and very likely to be on drugs or crime, or something, because of a hopeless future for them. It also denies our economy the skilled work force to compete as we go into the next century. Today alone in L.A. County, it is estimated there would be between 50,000 and 100,000 high-tech computer jobs that cannot be filled locally. And my office has been working with a lot of the multimedia and entertainment companies to bring talent from other countries, because we can't fill them here.
Now a second problem in the public schools is social advancement. They advance children who cannot read or write, or do math at grade level, because it will hurt their self-esteem if you don't promote them. What's the self-esteem of an 18 year old who cannot effectively read or write? The next fact, only 60 cents out of every education dollar goes into the schools. The rest is used for bureaucracy. And there are bureaucracies upon bureaucracies, upon bureaucracies, to the point where the people in the school district can't tell you the answers as to how much goes to the schools.
And the last point which really drives me nuts is this: At the end of every school year, there are a number of cases where the parents and the teachers are in revolution against the principals because they've done so poorly. What is the solution of the school district? Transfer them to be principals in inner city schools. Within the district, they call this, "the dance of the lemons." The whole system is built up to protect politicians and bureaucrats, not to educate children. We need a revolution where every leader faces every thought, every action, every plan, on a simple axiom: "What is in the best interest of children?" Not politicians, not bureaucrats, but children. So, if I have any message to give to this world it is that we need a revolution in education. We can't use Band-Aids, we can't use scalpels. We have to change the way education is governed, we have to put ownership in place. The word I said at the beginning of my speech, ownership—power and accountability together, in one place, where somebody is held accountable, and has the power to make the tough changes that are necessary to base our education system on this axiom of what is in the best interest of children.
So let me close on is note. I don't know how many of you saw Apollo 13, but remember when they were stuck in orbit around the moon? It was total panic. One of the crew members turned to Ed Harris, who was the commander and said, "Commander, do we have any options." And he said, "Failure is not an option." And with children, failure is not an option. Thank you very much. [Applause]
|Richard Riordan, Mayor, City of Los Angeles|
|8:25 am - 8:45 am THU 3/12|
|Introduction - Donald Straszheim|
|The Global Conference held in March 1998 was the most recent in a succession of conferences sponsored by the Milken Institute, a not-for-profit, nonpartisan non-ideological economic think tank. The Institute's mission is to explore and understand the dynamics of world economic growth. By bringing together in a neutral environment, research, experience, and analysis from a variety of related disciplines as well as applied areas of public policy and finance, we are able to provide better insight into the effects of economic, political, technological, and regulatory changes on the world economy and its societies. This will lead, we hope, to better public policy and improved lives for all the world's citizens.
The Global Conference focused on the impact of the economic turmoil that began in Asia in 1997 and was continuing as these proceedings were published. Last year, we presented several conferences that looked at urban issues specifically in the United States. In April, we cosponsored "Los Angeles, Rebuilding for the Next Five Years," an examination of our city's economic progress in the five years since it erupted in urban violence. Two months later came our conference on "Urban America: Creating Opportunities for Business and Places for People." There we expanded our discussion to all American cities.
The present conference introduces our global economic agenda. Over the next few years, we will strive to understand the influence of globalization and trade on economic development. Our broadened research agenda also includes: the impact of technology on all aspects of society and, in particular, on the economy; the implications of world demographic changes; and regional economies. We are continuing our traditional focus on education, the labor market, jobs, and human capital as well as on capital markets, corporate finance, and financial institutions.
Though some feel that the Asian crisis has been only a blip on the economic radar, many believe it represents the kind of event we might have to learn to expect in the future. Because the situation certainly was of current concern, because we believe it will teach us many lessons about our current economy, the Milken Institute Global Conference was undertaken to explore as many ramifications as possible within a limited two-day time frame.
Some of the questions the panelists considered: Why had the effects of this instability extended so far and so fast? How far might they continue to extend, and where might they be felt next? Was the International Monetary Fund (IMF) doing good or harm? What lessons were likely to be learned from this episode and would they be applied? Was the Asian Miracle over or merely interrupted? Had the Japanese and Korean planning models been discredited?
Asia's economic evolution has been rapid. In 1970, the region contributed 3 percent of world output. By 1996, output had grown to 10 percent. In the same year, the United States, Japan, and Europe together produced 76 percent of world output. So, while Asia's economy has been growing, it has yet to approach the proportions of the developed Western nations.
Market capitalization figures tell a similar story. In 1950 the United States and Europe accounted for 85 percent of the world's market capitalization. By 1970, the United States and Europe were still holding at 85 percent and the rest of the world outside the United States, Europe, and Japan was at 8 percent. By 1990, these "other" countries had grown to comprise 15 percent of market capitalization, while the United States and Europe were down to just over 50 percent.
Even though Asia's and the rest of the world's economies continued to grow, the early 1990s saw a dramatic increase in U.S. market capitalization. By 1996 the market capitalization of the 25 largest U.S. companies in 1996 equaled the total market capitalization of Asia.
Where growth rate is concerned, however, Asia leads the world. Over the last three years, 9 of the 10 highest rates were posted by Asian countries. Asia also leads the world in exports, having followed an export-driven policy and growth path.
Asia's economic growth occurred quickly; its fall has been as surprising as its growth. Over the last five years, output in these Asian countries has increased about 40 percent yet the market now is back down to its April 1993 level.
Although the crisis that began in Thailand spread quite quickly throughout Asia, it should well be noted that these are heterogeneous economies. Some are rich and some are poor; some have a large supply of natural resources, some have a small supply; some have human capital at advanced levels, others do not. Some are committed to the market system and some are not.
Despite the gravity of the situation for those now having to live within these economies, can these economies truly affect the rest of the world? Using the United States for comparison, the total GDP(gross domestic product) of Thailand is equal to that of Indiana, my home state. Indonesia has the GDP of North Carolina. The output level of the rust belt is the same as the Asian 8, excluding China, India, and, of course, Japan. India's GDP is the size of Virginia's along with North and South Carolina. China's is the size of the Oil Patch: Texas, Oklahoma, Arkansas, Louisiana, and Mississippi.
What will happen next only time will tell. This is not the first crisis in the world's economic history. In recent times, crises have occurred in Mexico, Europe, and South America. Despite the difficulty, recoveries can be made. Where there is financial pain, there almost always are opportunities as well.
We are pleased to present excerpts from the 1998 Milken Institute Global Conference. We hope you will find this document helpful to you in your work. We thank the Milken Family Foundation for its support and welcome the opportunity to share our work with you and your colleagues in the future.
|Donald Straszheim, Milken Institute|
|8:45 am - 10:15 am THU 3/12|
|C. FRED BERGSTEN: The Asian economic crisis is only beginning. Far from having it behind us, or even from being solidly en route to a solution, I believe we are only at the beginning. I say that for two reasons. The first is that the real effects of the crisis on the Asian and world economies are just starting to take place. This year for sure, and perhaps 1999 as well, will be lost years for most of the Asian countries. The 1980s were a lost decade for Latin America; I do not anticipate that the Asian problem will last that long. But the severity of the slump throughout much of the region will be at least as sharp as that which hit Mexico in 1995, when its economy dropped 6 percent. And this effect is, of course, much wider and spread far more regionally than happened three years ago.
For example, we can expect Korea to see a downturn of at least 5 percent in its economy this year. Indonesia′s future loss is anybody′s guess, but it could be easily 10 percent or more. And we should expect zero or negative growth in most of the other problem countries—Thailand, the Philippines, Malaysia, and others. Indeed, many in Southeast Asia see their current situation as equivalent to our Great Depression of the 1930s, and they may turn out not to be wrong. Beyond that, and critically important for the world, the other end of Asia—Japan—is also in recession and is likely to experience zero or potentially negative growth this year as well. When I look at the effect on Asia, I include Japan and Korea, and that is why I think the effects are so large.
Japan is in fact two-thirds of the Asian economy, at least if we make comparisons based on market exchange rates rather than purchasing power parity. How Japan will do, therefore, will go far in determining how Asia will do. Japan also is in recession; its outlook is grim. That makes it much more difficult for the rest of Asia to recover. China, Hong Kong, and Taiwan, what I think of as the strong center (as opposed to the structurally weak Northeast Asia and the cyclically weak Southeast Asia), will do better. They will certainly continue to grow; but even in this region, growth rates will be substantially lower—as a result of both the external crisis and of internal reforms in the case of China, by far the biggest other actor in the drama.
These effects are just starting. During the course of this year we will see millions of unemployed in all of the problem countries and even in the fast growers like China. Unemployment rates will double in Indonesia, Thailand, and other countries throughout the region. There will be tens of thousands of bankruptcies; there will literally be blood in the streets in many of the countries.
We at the Institute for International Economics have analyzed all 125 major financial crises that the world has seen since 1970. One thing we found is that the average period to recover a growth rate equal to the average of the two pre-crisis years is two to two and a half years. Some suggest Asia might do better because of underlying strength, but others suggest Asia might take longer because of the difficult structural nature of the reforms and changes that are required, which are much more difficult than simply bringing money supply growth under control or even bringing budgets into line. So we don′t know how long it will take, but we can be sure that it will be deep and intense. That means it will be extremely difficult in political terms to maintain stability in some of the countries and to sustain reform programs, even in countries that now seem committed to them, such as Korea.
Asia has been providing fully half the growth in the world economy in the 1990s. Thus, the kind of slowdown we envisage in Asia will have a major dampening effect on the world as a whole. However, we also could get another severe market disruption that would worsen the picture already described: It now seems clear that Indonesia will break with the IMF (International Monetary Fund), perhaps as we speak, or some time in the near future.
President Suharto has repudiated the IMF (International Monetary Fund)program on three different occasions. And there is simply no way that market confidence can be restored in Indonesia without prolonged faithful adherence to the IMF program or some alternative adjustment program, which seems extremely unlikely. Korea and Thailand only began to restore a degree of market confidence and credibility after political change took place: New governments came in and committed themselves to correct the situation. That has not yet happened in Indonesia, and until it does, the prospect for recovery is quite grim. Indeed, President Suharto said to his people in November, after the first IMF program, that he regarded the IMF as the enemy and that any of his cabinet who were with the IMF were against him—not an auspicious beginning to an effort to comply with the program. Instead, Indonesia has been groping for some silver bullet.
The last notion they had was the currency board idea. We did an extensive study of currency boards three years ago. It shows they do work in two kinds of cases. One is in very small, open economies heavily dependent on the world system that essentially have no exchange rate autonomy. That is the situation in Hong Kong, Estonia, and others. The second case is a country coming out of hyperinflation that desperately needs a nominal anchor and whose population is so shellshocked by the events of the past that they′re ready to take anything—20 percent unemployment, as in Argentina; sky-high interest rates, as in other countries—in order to wring inflation out of the system.
Indonesia, at least at this point, obviously qualifies under neither of those terms. I′m afraid President Suharto sees a currency board as an alternative to discipline, which it most certainly would not be. I fear that a currency board, with its aftermath, would lead to riots in the streets. Barring any action, we have to expect a renewed sharp decline in the Indonesian markets, including its exchange rate. The systemic and global question is whether that will lead to renewed contagion or whether Indonesia can be cordoned off from the rest of the world.
There is a significant risk, maybe one in three, of a renewed bout of contagion once Indonesia tanks substantially again. Some of the neighboring countries are still quite vulnerable: Malaysia, and maybe Hong Kong, whose economy has weakened substantially over the last 6 months. A renewed bout of exchange rate declines elsewhere could trigger the much-feared devaluation of China. China, of course, cannot be forced to devalue because its currency rate is not convertible on capital account. China does not need to devalue, though; it has only lost about 10 percent in terms of price competitiveness vis-à-vis its position at the outset of the crisis. Indeed, if it devalued, it could accelerate or trigger further currency declines elsewhere, after which it might wind up no better off, or even worse off.
On the other hand, if there are a series of renewed depreciations in competitor countries, if China slows substantially in the implementation of its accelerated reform program, then it is quite possible that China, too, would join the crowd. That event would seriously add to the world disruption. Countries outside the region could easily be hit. Brazil remains extremely vulnerable, and Argentina could be tugged down with it. There are lots of vulnerabilities; and there′s one more problem, what I call the "rogue devaluer," the country that you don′t expect to devalue, and indeed has no reason or justification for doing it, but does it anyway.
Taiwan did just this in October and brought on the second phase of the crisis. Taiwan had rapid economic growth, a large external surplus, huge reserves, and could easily have defended its exchange rate, but it chose to let its rate be driven down sharply. And that was what triggered the next market day, the 14 percent decline of the Hong Kong index, which triggered the 500-point dip in our index. More important, it put enormous competitive pressure on its main rival, Korea, and triggered the Korean phase of the crisis, which then escalated the problem throughout Asia and the world. Another rogue devaluer of that type could cause additional problems.
Finally, the IMF is not in a position to deal with additional crises. The usable resources in the IMF are down to $15 billion, not even half or a third enough to take care of a new program in, say, Brazil, or two or three other major countries, if there was a new bout of contagion. So the possibility that we have not yet seen the end of the crisis in market terms compounds the risks that we see on the real side, and suggests that the crisis may be only beginning.
What will be the outcome of all this on the world economy? The United States will probably lose a little more than $100 billion, or a little more than 1 percent of GDP in real terms—less than that in nominal terms because of the improvement in terms of trade, with the strengthening of the dollar and the sharp weakening of the other currencies—even if we do not get another market disruption of the type I described. Our model suggests that Europe would be hit a little harder. This is logical, as they export more to the problem countries of Asia than does the United States.
With the U.S. economy in such good shape, you would think we could absorb a disruption easily. But U.S. trade and current account deficits are already at record annual rates of $200 billion. They could be pushed to between $250 and $300 billion, approaching the share of GDP they hit in the mid-1980s, which triggered the dollar crisis of that period.
In Europe, the sharp decline in the external balance will worsen their unemployment problems, already at extremely worrisome levels and exacerbated by their move to economic and monetary union. So the global effects should not be underestimated in terms of their real potential for renewed difficulty.
What to do about it? The right strategy is straightforward intellectually, if difficult politically: The problem countries simply have to implement effective adjustment programs with or without the IMF. We know that the adjustment programs in most of the countries have a macroeconomic component, but they are primarily structural, focused on their financial sectors, and to some extent, their corporate government structures. That probably does make them harder to adjust. Nevertheless, that is the only likely answer to restoring both economic activity and market confidence.
Some countries have chosen to do so with the IMF, and others, such as Malaysia and China, have decided to reform without the IMF. Indeed, they have put programs in place in an effort to avoid going to the IMF. The IMF is not perfect, but it has shown a great deal of flexibility in altering the terms of its requirements, and its basic strategy is fundamentally right.
The second component of recovery is for Japan to get its economy going. The Japanese problem, of course, far antedated the Asian crisis; but as long as it persists, it will make recovery from the Asian crisis extremely difficult.
The third element is that the strong center—China, Taiwan, Hong Kong, Singapore—has to continue to hold in terms of exchange rates, growth rates, and output expansion. Taiwan flunked that test back in October. We have to hope and work hard to see that this doesn′t occur again, particularly in China, the biggest country and now the most pivotal actor in the whole drama.
The fourth key element is for the rest of the world, especially the United States as the strongest economy in the world, to do its part. That means providing financing, including new financing to the International Monetary Fund, an issue now being hotly debated in our own Congress. If we fail to contribute, the quota increase will not go through; the auxiliary financing and the new arrangements to borrow will not take place; and the IMF will be unable to deal with any additional crisis. But even more important, we in the industrial world have to provide the continued open and growing markets that permit the Asian countries to improve their current account positions and get back on the macro side of their adjustment packages.
In the long run, the most profound question arising from the Asian crisis is not so much whether it will lead to a change in the Asian miracle but whether it will produce a substantial backlash against the globalization trend of the last three decades. We already see a disturbing backlash of that type within our own country, despite the nirvana state of our economy. Congress has been unwilling to pass legislation granting fast-track trade negotiation authority to the President and unwilling, so far, to renew funding of the IMF. The multilateral arrangement on investment of the OECD (Organization for Economic Cooperation and Development) has failed for similar reasons. And the protectionists and antiglobalizationists believe that they are in ascendency. If all this can happen during good times, it is a major worry.
We know that as the blood begins flowing in the streets of Asia over the next year or two, as the unemployment rates and bankruptcies rapidly increase, there will be an enormous backlash against the open market model—whether it be called the Washington consensus, the IMF strategy, or the American approach. If that interacts with a seeming failure or withdrawal on the part of the United States itself despite its strong economic position, then I believe we will face a real risk to the world economy for at least three decades.
GARY BECKER: Is the glass half-empty or half-full? If Asia recovered to its previous growth rates in two to three years, that would be a great achievement. I think it is very possible it will happen, and I am glad to hear that studies show this is the norm—since that has been my forecast. I think the recovery will be good and that the long-term growth will make this time look like a minor dip on the growth rate.
A point often overlooked is that there was and is indeed an Asian miracle. The growth rates experienced by the seven or eight countries involved were fantastic. Korea went from a per capita real income in 1960 of roughly $300 to more than $10,000 today. That is a miracle by any definition. Most other countries of the world would love to have such a miracle, even with the current crisis; they would be a heck of a lot better off even so than they are now.
Furthering the miracle is not based on any sort of trick or house of mirrors. There are a lot of strong fundamentals in Asia that will remain. They have high savings rates, hard-working labor forces, and very high human capital. On almost any set of indices of economic freedom, virtually all of them (with the exception of Indonesia) rank very high. And some of them, like Taiwan, Singapore, and Hong Kong, rank in the top ten; Japan is not too far below; and Malaysia, Korea, and Thailand are somewhat low, but are still quite high by world standards. These strong fundamentals have not been destroyed by the current crisis.
Therefore, I've been a little disturbed by some of the specific reforms advocated by many commentators, in particular by the IMF. What does the Korean labor market have to do with the current crisis? Possibly it should be changed, but it served Korea very well for 30 years. I'd like to see more turnover; I'm a free labor market man. But it's a mistake to say that this is somehow a necessary ingredient to get out of the crisis or to reform an economy, when that economy has performed so spectacularly.
This is true for a lot of other recommendations that have been made. I think it is very presumptuous, based on no economic evidence, that these are the reforms that would be necessary to help resume strong economic growth in this region. I think many of the IMF's proposals have been misplaced and inadequate and haven't really appreciated the enormous achievements of these economies or the strong fundamentals that persist.
That doesn't mean I'm like Voltaire's Dr. Pangloss who believes everything is for the best. There obviously have been problems in Asia, and some of them have been of their own making. In the financial markets, the problems that I see as most fundamental are basically three. One, heavy government subsidies, sometimes to some favorite companies, favorite banks, and other financial intermediaries. Directed loans from government to favorite companies, in effect subsidies from the government, is unattractive in any industry, and it is particularly bad in the financial sector. This practice is common not only in Indonesia but in Thailand, Malaysia, and several others, including Korea.
The second difficulty I see in the financial market is what I call a double moral hazard issue. By moral hazard we mean providing incentives for people through insurance and the like to take risky actions because they anticipate that their losses will be covered through various forms of help. This is the phenomenon that we find in many of the Asian countries. Larger companies were favored and worked under the supposition that they would be helped through government support if they got into any serious difficulty. It encourages excess risks, and you find that in Korea, Indonesia, and Malaysia, as well as in other countries.
The doubling of the moral hazard is introduced by the IMF. The IMF showed in the Mexican bailout that they're ready to help both private banks and others if they get into trouble. My fear is they are doing that to some extent in this situation as well. If you have a domestic company, the government is saying, "We're going to help you out if you get into trouble," and the IMF doubles that by saying to the country as a whole, "We're going to help you out if you get into trouble." Nobody should be very much surprised when you see both companies and countries getting into trouble.
Some have claimed that this current situation suggests a number of problems that need radical surgery, but their solutions deviate from the multilateralism that many of us are trying to push. Some very intelligent economists and others have been suggesting that we have to introduce taxes and other controls over the movement of capital from country to country. I think that would be a serious mistake. The world tried capital controls for most of the postwar period and they were a dismal failure.
We've been unfortunate to move in only the last 10 or 15 years to a much more open capital market. On the whole, I think it has had a great record. It has brought resources to countries that need it, and it would be a terrible mistake to begin to deviate from that. If we believe that either international organizations or countries were like surgeons who could wield a scalpel and cut out those types of capital movements that were undesirable and leave all the others, I'd say, sure, let's do it; but we well know that neither international organizations nor countries are surgeons. I fear if we move down this path that we are going to move in the direction of the 1950s, the 1960s, and the 1970s, when many countries had major and serious restrictions on the movement of capital. That would be a disaster, particularly for the developing countries, which would not be able to develop without access to the international capital market.
I am also disturbed by the great emphasis on the governance of banks and the like in some of the Asian countries. There has been weak governance and weak control, but we should not forget, particularly at the international level, that the loans were made by European banks, Japanese banks, and U.S. banks, all of which have all this governance; yet, they still made a lot of short-term loans and dollar-denominated or marked-denominated debt. So it's not an issue of governance.
I cannot explain why these banks engaged in this sort of large-scale lending activity except by means of the moral hazard argument. They assumed if there was general difficulty the IMF and others would come riding to their rescue. Blaming this behavior on the short-sightedness of or the lack of governance in these Asian countries forgets the other side of the equation, the behavior of the lenders.
Finally, we have learned from the Mexican and other situations that have arisen, including the current Asian situation, that there are really only two (quite different and extreme) viable and efficient exchange-rate policies in the long run: fully floating exchange rates and rigidly fixed rates. By "fully floating" I mean clean floats and not government-dictated floats, where exchange rates adjust in response to changes in supply and demand for currencies, either from the capital or the current account, for merchandise or capital movements. The advantages of that are well known. They are probably the best instrument for allowing flexibility to a particular country for idiosyncratic shocks—that is, shocks that impact that country but are not regional or more general shocks. In nations that have responsible, well-functioning governments, flexible exchange rates are probably the best system.
Unfortunately, only a small fraction of governments fit into that category. Most governments, and particularly many of the Asian governments, have used the power of the government to help out in various ways, subsidizing particular companies, particular banks, and the like, which is true to some extent in Mexico. It was certainly true in Argentina before they went to change their system, and it has been true in many countries of the world. The best antidote that I know of, other than domestic reform, is a rigidly fixed system of exchange rates.
There are various ways to move to a rigidly fixed exchange rate: through a monetary union, currency boards, and other methods. I distinguish a rigidly fixed rate from the pegged rates found in some Asian countries, since they did not have a commitment to maintain in the event of a crisis. You need a rigidly fixed system to limit the ability of government to rate currency and other resources, through a central bank and other ways, in order to finance very dubious projects.
A rigidly fixed system controls government at the expense of less flexibility in adjusting to idiosyncratic shocks. A flexible exchange rate system allows great flexibility but imposes relatively few controls over government. Which is more important really depends on the situation. For a country like Indonesia, some form of rigidly fixed system that the government is committed to is probably best. For countries like Hong Kong, Taiwan, and Singapore, who have managed very well, a more flexible system may be more desirable. Hong Kong has done very well with its currency board.
SALVADOR ENRIQUEZ: What follows are observations, or perhaps confessions, of one from an Asian country afflicted by the currency turmoil that hopefully can contribute to the global overview.
Number one: It's too much too soon. The Asian crisis occurred after years of phenomenal growth. From 1993 to 1995, world GNP (gross national product) was growing at just a little more than 2 percent per year. Asian GNP grew at a yearly average of 8 percent in the same years. Such growth can be attributed to exports and investments. Most Asian countries enjoyed the benefits of their liberalization policies in trade, finance, and investments. But as we all know, as sure as a bust follows a boom, the Asian bubble burst.
Number two: It has been growth without development. I'm not particularly referring to Korea, but to the Asian four: Malaysia, the Philippines, Thailand, and Indonesia. Growth was fueled mostly by speculative investments in property and in services. The industrial sector did not grow as fast. The sequencing of trade liberalization, which was followed closely by the premature liberalization of the capital accounts, caused a massive influx of portfolio investments and short-term foreign funds. High trade and current account deficits peaked to as high as 9 percent of GDP (gross domestic product).
The third observation, or confession: Trade imbalances and comparative disadvantages persisted. For the period 1990-1995, the value of exports of developing Asian and Pacific economies grew by 14.6 percent, while that of imports grew at 15 percent. This implies increased integration into the global economy, but also an inherent structural trade imbalance in the developing economies.
Asian export products consist mainly of electronics, garments, footwear, and the like. Asian imports are mostly manufactured goods, intermediate products, and—a good part of them—capital goods. From the Asian viewpoint, this has implications as to how competitive Asian economies can be, even under (or perhaps despite) the WTO (World Trade Organization) regime.
The rigors of the global market, keen competition, changing preferences, technology advancements, and price fluctuations, demand continued upgrading of product and skills and ingenious product differentiation, the modernization of business practices, and so on. This may not be readily attainable in developing economies. Transnational companies have taken advantage of liberalized trade and investments, and have benefited from them. During 1990—95, the number of transnational companies increased from 37,000 to 39,000. However, foreign affiliates and subsidiaries grew quickly, from 170,000 to 270,000, controlling an investment stock of 2.7 trillion. Some 40 percent of world trade was actually done by companies trading with themselves through their subsidiaries and affiliates. So I suggest that a new international economic order may have to be studied—one that identifies the real needs of nations in the world; one that is sensitive to the aspirations of developing countries as they coexist with industrialized countries.
The terms of reference may have to be reviewed and improved. The developing countries have opened up wide. Have the developed countries opened likewise? I hope to see an international economic order where competition can be transformed into complementarity. I wonder if this is possible. I hope it is. Where before there were underlying imbalances and inequities in the relationships between developed and developing countries, the new order should enable both to give as much as they take; to mutually benefit, rather than force; to serve each other; and to distribute the gains equitably.
JAMES GLASSMAN: In a way I see the crisis in Asia not so much as a terrible event—although certainly it is serious and will create a lot of pain for people there and throughout the world—but as an opportunity. Perhaps it is an opportunity to bring down a second Berlin Wall. I am borrowing that phrase from my friend, Jose Pinera of Chile.
For years many American journalists, academics, and politicians were enamored of the Japanese system, of what I would call "command and control capitalism," the idea of the government playing a major role in the allocation of capital, and also a kind of neomercantilism. Now that model has been adopted by many countries throughout Asia. The stagnation of the Japanese economy over the last five, six, or seven years certainly has made this system a lot less attractive than it was in the past. There is a good chance for these countries to change their systems not only to the benefit of their own nations but also to the rest of the world.
For this conversion, or this revolution, to take place, for the second Berlin Wall to fall, the International Monetary Fund is going to have to step aside. That is really my main message. Though protectionist views do pose problems in Washington, those who oppose IMF bailouts are not necessarily all "protectionists." My colleague at AEI, Larry Lindsay, former governor of the Federal Reserve, is certainly not; George Schultz is not; Walter Wristen is not; Gary Becker is not; and I am not.
What are my problems with the IMF? First, it represents the diversion of capital from its best uses. When we take $100 billion or $200 billion out of the world economy and specify that it must be used to repay banks that made bad loans, that's a diversion of capital from its best uses.
Second, we are not really sure the IMF is doing the right thing. (The IMF has not done the right thing in many cases.) And what it does is not transparent. It doesn't tell us what it's going to do; it seems to change its mind a lot. But let's assume that in this case the IMF is doing the right thing. That its conditionalities, as they are called, are correct or will be beneficial. It wants transparency; it wants the affected countries to allow ownership of assets by foreigners; it wants to get the government out of running the banks and corporations and allocating capital. Those are, I think, the right goals. But can the IMF actually enforce those goals? The IMF's bureaucratic imperative is to give out money. That's what its business is and that's what it does despite the bad faith of several nations. The more money it gives out, the stronger the positions of the people who are there.
Fourth, and probably most important, is this problem of moral hazard raised by Gary Becker. Certainly there is a single moral hazard with the IMF. There is no doubt that the bailout in Mexico set the stage for what is happening in Asia. And we'll certainly get through this Asian crisis. But the third crisis, the one down the road and that may be encouraged by the moral hazard problem could be far, far more serious. There is no other explanation for the terrible loans that were made by U.S., German, Japanese, and French banks to corporations in Asia, Thailand, Indonesia, and Korea, except that they knew that they were backstopped in some way.
Finally, let me say that by focusing on the IMF bailout, we may be ignoring the most important problem in Asia, and that is Japan. Quite clearly the current crisis in Asia could be ameliorated to a great extent if the Japanese would change their fiscal policies. They just had a tax increase—an incredibly dull-witted way to approach the particular problem that Japan has, which is a lack of demand. Sales of automobiles in Japan over the past 11 months are now down 22 percent, the decline dating almost precisely from the increase in the tax. Many of my colleagues believe that what Japan should be doing is reflating.
If the IMF can step out of the way and act as a lender of last resort, not first resort, it may have a role. In the present case it is only delaying the potential fall of a second Berlin Wall.
BARRY HERMAN: If you look at the world as a whole, it doesn't seem to be in crisis. There is certainly a difficult situation in Asia, and this will have important social as well as economic and political dimensions. But the world as a whole has been on what we call a cruising speed of about 3 percent growth since 1994. Now, this hasn't occurred in each and every year. It did in 1994, 1996, and 1997. We believe the world economy in 1999 will also grow at this rate. 1995 and 1998 should have similar world output growth rates of about 2.5 percent. The main reason is a slower growth in industrial countries.
Three percent is not bad. It's better than it was in the 1980s. Moreover, it seems to be sustainable. It is accompanied by unusually low inflation. 1998 will be the fifth consecutive year for about a 2 percent rate of increase in consumer prices in the industrialized countries, and we expect that to continue. It has been super for fiscal positions, and budget deficits are coming down virtually everywhere. It has been lousy for unemployment if you're European, but unemployment correction was really not the highest item on their agenda. It was the forming of a single currency area in the economic and monetary union, and they are going to get it. So in that sense, for the world as a whole and for the developed countries particularly, economic activity has been progressing in a rather positive way.
You can also be encouraged by what is happening in the transition economies. In 1989 the Berlin Wall fell, beginning the fall in other things as well. Output has been falling every year from 1990 until 1996. Output in the transition economies—which is to say Central and Eastern Europe, the Baltics, and the rest of the former Soviet Union—will have risen in 1997 for the first time since the fall of the Berlin Wall. In 1998 we'll see output rise in more countries. The only country that will still see a fall in measured output is Ukraine, and in 1999 we expect output to begin to rise even there. In addition, several of the Central and East European countries are about to begin negotiations to join the European Union. So, from that perspective, there's a lot to be encouraged by.
I'd like to turn for a minute to Africa. There is a lot of conflict in Africa, and there is no point in talking about development while there are wars going on. Output is rising, though, and it has been rising by 3 to 4 percent since 1996. The population is growing by less than 3 percent a year, so for the last couple of years, output per capita has stopped falling in Africa. That's a major achievement, in light of the fact that it was falling for 20 years.
In some countries, like Uganda and Ethiopia, output is rising at 6 percent. They are still very poor countries, but the direction is up. In 1996 and 1997, there were about 15 countries that had per capita income rising 3 percent or more in Africa. And policy has changed in Africa. There is a new generation of people coming into policymaking roles, and I think there are new opportunities. To quote something the Secretary-General of the UN said last week: "Last month after meeting with representatives of the International Chamber of Commerce, we issued a joint statement emphasizing that the goals of the United Nations promoting peace and development, and the goals of business creating wealth and prosperity, can be mutually supportive. We agreed to join forces with a particular focus on Africa and the least developed countries. In this spirit, collaboration should help promote greater investment flows into the continent." I don't know if you would have seen a statement or a meeting of that sort 10 years ago.
In Asia, we expect growth of more than 6 percent this year; it has been growing at that rate since 1995. China's growth rate has slowed down every year since 1992, but the forecast is that it will still be 8 percent in 1998. At the end of last year there was some monetary easing because indeed China has been adversely affected by the Asian crisis. There is also a new fiscal stimulus, an agreement to expand infrastructure investment in China. Thus, China is still managing to grow rather significantly.
What we have seen in the Republic of Korea, Thailand, Indonesia, and so on is a confidence shock followed by a liquidity squeeze. I think we have seen a microeconomic, that is a sectoral, problem, that has been treated in such a way as to have major macroeconomic consequences. I think we have to do some rethinking about what is necessary for adjustments to what kinds of problems. This yields questions about the architecture of international cooperation, both cooperation for development and cooperation in international financial affairs. The World Bank is changing what it does: It is becoming much less a bank and much more a development institution. The IMF is also facing a tremendous challenge. I think we are going to go through a period of reform and discussion of the international financial architecture, which will make the next couple of years quite exciting.
GUILLERMO LE FORT VARELA: Regional financial crises like the current one in Asia are not unprecedented. Latin America suffered a severe financial crisis not long ago, in the early 1980s, with serious effects for all countries in the area. The 1980s was the lost decade in terms of economic growth in Latin America.
The global conditions under which the Latin-American crisis developed were much worse than the conditions we see today for the world economy. In recent years, world output has been growing at a rate on the order of 4 percent per year. In the early 1980s, world GDP was almost stagnant, with expansion rates of 0.5 to 1.5 percent per year. The same is true about the conditions of the region most directly affected by the crisis. While Latin American countries had an average current account deficit of about 6 percent of GDP just before the crisis erupted, the current account deficit for Asian countries as a whole is about 2 percent of GDP. Of course, there are particular Asian countries with larger current account deficits than average, such as Thailand and Malaysia—deficits on the order of 7 percent of GDP. But in the 1980s, some Latin American countries also had current account deficits much larger than the regional average. My country in particular, Chile, registered in 1981 a current account deficit in excess of 10 percent of GDP.
External debt in the Asian countries today is on the order of 100 percent of exports, while in Latin America, just before the crisis erupted, that percentage was twice as high; debt was 200 percent of exports. So we have certain elements to be optimistic about, in the sense that the conditions in this present crisis are a bit better than those that existed before the Latin American crisis. That doesn't mean, however, that solving this crisis is going to be any easier than it was to solve the Latin American crisis, but it does mean that there is a solution.
Some of the countries in Latin America during the 1980 crisis were affected by particularly bad fiscal policies. For them the solution was basically in a macroeconomic correction: adjusting the expansion in domestic demand through the use of corrective fiscal and monetary policies. In the context of the Asian crisis, there is a need for structural rather than macroeconomic adjustment. Although there are elements of macroeconomic imbalance, the problem seems to lie in rotten financial systems. The lack of prudential regulations and rules of financial transparency have seriously affected their performance and helped to distort the decision-making process. Financial institutions have been affected by moral hazard problems that distort their capability to adequately select investment projects. Government intervention is in some cases also at fault, creating hidden incentives and directions that also distort the project selection process.
The solution is deep structural reform in those financial systems: modifying rules and operating procedures to ensure transparency and limit excessive risk and government intervention so that these financial institutions can effectively select investment projects. Eliminating of distortions that affect the investment decision process is the key for success.
Something similar happened in Chile in the crisis of the 1980s. Chile got into that crisis after having a fiscal surplus. The macroeconomic imbalance that was present was created particularly by private spending and spending related to excessive financing provided by a not-very-well regulated financial system and massive international capital inflows. From that crisis, some lessons were learned. A completely new system for regulating the financial system was developed, letting the market work under conditions of ample information and transparency of the financial conditions of each institution, making risks clearly known when they are taken and limiting those risks to the strength of each institution.
During today's discussion a second type of moral hazard was mentioned—one that refers to the intervention of the International Monetary Fund. I am no longer an IMF staff member, so I am not going to take on defending the IMF in this discussion, but some points need clarification. Personally, I agree that financial help from the IMF, or bailouts, for countries in trouble may encourage foreign lending to those countries beyond what is reasonable, because those foreign lenders consider that in the end they will be repaid anyway, and that if needed the IMF will step in to provide the financing. However, I do not agree that the same argument applies to the governments involved in the process. The governments and populations of countries that have undergone that process of IMF programs do not feel as if they really have been bailed out from the troubles that they suffer. We have seen output falling by more than 10 percent in certain cases—15 percent in 1982 in Chile. Latin America took a full decade to recover the level of output that it had before the crisis; unemployment went up to double digits, even up to 20 percent. Inflation erupted when certain countries went to hyperinflation, like in Argentina. These countries have no incentive to adopt the wrong policies simply because the IMF is there to bail them out. IMF medicine is not sweet. And, among those who have taken it, the last thing that they want to do is take it again.
The lesson learned by many economists in Chile during the 1980s was that we should never again accept all the external financing that was offered to us. During periods of bonanza, capital inflows can go up to 10 percent of GDP and stay there for a while; but just as easily, everything can turn around. Financing can disappear and the country can be forced into recession and crisis.
One of the targets that has been followed is to keep the current account deficit at levels that are sustainable: limited in relation to GDP, and limited in relation to exports. To do so it is necessary to limit the impact of capital flows. The policies in Chile have been geared in that direction. We have a system of reserve requirements applied to some capital inflows, particularly to short-term debt. The reserve requirement consists of a dollar-denominated deposit in the central bank for the equivalent of 30 percent of the inflow, to be kept for one year with no interest paid. The requirement has a cost of about 300 basis points if the loan has a maturity of one year; but if the maturity is shorter, the financial cost would be much higher. Short-term financing or the succession of inflows and outflows is possible; but if you move in and out very fast, you will have to pay the price. We do not consider that reserve requirement to be a cure for all, but we think that it is an important part of our macroeconomic policy architecture, without which our monetary policy would not be as strong.
Even while we have restrictions to capital inflows, direct foreign investment is free of the reserve requirement; capital outflows are not restricted. Domestic residents have completely free access to foreign exchange, and the same is true for those who would like to repatriate their previous investments. We have learned from experience that a good and open capital account is good for the country, but that the use of external financing should be subject to limitations.
JAY PELOSKY: I just returned from a trip through Asia. I went there, notwithstanding our concerns about the Asian crisis, to get a sense of why the Asian markets have been the world's best performing markets year-to-date, and also to see if our global emerging markets model portfolio strategy is correct. That strategy has been to hold a fair amount of cash, because we are cautious; to be overweight in Latin America, because we do think that region is much further along in the restructuring process; and to be underweight in Asia, and particularly underweight in ASEAN, because we are quite bearish on the region. The strategy obviously hasn't worked so far this year.
My conclusion is that we should not give up on our strategy. In fact, what we need now in Asia is more bad news. Bad news is needed to keep stimulating the adjustment process, which is at risk of backsliding, because the money to a large extent has already been given out.
Let's spend a few minutes on two key markets: Korea and Malaysia. Korea is a very important market in terms of being a big industrialized country with lots of companies. It can be characterized as a country that's enjoyed excess investment financed by excess leverage and is now confronted with collapsing . We are now in the very early stages of working that back. Korean companies are now cutting capital expenditures. But this is just the first step. I'd like to see closure of companies and asset sales. Something like 11 of the top 25 companies in Korea filed for bankruptcy in 1997, yet virtually all of them are still operating, still producing product, and making it very difficult for those companies that are not yet in bankruptcy proceedings to make a profit.
My sense is that the targeted macroeconomic numbers, as indicated by the IMF, are way too optimistic. The IMF forecasts 10 percent inflation and -1 percent growth for Korea for 1998. Since the new government seems to be targeting inflation, growth will be significantly lower than projected. One of our economists estimates 1998 growth at -4 percent.
The government has got a good point and a bad point going for it. The good point of the government of Kim Dae Jung is that it's new, and therefore can use the time-honored tradition of blaming the old government for what's gone wrong in Korea. The bad point is that it is a minority government, a tough position to be in when having to put through aggressive adjustment policies. Therefore, it needs more bad news to push the adjustment process.
Malaysia is also a key country and market to focus on for the next six to twelve months. It is a symbol of excess property development, again financed by excess leverage. The Malaysian stock market last year peaked with market capitalization as a percentage of GDP of 350 percent. The U.S. market, at this point in a world-record bull market run, is around 130 percent of GDP in market capitalization terms. In Malaysia that 350 percent has come down to about 150 percent with the market correction, but it's still extremely high. The lending boom that has taken place in Malaysia is yet to be adjusted: Loans to GDP in Malaysia are at 160 percent. In 1994—95, loans to GDP in Mexico were 60 percent. The banking system in Malaysia is under huge strain, and it's just beginning to undergo an adjustment process. We have already seen some of the leading banks in the country fail. Unfortunately for Malaysia, it looks as if that country is going to continue this process as the real estate bubble bursts. Eventually they will run out of funding sources for failing companies, and they will have to ask for multilateral assistance. Malaysia is also the most exposed in terms of Indonesia. There are already reports of thousands of Indonesian refugees washing ashore in Malaysia.
Shanghai, China, is the single biggest property development in modern history. Unfortunately, the buildings are still going up, even though the ones that were put up last year are virtually empty. China is trying to do a really tough thing in completely adjusting its state-owned sector and its bureaucracy while stimulating its domestic demand profile. All to be done while the export engine of growth, which has led the country over the last few years, seems to be pretty much dead in the water. The economic forecast of 8 percent growth in China is going to be found to be extremely optimistic.
In sum, Asia can be characterized at this point as a region of excess capital investment that has been financed by much-too-readily-available debt leverage. It is now being confronted by a collapse in demand, and it does not take much to think about what that means for profits. Also, Asian governments seem to continue to want to bail out dead companies. This greatly retards the adjustment process. This is the case today in Korea (where the chaebols that went bankrupt last year are still operating), in Thailand (where the government spent about $25 billion trying to keep ailing banks—that later closed—afloat), in Indonesia (where the central bank is printing money at will), and in Malaysia (where the government is encouraging private businesses to take over failed institutions).
Finally, foreign direct investment in Asia will be, by definition, asset sales rather than greenfield investment. Asset sales are very difficult; typically owners don't want to sell unless they're forced to. Therefore, we need more bad news to continue to put the pressure on these corporates to sell their companies that aren't performing well and to focus on the companies where they have competitive advantage.
Where will demand come from? Mexico was able to recover from its crisis very quickly, in part because it lived right next to the United States. Exports in Mexico in 1995 grew over 30 percent in U.S. dollar terms. Although much has been said about the adjustment in Asia on the trade and current account sides, not enough attention is being paid to the fact that this adjustment is coming about because of import compression as capital investment collapses and not because of export growth. Part of the problem with export growth in Asia is that no single regional entity is able to take that export demand, particularly given the weakness in Japan.
The silver lining in all of this is the acceleration of the adjustment process in many of these countries and companies, particularly in Brazil, Russia, and China. All these countries are using external threats to make domestic political adjustments that would otherwise be tough to do. And that's all very positive.
On the corporate side, a lot of work is yet to be done. Asian companies are going to have to go to international markets to finance themselves to develop further. This will be a very good thing because it's going to subject them to comparative analysis on both a sectoral and stock level and thus accelerate the restructuring process. Our focus is increasingly on comparing companies across borders on a sectoral and stock basis. That is what is done in the United States, and clearly that has been very successful in terms of the stock market in this country. While I am not sure that the complete model of stock market investing should be exported wholesale to Asia, I think that comparative sector and stock analysis will a key part of the successful adjustment of the Asian economies and financial markets.
RICHARD TAN: From my perspective of managing an international company, I believe that the 21st century is here. The momentum is huge. It has challenged the old system, and made room for the new to be built. What happened in Asia? The new is challenging the old and destroying it. Globalization is in progress, with the financial services industry leading the way. Governments are trying to slow it down or prevent it because they believe they have to protect their own interests for their people. The turbulence of globalization will continue and probably not peak soon. It will be a bumpy and painful road.
Money is now flowing everywhere without boundaries, seeking the highest return. No single country or regional market can prevent it. The capital market is correcting what it thinks is not reasonable or proper. The U.S. dollar will become more and more international and more important. The United States is a safe port and has a stable economy. It represents a large share of export trade. The currency markets and securities will offer a lot of opportunities for at least five or ten years. These opportunities will come with high risk, but also high return.
Undervalued assets also will continue to surface in the world. Today they are in Asia. Later, they may be in another region. These represent the lowest risk with the highest return. So, I believe we are facing a lifetime opportunity in the business world.
C. FRED BERGSTEN: To the extent that there is consensus on this panel, we had four: (1) We are in the early stages of the crisis. It will last at least two or three years, maybe a little more. (2) However, it is unlikely to bring down the world economy, which is strong. (3) But we are likely to see some future deterioration in some quarters. (4) There is also some long-term opportunity and prospects that could well come out of the crisis. There is a risk of anti-globalization backlash as all this evolves, but there are some very different views on the role of the IMF.
|C. Fred Bergsten, Institute for International Economics|
|Gary S. Becker, University of Chicago|
|Salvador M. Enriquez, Jr., Republic of Philippines|
|James K. Glassman, American Enterprise Institute|
|Barry M. Herman, United Nations|
|Guillermo R. Le Fort Varela, Central Bank of Chile|
|Robert J. (Jay) Pelosky, Jr., Morgan Stanley|
|Richard Tan, Pacific Millennium Corporation|
|10:15 am - 11:45 am THU 3/12|
|DONALD H. STRASZHEIM: Is what is happening in Asia an opportunity or a problem? Mexico, Argentina, Chile, and other countries had unpleasant interludes but then produced better circumstances afterward. If reforms are made in Asia, it may be that after this dip it will end up with an improved economy, a faster rate of growth, and ultimately a higher level of output in the future.
We talked a lot about Japan in the last panel. During 1985 - 1990, the other G-7 nations regularly told the United States, "Get your budget deficit down." We listened politely and went our own way. In that same period, the other six G-7 nations regularly said to Germany, "You're too upset about inflation; ease monetary policy." A sovereign nation, Germany listened politely, and went its own way. And now the other G-7 nations are saying to Japan, "You've got to stimulate your economy." Japan is, quite predictably, listening politely and could go its own way. There are structural problems in Japan that are far more vital to Japan's economic performance and future than the problem of inadequate aggregate demand.
In this room there is probably fairly widespread agreement in principle on what needs to happen: Banking reform, openness, transparency, market principles, regulatory reforms, an end to crony capitalism, and rooting out corruption. This is summarized in the view that says the planning models from the Far East have been discredited and must be abandoned.
Is Asia ready to bite that bullet and make those reforms? I wonder whether we may be getting our hopes and our expectations confused. Jay Pelosky made the point, and I thought it was a good one, that we may need more bad news out of Asia to keep the momentum of reform going.
Asia's growth shows how extraordinarily important the region is. In the last three years Asia had growth rates of 6, 7, and 8 percent. The Philippines' growth is rising rapidly, although it is not quite at the growth rates of those other countries. The issue in Japan is reform and the lack of development of capital markets. In 1990, when Japanese banks led the world (10 of the top 15), the average return on assets for the top 10 Japanese banks was 608th among the top 1,000 banks in the world. So while they led the world in size, they weren't profitable even then. In 1997 the average rank was 889th out of 1,000. Much of Asia has similar problems. The China Bloc, China, Hong Kong, Singapore, and Taiwan, may perhaps make strange bedfellows, but there is an enormous bloc of reserves if those countries should want to get together in some kind of a currency stabilization action.
Exports from Indonesia, Korea, and Thailand, the three IMF (International Monetary Fund) patients, added together are holding up reasonably well. But imports are falling toward zero. You're not going to ship something to somebody if you don't think they can write a check to pay for it.
LINCOLN ANDERSON: I want to reinforce and heartily agree with the points made by the mayor and then again by Gary Becker. A couple of problems need to be resolved. First is the corrupt legal systems. We continue to see countries with very corrupt legal systems getting sizable capital inflows. I think investors both in banking as well as in the mutual fund industry need to take that in much greater consideration. We need to force more reform of the legal systems in these countries. Second, I wholeheartedly agree with their points about moral hazard. Moral hazard is often overlooked, especially in government circles, for very obvious reasons, since the banking system largely operates as a government entity around the world. And the moral hazard problem, both for banks inside and outside Asia, is quite severe. We see these in emerging markets as well as in developing markets.
The one very strong common denominator is bloated banking systems without controls, backed by explicit or implicit deposit insurance, making loans without any market-based assessment of risks or return. The same thing goes for the IMF; the creation of moral hazard there is severe. After the bailout in Mexico, we were guaranteed another problem. After the bailout in Asia, we will see further problems as moral hazard problems are compounded. I was appalled that the IMF came in with a bailout package for Thailand after Thailand had announced it was bailing out a whole slew of their major property-development companies. Thailand not only was covering depositors but also much of the equity in debt backing for those companies. The IMF came in with a package and didn't reverse that program.
NARIMAN BEHRAVESH: In the boom years in Asia there were a lot of myths that Asia was better or different. Some of these myths, thank goodness, have disappeared or are dying. But there are a lot of new myths coming out about the crisis itself, what caused it, and how we can get out of it.
Myth number one is that the Asian crisis was a short-term liquidity problem and not a long-term solvency problem. This is wrong on two counts. The first is that the banking systems in these countries before the crisis had serious insolvency problems. These were overguaranteed, underregulated banks that were being used as instruments of industrial policies. The second problem with this myth is that high savings in Asia and theforeign capital flowing in were used unwisely. They were squandered on real estate speculation and on the tallest buildings in the world. Thery were squandered on vast amounts of capacity expansion that had nothing to do with global demand. The Koreans convinced themselves they were going to become the fifth largest auto manufacturer in the world and just kept plowing ahead and expanding auto capacity with no regard to profitability or rate of return. They were just after market share.
Crises are not happenstance. They occur because of unsustainable policies and structural problems. The Asians committed two cardinal sins. They borrowed short-term in foreign currencies and they did not use those monies for productive purposes.
Myth number two: There are a lot of people saying that, before the crisis, Asians were pursuing responsible macroeconomic policies. Wrong again. Their budget deficits were fairly low. If you look at standard definitions, their inflation rates were fairly low. But, underneath the surface, there was incredible credit expansion, a lot of borrowing and lending, and an encouragement on the part of the government through implicit guarantees, including fixed exchange rates. Second, some governments like Thailand encouraged this borrowing by giving tax breaks for banks and corporations to borrow overseas. Third, some countries (such as South Korea and China) actually coerced the banks into making loans to loss-making enterprises. With this kind of directed lending and these kinds of implicit guarantees, the distinction between private sector debt and public sector debt is moot. It's basically public sector debt.
It's true that, in the goods markets, inflation was low. But in the asset markets, a bubble was being created. Any time you have a bubble economy, it's a sign of irresponsible policies. So the macroeconomic policies in Asia were irresponsible.
Myth number three: If foreign lenders had not panicked, this crisis would not have occurred. Again, wrong. Clearly there was a powerful herd instinct on the part of foreign investors and foreign banks. With the exception perhaps of U.S. banks, very few banks did any kind of meaningful risk analysis regarding the loans they were making in Asia. However, as is the case in most of these crises, Mexico included, the domestic investors were the first to bail out. In every single country undergoing such a crisis, it's the domestic investors that bail out first; then come the hedge funds, and then the banks. This logic has been used to argue in favor of capital controls. I won't get into that. Gary Becker made a very nice argument against capital controls.
Myth number four: The IMF has mishandled the crisis and exacerbated it. Ironically, there are arguments on both sides. One argument says that the IMF didn't catch the scope of the private-sector borrowing in Korea and Indonesia soon enough and therefore mishandled it by not understanding what the problem was. Well, basically the Koreans lied about the extent of their foreign borrowing. And in the case of Indonesia, clearly there's been a flagrant violation of the spirit and the letter of the IMF agreements. These have been overt acts of defiance on the part of the Indonesian government. It is impossible for the IMF to stabilize a crisis when you have this going on.
For those who argue that the IMF has done too much, the argument is that it doesn't make sense to advocate structural adjustment when you basically have a macro problem. But as I said earlier, it's a serious fundamental structural problems in Asia. If you don't reform the banking system, throwing money at the problem is like throwing money down a rat hole. This is exactly what's happening in Japan. Without addressing the fundamental insolvency of the banking systems in these countries, and the fact that they're not well regulated, throwing money at the problem just prolongs the agony.
These myths are confusing the issue and essentially deflect attention from the fact that the Asian model, the Asian way, has basically failed the first major test in globalization. Unless Asians develop open, transparent, well-regulated, market-based economies, they're not going to get out of this crisis in the near term. These myths just prolong the problem.
LINCOLN ANDERSON: Nariman Behravesh is absolutely right that you have to clean up the banking system. People are spouting platitudes that we need increased transparency and more regulation, but regulation has been a complete failure here and transparency doesn't really get you anywhere. We may find out about problems quicker, but banks are adept at bearing problems on their balance sheets.
What you have to do is get rid of the whole deposit insurance system. Everybody thinks that's impossible. In the United States we've clearly led the way, in the money-market mutual fund industry in particular. With money-market funds, you can have a deposit system with basically a 100 percent reserve requirement, where the deposit base is backed with U.S. government or other government securities. That can function just fine on the deposit side. Then, the lending side is financed with risk capital. GE Capital, the Money Store, Household Finance, all sorts of lenders at the high and low end, do just fine running lending programs financed with capital raised in the markets that is at-risk capital. And you don't need these fully integrated financial intermediaries to run a financial system.
Imagine that Citicorp considered giving up its charter. If they gave up their charter and moved away from the classic deposit insurance banking system, they would have dropped all or most regulation. You don't need regulation when you don't have the severe moral hazard problem. But why didn't they do this? One of the principal reasons is because foreign governments insist that they have American deposit insurance to operate overseas subsidiaries. In other words, foreign governments are taking a ride on U.S. deposit insurance. Take this into consideration when you think about the whole deposit insurance in both international as well as domestic banking systems around the world.
NARIMAN BEHRAVESH: Banks have played too big a role in financing in Asia. A lot of people have said that Asians need to develop much better bond markets. Bond markets seem to be much more transparent than banks. It's harder to hide things.
JEFFREY WINTERS: Are we on the verge of some kind of revolutionary change in the structure of Asian political economies? I would caution that we continually underestimate the capacity of these systems and these leaders for partial, limited, focused change where the pressure is greatest. What we really end up with after the dust settles is a lot more continuity and a lot more of the same. Real change is a much longer-range process that happens over many decades, not something that happens in moments of discontinuity like this crisis, although it is the time when you see the most reforms. Don't expect a revolution.
RANDOLPH READ: I agree that you need a fundamental shift. The question is timing and how to promote it. The way to promote it is to democratize capital so that more people can share in the benefits of the reforms that are necessary. When the mass of people, and not just the cronies at the top, are benefiting from economic expansion, these reforms will happen more effectively. The question is, how do they do that? Bond markets are a great way to do it, but that's a longer-term solution. They have to develop the access to capital so that the benefits of growth can be shared on a more equal basis throughout society.
C. DANIEL TYREE: The economic and financial problems of Asia today are in considerable part linked to political issues and political systems. Each country is different, and yet across some countries there are similar systems on which it is very difficult to impose change. That makes it difficult to take the medicine that's required to reform these different countries. That is true in Thailand and Indonesia. It is also true in India, where the crisis has not been that significant. But on the other hand, India has had really no growth in the last few years, because in 18 months they've had three governments. We don't even know whether this new election will form a government.
So there are structural issues that are political in nature. I'm pleased to see some of the changes in Korea, because that may be the first significant political change in Asia that can address some of these economic and financial problems going forward.
JAMES KELLY: These changes to the fundamentals may be made gradually, but is there enough bad news to force this kind of progress? I think there's going to be some more bad news to come and then more progress. Daniel Tyree's point about Korea is certainly right. Last week's session in China showed that this lesson is being taken there.
NARIMAN BEHRAVESH: Korea may actually lead the way in the sense that they seem to be more aggressive in implementing some reforms, although I think there may be some backsliding. But to the extent that Korea does it well and comes out of this, it may lead the way for others.
LINCOLN ANDERSON: The key right now is what happens in Japan. I'm very worried about Japan. What we see coming out of the U.S. Treasury, the IMF, and the G-7 is something I would characterize as 1960s Keynesian economics at its worst, which is just what the Ministry of Finance and the Bank of Japan have been engaged in for the last 10 years. Fred Bergsten was talking about how Japan hasn't had any growth when they've had half a trillion dollars worth of stimulus. But that sort of stimulus is irrelevant to the issue and actually can retard progress. How can they have no growth when they have a huge current account surplus? Economies that are staying flat and in recession tend to have huge current account surpluses. Japan's current account surplus is going to get far larger. But they aren't dealing with their fundamental issues. They need to deregulate. They need to cut corporate and individual tax rates. And they haven't done anything really significant to bail out their banking system. They have close to a trillion-dollar problem.
NARIMAN BEHRAVESH: Japan is so huge, and it's so much a part of the problem, that without Japan solving some of its fundamental problems, it's hard to see Asia getting out of its mess.
C. DANIEL TYREE: One way we can see it is if China takes that opportunity and moves forward.
NARIMAN BEHRAVESH: Well, that's going to be awhile.
C. DANIEL TYREE: On the other hand, China says they're going to recapitalize the banking system and sell the equivalent of U.S. $32 billion of bonds to the banks that need to be bailed out. I don't know how they're going to do that. They're going to privatize 300,000 companies. I don't know how they're going to do that. And they're going to reduce by at least 5 million people the amount of bureaucracy by cutting down ministries from 40 to 26. That's a huge undertaking and even Zhu Rongji with his magical wizardry is going to have a difficult time doing those things to move China ahead.
LINCOLN ANDERSON: Well, he's got a better shot at it than these bureaucrats in Japan. That's probably one thing you've got to give him credit for.
JEFFREY WINTERS: One more comment about the IMF moral hazards. One of the problems with this moral-hazard argument is that it's premised on the notion that, if you don't have the IMF or some bailout organization in place, you have bankers and money managers and so on who make all kinds of excellent decisions that don't cause all kinds of problems. The reason the IMF was put in place in the first place was to iron out and try to manage and lower the amplitude of the disruptions caused by these very same people.
The business community really needs to think through the question of transparency. On the one hand, crisis is supposed to open up a chance for change. But who enforces real transparency and the rule of law? It's the people in each of these societies. It's a free press and independent organizations in each of these societies. And the problem is that every time U.S. foreign policy speaks up about trying to strengthen human rights, independent organizations, and free presses in these societies, the business community is one of the first to say, no, no, no, no, this is an automatic process that somehow will take place, and if we just open up markets, everything else will fall in place. I think this needs to be thought through much more carefully.
Let me turn to Indonesia, having just returned from there. Indonesia is different from all the other crisis cases in Asia in that it is primarily a political problem, not primarily an economic problem. This really sets Indonesia apart. It's regrettable that an organization like the IMF is out in front trying to handle the Indonesia problem because it is not well equipped to handle a political reform process. It's a no-win situation. None of the options is good.
The news coming out of Jakarta earlier this week is very grim. Suharto has been re-elected—sorry, that's not the right word, he's been reappointed. He's never been elected. No one has ever cast a vote for President Suharto, because you're not allowed to vote for President Suharto in that political system. He's also never run against an opponent. He appointed the organization that appointed him. So it's not surprising he's now won a seventh term. This virtually guarantees that the crisis in Indonesia is going to deepen. It is not going to get better. Most people don't want to be associated with a New Order regime at this point and that doesn't bode well for his cabinet. It's now clear that Suharto and his government have lost all credibility and legitimacy and he is now seen as a pure liability by everyone except his kids and his cronies.
Now Indonesia remains locked in a standoff with the IMF. And you also have this on again-off again threat of a currency board. I believe that Suharto is not going to put a currency board in place, for two reasons. One, he simply doesn't have the usable foreign exchange reserves anymore. The quoted number is $16 billion available; that's down from $19 billion in January, of which only $8 billion is usable. The other $8 billion has been set aside and guaranteed for the state and private banking system. So you've got about 8 billion left. That's not enough. That would last a few days at 5,000 rupiahs per dollar for everybody who is waiting desperately to be able to change their rupiahs into dollars and move them out. It would be political suicide for Suharto to put the currency board in place. Meanwhile, Suharto's playing a very smart game of keeping money speculators and everyone else on guard.
On the IMF package, the IMF cannot back down. If it does, it loses what little credibility it has left. How can you hold Thailand and Korea if you let Suharto get away with it, when he's a proven kleptocrat? On the other hand, it's impossible for Suharto to implement the core elements of the IMF package and remain in power. There are 50 elements in the package that has been negotiated with the IMF. Most of them have nothing to do with stabilizing Indonesia. What tends to happen in places like Indonesia is that you have long periods of a status quo and business as usual, and you can't implement any reforms. So you've got this huge backlog of things you want to ram through. Then there's a window of opportunity. Suharto's on the ropes—we saw it in the mid-70s, we saw it in the mid-80s, and now it's happening again. You bring out the whole cart and try to get as much in place as you can, even if many of the elements are mutually contradictory.
The key part of the IMF package is an international audit of the state banking system and the private banking system, followed with a restructuring and consolidation process. Why can this not be done in Indonesia? If you have an open international audit of the state banking system, you're going to quickly discover that roughly $8 billion has been directly stolen by Suharto and his family. The IMF, as an institution, will lose its credibility if it doesn't follow through. I think Americans should oppose giving any further money to the IMF if it doesn't pull the plug on Suharto.
There is a very serious problem with the kind of imagery that's floating around in the debates on Indonesia. I saw it in the Asian Wall Street Journal as I was flying back here. In both an editorial and in an op-ed piece, an image was put forward that Indonesia is about to enter total social chaos and a meltdown. Potentially the country is going to fly apart, "island by island."
By the way, these writers added that if this happens, it's going to be the IMF's and President Clinton's fault, which I think is absolutely wrong. It's Suharto's fault. But the imagery that people have about Indonesia is The Year of Living Dangerously. Let's face it: the vast majority of Americans don't know much about Indonesia. Sadly enough, most of what they do know has come through a Mel Gibson film. Of course, the two white people in the film get on the plane just as the massacre is starting and off they go and fall in love.
The notion that Indonesia is on the precipice of blood in the streets, massacres, 500,000 to a million people killed, running amok, the country flying apart in some kind of Yugoslavian scenario, I would submit to you is absolutely wrong, alarmist, and inaccurate. Indonesia of 1998 is not Indonesia of 1965. In 1965 there were ideological battles, peasants at the village level taking over land, and it was they who were killed and massacred. There is no such target or group in Indonesia today. There is not intercommunal hatred, not even toward the ethnic Chinese who are seen as the group most targeted.
If you can say anything about the unrest in Indonesia, it's that it has been so restrained. There has not been killing and massacres. There has been destruction of property. There has been the burning and looting of stores and shops and some houses. The people who have been killed, if they haven't been killed by the military or police, have been killed accidentally. Indonesia is showing restraint. I think there is going to be further unrest in Indonesia in 1998, but the imagery of pending bloodshed is being used to great effect by Suharto to defend himself and his family. Indonesia needs reform.
Everyone says there are no alternatives in Indonesia, partly because of the danger and partly because there is no "credible" opposition with a vision that we know and could trust. I disagree completely. I've been in Indonesia for most of the last two months and have been able to sit in as an observer on some 15 meetings held by Megawati Sukarno Putri, together with a hidden cabinet. Hidden, why? Because to be out in front in Indonesia is very dangerous. Yet she not only is the most beloved person in Indonesia, she has much more credibility and claims more of a following from the population than Cory Aquino did in the Philippines, or Aung San Suu Kyi did in Burma, or Benazir Bhutto did in Pakistan. She doesn't have a following among elites, because she's not one of them. But her following among the population is tremendous and deep and powerful. She has around her excellent bankers, financiers, economists, and a lot of very intelligent people who have been waiting in the wings for a long time to be able to lead Indonesia in a direction that is much better, fairer, and just. Her government, if she gets the opportunity to come to power, will be committed to the rule of law, to transparency, and to reducing corruption. Her government will be committed to keeping Indonesia integrated in the international community, both economically and politically, as a responsible regional player.
This bodes well for U.S. business. Most of the other countries that the United States competes against in foreign investment don't have foreign corrupt practices acts. If a level playing field is created in a place like Indonesia, it's going to be a great boon for United States business.
My own sense is that for every three months Suharto stays on, the crisis in Indonesia will be extended for another six to twelve. Indonesia cannot turn the corner until there is political reform and change. To expect Suharto to do it is like expecting the Gambino crime family to clean up the mob. It's not going to happen.
NARIMAN BEHRAVESH: I'm not as optimistic as you are about the opposition taking over. You didn't mention the role of the military. It's hard for me to see the military in Indonesia supporting Megawati.
JEFFREY WINTERS: I disagree. She's actually been in conversations with the military over the last three weeks.
NARIMAN BEHRAVESH: The hierarchy in the military is very much a part of the Suharto clan. Some of them are relatives by marriage. I'm just as pessimistic as you are about the outcome, but I don't see a smooth transition. We've seen some scary parallels between what's going on in Indonesia and what happened in Iran in the 1970s, in terms of the bubble that was burst, the kind of foreign capital that went in, the cronyism, and the corruption. We haven't talked about the fact that Indonesia is the largest Islamic country in the world.
JEFFREY WINTERS: It's also the most moderate.
NARIMAN BEHRAVESH: Well, true. But they're a force to contend with. I am much less optimistic that there will be a smooth transition to the empowerment of the opposition.
JEFFREY WINTERS: I don't think the transition is necessarily going to be smooth or nonviolent. It is going to be tough, partly because the military is going to be out front. I think they want to follow a people-power movement. That means the people are going to come to the street. So I don't necessarily think it's going to be smooth, but it is going to happen.
JAMES KELLY: There will be effects outside of Indonesia in the region. There are and will be serious food problems. There is a drought effect on the rice crop. Fires are starting again in Borneo. That haze, at the very minimum, puts a real pall over people's lives in the region and their attitudes. We're already seeing plenty of economic immigrants, a.k.a. refugees, headed for Malaysia and Singapore. One of the unfortunate lessons of this is that the essential vulnerability of Singapore is being underscored in a way that's not very pretty. It's a small place with very little capacity to take new people. They may get them without any vote on the matter before long. Also, the Southeast Asian--vaunted ASEAN solidarity is, if anything, in tatters.
However, China's news has been awfully good. The lessons of sending enough troops to fight a war seem to be part of that $32 billion package for the banking system. The banking system in China is sick, as our colleagues have identified. But even so, this growth seems to be holding up. Investment into China has abated only slightly with the exception of that coming from overseas Chinese in Southeast Asia. There seem to be, so far, some dogs that haven't barked. In particular, China's exports have not been much affected. But we do have this overhang of devaluation of the renminbi.
As a noneconomist here, I want to be the first to throw in my two cents on that one. In my view it is unlikely to occur this year. But in 1999 the question is open and even likely. The possibility of devaluation in China is seriously slowing the recovery in Southeast Asia and is hanging over Hong Kong.
Taiwan seems to be doing well. Dr. Bergsten was a little tough on them about their devaluation last October. I suggest that this might be part of the reason of keeping a serious economic player out of international financial institutions for political reasons. Their need to rely on themselves is understandable. Then there's Korea, which seems to be doing the right thing and has had a change of government. It is showing leadership in a positive way so far. But it is going to have problems later this spring with burgeoning unemployment.
What about North Korea? Is it going to starve or collapse? What will collapse mean? Are there splits within the leadership? I don't know the answers to these questions and I don't think anybody really does, but North Korea is in seriously bad shape on any scale. If something serious happens in North Korea, it could have major effects, not only on the whole region but on the whole world, financial as well as political.
RANDOLPH READ: I agree with Lincoln Anderson on some key issues here, because Japan and China are the key to the region. Either one can lead. I think Japan would be at the top if they would do it, but they have some structural impediments. Japan has gone backward recently from where it should go. It raised taxes; it needs to cut taxes. You're seeing in Japan a reflection of the United States, 15 or 20 years ago. You're seeing a downsizing of major corporations. You're seeing job growth coming from small corporations. But, unlike in the United States where you had capital markets, and particularly the high-yield markets to bring capital to small entrepreneurial businesses, you have limited access there.
I'm coming from a real world perspective. Stone Container is the largest brown paper manufacturer in the world and we're also the largest box maker and newsprint manufacturer. We operate almost everywhere. From the most recent statistics we can get, paper consumption pretty much follows GDP (gross domestic product), with the exception of China. In the developing countries, where the economic sector is driven so much by the manufacturing segment, we're a pretty good indicator of the economy.
But we have seen an interesting development on the brown paper side of the business—-just what you might expect from what would happen with a devaluation of currency. For example, our shipments of brown paper to China in the last three months are up almost 40 percent. Now, they're down for pulp and they're down for white paper, which is a different story, because that follows from the lack of a free press and other issues.
So China is moving ahead, given that Japan seems to not want to take the leadership position. Japan claims more than 70 percent of the economy of the region. Japan can clearly lead the region if it wants to. Does it have the political wherewithal to move its systems or to cut its taxes, which would be the fiscal stimulus that it needs to encourage entrepreneurism? The bond market would be a great way to do it. In the long term that's exactly how to do it. In the short term, can Japan reform the banking system enough to push things forward? That's where I would place my money for a near-term solution. Throughout history, economic development cannot occur without social liberalization.
C. DANIEL TYREE: I'm an investment banker, so despite all the economic problems and political issues, my job is to try to work with the governments and the companies of Asia and keep them working with the institutional investors so that the money continues to flow.
Where are the markets in Asia? Are they closed totally? In 1997, probably $26 billion plus of new equity was issued internationally by Asian countries. We don't know what it will be for 1998. Clearly it's going to be very difficult to get close to that number again this year, given the start to the year that we've had.
On the other hand, the markets are not going to be completely closed to Asian equity issuers. Some of the Japanese banks are issuing new equity and some of the Chinese companies are doing convertible issues as we speak. We are preparing two big equity issues for what we believe are two of Thailand's best companies, which will come out in the next couple of months. They will be over $300 million, possibly as large as $500 million each.
So we don't believe that the international markets are completely closed to Asian equity issuers. But we do believe that Asian equity issuers will have to tell a very convincing story. They'll have to have a very strong investment thesis; they'll have to be able to sell their economy and why institutional investors should invest in both that company and that country at this point in time. So there's going to be much more discriminatory investing in the sense of choosing which country and which kind of company institutional investors globally will enter.
On the debt side, the ratings of these countries have changed dramatically since the beginning of 1997 and through early 1998. Virtually all of them have lowered their ratings significantly. As a result, these countries are paying considerably more in terms of interest cost on new borrowings. None of these countries has borrowed new money because, frankly, it would be very difficult for them to come to the market right now. I have to hand it to Minister Enriquez because it appears the Philippines will be coming to the market soon. I think they will be able to sell their fixed-rate debt at a reasonable spread—much higher than it used to be but still reasonable in absolute terms, particularly in the context of U.S. Treasury rates at a 6 percent-type level. If you put a few hundred basis points on, it's still significantly below a 10 percent long-term interest rate, which isn't so bad for many of these Asian countries. So I think there will be significant debt market activity.
South Korea will be readying a significant package. It's rumored to be two or three tranches of up to U.S. $9 billion, which it will bring to the market in the not-too-distant future, probably in a couple of months. I expect that Thailand would try to come into the market later this year with a significant package as well. Clearly, Indonesia will have to wait until its problems are more addressable. And I think that we'll continue to see China coming into the market from time to time, whether it's through its different companies or the government itself.
So, the markets are open. But the spreads have widened considerably although, on the other hand, U.S. Treasury rates are so low that it compensates for a slightly higher spread in these markets. If anything, spreads in some of these markets will decline, whereas in places like Indonesia the jury will still be out for a considerable period of time.
|Donald Straszheim, Milken Institute|
|Lincoln F. Anderson, Fidelity Investments|
|Nariman Behravesh, DRI/McGraw Hill|
|James A. Kelly, Pacific Forum CSIS|
|Randolph C. Read, Stone Container|
|C. Daniel Tyree, Lehman Brothers Asia|
|Jeffrey A. Winters, Northwestern University|
|12:00 pm - 1:30 pm THU 3/12|
|The IMF/Financial Market Issues|
|JAMES BARTH: In November 1997, Michel Camdessus, the IMF's managing director, stated: "The Asian crisis resulted from overvalued real estate markets, weak and overextended banking sectors, poor prudential supervision, and substantial short-term borrowing in foreign currencies." Robert Rubin, the U.S. Treasury secretary, stated in January 1998 that "The Asian crisis demonstrates that markets cannot be trusted to correct their own excesses." Finally, Joe Stiglitz, the chief economist at the World Bank, in December 1997 stated that "The buildup of short-term unhedged debt left East Asia's economies vulnerable to a sudden collapse of confidence. As a result, capital outflow, and with it depreciating currencies and falling asset prices, exacerbated the strains and private sector balance sheets, and thus proved self-fulfilling. This should be addressed by establishing an effective regulatory system improving corporate governance and enhancing transparency more broadly."
GLENN YAGO: Gary Becker stated that "obtrusive regulations and excessive government control over the financial sector were the weakest links in the economic superstructure of Indonesia, Malaysia, Thailand, and South Korea. Their governments regularly gave subsidies and other assistance to favorite companies and bailed out those that got into financial difficulties. The IMF and other international organizations are distorting incentives further." And Bob Kuttner wrote in The American Prospect that "The IMF was designed in 1944 expressly to prevent the currency deflations and financial panics that deepened the Great Depression. But the IMF is now the premier instrument of deflation as well as the most powerful unaccountable institution in the world."
What are the issues as seen from perspectives of other leaders in the world? In an extremely impressive inaugural address, the new president of Korea, Kim Dae Jung, noted that "political, economic and financial leaders of [his] country were tainted by a collusive link between politics and business and because of government-directed banking practices, and because large business groups set up a large number of uncompetitive subsidiaries." George Shultz, Bill Simon, and Walter Wriston all commented similarly that "as is typical when the IMF intervenes, the government and lenders were rescued, but not the people. The IMF is inefficient, unnecessary and obsolete," to state the most extreme criticism of the IMF.
JAMES BARTH: Henry Kaufman has stated that, "The IMF needs to be reorganized." Henry Kissinger has stated that "the typical IMF rescue program is in urgent need of re-evaluation." And Jeffrey Sachs, a fairly prominent and outspoken critic of certain aspects of IMF programs, has stated that "Asia has been hit by a financial panic that vastly exaggerates the fundamental ills of the Asian economies. The IMF has not stopped the panic, and arguably has added to it, both by its rhetoric, which underplays the role of panic and overplays the weaknesses in Asia, and by its draconian economic policy conditions."
One solution individuals have proposed with respect to dealing with certain aspects of the problems is deposit insurance. Yet some economists at the World Bank have recently performed studies indicating that deposit insurance makes banking crises more likely and severe. The New York Times reported in January 1998 that a confidential report by the International Monetary Fund on Indonesia's economic crisis acknowledges that an important statement of the IMF rescue strategy backfired, causing a bank panic that helped set off financial market declines in much of Asia.
GLENN YAGO: Should the IMF intervene when there is a currency crisis, or a crisis of confidence?
DAN BRUMBAUGH: My goal is to try to explain what caused the difficulties the banks are facing in East Asia and perhaps suggest the best path to resolution.
The 19 nonoverlapping countries of the European Union and the G-10 account for only 14 percent of the world's population, or 770 million people. But those countries account for 76 percent of world GDP (gross domestic product). The remaining 180 countries in the world account for 86 percent of the world's population, 4.7 billion people, and they account for only 26 percent of world GDP.
Similar disparities exist for world banking assets, world equity capitalization, and international debt securities. These disparities are the key to understanding what the overall goal should be in resolving these banking crises, namely, to help make certain that developing and emerging countries are able to access the capital markets from the developed world, where the world's wealth is lodged. For a long time, however, the general approach taken by the transnational agencies in banking crises has been clear. The Basle Committee of Bank Supervisors, the Bank for International Settlements, the IMF, and the World Bank all have been moving toward international bank regulatory protocols. These protocols are based, in general, on the prevailing view that international banking crises are caused by or reflect lax examination, supervision, and regulation and by inappropriate closure policies and capital level regulation.
The regulatory prescription that generally follows is to establish international capital requirements and closure rules as well as internationally approved bank regulations for allowable activities, examination, supervision, and location, among other things. This prescription also is based on the notion of imposing a deposit insurance system similar to the one we have in the United States.
This interpretation presents only a small part, and a distorted part, of the overall picture. Rather, the most important issue that needs to be addressed is the widespread and inappropriate intrusion of the region's governments in the banking and financial markets. The results are financial decisions based on nothing resembling a market analysis of risk and return. The remedies that should be adopted are substantially different than those that the transnational agencies are pursuing.
It is true that the IMF has supported "transparency" and that, on an ad hoc basis in this crisis, it has supported private ownership of banks, limitation of state ownership of banks, and the like. However, since 1989 and the original Basle accord, which began the transnational agencies' involvement in these sorts of things, these policies have not been anywhere near the central components of what they have proposed.
It is important to get an understanding of just how prevalent state-owned banks are. As a percentage of total assets in emerging East Asian countries relatively recently, state-owned banks have accounted for over 20 percent of bank assets. Approximately 43 percent of bank assets in Indonesia are in state-owned banks. Though that's substantial, it's down from about 54 percent in 1991. There's been a corresponding increase in the assets of private banks. But the assets in joint-venture banks and foreign banks have only been 10 percent of assets through this period.
In terms of the efficiency of state banks relative to private banks, nonperforming loans among state banks have been substantially higher than private banks. Very recently, for example, nonperforming loans in state banks were 15 percent of total assets, whereas in private banks they are only 5 percent of assets.
The return on average assets for foreign banks is substantially greater than for state banks. Even in countries where state banks are not prevalent (for example in Korea, where there are only two state-owned banks, neither one of which is in the top ten) one can still see substantial state intrusion in the financial markets. Political influence on lending decisions appears to continue. A World Bank footnote says commercial banks still had $4.5 trillion in loans on their books at the end of 1996, 56 percent of which were nonperforming. This is the outcome when state-owned banks are not predominant but the state directs lending to selected enterprises. But depending on the degree of state influence in this fashion, if lending decisions are directed by governments to private banks, the notion of inadequate supervision, or regulations, simply cannot apply.
It's important to evaluate the composition of the financial markets in terms of the percentage of GDP, for example, that are allocated to banks as against bond markets and equity capitalization. With the exception of Hong Kong's, Malaysia's, and Singapore's equity markets, the banking sectors in all of the other countries are very large relative to the bond and equity markets. This can be important because for a given level of state ownership of banks, if the banking sector is large relative to the other sectors, the other sectors can be dominated by the banking sector, which has tremendous government involvement. In addition, commercial firms will have much less access to nonbank, nonstate bank sources of funds. In addition, the financial market is going to be subject to greater instability if one sector dominates another. And if that one sector falters, the effects on development and the economy are going to be greater.
Once again, the example of Indonesia is instructive. The Indonesian banking sector is substantially greater than either the bond or equity sector. In contrast, the U.S. banking sector is dominated by the equity markets and bond markets. In Indonesia the bond market is only approximately 5.8 percent of GDP. In Indonesia, Thailand, and India, the percentage of state enterprise bonds, which are state bonds for commercial purposes, exceeds 60 percent of the corporate bond market plus state enterprise bonds. So there is dramatic involvement in the government in these countries throughout the financial markets.
It is helpful to look at the developing countries for some answers, because since 1980, three-quarters of all IMF countries have faced some sort of banking crisis. Indeed, at the moment, 58 countries in the IMF in 1997 were receiving some kind of state assistance, either to improve their monetary policies or bank practices. But in developed countries that have all the attributes of a regulatory system of the IMF, there have been dramatic difficulties in recent years. Spain, Canada, Denmark, the United States, Germany, France, Italy, Finland, Switzerland, and Japan all have had severe banking crises in the last 20 years.
Perhaps the best window through which to see the implications of this is the savings and loan crisis that occurred in the United States in the 1980s and 1990s. The savings and loans had every regulatory apparatus that the IMF wants to apply to international banks, including, among other things, prompt corrective action mechanisms. The savings and loans were the most highly regulated privately owned firms in the world at the time of the crises in the 1980s. What happened? Simultaneously, with all this regulation, examination, and supervision, the savings and loans were required to make fixed-rate, long-term mortgages. They were actually prohibited by law to make variable-rate loans or to hedge their interest risks in the futures and options market. Then the yield curve inverted, and as a result the institutions were entirely insolvent by 1981. At the same time, the deposit insurance reserves of the savings and loan insurance corporation were approximately $100 billion short of what was going to be required in order to resolve the total number of institutions that were underwater.
With full knowledge of the situation, Congress jettisoned all the prompt corrective action mechanisms, lowered capital requirements, and allowed the Federal Home Loan Bank Board to keep insolvent institutions open and operating. As economists, we would say that the problems that are thought to create bank instability, problems with information asymmetry and moral hazard, were swamped by problems created by the regulatory mechanisms that we had. That created even greater moral hazard, principal-agent problems, and adverse selection, which completely swamped the savings and loans.
If governments can restrain themselves from intruding into the financial markets through state ownership of banks and from intruding into bond markets and other markets, the markets could actually provide solutions today, given the availability of technology to gather, evaluate, and monitor relevant information. Markets can work if they are allowed to do so.
PAUL HOLDEN: I could start by paraphrasing Shakespeare and say, "I come to bury the IMF not to praise it." But the context is a little different, and I don't mean to say exactly that.
In 1900, Asia contributed about one-third of world GDP. After the Asian miracle it is starting to approach that level again. So, historical context is often important when looking at trends that last 20 years or less.
I am going to dwell on two things. One is how the institutional underpinnings of financial markets relate to market structure and influence behavior. The second is to relate them to circumstances under which the IMF can influence these factors, under which I think the IMF can help, and under which it does the opposite.
But first, consider the process of economic development. Essentially it is a large increase in the number of transactions. It is closely associated with industrialization and commercialization. It involves business relationships opening up to transactions that are geographically more distant, and with people whom the contractors do not necessarily know very well.
In other words, transactions become increasingly impersonal. As a result, the amount of risks as economic development proceeds increases, because development requires increasing specialization and division of labor. It requires greater investment and initiation of transactions and investments over a long period, the fruits of which come only after a period of time.
So, as development occurs, institutions, which underpin that development, need to evolve. A lot of them are associated with the provision of public goods for governments.
We have heard of the damage governments can do by intervening where perhaps they don't have a comparative advantage intervening. But there are other areas where they have a distinct comparative advantage, for example, in implementing systems like law and order. In development terms, they should be associated with institutions that allow stable contracting, help define secure property rights, and provide a basis for managing the risk associated with development. It is not only government that has a monopoly on risk-bearing institutions, but government has an advantage in some areas. And I believe that however libertarian one wants to be, government certainly has a role to play.
For those of us lucky enough to live in industrialized countries, particularly in the United States, we take many of these institutions for granted. In reality, many of them either do not exist in the developing world or are extremely underdeveloped. First, let's look at property rights.
In Latin America there are few countries in which property is clearly defined. Even in Chile, the number of property-titled dwellings is very low. This means that the financing of mortgages simply does not work. It is not available to the vast majority of people in Latin America and in many other developing countries. Banks don't lend because the institutional underpinnings simply do not exist. Repossession of property in the event of default is banned constitutionally in many countries. So the basics, in terms of financial markets here, don't exist there.
The situation is even worse when it comes to lending against movable property. Movable property loans are almost unknown in most of Latin America. They are not very well developed in most other parts of the developing world. As a result, the financial structure of markets, as Dan Brumbaugh pointed out, is dominated by banks.
This is not necessarily a bad thing, because in the initial phases of development, the banking system is probably the most efficient way of channeling funds from savers to investors. But it also means that access to the banking system is available to a very small number of people, or a relatively small number of people. This is happening not only in Latin America but in many countries in East Asia.
Furthermore, bankruptcy laws, which exist because bankruptcy is a way of transferring assets from an inefficient use to an efficient use, are also problematic. In many countries it is impossible to close down businesses in the event of default. Indonesia is a case in point. There was an article in The Economist recently about a Hong Kong bank that had made a large loan to a company in Indonesia. The Indonesian company defaulted. The Hong Kong bank had to close down. The Indonesian company is still operating, business as usual.
This example is a perfect illustration of my point that bankruptcy laws don't work. It also shows that it is almost inconceivable that the Hong Kong financial institution did not know that it was impossible to put its client out of business in the event of default. Similar factors apply in contracting systems; the former Soviet territories are a perfect example. Many businesspeople have gone there attempting to enter into contractual relationships. They find that contracts are simply not enforceable. Several people have lost large amounts of money because of this. It has one particularly unfortunate effect in many developing countries: It perpetuates the concentration of wealth to a relatively small number of people. Latin America has one of the most unequal income distributions of any area in the world. Indonesia is a similar case in point. This creates or adds political risks to the economic risks, because reforms benefit a relatively small portion of the population, which makes the political dynamic very unstable. And if one looks at the extent of reforms in Latin America over the past 10 years, this is only one, or it's only the most recent, of at least four waves of reform, all of which were previously reversed.
How does the IMF feature in this institutional soup? Not very well. The IMF does some things quite well. When there are serious macroeconomic imbalances in the form of budget imbalances, high inflation, and exchange rates that are not reflected by the underlying fundamentals, it does quite well. When I was at the IMF I was involved in several arrangements to "bail out" governments, and those governments would rather have taken poison than do what we said. This is not something that's politically palatable. They find it humiliating and I don't believe that it is a factor in governments' behavior. The IMF has been a useful policy scapegoat because when governments have had to make difficult decisions in the macroeconomic area, they have been able to use the IMF as the reason for having to do it and have been able to say things are out of their hands. So from that point of view, I think the IMF was quite good.
However, in the current situation in East Asia, one has to question whether the IMF even has the expertise to deal with these issues. I have great admiration for IMF staff. It is very highly trained, but it subscribes to a particular macroeconomic model. And the events there, I believe, are outside the ambit of that model.
GLENN YAGO: To what extent does the IMF create or mitigate risks in this market?
HENDRIK KRANENBURG: There has been a lot of focus on financial institutions and the risks in the way financial systems, in Asia or in various Asian countries, have been constructed as a key element that led up to the crisis. There's also been commentary on the role of ratings. I would like to share a couple of views on what the environment looked like going into the crisis, both for banks and corporates in the region, and then draw some implications for those who were involved in analysis, either on the fixed-income or equity side. Finally, I will comment on the systemic issues.
First, I am considering Japan as being "in Asia." The fundamental lesson is that it was no surprise that Japanese banks and other banks across the region encountered serious difficulties. Banking institutions in Asia have long been recognized as having significant risks, particularly in the property portfolio. In countries like Korea, there were high degrees of leverage in the corporate portfolio. And if you compare the ratings distribution of Asian banks to the distribution for bank ratings in Europe or in North America, clearly banks in those two latter regions distribute much more in the single A, double A category. Banks in Asia have long been recognized as having riskier profiles.
There has also been a lot of discussion about the way Japan has or hasn't moved quickly enough to reform its financial system. Japan does need to stand out as one country that has allowed institutions to fail. And there are other countries in the region that have done that. A major issue is that domestic market confidence is sometimes lost when this takes place. Japanese regulators are wrestling with issues that reflect the consequences of the collapse of Hokkaido Takushoku and Yamaichi Securities. Those two institutions clearly were the weakest links in the convoy going into the crisis. The fact that those two failed should actually be seen as progress in the sense that the Japanese system allowed an analysis of risk and allowed institutions to fail.
Turning to the corporate sector, there is evidence that corporates can survive even when they fail to pay their banks. The fundamental trend is a growing number of corporate credits with ratings in the region. What underlies that is a growing credit culture in the region and a growing use of objective analysis by lenders and investors in Asia, not only for cross-border purposes but also domestically in systems like Japan and in Taiwan, to look at credit risk and seek to price assets accordingly.
Clearly throughout the region, financial system stress has been at the heart of the meltdowns that we've seen. When there is systemic stress and illiquidity, all of the work that goes into differentiating credits and types of issuers falls apart because the system as a whole is at risk. The best and the worst all seem to collapse together. The issue in many of these countries has been one of illiquidity, and that has been a fundamental risk that increasingly needs to be incorporated to the way analysts look at investments. It also means that debt and liquidity management are increasingly important for banks, for corporates, and for sovereigns. Certainly debt mismatches have featured prominently in a number of the corporate bankruptcies and indeed some of the most stressed financial institutions. We do believe that credit differentiation remains important, but it can be overwhelmed by systemic liquidity problems.
Transparency needs to be a risk factor in the investor's equation. Calls for the governments to enhance transparency ring a little hollow. I know many lenders who would prefer not to have transparency in their effort to improve their own knowledge of a situation and position in the marketplace. So, if investors do value transparency, it seems to me that it is up to them to call for it.
In emerging markets, there will be volatility in the credit situations and in credit ratings. Clearly the modern environment of capital flows and short-term capital flight exacerbate this problem of systemic liquidity. The heart of the issue of the role of the IMF is that capital flows have been one added source of instability, among a number of other factors. One of them is a regulatory cliff, situations in which regulations have a binary impact. They are a "go" or "no-go" situation. In the ratings industry we are very familiar with the impact that movement from triple B to double B can have on a credit like Korea. With a movement in the rating, it actually accelerates the institutional outflow that exacerbates the liquidity crisis.
Finally, default inexperience is a real issue for a number of the institutional investors. Having as major investors the insurance companies and pension funds that don't have the experience with non-U.S. defaults or with sovereign defaults that the banks do contributes to volatility. It contributes to a rush to the exit when things seem to be turning south.
The final message is just that we need increased recognition and differentiation of risk. The role of the IMF should be to encourage all institutions to engage in that. It is unfortunate that the IMF is regarded as a way to bailout. The emphasis should be on providing liquidity in the pricing of goods, services, and capital, and not on the role of being the ultimate bailout lender.
STEVEN HESS: The rating agencies, by giving their opinions to investors in the form of ratings, do play a role in the direction and magnitude of international capital flows. Of course our opinions are only part of an investment decision, so it is hard to quantify exactly how large the role of the rating agencies is in that regard. Nevertheless, there recently has been a whole spate of articles in the press criticizing the rating agencies for not giving an early warning of the East Asian financial crisis and therefore for causing capital inflows into the region to be greater than they would have been otherwise, making the problem even deeper than it would have been. Rick Kranenburg's and my firm are prominent in having been blamed for this.
At Moody's, in retrospect, we do believe that some of our ratings were probably too high just prior to the outbreak of the crisis—although we did have the lowest ratings in the industry for Thailand, Korea, Indonesia, and Malaysia at that time. In addition, I think we had given some very clear warnings to the market, especially about Thailand and Korea. In September of 1996, about 10 months before the Thai devaluation, we downgraded the short-term rating for Thailand. In February 1997, we placed the country's long-term debt rating on review and downgraded it in April. During the time that our rating was under review for Thailand, an article in the International Financial Review said many disagreed with Moody's view of Thailand's credit rating. So, we did have this warning that I think was fairly clear, and we had identified the risk correctly, although I have to admit, the rating was absolutely too high. We were, however, moving in the right direction and pointing out the risks involved.
In the case of Korea, in 1996, we had a report that very clearly discussed the buildup of short-term debt and the vulnerability of the country. And in June 1997, still before the initial Thai devaluation, we published a press release announcing a negative outlook for Korea's rating. It stated that Korea's sovereign rating outlook had deteriorated in view of the vulnerability posed by the weakening health of the corporate and banking sector, accompanied by a short-term external debt that had grown to twice the level of international reserves.
So, we think that the warnings in these two instances, at least, and there are others, were fairly clear and to the point. Nevertheless, the ratings were probably too high at the time. And the ratings were too high, because like everyone else, we did not foresee how sudden and how large the shift in investor confidence would be, even though we clearly had stated that these two countries were vulnerable to a shift in investor confidence. As a result of that, in the future, the weight that we place on short-term liquidity in our analysis of countries is going to be greater than it was in the past.
Another reason that the ratings were too high was, perhaps, that despite the experience in Latin America in the 1980s, we did not take fully into account the contagion effect, which was much greater and much quicker than anyone had anticipated. It was exacerbated by the rather gratuitous devaluation of the new Taiwan dollar, which came out of the blue.
I would also like to say a few words about how the IMF affects Moody's ratings. In many countries, where there is a doctrine of too-big-to-fail, or where one way or another it is explicit or implicit that the government will not allow banks to fail, our ratings have to take that into account. Therefore, the ratings are somewhat higher than they would be if the bank was analyzed on a stand-alone basis. We make that explicit in our report. But we also have a second ratings scale at Moody's called the financial strength rating; this is for banks. This is an analysis of the stand-alone position of the institution.
The IMF plays a role in global financial markets that is rather similar to that of a national government vis-à-vis its own banking system. This is the double moral hazard that Professor Becker was referring to. For us, when we believe that IMF support is coming, it is a factor in the ratings, which, after all, measure default risk. If you think that there is a rescue package on the way, the risk of default is less. It's worth noting right now that no Asian government has yet defaulted in this whole crisis, although, in my view, Indonesia is coming close; it is, by the way, the lowest-rated country in the world at this time.
We are now, as a result of all this, considering developing a ratings scale for sovereigns analogous to the financial strength rating of banks. This would seek to measure the country's ability to sustain its external financial position independent of foreign aid or the IMF. So, it would indicate whether or not a country was headed for a situation where it might be bailed out. But it would not directly measure default risk.
GLENN YAGO: If you could develop that financial strength rating, would one factor be the level for which the country is developing its domestic economy, democratizing capital, or opening up its access to capital more broadly in terms of nonstate ownership and development?
STEVEN HESS: Sure. All those factors are already in the ratings that we give now. But in addition we ask, what outside support is this country going to get? That raises the ratings to a higher level than they would be otherwise.
JAMES BARTH: Do you believe the IMF itself is not being transparent enough? It has information that firms like your own do not possess. If the IMF released such information, could it be incorporated into your ratings to enable you to perhaps do a better job rating firms and countries?
STEVEN HESS: The IMF is becoming much more transparent now. If you look at their website they now have regular press releases, and a lot of financial data is released every time they go on a consultative Article IV mission to a country; they release their report, which they didn't use to do at all.
JAMES BARTH: But only with their permission.
STEVEN HESS: I think there is some editing in there; it does not necessarily have all the details that you would like to have. In our own case, I think we generally have access to much of the same information. We would certainly favor the IMF publishing virtually everything that would make their life difficult, I presume.
JAMES BARTH: Would you prefer that the IMF, as some people would prefer, actually rate the countries itself?
STEVEN HESS: Of course, we think that we can serve that function. But another rating scale from the IMF could be useful. We don't mind competition.
HENDRIK KRANENBURG: I think the IMF has actually said they find that to be a conflict of interest to them.
PAUL HOLDEN: There are two issues. One is that when the IMF begins to publish its reports, the frankness of the reports goes down. When I was at the IMF, when reports were not published, we always compared ourselves with the OECD (Organization for Economic Cooperation and Development), whose reports were published on a regular basis and which went through extensive vetting by the government in question, as do IMF issues. The meetings are all ministered and then the governments vet the minutes. Sometimes governments are less than frank. In the Mexico crisis, the Mexican government never let on the extent to which their international reserves had been depleted. These were confidential data.
STEVEN HESS: Not to mention Korea.
PAUL HOLDEN: So there are some confidentiality issues. And if the IMF begins publishing those things, then it is going to be hampered by even less frankness by the governments that are getting themselves into trouble. So it is a tricky issue.
RAYMOND MIKESELL: Reference has been made to bailouts by the IMF. Originally the purpose of assistance by the IMF was not bailouts for countries experiencing a capital market and debt crisis. What evolved was something quite different. I want to provide a little history and raise the question of whether we should look at the IMF's function mainly in terms of dealing with immediate crises.
I do not think that the IMF can deal satisfactorily with capital crises. I think it should deal with problems that are much more fundamental. A major criticism of the large loans that the IMF has been making to East Asia and that it made to Mexico in 1995 is that these loans finance short- or medium-term debt repayments or speculative short-term capital flight. This contrasts with financing current account deficits, which was initially the primary purpose of financial assistance by the IMF.
The question of whether the IMF should finance capital movements, or whether it should only finance only imports of goods and services when they exceed current export earnings plus long-term capital imports, is an issue and source of dispute within the IMF that goes back to the beginning of its operations. As one of the few surviving participants in the 1944 Bretton Woods conference, as well as being present at debates between Harry White and John Maynard Keynes back in the early 1940s, I will engage briefly in my academic propensity to cite history.
The IMF evolved from Harry White's plan of 1942, which was designed to promote a world of stable exchange rates, free from exchange controls that impede trade and foreign investment. Under the White plan, the IMF would provide foreign exchange to a member when needed to meet an adverse balance of payments, predominantly on current account. But White did avoid any specific requirement of exchange controls or capital controls as a condition for obtaining foreign exchange from the IMF.
Keynes' Clearing Union, which was the major rival proposal for creating a post-World War II financial order, also provided that the clearing union would not cover member deficits unless they were current account deficits. Members were required to control their outward capital movement. In fact, Keynes argued that all countries, including the United States, should adopt exchange controls—but that was related to his desire to perpetuate the sterling bloc, which he was not able to do.
A compromise position between White and Keynes was embodied in Article VI of the IMF Charter, adopted at Bretton Woods. This states that a member country may not use the IMF's resources to meet a large or sustained outflow of capital, and that the IMF may require a member country to exercise exchange controls or some form of capital controls to prevent such use of the IMF's resources.
Shortly after the IMF started operations, the problem of how Article VI should be interpreted came up; there were a series of interpretations, but no formal rules. Over the next decade a number of cases arose involving the application of Article VI. An early one was in 1954 when Mexico applied for a standby credit at a time when the country had both a current account deficit and a very strong speculative outflow of capital, which was really the basic problem. But Mexico did not employ capital controls; it was one of the few Latin American countries that did not at that time. Mexico's request was approved because Mexico agreed to devalue the peso in order to correct the current account deficit. In 1956, Britain requested a substantial drawing to deal with the loss of confidence in sterling during the Suez Canal crisis. The IMF approved Britain's request, but on the grounds that it needed to restore confidence in sterling rather than to finance a current account deficit, which it really did not have.
STEVEN HESS: That seems to indicate that Lord Keynes, Harry White, and those of you discussing it at the time felt that the IMF could have been put into a position of subsidizing capital flight rather than constraining it?
RAYMOND MIKESELL: Neither Keynes nor White believed that the IMF should subsidize or finance substantial capital flight. What both had in mind with regard to IMF assistance was that if a country incurred a deficit—and they usually thought in terms of a fall in export prices or of some internal condition that would cause the country to have a current account deficit—the IMF would provide assistance. The deficit would be financed while the country adopted the necessary measures, such as changing its exchange rate and its policies, to correct the deficit. They looked only at the deficit on current account because the country could not promote growth and full employment unless it had sufficient imports.
|James R. Barth, Auburn University|
|Glenn Yago, Milken Institute|
|R. Dan Brumbaugh, Milken Institute|
|Steven Hess, Moody's Investors|
|Paul Holden, Enterprise Research Institute for Latin America|
|Hendrik J. Kranenburg, Standard & Poor's|
|Raymond F. Mikesell, University of Oregon|
|1:45 pm - 3:15 pm THU 3/12|
|MICHEL OKSENBERG: The underlying theme of the presentations today is that most countries around the world—especially China—would be much better off if only they could become more like the United States, particularly in terms of their economic institutions. I largely agree with that notion. But, would we feel so confident about that prescription if the U.S. economy were doing less well? That is to say, to what extent is our analysis of the situation conditioned by how we feel about ourselves at this moment?
We also have learned that Japan is in a protracted period of difficulty; that Korea perhaps has begun to make some adjustments necessary for its recovery but that it may take two to three years before its growth rate returns to previous levels; and that much of Southeast Asia, with the possible exception of Indonesia, has turned the corner (although some question remains about Malaysia), perhaps leaving room for cautious optimism, two, three, or four years down the pike. Indonesia remains a huge question mark.
Thus far, this picture has not considered the two giants of the region in population terms, India and China (defined as greater China, including Hong Kong and Taiwan). In China, there has been a dramatic increase in foreign currency reserves in the hands of what might be called the largely ethnic Chinese governments. We should not treat the three as a singular whole, as there are deep divisions among them, but their $300 billion in foreign currency reserves shows the cumulative strength of these entities.
Can China broadly defined and/or India serve as locomotives for regional and perhaps even global economic growth in the coming three or four years and in the absence of high performance by the other parts of this region?
NICHOLAS LARDY: China, like Korea, Thailand, and Indonesia, has experienced a huge buildup of domestic credit. Credit has been growing at an extraordinarily rapid rate for over 20 years. Even in these years of so-called tight money, credit is growing at more than twice the rate of GDP (gross domestic product). The average firm in China, a state-owned company, has a debt-to-equity ratio that's greater than the average Korean chaebol. There's a huge increase in credit, a huge buildup of debt on corporate balance sheets, and as a consequence, very low rates of return on real assets.
China, like other Asian countries, has an extraordinarily bank-dominated financial system, even within the Asian context. Several have pointed out that bank-dominated systems with underdeveloped capital markets allows the underpricing or mispricing of capital. China is Asia's best example of this phenomenon. The United States' biggest bank, Chase (after the merger) has assets that are 4 percent of U.S. GDP. The biggest bank in China has assets that are 60 percent of Chinese GDP.
Additionally, there is a very weak regulatory regime and supervision of banks. This is critically important because China has been trying for several years to commercialize its banking system. You're never going to succeed if you don't have any reasonable system of supervision and prudential regulation.
China is similar to other Asian countries in that it has a huge buildup of nonperforming loans in the banking system, higher than in precrisis Korea, Thailand, or even Indonesia. China's major state banks are insolvent by a very wide margin. They are not illiquid, because the savings rate is very high. There are no alternative financial assets, so the money keeps pouring into the banking system, and the banks keep making more bad loans.
It's a recipe for disaster. Why has there been no crisis? Several things contribute: no capital account convertibility; a very strong current account position (China is coming off its greatest single year of current account surplus); the borrowing that is done is mostly long term; and significant reserves. Thus, China has a lot of insulation in the short term. In the longer term, it is as vulnerable as other Asian countries because of its similar structure.
What are the Chinese doing about it? Under Zhu Rongji, over the last four months, China has made an extraordinarily intensive effort to follow what has happened in Asia, what its causes are, and what its solutions are. I think you see that reflected in the Party congress last fall, in the National People's Congress that is still under way in Beijing, and in all the reforms that have been announced piecemeal over time. Cumulatively, they are fairly impressive. The first is reorganization of the central bank to improve its independence and particularly to reduce the power of provincial and local officials to force banks to make political loans. That's another respect in which China is very similar to other countries in Asia: a great deal of the lending has been based on political considerations rather than any hard-nosed credit assessment.
Second, there is going to be a significant recapitalization of the banking system of U.S. $32 billion, roughly 270 billion domestic Chinese currency units. It's too small by a substantial margin, but it's a very nice first down payment on what will be a long-term process of rebuilding the banking system. Combined with that they are providing more funds for restructuring. This is what is really needed in the industrial sector, where there is a large excess capacity and a huge buildup of nonsalable inventories, as a result of the underpricing of credit over the past 20 years. The government is now in a posture of encouraging mergers and acquisitions, and they have put considerable amounts of money toward "de-leveraging" the industrial sector so that when mergers occur, the acquiring firm can agree to pay only a portion of the liabilities to the banks of the firms it's taking over. That is a very encouraging development.
Banks are under more and more pressure to operate on a commercial basis. The lending quotas that have driven much of their activity in the past are being eliminated. Incentives for bank managers are dramatically changing, so there will be more concern about profitability. Historically, bank managers have reported on only one thing and that is how much their assets have grown. There's been a huge reach for assets without any consideration of quality that has led them to the terrible position they're in now. That is beginning to change. Interest rate flexibility is also being introduced, and there will be more encouragement for pricing loans at least somewhat taking into account risk, as opposed to the old system where every one-year working-capital loan had the same interest rate. The regulatory environment is being tightened; a new loans classification system based on international standards will be introduced by the end of the year, and a lot of unauthorized, unlicensed financial institutions are being closed. These are all steps that are to be welcomed.
Finally, a very concerted effort is now under way to get a better measure of what China's total foreign currency-denomination debt really is. The official numbers quite frankly are highly fictitious. They are not only, however, trying to measure it more accurately by tightening up the reporting requirements, expanding the definitions, and so forth but also they are putting into place a number of regulations that are going to prohibit certain kinds of nonfinancial institutions with no foreign-exchange assets or no foreign-exchange earnings from borrowing abroad in the first place. Again, that reflects their reading of the Korean situation.
Zhu Rongji has set for himself an extraordinarily ambitious agenda of solving these problems in the banking sector and in the real sector, on the industrial side, and on a very accelerated time program of about three years. He is coming out of the congress now with an unprecedented degree of power and strength, particularly in the economic area, and has the support of Jiang Zemin, who is only too happy to have him take the brunt of a very, very difficult assignment.
If China can push through on these reforms, they will have two tremendous assets going forward that make me somewhat more optimistic about China than India. First, its savings rate is twice as high as India's. The savings rate in China has been in recent years over 40 percent. If they can begin to use this capital more efficiently, they are going to be able to sustain very high rates of growth and even have more improvements in consumption than they've had over the past couple of decades. Second, government debt—domestic debt—is extremely low, less than 10 percent of GDP. They are in a strong position to take aggressive action as they move forward restructuring the enterprise sector and enforcing commercial behavior on the banks. The direction in which they are moving is promising in terms of China's ability to sustain economic growth and be a source of stability in Asia. I believe China is likely to be much more important to the stability and future of Asia than is Japan.
JOHN PRAVEEN: Can India or China step up and provide the engine of growth within the Asian region? First, as to the issue of why India has been relatively less affected by the Asian crisis, the level of external debt in India is quite low. The latest numbers show it is under 25 percent of GDP. Now, within that, the level of short-term and interest rate-sensitive debt is about $7 billion, which is under 2 percent of GDP. Second in terms of current account balance, unlike China, India does have a deficit, but it consistently has been under 1.5 percent of GDP. And it is financed by a large inflow of portfolio and foreign investment, so it is at a low and manageable level.
Third, unlike the case for most of Asia, where banks made very aggressive property and speculative real estate loans, as well as loans that served to build up a lot of excess capacity in industries, Indian banks have not aggressively lent for property and for speculation in real estate. The level of nonperforming loans in India is low relative to the other countries in the Asian region.
Finally, India is not very closely linked through trade with the rest of Asia. The level of intra-Asian trade is very high. For example, about 40 percent of Chinese exports go to the rest of Asia and about 33 percent of Chinese imports are from the rest of Asia, whereas just about 20 percent of India's exports go to the rest of Asia, and less than 7 percent of India's exports and imports are with the Asian region. Therefore, India was able to escape the contagion effect from the rest of the region.
The government of India has admitted that growth in the last year is going to be down to about a 5 percent rate. The average for the last couple of years was around 7 percent. The reasons are that investment spending has decreased because the government is working toward deficit reduction and public expenditure on fixed investment has come down. Because of political uncertainty business confidence is down; that has taken a toll on private investment and capital expenditure. Indian exports are also down, because a very large share of India's exports—about 25 percent—go to Europe, and soft demand conditions in Europe and in Japan have had a very negative impact on India's export performance.
The Indian rupee has also appreciated, and that has taken a toll on Indian exports. Therefore, growth is going to be down this year. The currency has lost about 10 percent, moving from rupees per U.S. dollars 36 to 39. But that is a very small move relative to the 60 percent-70 percent currency depreciations that many of the other Asian countries have experienced. And since these are cyclical factors, I do think that there will be a recovery. The government has decided it will undertake increased expenditure on infrastructural projects, which should stimulate investment demand. We should also expect a pickup in exports because of the recovery in Europe and because of the depreciation of the Indian rupee. So all of these factors suggest that the Indian economy will recover and will not experience the kind of slowdown and the kind of recessions that are predicted in the other Asian countries.
With respect to the medium-term and long-term outlook, both India and China are expected to undertake massive amounts of infrastructure expenditure. In India, it is projected that about $150 billion will be spent on infrastructure over the next five years. It will be a positive development if India and China do so because in the rest of Asia capital expenditure is going to be down significantly. Hopefully, this infrastructure expenditure in India and China will pick up the slack.
In 10 years, India and China will emerge as even more dominant global players. The World Bank projected that over the next 10 years China's share of global GDP will increase from about 1.5 percent now to more than 4 percent. India's share will increase from about 1 percent now to about 2.5 percent in the next 10 years. The share of China and India in global trade is also expected to increase significantly. In the next 20 years China is expected to emerge as the second biggest trading nation in the world, under the United States and higher than Japan. Japan's share is expected to be about 5 percent of global trade and China's will be 10 percent. India's share is also expected to go up, from less than 1 percent now to about 4 percent. So, both India and China are going to be major global players in terms of trade and of the level of economic activity.
In India and in China right now, capital markets are not very well developed. In India they may be a little better developed than China. China has more bank-related finance. In terms of statistics, the market capitalization/GDP ratio for India is about 35 percent; for China it is about 15 percent. For the industrialized countries as a whole, the average is about 70 percent. If over the next 10 years India and China's growth rates increase at a very fast pace and if the market capitalization to GDP ratio increases to one that is close to the average industrialized nation's, there will be a tremendous increase in equity markets in both India and China. For those of us who have been nervous about investing in emerging markets, this suggests that there is still a lot of life left there.
HARALD MALMGREN: Over many years of negotiating government-to-government with politicians, trying to liberalize markets and deregulate, I have found that politicians in every country, not just East Asia, almost always vote against change. They generally want to slow the change down because it is painful. Moreover, they have to do one thing that is very popular with voters: insulate the domestic economy from foreigners. This process is at work throughout East Asia now when you have so much advice being given.
Everybody has talked about the need for leadership, and it reminds me of the immortal words of the former U.S. Senate Finance Committee Chairman Russell Long. I once told him, "Chairman, we have a leadership crisis." And he said, "Look around you. Look at all those governors, congressmen, senators, mayors, PTA leaders. Everybody is a leader. Nobody wants to follow anybody. We've got a followership crisis, not a leadership crisis." I think in Asia this is a big problem, either with the present governments or with governments to be. Corruption is endemic in much of East Asia. High officials tend to spend most of their lives planning for retirement. The irony is they never retire. So they stay there and they fight against change.
The population growth rate in India is higher than in China. So in 2025 or 2035, India will be bigger in population terms than China. What we have is population change that is structural; that is significant. Unemployment will certainly rise in China, and it will be a significant and prolonged problem, especially in the nonurban areas. But eventually it will be in the cities, too, because people move from the country to the cities. Unemployment is going to be a really serious problem, and that could cause social unrest.
In China, we have a vertical and horizontal fragmentation of authority. There are overlapping ministries and jurisdictions; many signatures are required for anything in Beijing. Worse, all business is local, so you find that people at the local level, in a city or in a small area, ignore completely what the national government wants to do. Everything is then very specific. So there is a kind of centrifugal force at work in China, and Zhu Rongji is trying to catch hold of it. But it's not at all clear he can. China is a big place, not so easily managed with a small cadre of people at the center. And tax revenues are collected locally, which gives power to the local people. They can turn the tap off and argue with the central government.
India is also fragmented. There is internal warfare between various political groups, not only at the national level but also between the national government and the states. The BJP took a larger role in this election on the national level, but in Maharashtra, the most industrial of the states, the BJP was thrown out. All of these forces are at work.
China is strong in its administrative structure, but it is lacking in depth. India does have the British administrative system: an unyielding rigid system that doesn't like to give in. Bureaucrats compete with each other for jurisdiction. Both have the problem of administering huge countries.
We don't know even now what China's financial problems are, just as we don't know in most of East Asia yet what the full dimensions of the problems are. In India we know a lot more because it has, again, the British system; at least it has an accounting system of some kind.
I expect that India, for the time being, is likely to slow down reforms partly because the BJP will be opposed to economic reform and partly because in the upper house of the Indian Parliament the BJP is not very strong; it can't get through any troublesome reforms other than the budget itself.
In China, there will be a continuing battle as to who really decides what. Will the central government be able to enforce its decisions at the local level? This is a big problem in terms of the continuing saga of whether China can be brought into the WTO (World Trade Organization). There are many people in the United States and Europe who are saying that although the Chinese government nationally can commit to many things, it can't carry them out because the actual decision-making power will lie elsewhere in the Chinese economy. China's legal systems are weak, as are judicial systems and the enforcement mechanisms.
China is trying to enter the WTO both to achieve some legitimacy and to use international pressures to help bring about reforms internally. India has been in the World Trade Organization and in the GATT (General Agreement on Tariffs and Trade) for years. And, frankly, India has been the most troublesome member of the WTO and the GATT ever since it was a member. It's always looked for exceptions, trying to organize various developing countries against whatever the developed countries wanted to do. I am not sure whether it is great to have a country like India in, and I'm not sure exactly what we do with China if it is brought in, if it behaved in the same way. I would hope that it would be a completely different picture.
We have a short-term debt problem right now, and there is tremendous relief in financial markets that somehow it's all over. But it is just beginning. Phase 2, restructuring, is going to take two, three, or more years, because we need generational change—not only in transparency, regulation, and so forth, but in a generation of people who can count, who can be diligent, and who can evaluate assets. This does not exist, and you can't just parachute in outsiders to do it, because they are not going to be accepted. So, a generational change is required. I am not sure how long such restructuring takes.
But if phase 3 comes and growth resumes in three, four, or five years there will be a problem because India and China will have huge energy demands. Most of the energy companies feel that when growth resumes at a high pace in India and China, and some moderate growth occurs in East Asia, that within six to eight years there will be huge bottlenecks in the energy sector. There will still be unemployment problems because no matter how much restructuring occurs, not that many people are needed to do most of what is involved in world trade today.
Because of the energy constraint and the unemployment constraint, national security planners now feel that there will be a strong compulsion for China to engage in blue water power projections to push its navy out—not to take land but to take the South China Sea as its domain, in order to establish its sovereignty over that energy source. That is a big question mark in the future, and that is not something that India will do. I do not think China will do it. But as we look to the future, phase 1 is troublesome, and phase 2 is going to consist of many failures on the way to progress in India, China, and throughout East Asia; there will be lots of troubles and, from time to time, another tsunami if one of them adjusts its exchange rate. Finally, in phase 3, other constraints start to apply, and we should be thinking about those later.
ANDREW TANZER: We have not heard too much about Taiwan today, and I think the main reason is that, by and large, Taiwan has managed to stay out of trouble in Asia, which is no mean feat for Asian countries these days. For example, from the beginning of 1997 to date, excluding India, the Taiwan stock market has been the only Asian stock market to rise, both in local currency and in U.S. dollar terms. In fact, in 1997, eight out of the best ten performing stocks in Asia were in Taiwan, most of them in the technology sector. Taiwan's GDP growth of 6.7 percent was pretty much in line with previous years. This year it will fall a bit, maybe to 4-5 percent, because exports inevitably will be affected by weak markets in Asia.
Taiwan's currency depreciation has been 15-20 percent, which by Asia's standards is pretty moderate. In Southeast Asia now you see many Western multinationals scouting for acquisitions. You also come across many Taiwanese companies flush with cash looking for acquisitions. And there have been a number already. For example, Yamaichi's Hong Kong business was acquired by a Taiwanese securities company.
How has Taiwan managed to stay relatively resilient? One reason is macroeconomic management; the second reason is the structure and financing of Taiwan's private sector. On the macroeconomic side, Taiwan has historically been extremely conservative. That was probably driven more than anything by its political vulnerability; it was kicked out of the IMF (International Monetary Fund), the World Bank, and just about every other international organization many years ago. So, it essentially has no lender of last resort.
Historically, Taiwan has maintained extraordinarily high levels of foreign exchange reserves, which are almost off the charts in terms of imports cover. Currently is has about $84 billion of foreign exchange reserves. This has been useful in recent times in defending or protecting the currency, the NT dollar. Taiwan also has had a tiny foreign debt. It has chosen to grow mainly on domestic savings. This is quite unlike Korea, Thailand, or Indonesia, especially in recent years for those countries. For 17 or 18 consecutive years Taiwan has run current account surpluses, and it remains today a very large net international creditor.
I think it is especially interesting to compare Taiwan to South Korea. In Taiwan's economy the private sector is dominated by tens of thousands of small- and medium-sized enterprises. These have proven to be very flexible, reacting to market forces, not protected by government. They tend to have very low debt levels, and they are allowed to go bankrupt. They are highly entrepreneurial. Korea has an especially large concentration of resources in the chaebol, or the family-run conglomerates. And historically the government, through a very compliant banking system, has allocated resources to the chaebol. It sounds a little simplistic, but Taiwanese companies are very much interested in profit seeking. This does not sound so strange in America, but in Korea and Japan, the focus in the past was on market share and volume growth.
In Taiwan the allocation of capital has been left more to market forces; this is one reason it does not have the huge overcapacity, with a few exceptions, that exists in Korea, Thailand, and Malaysia. Overall in the 1990s, Taiwan's capital investment level has been relatively low by Asian standards. It has been generally 21-24 percent, and yet it has generated a very high level of economic growth, between 5.5 percent and 7 percent nearly every year.
The computer industry is a microeconomic case of the flexibility of Taiwan. Taiwan, after the United States and Japan, now has the third largest personal computer industry in the world. And just like in the rest of the economy, you see hundreds, even thousands of companies, small- and medium-sized enterprises, dominating this industry. You see keen competition. The companies tend to be specialized in niches—in components, peripheral devices, even assembling computers, which contrasts with Korea and Japan, where the electronics companies have tended toward considerable vertical integration. Taiwanese companies and their niches collectively have achieved very high global market shares in the PC industry.
China is now casting about, looking for ideas and models for state-run enterprise reform and for its industrialization process. It could do worse than look at Taiwan. Taiwan has a very dispersed, decentralized decision-making process in the private sector, a bottom-up approach. Korea has much more of a top-down command approach. Unfortunately, China, at least recently, has talked about the Korean chaebol model, although maybe this has been somewhat discredited by recent events. Taiwan's system has consistently had a better income distribution than Korea, lower unemployment levels, and better labor relations.
Only two years ago China was firing missiles in the Taiwan Straits, and less than a year ago Hong Kong returned to Chinese sovereignty. And less than a year ago the media were making all sorts of apocalyptic predictions and speculation about Hong Kong after the return to China. Overall, China has handled the transition to Chinese sovereignty of Hong Kong very well. It has been quite smooth. China and Taiwan economically need each other more than ever. As the assets of overseas Chinese and Southeast Asians have been decimated and as other important foreign investors like Korea and Japan are in considerable distress, Taiwan's direct investment will become even more important. China needs the capital from Taiwan, the technology and the marketing know-how; Taiwan needs the China market. In the 1990s, the export growth from Taiwan to China has accounted for a considerable share of Taiwan's overall economic growth.
Over the medium- to long-term there is still considerable political risk between Taiwan and Hong Kong. The power of the KMT, the party that has ruled Taiwan since 1945, is eroding now. Last year it lost local elections. Late this year there will be legislative elections, and it could very well lose control of the legislature. The principal opposition party, the Democratic Progressive Party, has in the past made calls for independence for Taiwan. It recently gained power in local elections and it looks like it could potentially gain power over the island. It has moderated its call for independence; yet I think the rise of the DPP, as it is called, could create great uncertainty in Taiwan-China relations.
MICHEL OKSENBERG: At the end of last year, the DPP became the dominant power at the local levels. There are some more elections coming in the spring. The DDP is likely to do well again. The consequences of this for the presidential election of the year 2000 in Taiwan are still quite uncertain.
CHRISTOPHER LEGALLET: It's important to separate countries in Asia. Comparing these countries is like comparing America to Canada and Canada to Mexico; it doesn't always make sense. The only investments we have found over the last couple of years in Southeast Asia are in Singapore, where we find the banking and services sector to be attractive, highly capitalized, well managed, and conservative. Most of the rest of our investment is in Hong Kong and China. Greater China, Hong Kong, and Taiwan are very well-managed economies, very fiscally prudent. The corporations have fantastic management. The debt levels are very low compared to the rest of Asia. Average debt equity in Taiwan is 7 percent; in Hong Kong it is only 14 percent. Analyzing China, however, there are some very highly leveraged companies. They tend not to be listed as much on the stock exchange. Many of the companies listed on the stock exchange right now that are investing in China actually have net cash positions as well. Looking at greater China, one of our main investment premises is that if you combine the natural resources and the labor of China with the technology and capital of Taiwan and the financial know-how and capital of Hong Kong, you have a global competitive advantage that I think is going to be very hard to beat in the next decade.
Is China going to be able to sidestep the current Asian financial turmoil? I think it will and, in a strange way, it may actually be benefiting from it right now. Exports will slow—that is only natural—as will foreign direct investments. There will be some loss of competitiveness due to the devaluations. But what is important is that although net exports have been an important driver of marginal growth in the Chinese economy for the past few years, the main reason for that is because domestic growth has been stagnating. Domestic growth is still the main engine of the total economy. Net exports make up a small percentage of the total economy. So domestic growth is the key in China. And reforms are the catalyst.
China can finance itself, and in spite of the devaluations, China will remain competitive. With regard to domestic growth, there has been quite a few announcements on fixed capital formation. Most recently, the governor of the People's Bank of China announced that they would spend about U.S. $1 trillion over three years in fixed capital formation. It is possibly achievable; according to some documents, they spent about $850 billion in the past three years, so it is not as big of an increase as one might think. But it is probably not completely realistic, either.
In 1992, Deng Xiaoping made his infamous visit to Shenzhen. He said to be rich is glorious. He embraced capitalism and free markets, and at that time there was a massive fixed-investment boom. In 1993 fixed investment grew at 70 percent year on year. A lot of that was duplicated assets, manufacturing over 30 million televisions when the demand for televisions was only about 16 million. They have airports that they are not using and commercial real estate that is sitting vacant. There was a lot of unbridled enthusiasm toward investment; it all went down the drain and it is going to have to be written off. That is where a lot of the nonperforming loans are coming from.
Today's top level of government was there when that happened. They want to prevent that from happening again. So although they're talking about this $1 trillion worth of investments, they would like to see that it is done not from the government coffers but rather on a private basis, and that it earns a reasonable return on the investment. That is going to create a tremendous investment opportunity for us as well as companies that are taking a look at these different investments—whether it is going to be in low-cost housing, roads, infrastructure, or toll bridges—if they're allowed to get a reasonable return on investment.
Over the last 20 years, the real success of China has been the reforms. China is still very much a rural economy. In the early 1980s, they started with reform. Since then their leaders have gained the confidence to continue to reform. Now with the Asian contagion and despite the worries there, they have quickened the pace, since the 15th Party Congress in September. Just looking at some of the things they are trying to do—banking reform, the $270 billion in banking recapitalization—that is a huge positive. Back in 1993 when they had all those problems, they tried to stop lending to the weak. They have let several hundred of the weak companies go belly-up. They are going to need to let a lot more go, admittedly. They are letting the stronger ones survive and gain market share.
Another area of reform is government reform. In the Ninth National People's Congress that is being held this week, there was a vote to cut government by half, from 8 billion to 4 million workers. That is a great example of the government saying to the people, we are going to be part of this downsizing as well, which will alleviate some social tension—not all. But Zhu Rongji, who championed most of these reforms, is trying to separate politics and regulatory bodies from operating companies in business. That is huge—something that the World Trade Organization and many academics and economists have asked them to do for a long time. And they are doing this right now. I think these are sweeping changes this week, and we are sort of yawning at it.
MICHEL OKSENBERG: China is a Communist country, dominated by a Communist Party. All personnel appointments of significance are made by the Communist Party. Can the Communist Party transform itself in order to enable these various reforms, so promising in their enunciation, to be actually implemented? I am very struck by the continual statements that the government should be separated from enterprises. I haven't heard the statement that the party should be separated from enterprises. I haven't heard a resurrection of the slogan made in the 13th Party Congress in 1987, when Zhao Ziyang was the general secretary, that the party and the government should be separated. If crony capitalism is to be avoided in China, core to the separation must be that personnel appointments must be truly based on merit, not on political criteria, and that, for example, the banking systems' personnel will no longer be under party purview, that the financial system and the people who collect taxes will no longer be under party purview. The territorial party committees control the appointments, and so the linkage between politicians, bankers, and enterprises is made in the management of personnel. Moreover, I have not seen any desire to create a judicial system in which the judges are not appointed by the party.
Why are you so optimistic that the Communist Party in China will be able to transform itself into a corporatist party, as the Kuomintang in Taiwan or the PRI in Mexico? Why the optimism that the recently enunciated changes will amount to anything? Or must we not remember one of my favorite old saws about China: namely, usually there is less change there than meets the eye?
NICHOLAS LARDY: One reason for optimism in terms of the party transforming itself in some kind of coherent rational fashion is that the alternative to these reforms is the certain end of the party. If they do not fix their banking system, if they do not have a more efficient system, the long-term rate of growth of this economy is going to grind down; it is going to get slower and slower, and then they will have unemployment that is not just part of some transitional restructuring process but that is permanent. They can restructure the system if it is perceived as a transition. At the end of the day, they will have a more efficient system generating more jobs. If they can really push to commercialize the banking system over a period of two to three years, as Zhu Rongji says, they will generate more jobs than they have ever generated in the past. You can have higher consumption and still have a 6-8 percent rate of growth. I think this is the only chance the party has of staying in power.
If they don not change things, the growth rate will decline and they will have permanent problems that they will never be able to deal with. It will be the end of the party. I think they understand that. And I think that is why they are pushing very hard on reform. Zhu Rongji certainly understands it—this is why he is going to this organization of the central bank on a regional basis like the Federal Reserve in the United States: political leaders at the provincial level will no longer be able to command resources through the banking system.
Obviously there are lots of complications, and many of their problems in the larger state firms do stem from the intrusion of politics, the continuing role of the party. But many enterprises, about a million, really have been effectively taken out of the government system. These include township and village enterprises, a lot of small state-owned enterprises that have been effectively converted to stock cooperatives. The role of the party in those enterprises is dramatically reduced. They are going to a shareholding system, limited liability. The role of the party in these enterprises is going to be squeezed out. They're going to have to compete for funds and over a period of time, we will see a substantial transformation.
On the larger political scene, then, the only reason for optimism is that if they don't change, they're history.
MICHEL OKSENBERG: Could you see fragmentation of India because of the multiparty system, growth in regional parties, and the decay of the Congress Party?
JOHN PRAVEEN: No, I do not. Yes, there have been a lot of regional parties, which have been doing well in some of the states. But we are clearly seeing the images of two major parties: on the one hand the Congress and on the other hand the BJP as dominant national parties. There will also probably be some regional parties with some influence on local issues. But that will probably not be an impediment at the national level.
I do not see a demise of the Congress Party. It has probably been in decline until at least recently. Actually in this election year there has been a change of fortunes, and under proper leadership and better organization, they will be able to re-emerge as a dominant political party, able to articulate national issues. I do not see any kind of a disintegration in that sense.
|Michel Oksenberg, Stanford University|
|Nicholas R. Lardy, Brookings Institution|
|Christopher Legallet, Newport Pacific Management|
|Harald B. Malmgren, Malmgren-O'Donnell|
|John Praveen, BEA-Credit Suisse Asset Management|
|Andrew Tanzer, Forbes Magazine|
|3:15 pm - 5:00 pm THU 3/12|
|C. FRED BERGSTEN: Japan represents two-thirds of the Asian economy, so it is hard for Asia as a whole to recover without some significant improvement in Japan's situation. The problem is that Japan's growth has been very slow for seven years, under 1 percent on average---for all practical purposes, close to zero. So Japan is not adding to the region's growth.
In a way Japan has exploited growth in the rest of the world, exporting some of its problems to the rest of Asia and to other regions. So in a sense Japan is part of the problem, rather than part of the solution. What the world, and particularly Asia, needs in operational terms is a decline, rather than a continued increase, in Japan's external surplus.
Japan can lend extensive amounts of capital to the Asian problem countries, as it has done. But what Asia needs even more than credits is growing markets that will enable the other Asian countries to improve their external positions and achieve that part of their necessary adjustment. This is also important to the other industrial countries, including the United States and Europe.
This leads back to the problems of Japan's growth, both its level and particularly its nature. Over the last seven years Japan's average growth has been 1 percent or less; yet until the last six months, it has lived in what is by far the most rapidly growing neighborhood in the world, one that provided half of world expansion. Further, Japan has had over $500 billion worth of fiscal stimulus programs; for the last three years, it has had essentially zero interest rates; and it has had a huge trade surplus. With all those factors, how was it possible to achieve virtually zero growth? It seems to have taken some effort to do it. Japan has been the sick man of both Asia and of the industrial countries in the OECD (Organization for Economic Cooperation and Development). This is both a policy and an intellectual challenge.
How did this happen? Why has the Japanese public let it happen? Why have they not demanded policy change? Why must it be gaiatsu, pressure from the foreigners, to try to push for change? Has Japan lost its potential for leadership in Asia, or in the world more broadly? Is it increasingly an anomaly that Japan is the only Asian country in the G-7, in the leadership group? Should China bypass Japan as the leading economic light in Asia?
NORIKO HAMA: The Japanese economy suffered from what I call the Luciano Pavarotti syndrome: It grew too large for its own good.
Japan at this point in time reminds me of a novel written by the American author, Stephen King, called Thinner. It is about a chap who has the curse of the gypsy upon him, as a result of which he gets thinner and thinner, almost shrinking into nonexistence, even though he consumes a huge amount of high-calorie junk food. This is what is happening in Japan at the moment. Huge amounts of money are being ingested by the economy, but the economy gets ever thinner. At the focal point of this shrinking process lies the financial crisis.
To give an example of the effects of the shrinking process: A couple of weeks ago, three Japanese small-business owners committed suicide because they saw that they were not able to meet their debt obligations for the end of this fiscal year. Why were they not able to do this? Because the banks were not there to lend to them. Why were the banks unwilling to lend to them? Because the banks themselves had to put their houses in order in terms of capital adequacy requirements. We have to find a viable course that lies somewhere between Luciano Pavarotti and the shrinking man.
The moment for Japan has not passed. I think we are going to be able to find a viable path between these two extremes. But probably more important and more interesting, we need to rediscover in Japan our heterogeneity. All this business about a homogeneous Japan is completely untrue. The diversity in Japan needs to be rediscovered, and I think it will happen because it is becoming a matter of survival.
The public have been locked into an ancien regime, a postwar institution that was rapidly becoming outdated. But now that they realize that this is not the way to survival, they are revolting. The so-called Japanese capitalist system was a system for a certain point in time. There is nothing that cannot be changed about it, nothing quintessential or culturally Japanese about it. It was a thing that was taken up as an expediency in order for Japan to make it in the world in the early years of this century. In the future I think we will return to great diversity.
ERNEST HIGA: I am an entrepreneur, so my views might be a bit more nitty-gritty.
I have had to deal with the economic environment in Japan for the last few years. Japan has been in one of the worst recessions since the war for the last seven years, and the Japanese government reacted by increasing the consumption tax from 3 to 5 percent, increasing health costs, and taking away a very small tax break. Of course, the economy got even worse, and the Japanese government was surprised that this happened. It caused a credit crunch, and now even companies in the black are going bankrupt because banks are pulling back from lending to them. This is also being reflected in the Asian markets, because now the Japanese banks are pulling back from lending to the Asian companies, too.
This very large bubble is open to implosion if there is any prick. The prick in the Japanese economy was the Japanese government suddenly saying, "This economy overheated too much; perhaps we should put in some regulations, and reduce the cost of real estate." That decision may have been a bit heavy-handed, and it caused the implosion we see today.
It is hard to say why the people let it happen, except that often the Japanese government is run not really by the people but by the bureaucrats.
Has the moment passed for Japan? Japan in the past has faced many kinds of issues, and it has come back every time. Japan is very resilient, simply because the biggest resource it has are its people. I am sure that it will come back from this crisis.
ALEXANDER KINMONT: Essentially, Japan is not a capitalist country. It made that decision in the late years of the 1930s, and at no point in the postwar period has that decision even been questioned, let alone revoked. The system that was constructed in that period is now coming under strain, but there are still no major attacks being made on capital market structure, which is the determining feature of Japanese capitalism. It is the determining feature because the capital markets have no role in the allocation of capital within the economy. Therefore there are no owners of capital; no one is demanding a return. And therefore, there is no return.
This relates directly to the question of why the crisis happened: because no one has been hurt except the shareholders. But nobody feels that they own the life insurance companies. Ordinary life continues, unemployment is at 3.6 percent; even on wider measures it has not gone above 7.5 percent. Ordinary people have not been hurt. Japanese companies are not downsizing; they are still expanding—just expanding more in Asia than in Japan. For example, Hitachi has added in the last eight years 1,000 employees in Japan, but 50,000 in the rest of the world. That is not a reduction in Japanese employees; therefore, nobody has been hurt enough to complain.
The low productivity of Japanese capital is the root cause of every event that has occurred since the end of the high-growth period in 1969. We need to know why Japan was able to grow rapidly with such a fundamentally unusual system in the period up to 1969. The answer is easily at hand. It took until 1968 for Japan to return to where it would have been had the trendline of prewar growth been extended uninterrupted through the postwar period. Japan's miracle was essentially a catch-up miracle made up almost exclusively of the mobilization of additional capital and labor inputs, and no increase in capital efficiency.
Resource misallocation is a fundamental, built-in, preprogrammed feature of the Japanese economy. In recent years we have seen resource misallocation on a grand scale in the bubble, and we are now dealing with the aftermath of the accumulated resource misallocation of the last 50 or 60 years.
Clearly there is hope for change if one takes a very long view. There are no major countries that have failed to challenge the pre- and postwar settlements they inherited from the 1945 generation. In Britain it took an economic collapse, an appeal to the IMF (International Monetary Fund), the rubbish being left uncollected for 20 weeks, and a three-day week because there was no electric power on the other four days, before Britain woke up to the fact that its postwar settlement was fundamentally bankrupt. It will take a similar shock, that level of social dislocation in Japan, to force people to complain and change the system. Foreign pressure will not be enough and could in due course become counterproductive if seen as unfair foreign demands on a weak Japan. The weaker that Japan gets, or appears to get, the more that reaction is likely to come out.
In the last seven years, Japan has added productive capacity willy-nilly, irrespective of returns or of shareholders in Asia, equivalent to the entire output of France. In the 1980s it similarly added, irrespective of potential return, industrial output equal to the entire output of France. So why have we got an Asian problem? Because Japanese capitalists do not matter, Japanese shareholders don't matter. Therefore, they did not insist that the companies close the factories in Japan which were being duplicated by factories overseas. There was vast overcapacity irrespective of capital efficiency or capital returns in every Japanese-dominated industry. That has been exported to Asia. Now if the yen goes up, Japan goes bankrupt; if the yen goes down, Asia goes bankrupt.
We should be asking Japan to embrace capitalism and close some factories in Japan. Laying people off is currently illegal. Until labor laws are attacked, I am not optimistic that a new growth era is around the corner for Japan.
RICHARD KOO: What's happening in Asia has a lot to do with Japan in the sense that the four countries that suffered most from the recent currency turmoil (Thailand, Malaysia, Indonesia, and South Korea) benefited most from the strong yen Japan had from 1985 to 1995, fully 10 years. The yen dollar exchange rate went from 240 yen to 80 yen to the dollar. The collapsing currency was the dollar in those days, not the Japanese or Asian currencies. The Japanese then had to move their factories out of Japan. The United States at that time hoped that the factories would come here, but instead they all went to Asia and to three countries in particular: Malaysia, Indonesia, and Thailand.
Malaysia by 1990 was the second largest producer of videocassette recorders in the world. Malaysia grew from nothing to one of the world's premier economies by 1995 because of the huge inflow of Japanese capital. This also happened in Thailand and Indonesia. Korea also benefited greatly from the strong yen. But beginning in August 1995, the yen had become the weakest of the major currencies.
The good times lasted for a full 10 years, and when it lasts that long, people take it for granted. In the beginning they appreciate the Japanese coming in, but by the tenth year they think that it is a natural course of events: The Japanese will naturally bring their factories over here, employ our workers, and then ship the goods to the United States for us. But after August 1995 it all changed. The yen was becoming weaker, and Japanese factories were pulling back. It took the investment community a long time to realize that the external circumstances had changed. Of course, the Chinese factor was there, but the yen falling was the major reason for what happened in Asia.
CHARLES MORRISON: I am concerned that Americans are working themselves up into a dither based on unrealistic expectations about Japan that could be counterproductive. A few years ago the two countries agreed that they should have a global partnership. In a lot of areas it is very difficult to have a global partnership - in security areas where Japan has political and constitutional constraints, for example. But the Asian financial crisis was an area that was tailor-made for the United States and Japan to work together, and it did not happen. In general, this crisis has shown how our encrusted ways of looking and acting toward each other are counterproductive. Japan has invited outside pressures by its own lack of action, and it sees itself in many respects as a victim. The United States tends to lecture and hector Japan as if it is a naughty child.
Our political system encourages escalation of rhetoric and paints us into corners by demanding action that makes sense in terms of our economic and political needs, but from a Japanese perspective is something that they cannot or will not do—at least not enough to satisfy us. So time and time again, we back down.
Americans and Japanese have very different perceptions. We think that economic stimulus is good. The Japanese are profoundly ambivalent about this. It is not just the Ministry of Finance orthodoxy. It is not just that Prime Minister Hashimoto has committed himself to fiscal reconstruction. There is a basic general public attitude that every time they have followed American advice, they have gotten into trouble. Second, we think that a permanent tax cut would be great for Japan. Politically and economically, it should be attractive. But the leadership of the ruling party thinks that the Japanese are the lowest-taxed people in the world and that tax reductions would basically go into savings. The tax-cut party in the last election lost. The bottom line is that it is very hard to force another major country to change basic policies for the good of a relationship with us or based on our economic wisdom unless it makes domestic political sense for them.
What is the danger? Some in Congress may be encouraged to think that linking our policy to what we think they should do would be a great way to bring leverage on the Japanese. This makes no sense; it holds our policy hostage to their politics. We should make our points strongly and tell them that they are part of the problem, but we should not think that we are going to make a big difference in the short term as a result of this.
We need to focus our friendly advice on the right issues: the financial and banking system problems and deregulation. Fiscal stimulus will not encourage consumer spending on investment if people have no confidence in the health of the financial system.
KIICHI MOCHIZUKI: First, I will defend Japan a little bit—because nobody defended Japan—and I will also criticize Japan.
The United States has a habit of preaching to other countries. The IMF is in some quarters in Asia considered to be an instrument of Washington foreign policy. There is a lot of resentment about this. Suharto may not be wise in his economic policy, but he devoted his whole life to the independence and prosperity of Indonesia. He is old and in his own way he tried to keep the unity of the country, which may be more important than the exchange rate or the economic situation; he bet his life on that. I understand his position.
People talk about the lack of Japanese leadership, but the leaders have tried very hard. For example, at the beginning of this crisis, they talked about establishing an Asian Monetary Fund. The United States tried very hard to suppress it, and Japan was accused of not showing leadership.
Now the Japanese problem is bureaucracy and government intervention. We have to correct this. All the other suggestions, such as tax cuts and spending increases, will not work without reducing government spending. But the final, most basic point nobody talks about is that government spending should be reduced before allowing a tax cut.
DOUGLAS OSTROM: What is the real Japan? Is the real Japan an economic juggernaut growing at 10 percent a year and rolling over other countries in Asia, the United States, and Europe? Is that the real Japan, or is it the Japan we see today? I argue that it is the latter, because the kinds of policies that we see in place today have a long history.
In the early postwar years, the fundamental factors for economic growth in Japan were unusually favorable. There was a large amount of capital accumulation from savings and a high rate of return on capital, because there were many investment opportunities as a consequence of being isolated from the other industrialized countries. There was a benign international environment in which Japanese goods could be sold freely around the world, with some important exceptions. Japan also pursued a national policy of helping industries, using the famous MITI (Ministry of International Trade and Industry) model, and a bank regulatory structure with a banking system that was seen as facilitating that growth.
Now in Japan, the economic growth rate has declined dramatically. But even in that earlier period, the policies in place were counterproductive. They resulted in a misallocation of resources as agriculture got more than its share, for example. In addition, the banking system resulted in a misallocation of loans.
Asian countries copied Japan's counterproductive economic policies, which were not helpful to Japan even during the high-growth period when the economic fundamentals overwhelmed their counterproductivity. They even exaggerated the Japanese model by doing what the Japanese policymakers and bureaucrats told them they were doing. Of course it was in the interest of these bureaucrats to take credit for success, even if they did not deserve it. So, the Asian countries actually borrowed an exaggerated version of the Japanese model. That is one reason why both Japanese and Asian countries are in trouble today.
Will Japan get out of this box? Possibly. Japanese economic growth has slowed dramatically; the Japan Center for Economic Research, which is affiliated with Nihon Keizei Shimbun, has forecast economic growth rates through the year 2025. Within a couple of years, the growth rates in Japan will become negative, assuming there is no policy change in Japan. That is very unusual in an industrial country, or in any country, over such a long period of time.
If the banking system were restructured to allocate capital efficiently; if the other dimensions of Japanese inefficiency in the distribution sector, in transportation, in agriculture, and in services in general were to be fixed; and if Japanese productivity merely moved to 1995 U.S. levels, instead of the current 60 percent of U.S. levels, Japan could potentially grow several percentage points a year. Will Japan do that? If it did, Japan could play the role of a long-term locomotive for Asian growth, as it arguably has been in the past.
But the long-term continuity of Japanese economic policy that we see with those industrial policies and banking regulatory policies dating back to the 1950s suggests that meaningful change in Japan is by no means guaranteed. We are likely to see something much closer to zero economic growth in the foreseeable future.
JACK RODMAN: I can sum up the problem that has taken place in Japan and Asia in one word: fudosan. In English, real estate. This is the biggest real estate problem in the world, and Japan is the common denominator in real estate lending for the overbuilding and speculation in every one of the countries—whether in Europe, where we have seen the vast oversupply, or in Japan, Thailand, and Malaysia, for all the reasons that the economists mentioned.
E&Y Kenneth Leventhal's accountants in Japan have moved one trillion yen on unpaid principal balances off the balance sheets of Japanese banks. We are going to get the bad loans off the Japanese banks by good bank/bad bank, by securitizing them, and by the bulk sales programs that are taking place today. There is $20 billion of U.S. capital today competitively seeking to acquire nonperforming loans.
What does that have to do with the economy? We have hired practically every appraisal firm in the country to inspect the property and make evaluations, as part of the due diligence. We have hired practically every real estate lawyer in the country who can opine on what the foreclosure process is and how to take title to these assets. The Bank of Japan and the Ministry of Finance are taking steps. What was missing in all these markets is that there was no rule. The accountants were not doing their jobs; nor were the regulators. Now the free-market capital system is doing its job.
The market is going to recover a lot faster than anybody thinks. In fact, it is so good that the U.S. investment banks are trying to get in early to get all they can, because as soon as the Japanese figure out how to do it, they are going to squeeze the United States out of the market. Then the Japanese life insurance companies will come in and say, "We're happy with a 10 percent return. Why are we giving the Americans a 20 and 25 percent return on investment?" And then guess what we're going to do? We're going to go to Thailand, where they've already set up an RTC, and then to Korea. Eventually they'll figure this whole problem out with Indonesia and they'll be in Indonesia.
In Japan, these "inept" politicians and ministry officials have funded a 30 trillion yen bailout program - that's $238 billion, more money than was appropriated for the RTC - and they are thinking about how to spend it. You're going to see a recovery in Japan that'll make your hair fall out.
C. FRED BERGSTEN: Alexander Kinmont said there is a profound underlying structural problem, that Japan really was caught up in the MITI double-the-national-income period through the late 1960s; but that since then, it really has not done much. He said the problem is an underlying lack of productivity growth, which reflected a lack of efficiency in the economy and misallocation of resources, all based on faulty incentives and capital markets.
Note that is very similar to Paul Krugman's thesis, as applied to all of Asia a few years ago. Indeed, Kinmont and others, Douglas Ostrom in particular, said that the Japanese model has been exported to Asia and, to some extent, it explains the whole Asian problem. They are saying that there is a fundamental underlying structural difficulty out there. This contrasts to the last comment from Jack Rodman that this is a short-run problem, tied up with a property boom, a credit crunch as Ernest Higa said earlier, and maybe relapse from the bubble economy.
So, is it an underlying structural problem, or more short-term and readily remediable? If it is as basic and structural as Alexander Kinmont suggested, then was his second point right that it must get worse before it gets better? He suggested the reason that nothing much has happened in Japan is that nobody has been hurt very much.
Finally, if it is true that Japan's record is really lousy—if its productivity growth has been poor and its allocation of resources has been grossly inefficient—then it must have a tremendous potential, because of all the poorly utilized resources and unutilized resources. If Japan corrected its policy, perhaps then Japan could recoup an enormous growth period. Indeed, the good news from the bad analysis is that if the problem is really structural and nothing much has happened for 30 years, and they get a shock that gears things in a constructive direction, then Japan could again be hell on wheels. What do you think of the feasibility of that?
KIICHI MOCHIZUKI: The gist of the argument so far is that the manufacturing sector is up-and-down but is mostly doing fine, thanks to its exposure to international competition. The financial and other sectors are doing not well at all because of a lack of competition. The Japanese are lazy, incapable people. If they are kept on their toes they will do all right; but when they are not exposed to competition, that is not good.
Japan is not the United States, not arrogant enough to say that we are going to export our system to you. They have their own socio economic system, history, and culture, and therefore they take whatever they can take. We certainly put a lot of money into technology for manufacturing. Most of the manufacturing businesses in Asia are probably affected by the Japanese or invested in by the Japanese. But the problem is not the manufacturing sector there; it is the real estate subsidies and so forth.
NORIKO HAMA: The problem is certainly underlying and structural. Japan's system is outliving its usefulness, therefore losing its efficiency and effectiveness in terms of growth and employment. Everything that stood for stability in the past in Japan now stands for rigidity. Everything that stood for security now stands for stagnation. Everything that stood for efficiency now stands for lack of creativity. We have an outdated system that we need to get rid of.
I actually do not agree that no one has been hurt in the adjustment process. A lot of people got hurt in terms of the collapse of the stock market, and small investors actually lost a lot of money. Then people felt disillusioned with the system; in the past, however much Japan was bashed by the Americans, it was a system which still cocooned people. Once the bubble collapsed and a whole series of other things followed, people genuinely felt that they were being betrayed by the system. Therefore, their voting behaviors changed. They started to complain to the press about everything that was happening, small businesses started to stand on their own feet, and there was a groundswell of change occurring in people's mentalities and attitudes toward public institutions. So things could well get worse before they get better, but people have already been hurt enough to realize that there is something wrong.
But the potential for good news is great. After all, Japan is still the largest capital exporter of the world, and it has tremendous manufacturing resources. One symbolic thing that bodes well for Japan's future is how well it did in the Nagano Olympics. It shows that when the economy gets to be lousy, people start to think for themselves. Individuals start to take initiative, and therefore Japanese athletes have become a lot more competitive in sports. Also, winter sports happens to be a very expensive exercise; that is where our stock of funds come into play. These two things converged to make us perform so well in the Nagano Olympics. If that is a harbinger of what is to follow, then I think the future does hold good news.
ERNEST HIGA: Globalization has been playing a big role in every country. Until now, Japan was able to play by its own rules and succeed. But now, with the influence of major foreign institutional investors, both in the stock market and otherwise, there are repercussions for not playing by the global rules. Prior to this, we did not have to worry about it. There was even not a concern about BSI requirements, or about Moody's or Standard & Poor's. But in today's environment, simply because the global flows of funds both in and out of the country, all of those things have repercussions. What we are seeing now is a change in the rules of how things are being done in Japan, and it will happen a lot quicker than has been mentioned.
Will it get worse before it gets better? I think it has gotten worse; it has gotten to the point of a true sense of urgency. There is strong momentum for another 10 trillion yen in terms of either spending or tax reduction. Those commitments are already being made simply because it has gotten so bad and people are being hurt. Corporations and individual investors are at the point where the Japanese government can no longer ignore this situation. Even if the Japanese government is not able to get over some of the bureaucratic issues that might stop it from actually going through with some of these things, the issue of gaiatsu, or external pressure, particularly from the United States, will force the issue. This is because of globalization; we are all integrated financially. The world cannot afford to let Japan go down the tubes.
RICHARD KOO: For the first time in 10 years I am optimistic about Japan; I was pessimistic for the last 10 years. I am optimistic about financial issues because, for the first time in eight years, after the collapse of the bubble, we are finally doing something about the banking system. We could not touch the banking system for this long precisely because there was no credit crunch in Japan. We had a very strange situation for eight years where we had a major banking crisis without the credit crunch. We got to that stage because the demand for funds fell faster than supply. As late as six months ago bankers were begging borrowers not to pay them back. What kind of banking crisis is this? The bankers were saying, "Please don't pay us back, because we don't know what to do with the money." A lot of people in the United States and elsewhere say that Japan should reflate. How? When bankers have too much money and borrowers are all trying to pay down this debt, you cannot reflate.
But now we have a banking crisis and a credit crunch of unbelievable proportions. In 1992 in the United States, the credit crunch killed George Bush politically. Something similar is happening in Japan. I warned the Japanese politicians about what happened to George Bush. Their eyes popped out and they started doing something about it. So we went from zero to 30 trillion yen in fiscal stabilization packages in only two months. That is supersonic by Japanese standards.
Seventeen trillion of the 30 trillion yen will go to deposit insurance. This will make all the difference in Japan for transparency and accountability. This is because until now there was no money in deposit insurance, which made it very difficult for the authorities to tell bankers to disclose the size of their problems.
The other 13 trillion yen is going to recapitalize the Japanese banks which were never well capitalized. The fact that money is going in to recapitalize the Japanese banking system will go a long way to keep the credit crunch from getting worse. Although the Japanese government decided to recapitalize all banks without first differentiating good banks from bad banks, there was really no choice. When you have a nationwide credit crunch, there will be no takers of assets of failed banks. This means when a poorly managed bank is allowed to fail, all borrowers of that bank will be killed as well. And that is exactly what happened in Hokkaido, when Hokkaido Takushoku Bank failed. When you have a major national credit crunch, it is not just credit nationwide at stake, it is global. Just the other day, one of the treasurers of a major U.S. corporation came to Japan to beg the Japanese bankers not to cut their credit lines. It is happening in the United States as well; these are not just Japanese or Asian problems. Japanese banks are 20 percent of the syndicated loan market in the United States as well, and they are pulling out, making many U.S. operations very scared. The money going in to stop the situation from getting worse is a major step forward.
Foreign observers have asked, when will Japan change? At 80 yen to the dollar? At 14,000 on the Nikkei? None of the above. This is because Japanese companies, unlike U.S. companies, kept most of their profits at home during the good times in preparation for bad times in the future. When the reserves of Japan's companies run out, that is when Japanese companies and the Japanese system will change. It is about to get to that stage. A lot of companies have run out of reserves. They are putting a lot of new systems in place, so I am optimistic that the new Japan could be with us very soon.
CHARLES MORRISON: We too easily say that the rest of Asia was following some kind of Japanese model. There are many differences; for example, in the treatment of foreign investment by other countries in Asia, in the treatment of technology, and in the ability of the bureaucracy to direct and guide the economic development of process. Only Korea explicitly followed the Japanese model. China perhaps would have liked to, had it not been a communist country and had problems in adjusting a communist system to something else.
Japan and Korea, having this government-led model, have the most difficulty in Asia in dealing with the demands of globalization. Southeast Asian countries have been traditionally globalized. They were on trade routes and in many ways have open systems compared to the Northeast Asian systems. Korea, however, had a shock, and so Korea is being compelled to make changes that would not otherwise happen. I am skeptical about whether there will be any equivalent shock for Japan. I have heard for 25 years about how Japan is changing. Many times I thought that the forces of economics and globalization were changing Japan. I suppose there is some point where it gets over the hump and starts to move more quickly on its own steam, but I do not know where that point is. I am cautiously optimistic, but I still need to be convinced.
ALEXANDER KINMONT: I am discouraged that there is so much optimism. It is based on the fundamental misunderstanding and misreading of history. We should look at what the Japanese say when they are free to say it about their own system. I emphasize "free to say it," because in a period when Japan was "the problem," because it was running gigantic trade surpluses with America, it was necessary for Japan to pretend that it was a nice cozy capitalist system like any other. In the early 1970s, Sakakibara Eisuke, who is every hedge fund manager's Mr. Yen and favorite bureaucrat, cooperating with Noguchi Yukio, now a professor emeritus economics at Tokyo University, stated the situation a bit more clearly: Japan had adopted a noncapitalist system, based on Marxist doctrines and learned by an individual who went to Moscow University and brought it all back. The Japanese system is clearly based on that.
This idea of a postwar/prewar divide is fundamentally wrong. The Japanese economy is a wartime economy, as Professor Noguchi has written in a recent book. It is the 1940 system turned into the 1945 system. Wartime economies are resilient by nature. There are numerous levers that the Japanese government can pull to fudge all of the problems that might present themselves in the short run, except for two. The first is Asia. The Japanese system runs on the consumption of capital rather than earning a return on it. That is sustainable so long as, to put it in concrete terms, the number of people who have worked for Hitachi in the past is less than the number of people who do work for Hitachi now. In another five to ten years, the number of people who have worked for Japanese companies will be larger than the number of people who do work for Japanese companies. At that point, the interests of savers, the providers of capital, will become more important than the interests of the consumers of capital, labor. Labor's share of GDP (gross domestic product) in Japan is vastly higher than anywhere else. That is one thing that cannot be fudged and will become a question in due course.
Shorter term, the only thing the Japanese system cannot fudge in some way is a recession in the United States. We are not pessimistic—we are very optimistic about the U.S. economy. We are not expecting a recession. So long as Japan's export escape route is not cut off, Japanese factories can be kept open, and Japanese factory workers can be kept employed, even if their labor is uneconomical. This is a bizarre concept, but we have to go back to the system upon which Japan is modeled, the Soviet system. A Soviet aluminum factory can produce aluminum without being a viable enterprise. The only way that can be changed is by laying Japanese workers off, because there is simply no final demand into which to export their goods.
I argue that you have one medium- to long-term possibility of change, and another, perhaps shorter-term possibility of change if there is a U.S. recession, but that everything else is fungible within what is essentially a wartime economic system that is Marxist in orientation. To emphasize the point, it took until 1969 for any of the former imperial universities in Japan to appoint a professor of economics who was not Marxist. Even today, the Tokyo University Economics Department is solidly Marxist, or of Marxist orientation. This is a fundamentally different system, a noncapitalist system, and it is going to be very difficult to break it down.
C. FRED BERGSTEN: So we have a huge degree of consensus: Either the problem is underlying and structural or superficial and immediately remediable. Either it is going to take a massive shock like U.S. depression to spur solution to these problems or the solutions are already under way and will happen quickly. Either the rest of Asia is going to suffer the same fate as Japan or Japan is so different from everyone else we needn't worry. Thanks to the panel and to all of you.
|C. Fred Bergsten, Institute for International Economics|
|Noriko Hama, Mitsubishi Research Institute|
|Ernest M. Higa, Higa Industries|
|Alexander Kinmont, Morgan Stanley|
|Richard C. Koo, Nomura Securities|
|Kiichi Mochizuki, The Pacific Institute|
|Charles E. Morrison, East West Center|
|Douglas R. Ostrom, Japan Economic Institute|
|Jack Rodman, E&Y Kenneth Leventhal Group|
|6:30 pm - 9:30 pm THU 3/12|
|Presentation: The Asian Crisis in Perspective|
|If we were to have held this conference 30 years ago, almost all of today's discussions might have been directed not at Asia but at the United States of America: lack of lending to growing businesses, denying loans to companies despite their profitability, the redlining of communities, marketplace volatility—all of these issues have held a place in our own history. I hope tonight to say, as we examine these issues, that we must look at them in the light of our own history before asking other countries to take drastic actions—actions that we as a country were never willing to take ourselves.
Los Angeles typifies in many ways the conditions in the United States as a whole. It is, of course, a very important place to me. It was only a few blocks from the site of this conference, on August 11, 1965, that the Watts riots began. Today we heard talk of the potential for blood in the streets of Asia, but there was blood in the streets here just a few blocks from this hotel. This city, a city that supposedly knew no discrimination, was on fire in a riot that lasted for days—a riot that caused me to reevaluate both what was going on in America in the 1960s and to my own life.
In the America of the 1960s, when civil rights isuses and the Vietnam War dominated the news, another even more fundamental issue was at stake, and that was the right to capital—the right to the American dream and participation in a capitalistic system, not based on who your father or mother was or where you went to school or what your religion was or what you looked like, but on your ability.
It was obvious to me in the 1960s that capital was not available to all in America. The concept of democratization of capital was not alive and well. Two weeks after the riots, I went back to Berkeley, where I had been studying mathematics and science, and became a business major. The lesson of today's economy and of financial institutions in Asia—and I think also of our own history—is that the leading financial institutions of the world now have a true understanding of what credit is.
As the world changes, you cannot focus in a rearview mirror on credit. You finance the future. For example, the fact that Singer Sewing Machine Co. in the 1970s had paid dividends for more than a hundred years was of questionable value if women were all going to work and were going to stop buying sewing machines. The world was changing for Singer and so was Singer's credit.
If you study credit, you see very simply that the worst credit in the history of world has been sovereign credit, country credit, municipality credit. Yet the world continues even today to believe that a country's credit is superior to that of a business or an individual. The whole history of credit for countries is one of default.
At a conference in the mid-1980s, the leaders of many of the country's largest banks put forth the concept that no one had ever lost money loaning money to countries. Had they studied the history books, they would have known that Latin American countries twice in this century, prior to the funding in the 1970s, had recapitalized their debt at 33 cents on the dollar. So, it is obvious that many of the people who study credit have not studied history.
Technology has changed our world in may ways, including the way it relates to the democratization of capital. It is very easy for us to see the results of this democratization, with the performance of Microsoft and Intel and other successful new companies being cases in point. Not only has capital been democratized but so has power. I would suggest to you that once you have the democratization of capital, democratization of industrial power follows, which in turn leads to economic growth, and, finally, allows countries to focus on the democratization of human and social capital—the world's most important resources.
I think all of us would agree that the world's economic structure has moved from being based on a natural resources to being based on financial resources, and ultimately on human and social resources. Our history books tell us a story of countries such as Spain and Portugal, who many centuries ago brought back gold and silver in their pursuit of spices, and added great wealth to their countries for that period of time only to see other countries (in Northern Europe) take the economic lead in later times.
Nevertheless, the concept of financial resources in a knowledge-based society only goes so far. With the digitization of money, today financial resources move at the speed of light to find human resources that today can move at the speed of sound. As we search for these human resources, we will be led to those countries that will become the leaders of the next century. And, the human resources within their borders will be searching out social resources, as they begin to choose where they will live and work.
We've talked about Asia being in a period of crisis. I personally view this as not a period of crisis but an opportunity for rebirth and sustained growth, an opportunity to pioneer new businesses and industries and to fundamentally change our society.
Change requires catalysts, and quite often it is a series of changes that bring about the ultimate change. I would suggest to you that history will not view the current flux as the major crisis of the past decade. In many ways, it is a minor financial crisis compared with those that occurred earlier in this decade. However, it possibly will provide the opportunity for countries to open their markets and embrace modern financial technology, and thus to sustain growth well into the next century.
Why are we so focused on Asia? was one of the questions asked today. Maybe we need a geography lesson to remind ourselves of the reason.
In terms of population, we find that Asia moves from a 35 percent share of the world to a 65 percent share. If we assume the world of tomorrow is a world of democracy and capitalism, then ultimately 65 percent of its inhabitants will have a pretty important vote as to what its future will look and be like. That's another reason why we're so focused on Asia. Economic output presents a slightly different picture. At the end of 1997 Asia made up about 30 percent of world output versus 34 percent for Europe, 30 percent for North America, and 4 percent for South America, and 2 percent for Africa. Even more important is the question of future output: What will output be like in, say, 30 years? If we project the same world economic growth that occurred in the past 20 years over the next 30, we find that 52 percent of the world's economic output will emanate from Asia, 22 percent from Europe, and 21 from North America. In short, we must begin to think about a region whose land mass occupies over a third of the world's total, whose current population comprises almost two-thirds of the world's total, and that is projected to contribute over half of the world's economic output in just three decades.
Of all Asian countries, Japan has had the greatest influence on the West in recent decades. But one should not view that country's current crisis without the benefit of an historical framework.
If one compares the 1989 drop in the Japanese market with the 1929 drop in the U.S. market, one can see a very similar rise in both markets during the three or so years prior to reaching their peaks (see chart).
By the time it reached its apex on December 29, 1989, the Nikkei average had risen 59 percent. The Dow Jones peak on September 3, 1929 represented an 58 percent increase in value over the past few years. Similarly, the graph looks at the aftermath of the two events. Four years after the crash, the Nikkei has been able to climb only to 38 percent of its former value. The United States experienced an even slower market recovery: four years post-crash, it retained only 11 percent of its former value.
This current episode, particularly for Japan, is indeed severe. Security prices in Japan have dropped $2 trillion. Additionally, real estate prices have experienced a $4 trillion drop. Together, $6 trillion in market value has been lost. This is not unusual in world events: The United States took seven to eight years before recognizing losses due to its lending to Third World countries in the late 1970s and early 1980s.
How long will it take Japan to recover? It took 25 years for the stock market in the United States to return to its September 3, 1929 level. Today, when we ask Japan for immediate solutions to problems, we have to recognize how long it took the United States to bring its own stock market back after a comparable shock.
From 1929 to what I consider to be the most important period of time in the postwar period in the United States (and the period that has set the tone for the financial structure of our country today), 1974, market capitalization was almost unchanged as a percentage of GDP (gross domestic product). Only in the last 24 years has the U.S. market run up to about 150 percent of GDP. More recently, on October 19, 1987, the U.S. stock market sustained a loss of 500 points: $500 billion in market value was lost in only one day. This is 60 percent more than the entire value lost in Asian markets over six to nine months.
We often hear lamentations that the capital invested over this period of time in many Asia countries was not used for productive things but was used instead for such things as excesses in real estate or the world's tallest building. A thorough study of U.S. lending to Latin America, particularly in the 1970s, would show that a high percentage of the money that went into those countries provided liquidity for Latin American nationals to move their money out of the country. In the case of Venezuela, for every dollar that Chase put in, $1.50 was taken out by nationals. They had a balance-of-payment surplus from oil. American banks provided liquidity to the tune of hundreds of billions of dollars for Latin American nationals, who knew a good investment when they saw it, to transfer their money out. The money was lost the day it was lent. It took a decade for us to admit it.
In the early and mid-1970s, I used to travel to Mexico and visit some of my friends. When I told them we could provide them capital at 12 percent and 20 percent of the company, they responded that although we were nice, courteous, and energetic, we were off our rockers, because the major Western banks of the world would loan them as much as they wanted at a half or a point over libor—a quarter of a point more than IBM.
Russia, you might remember was able to borrow money at an eighth over libor. And this was a country that had once told its creditors that it was unilaterally disavowing all obligations.
The money that was invested in Latin America was a two-edged sword. U.S. financial institutions invested capital in countries that did not need it while at the same time forsaking their own country's cities and communities. Many of the problems surrounding human capital in education and social issues in the United States find their root in the fact that hundreds of billions of dollars did not go into building a social and educational infrastructure. This money was invested in countries that did not need the capital, and, for the most part, never repaid their debt.
I refer to this as America's near-sightedness. You might not remember some of these prices, but Nicaraguan debt sold for one cent on the dollar; Argentina traded at 14 to 15 cents on the dollar; Bolivia 4; Peru 7. And, we are talking about countries that borrowed 10, 15, 20 billion dollars. So when we focus on Asia and its banks today, and ask why they made questionable loans, we should look back to our own credit lesson just 20 years earlier. We might ask ourselves the same question. The loss is more than just the loss of capital and the return on that capital. It is what that capital didn't do. Bank of America could see Buenos Aires, but it couldn't see Oakland; and it couldn't see San Francisco; and it couldn't see East Palo Alto.
So, as these financial institutions spent a decade rebuilding their capital, the cities and business that they might have supported went wanting. Similarly, while there's a great deal of enthusiasm in some parts about the opportunities for Asia, this enthusiasm often does not translate to many of the people who live there in depressed conditions. Current conditions can color perception of the future and blind those closest to a problem to its solution. The case of New York City is one recent example.
If you go back to the 1973-74 period, you might remember that New York City bonds were selling for 30 cents on the dollar; Con-Edison senior mortgage debt was selling at 28 cents on the dollar; State of New York debt was selling at 30 cents on the dollar. The perception in the United States was that New York and other parts of our country were failing. Those who saw the opportunity were not New York's own real estate investors. Instead, many were from Canada. They made their fortunes by investing in New York real estate at a time when no one else saw an opportunity.
Even more recently, just at the start of this decade, Citibank, a company that has a value today of $62 billion in the marketplace, sold for as low as $3 billion. When people perceived Citibank to be on the verge of bankruptcy in the early 1990s, it wasn't Wall Street that came to its rescue; it wasn't the leaders of merchant banks and LBO firms that came to its rescue. It was a 35-year-old Saudi Arabian prince who had the courage to invest $590 million in Citibank at $16 a share and had the right to convert up to 14.9 percent of the company. He now has an investment showing a profit of over $5 billion.
So when you ask who sees the opportunity, sometimes it is not the person who is closest to it. Sometimes you need to step a little farther away and sometimes all the way to Los Angeles from Tokyo, or all the way to Los Angeles from Bangkok, to see the tremendous opportunities lying before you and the tremendous investment that those countries have made in their own human capital over the past generations.
We talked about bankruptcies and about what happens when you can't foreclose. The history of the United States is filled with story after story. The Boston and Maine Railroad went bankrupt and, shortly thereafter, Penn Central. It was 14 years before the creditors could take action—and this occurred in the United States of America during the 1970s. In fact, railroad equipment bonds and the airline equipment certificates were an answer in this country, because you could not foreclose and get at your assets. The United States by no means has been immune to the same issues that now affect Asia. Even now, our desire to create new financial technologies is born of the fact that, in the past, quite often you couldn't get to the company with a rule of law even in the United States.
Probably an even more important credit lesson occurred in 1981. It is a trillion dollar credit lesson yet it had nothing to do with credit. It had to do with only one thing: interest rates. Interest rates went up and, as a consequence, fixed-income securities went down. Firms considered to be among our country's most conservative lost a great deal of money. Ten insurance companies alone had a $50 million unrealized loss on their mortgage portfolios, government bond portfolios, and high-grade bond portfolios due just to interest rates. Their total capital at the end of 1981 was $8.8 billion, meaning that their unrealized losses just from their high-grade fixed-income portfolios were five to six times their capital.
Not one of those institutions filed for bankruptcy. Not one policyholder has ever lost money in any of those institutions. Yet today we do not think twice about asking many of the Asian countries to close their major financial institutions because mark to market they're underwater. In fact, I believe the study of our recent economic history will find this to be a very interesting period of time, since we did not have a run on the bank, we did not have a run on the insurance companies, and little to no money was lost in our financial institutions when they had a trillion dollar loss. Yet at the end of the 1980s, when we had small losses, we were able to generate those and turn them into $150 to $200 billion loss when we did have a problem. And here where we had a serious problem we were able to live through it. I think this recent history provides an interesting backdrop of how to deal with the problems of any given country today.
Other companies and other countries were faced with a different problem. It was not a problem of credit. It was instead a problem of borrowing short and lending long. It was a problem of fulfilling a national commitment. Some might ask whether the lending banks were an instrument of the government when they made these loans. Well, I think we can go back to this period of time and see that—at least according to the chair of the Federal Reserve—they were. Remember that he had promised that as long as he was at the Fed no one would lose money on loans to developing countries.
The top 10 banks in Japan today have decreased their percentage of financial assets in the banking systems, though it still approximates 60 percent. So as you think of the rebuilding of its capital base, the challenge for Japan is that it cannot count on its leading banks to provide the capital for growth for 5 or possibly 10 years, as they have to build their own liquidity and profitability.
This is no different than what occurred in the United States. The Bank of America, which was the largest bank in the world at the end of the 1970s, had $112 billion in assets. It had $111 billion in assets at the end of the decade. The difference was that the United States, after 1974-75 was no longer dependent on the banking system to finance business. The public marketplace had been developed: public and private institutions, the mutual fund industry, and private investors had taken the lead. Therefore, the fact that the Bank of America and other financial institutions spent a decade rebuilding their capital did not slow down the growth of our country.
The fact that the Bank of America sat out the 1980s has given it a chance to participate in the 1990s. It already had more than doubled its assets to $232 billion by the end of 1996. When you recognize that the market value of Japan's 10 largest banks at the start of this decade was $700 billion, and that today it stands at $290 billion, you can see they have a lot of work to do in rebuilding their balance sheets, just as Bank of America, Citicorp, Chase, Manufacturers Hanover, and First Chicago, among others, had to in the 1980s.
Whereas it took almost 20 Citibanks to equal one Sumitomo at the start of this decade, today it takes almost one and a half Sumitomos to equal the value of one Citibank. There has been a 30-fold change in value between the leading financial institutions in Japan and the United States in less than a decade. And so when we ask them to do things that we think will alleviate their situation, we must remember that their own survival is first and foremost in their minds, the same as was true for our own financial institutions in the decade just past.
Japan has an even greater challenge than represented by the banking system, and this is its brokerage firms. At the start of this decade, the four largest brokerage firms in Japan had a market value of $150 billion; the market value of the four largest public brokerage firms in the United States was $8.6 billion. At the start of this decade, Nomura alone had a higher market value than all of the public and private investment banking firms and all of the brokerage firms in the United States combined.
It would have taken 30 Merrill Lynches to make one Nomura at the start of this decade. Today, Nomura's market value has fallen from $150 billion to $40 billion. By way of comparison, the four largest U.S. public noninsurance companies (Travelers being the largest, $66 billion alone) now have a value of $83 billion. While brokerage firms have lost $111 billion in Japan, they have gained over $70 billion in the United States. With concentrated financial institutions, each focusing on building its capital, its reputation, and on surviving, it will be almost impossible to count on the traditional financial leaders to fuel the growth of Japan.
The only alternatives are to find other financial institutions in that country that we can assist or help to allow the country to grow. This will be a time during which its concentrated financial power, both in its brokerage firms and in its banks, is dealing with legal and capital problems. They will probably be so engaged for the balance of this decade and well into the next.
Asia needs less concentration of economic and financial power. It needs to open up its financial markets, let in new firms, and make way for new financial technologies. There are hundreds of them today. From mortgage-backed securities to preferred stocks to convertible securities, there is no end to the creativity of people in the financial community, particularly in the United States. When you use these tools correctly, they eventually build buildings, countries, industries, and societies.
It's important to recognize that this country's use of financial technology did not occur overnight nor was it a cakewalk. So, when we say Japan, China, and other countries should adopt more modern financial techniques, I think we need to understand that U.S. progress occurred over a 25-year period.
I take you back to one of the most important periods, in my belief, in this century, to 1973-74. At that time, the stock market fell almost 50 percent. Importantly, at the same time short-term interest rates doubled. The REIT (real estate investment trust) industry at the time had over $20 billion in commercial paper outstanding, backed by bank loans. Through help from the Federal Reserve, the banks stood up and took on the loans that paid off that commercial paper. The stories of the day were that 70 percent of the major companies, 700 of the thousand largest companies in the United States, would file for bankruptcy within the next 24 months.
This was also the period of time when the banking industry lost its position as the provider of capital to businesses in the United States. In order to save themselves, they had to call their loans, find ways to cancel their outstanding commitments. The group they approached comprised growing businesses that were making money and could actually afford to pay them back.
The companies of this country were creating jobs. Yet the banking system did not stand by them. Corporate America collectively made the decision that if it ever had the opportunity again, it was not going to be dependent on a financial institutions for growth and/or survival. Hence, the public security markets grew. The banking system of this country has never again had its day in the sun as a provider of capital.
The gap created by the banks was taken up greatly by mutual funds. At the start of the 1980s, the banking system was more than 30 times larger than the mutual fund industry. Today the assets in mutual funds and in our banks are about the same. Four and a half trillion dollars have flowed to an industry that was only a $50 billion industry, as people looked for a higher rate of return on their money and money managers were given more freedom to invest. It's quite possible sometime this year there will be more mutual funds than stocks. We have now nearly 7,000 mutual funds, while at the same time the number of banks in America has fallen from over 14,000 to 9,000. If you look at the asset structure of our country, you'll find the commercial banks' percentage of assets in the country has fallen to somewhere between 25 and 30 percent.
So, as we talk about Asia and its dominance by the banking system, I would suggest to you that the United States provides a good map of how to finance business, how to finance growing companies, how to finance entrepreneurs, and how to finance the creation of jobs in all democracies and in all capitalistic systems. Where did the jobs come from? They came from the securitization of loans and equity in the marketplace, both the public and the private marketplace, as commercial loans from banks have continued to drop off. Banks began to take on the role traditionally held by mortgage bankers, and today their role is more that of a loan broker, originating loans for later securitizations sold into the public or private marketplace.
The democratization of capital has the added benefit of reducing the concentration of industrial power. In the United States, between 1930 and 1997, the percentage of the total U.S. market dominated by the top 25 firms dropped steadily. The effect of breaking down the control of capital from few financial institutions to many is an immediate increase in people looking for new businesses to finance. Then, the old closed relationships also break down.
If you take a look at some of the other countries around the world, for example those shown in the figure, you will see that in Germany, the 25 largest companies today still make up 65 percent of the market—and when you consider the cross-ownership between financial institutions and their corporations, that percentage is probably even larger.
Japan today is now down to about 25 percent, in terms of its market, close to that of the United States, and the United Kingdom is below Germany. Argentina still has an enormous concentration of 90 percent, by 25 companies. If you turn your attention to Asia, you will find that in Indonesia, 90 percent of the market is in the hands of 25 companies.
I want to point out one very important element here as we talk about the difficulty of adopting new financial policies. By the mid-1980s it was fairly well recognized that most job creation in the United States was by non-investment grade companies. In fact, our larger companies were eliminating jobs. General Electric, the world's most valuable corporation today, increased its value from $25 billion to over $250 billion in the past 20 years and today GE has one-third fewer employees than 20 years ago.
The history of the United States shows that, as we've matured, we've replaced workers with capital. This condition existed in the mid-1980s, yet we passed legislation the latter part of the 1980s that essentially banned lending to all businesses. I refer to this as the "neutron legislation" period, during which it was okay to lend money to build a building but it was not okay to lend money to any company that would hire a person to work in the building.
As a result, job formation was shut down and the real estate market was essentially destroyed. Further, because there was not at that time one investment-grade company in this country owned or controlled by an African American, African American-owned businesses were prevented from growing. The same was true for other minority-operated institutions. Their borrowing power was eliminated. As a result, although we had 305 African-American mayors in the United States, no city pension fund could invest in any business headed by an African American.
The fear that drove this legislation should make us think twice before we lecture the rest of the world about what type of regulation or legislation they will need as they begin to grapple with their own financial problems today.
Our well-meaning safeguards led to a virtual end in 1990 and 1991 of debt financing, equity financing, and private equity financing: We had shut down the capital markets in our country.
Today, having overcome the challenges earlier in the decade, we have thousands of financial institutions providing thousands of different companies access to capital, based on their value. The challenge that has yet to be met in this country, however, is the challenge of democratization of education. We've had an enormous and widening gap between the haves and the have nots in our United States. That disparity is really one of knowledge and education. The gap between a high school graduate and a college graduate in our country has increased dramatically in the past 25 years. Today, compared to 1973, a male high school graduate, 30 years old, is only earning two-thirds of what he earned in 1973 adjusted for inflation. So if non-college graduates in the United States make up 70 to 75 percent of the population, we could ask ourselves, where is the revolution? Where are people marching? Where is unrest in our country? If we have a have and have-not society, if we're building two Americas, not one, where is the outcry? I would suggest to you the outcry has only been postponed.
The challenge to our country is one of human capital, an area in which Gary Becker won his Nobel prize. It involves not only education but training. Why has this outcry been postponed? Well, one reason is the wealth effect. Over the past 13, 14, or 15 years, the stock market in this country has gone up 21 percent per year. All you had to do to increase your wealth was invest in a 401K plan. The financial technology that allowed the individual to invest his savings did the rest. A second reason is that many families have two or even three wage earners, thus making up for the loss of earning power and forestalling the issue.
But it will be very difficult for equity markets to continue to grow in this country at the same rates in light of what long-term real growth might be. When the wealth effect slows down, and everyone doesn't wake up in the morning and turn on the financial news to find out how much richer he is than he was the day before, then we're going to be faced with the issue that we have essentially two Americas.
A generation ago the United Steel Workers and the United Automobile Workers employed 3 million people, 60 percent in unskilled jobs—60 percent of 1.8 million jobs. This was the fulfillment of the American dream— home, kids, a college, education for millions whose parents were without a college education themselves. Today the automobile and steel industries employ 100,000 unskilled workers, representing a loss of 1.7 million jobs.
The stock market wasn't always like it is today, I remind you. Between 1964 and 1983, time after time it had tried to go through 1,000. Not until in 1993 did it finally do so.
Thirty percent of the net worth of Americans today is in equities. That compares to just 11.4 percent in the 1980s. This enormous growth in wealth, in stocks, in rate of return, has forestalled the challenge of our own society, one of a lack of knowledge workers, for the next generation and into the next century.
The United States does have one enormous advantage. At the start of this decade there were more teachers in college in the United States than college students in China. I'd suggest there's a couple of things we can learn from that. First, investing in and continuing education programs in China will be fabulous investments. Second, the United States is probably going to rethink its higher education system, particularly with 50 percent of our students over 25 years of age.
Social capital is the next major challenge we face and poverty is paramount. In the United States we have a very unusual situation in that poverty is weighted toward the young. As the figure shows, while 10.5 percent of those over 65 are living in poverty, this is only half the poverty rate among children.
Comparing this with the childhood poverty rate in other nations, we can see that this is among the world's highest: In the Netherlands, the rate is only 6 percent; in France, a nation with a great deal of unemployment, it is only slightly higer, at 6.5 percent.
Yes, the United States has adopted financial technology. This has allowed us to finance new industries, reduce the concentration of economic power, reduce the concentration of financial power, allowed us to move to a market economy, and allowed financial institutions to mark their assets to market.
But the United States has fallen considerably behind in social capital issues and the enormous 25 percent growth of our population causes us, and hopefully you that have come from around the world, to think about our challenges. We see the challenges in Japan; we see the challenges in China; we see the challenges in Indonesia. We ask you why you haven't democratized your financial systems. We ask you why you haven't moved to a real market economy. At the same time we can also ask ourselves, and we would like you to ask us, why haven't we dealt with the issues that we should be dealing with now, the challenge of one America.
This city has been on fire twice in the past 33 years, a city where the leading entertainment companies spin dreams for the world. It is a city that for good or bad, leads the nation in terms of change. This city, along with other major cities in our country, is crying out for private-industry solutions and for using technology to improve our social capital and human capital.
Whereas the challenge of Asia today is to deploy financial technology to allow their economies to grow, the challenge for the United States is to reaffirm the social capital, the family unit, communities, neighborhoods, and schools, to make sure that we are not torn apart from within as the rest of the world continues to grow.
QUESTION: (inaudible) has opened up a corporate market in Asia.
MICHAEL MILKEN: I think a corporate bond market, if it existed in Asia today, would take significant pressure off the leading banks and the traditional financial institutions. It could provide the capital for businesses to grow, not just the corporate bond market, but a convertible bond market, a preferred stock, a better market for IPOs.
I think you need that growth and you need two things. In talking about 1974 I only discussed the failure of the banks to provide capital to the country to conduct its businesses. But there was another element that occurred, and that was the failure of growth stock investing, the nifty 50, and the downfall of the traditional money managers who bought one decision stocks. But another thing had occurred, and that was that predictions of bankruptcy of just about all the major companies in our country, did not come true. And those people who rode out this perceived panic of credit made almost 100 percent on their money in 1975 and '76, and were willing then to invest in non-investment grade debt.
This set the stage for public financing, because you needed two elements. You needed corporations who wanted to borrow. Because they didn't want to have interest rates double on them in six months again, they wanted to borrow long. And they wanted permanent capital. And, two, you had investors who were willing to invest in corporate bonds and corporate securities.
I think you need both of those elements in the marketplace. The world today I believe has the capital if Asian countries would open their markets to world capital. The stock market in the United States has gone up more than $10 trillion, the markets throughout Europe have gone up. There is ample capital in private hands to finance Asia's needs, if Asia would open its markets to that capital.
QUESTION: I would like to know about Black Monday in October of 1987, if in fact you think we have recovered fully from that.
MICHAEL MILKEN: I don't believe that the Depression really is relevant today in the United States. The securitization of the marketplace that exists today, and the movement of capital, I think allows for the enormous resiliency of the markets as we know them today. You've eliminated the potential weakness of the financial intermediary. A corporation is no longer dependent on a bank or an individual insurance company for capital. It's dependent on any potential bank, any potential investor. So, the securitization of loans or even equity has allowed indirectly an individual investor, a pension fund, a state pension fund, to find that corporation or that business entity in the marketplace that's looking for capital. They might find it through an LBO or merchant banking, or a venture capital firm, which has raised over $170 billion, or they might find it through Banker's Trust, or Morgan Bank, or Citibank, which is really a loan broker that originates a loan and then sells it into the marketplace rather than hold it themselves.
I believe we fully recovered from the 1987 period of time. I actually was sitting on a train and I didn't really feel the volatility of the marketplace, even though $500 billion was lost that day. But through hedges, through derivatives, through much of the work that many of our Nobel prize winners have contributed to us today, many of those losses are substantially reduced by hedging and changes in the marketplace.
I also believe that fundamentally the marketplace had run up too far, too fast and we were having an adjustment. Now this is a discussion as to whether we have perfect markets or not. I don't believe markets are perfect and any of you who have dealt with institutional investors, or any of you who are institutional investors, know there is periodic irrationality in the marketplace.
I would analogize it to what David Birch had said. If you get high enough up, everything looks random and rational. Tomorrow morning, if you go up in a helicopter at 6:00 a.m., and look at the freeways in Los Angeles, everything will look like it's in an orderly pattern. Everyone in their cars is working as a team, they're all moving in their little lanes, it's all coordinated, everything is flowing perfectly. Now when you get in an individual car, you discover that this person's trying to cut the other person off, this person doesn't like that person, you're trying to get to work quicker, you're looking for alternative routes. So my view is that if you get far enough away from markets, they all look rational, and perfectly priced. It's only when you're actually there that they become so irrational. I'll just tell you one brief story.
About 15 years ago I was sitting in my trading desk, it was hot, and it was about an hour before the close. It was a Thursday afternoon, and I received a call from a friend of mine in New York. He had just come back from lunch with the family that owned The New York Times, and they had mispronounced his last name.
So, I said, okay. He said, "Well, I want them to know that they shouldn't mispronounce my last name." I said, "So I assume you corrected them over lunch." He said, "Yes, I did, but I want to buy more than 5 percent of the stock in the next hour, just to let them know that they shouldn't have mispronounced my last name."
So, I said to him, "Well, it's a Thursday afternoon, the family owns a lot of the stock, and no matter how much stock you bought, they still control the company. But their votes, couldn't you just send them a little note, wouldn't that be better? " [Laughter] And he said, "No, I want to buy more than 5 percent of the stock."
I said, "Well, my guess is we'll probably have to offer a premium to the market if we're going to buy more than 5 percent of the stock. Not everyone who owns the stock is thinking about selling right this minute." He said, "Okay." So, in the next 45 minutes we went out and called everyone we could find that owns New York Times common stock. The stock went up almost 10 percent, I think, before that day was over, in the next 45 minutes and he had purchased more than 5 percent of the stock of The New York Times. I told him he was really teaching them a lesson. The next day I read in the paper, that obviously something miraculous is occurring at The New York Times, change in publications, change in advertising rates, this is a harbinger of things to come, it's just broken out of its head and shoulders pattern. And over the next week or two the stock goes up another 15 to 20 percent.
So, it's these elements that make me wonder about a perfect market. I think that 1987's Black Monday, like other issues, was extremely painful for the people who were intimately involved, or were overextended. But, as far as the country is concerned, over time it became just a little bleep on the chart. And our rate of return on equity since 1983 is 20 percent compounded. It was quite different than 1929. I truly believe that the securities markets in technology, financial technology—if we would allow it the freedom to move, as we've allowed technology in the sense of computers and cellular telephones—would finance everyone in the world who's got a good idea and a good dream, who's got a commitment and can execute a business plan.
If the Mayor of Los Angeles was up here tonight, he would tell you that the shortage of today in South Central Los Angeles, or East Palo Alto, or East St. Louis, or Harlem, isn't access to capital, it's access to individuals with the ability to execute a business plan, with experience to deliver that business plan, and with the courage to follow that business plan through. And that he as an individual, as thousands of other individuals, is looking for those opportunities.
|Michael R. Milken, Milken Institute|
|Friday, March 13, 1998|
|8:30 am - 10:00 am FRI 3/13|
|Mexico / Latin America|
|ABRAHAM LOWENTHAL: This past September, I had the honor of chairing a plenary session in Santiago, Chile, when-for the first time-the Pacific Economic Cooperation Council (PECC) held one of its annual meetings in Latin America. I never thought I would have the experience of going to an international meeting in which all of the Latin American participants—the presidents of Brazil and Chile, a number of cabinet members, key business, industrial, and financial figures, media, and academicians—were confident, if not ebullient. Conversely, almost all of the Asian participants were nervous, telling us that things were not as bad as they looked, and that things would not get worse—although things were quickly getting undeniably worse in a number of countries. So things are not always as clear as they seem in our projections, in our analyses, in our media, and in our government statements.
Three important positive shifts have occurred in Latin America over the last few years. First, virtually all Latin American economic policymakers have come to share a general diagnosis of what was wrong with the Latin American economies in the past and how to deal with those problems, namely, by embracing the market as a way to organize the economy and getting the state out of unnecessary economic production and distribution roles. The second shift has been the nearly unanimous consensus on the desirability and possibility of constitutional democratic politics. Third, there is a regional tendency toward seeking cooperative relations with the industrial countries, particularly with the United States, as opposed to the antagonistic South North confrontation that existed in the 1970s and the early 1980s.
These three changes - the shift of Latin America toward free market economics, toward democratic politics, toward inter-American cooperation, and, I might add, toward inter-Latin American cooperation in terms of regional agreements, trade expansion, and various other kinds of exchange-these are very significant changes. They are not merely cyclical. They are responding to profound experiences within Latin America during the last generation, and to the effects of the changed international context: the end of the Cold War and of socialist ideology, and the globalization of the world economy.
The key question is whether these shifts—which have changed the ways in which Latin American politics work, and the framework and arena for foreign investment—are firm and irreversible or whether they are likely to be affected by various driving forces. These changes, however important, are not all equally invulnerable. The hard truth is that representative democracy is not being consolidated in most Latin American countries—in many cases, because it has not yet been truly constructed. The fundamentals of democratic governance are still lacking in many countries; that is, the rule of law, accountability, personal security, and respect for human rights.
There is also another question, the so-called social question. Although foreign investment has been coming in and both investment and growth have been increasing in most Latin American countries, poverty is also increasing. Some 210 million people out of 491 million live at poverty levels, according to United Nations statistics. About 24 percent of the residents of Latin America live on less than a dollar a day. In fact, the divisions in Latin America have become sharper in the last few years.
There are reasons to be optimistic about Latin America and its growth prospects. The region has shown a remarkable capacity for positive advance, even against severe obstacles. It has made clear headway in the last few years. But it does face both internal and exogenous problems. One of those exogenous problems is how to respond to the Asian shock.
ENRIQUE SANCHEZ: Yesterday, Glenn Yago of the Milken Institute asked if there was a pattern to crisis. I can describe this pattern, as I have gone through three financial crises since the 1980s. The fourth financial crisis in this period was in a region of the world I was not covering: the Nordic countries. This is a financial crisis few people refer to, but it has lasted about four or five years.
Based on my experience, the crisis in Asia was quite predictable. It responded to the classic recipe of how crises are born. The countries in Asia had large structural imbalances, external shocks, and propagating mechanisms. Looking at how these three sets of factors have changed from Latin America to Asia should help us diagnose the next crisis (which will certainly come).
The structural imbalances in Latin America were completely different from those in Asia. Latin America followed the classic paradigm of large current account deficits. It had concurrent currency devaluations, large fiscal deficits, persistently high inflation, and large short-term foreign-denominated debt. Asia had some problems that were exactly the same, namely, the large amount of short-term foreign-denominated debt and a large current account deficit. The error that analysts and politicians made was to excuse these imbalances with the lack of other traditional Latin American deficits, such as high fiscal deficits and high inflation. Nevertheless, in the new paradigm that developed for the Asian crisis, we saw new characteristics that we could still call structural imbalances. Namely, there was a weak, unregulated, and overextended banking system, as well as classic asset price bubbles.
A new paradigm will be developed in the future. We will not be able to avoid new crises, but we will have to form new ways of looking at how crises develop. The next crisis will likely have a combination of structural imbalances of each of the last two crises.
External shocks in the Latin American crisis consisted of sharp declines in commodity prices, including oil prices; sharp increases in interest rates; reduced access to funds (for example, when lenders were withdrawing funds in the late 1970s and 1980s due to their weak balance sheets); and monetary expansion. Monetary expansion is often tied to elections, reflecting increased public spending. This is the same type of external shocks that Asia went through over the past three years. The first shock in Asia was the Chinese devaluation in 1994; the second was the decline in commodity prices for semiconductors starting in early 1996; the third was the yen depreciation in 1997.
A succession of shocks is what we have to look out for in terms of Latin America's future. The first recent shock to Latin America was the contagion effect from the Asian crisis from which it has defended itself very successfully, so far. The second shock is already in progress: the sharp decline in commodity prices, including oil. We need to keep in mind that the paradigm for the next crisis is that the external shocks could be the same or different from the ones we already have mentioned.
In the past, Latin America failed to accept early warning signs. In the early 1980s, that was a classic characteristic of Latin America. They denied the withdrawal of funding, the effects of the declines in commodity prices, and the increases in interest rates. Consequently, the longer it took Latin American politicians to respond to the crises, the more difficult the crises became. That delay was also the consequence of policy mistakes in the adjustments, as it occurred in Mexico in 1994. This is exactly what happened, only worse, in the Asian crisis. In Asia only one country had crisis management experience: the Philippines. They had been through it for the last 10 years, and they were the first to respond in 1997. That is why they were so successful in isolating the contagion in the present crisis.
One more element surprised everybody in the Asian crisis: the increasingly fast electronic transfer of short-term funds. This factor combined with more open capital markets, magnifying the crisis, and will likely be the most important factor in future crises.
Given this framework, let us step back and look at Latin America today. What are the structural imbalances and external shocks already in progress or that might be coming in the near future? Brazil has a fiscal deficit of more than 5 percent of GDP (gross domestic product) and a current account deficit of more than 4 percent of GDP. These are very serious structural imbalances and fit perfectly in what we called "the Latin American paradigm." When there are structural deficits that cannot be corrected in the short term, it is very hard to respond to external shocks. At first, Brazil had major success in doubling interest rates in November 1997, but now, in the middle of a recession, it has less degrees of freedom. Colombia has a fiscal deficit and current account deficit equal to 4.5 percent of GDP. Ecuador has fiscal deficits larger than 3.5 percent of GDP. Peru has fiscal deficits equal to 6 percent of GDP, two years after they posted a balanced budget.
The Asian devaluations, which increase competition to Latin products in third markets, already are affecting Latin American countries. The Asian adjustment process, consisting of deep recessions, may last up to two or three years. That will impact in particular Chile, Peru, and Ecuador, all of which trade heavily with Asia. Increased imports from Asia will also impact Latin American countries. We have already seen collapsing commodity prices, particularly for oil, with negative effects on all oil exporters; any positive effect this has had in Brazil is relatively minor. The collapse in copper prices—to 75 cents per pound—has led to an increasing current account deficit in Chile.
Other possible shocks to Latin America are also predictable. One is the political uncertainty brought into the region in an election year. Colombia's presidential elections are due in May (with the second round due in July); Ecuador's elections will be in May (congressional) and July (presidential); Brazil's will be in October (with the second round in December); and Venezuela's will be in December. Whenever there are elections, not only in Latin America but also in many other countries, public spending goes up. When there are fundamental structural imbalances during an election year, the risk is raised further. El Niño will also have a major negative impact on Latin America's Pacific region, although in the Atlantic region of Argentina and Brazil it has had a positive impact. Of further concern is the possible contagion effects from Indonesia, Russia, Eastern Europe, and Turkey. Contagion effects are moving extremely fast. Finally, reduced funding could result from increased issuance of bonds for restructuring the Asian debt. Clearly there is going to be a squeeze effect.
In short, from a credit risk perspective, serious risks could affect Latin America in the short term. This will be the second test to the capitalist revolution that started in Latin America in 1990. The first one was the Tequila Crisis of 1994. But I suspect that there is sufficient crisis management experience to continue that revolution in the future.
PATRICK DURKIN: In 1997 the United States completed its seventh year of being the largest exporter of direct as well as portfolio capital in the world. What happens in terms of investors' corporations that are expanding their businesses to Latin America and the world makes an enormous difference to what happens in developing nations around the world. I will address the effect on investment capital, by answering three questions and posing a fourth. Question one: Does Asia put in jeopardy economic and financial stability in the world? What are the ripple effects? In fact, the problems in Asia are systemic to the developing world. The developing world is not out of the dark. Asia has a flu; other markets, including Latin America, have a cold; and they should take notice because the United States and Europe are healthily leaping buildings in at least a single or double bound. And that is where capital is going.
Question two: Could these crises have been averted? Absolutely not. Certain of these economies and governments have been on a collision course for the last eight or ten years. And it is only in Asia, through enormous growth, that the profligate fiscal, monetary, political, and regulatory policies have been allowed to survive. In fact, it amazes some of us who work in these economies that these countries, and the economics of the countries, have not blown up earlier.
Question three: Is the Asian miracle a thing of the past? There are no miracles. Mexico taught this, we forgot it, and Asia has reminded us again.
Finally, are there lessons to be learned? The headlines of reform are simple: monetary and fiscal restraint, reasonable exchange rate policies, effective regulation, and, perhaps most important, political reform. The responses of presidents and central bank heads to the Asian crisis are instructive: Brazil: "We will increase interest rates." "We will tighten our fiscal position." "We will promote exports." "We will accelerate structural reforms." Mexico: "Continued reliance on flexible exchange rates." "Tightening of fiscal stands, political reforms." Argentina: "Continued reliance on currency convertibility." "Tightening of fiscal stands, increasing the reserve requirement." "Employ trigger mechanisms under the program with the IMF (International Monetary Fund)."
But despite these Latin American governments' responsible response, look at what has happened. The year 1997 was to be Latin America's most consistent year of GDP growth in two decades. Argentina's growth was up 8 percent; Chile's was up 6.5 percent; Mexico's was up 7 percent; Brazil's was up 3.8 percent; and the region overall was up 5.3 percent. Still capital flows have slowed to a trickle, the slowest in five years. External financing needs of Brazil, Mexico, and Argentina are estimated in 1998 to be $170 billion. At today's rate of investment, they will receive less than $100 billion. And despite robust economies, not one equity capital raising has been completed from the entire region. History since 1990 has been matched only by the first three months of 1995, close to the peso devaluation.
Coupling economic growth and stock market response, all major Latin American indices are down. European and U.S. capital has remained on the sidelines and will remain there. This is bad for Latin America and for all developing nations, yet it is reality.
But the major Latin American markets and government leaders are fortunately, for the first time, sticking to the script. Predictions: Markets will rebound in the second half in Latin America, and the major indices will be up on average approximately 15 percent. Brazil's will be in excess of that, Argentina's will be at that number, and Mexico's will be disappointingly below that.
U.S. and European markets will again outperform the Latin American region, but that relationship will switch in 1999. This is a terrific scenario for Latin America, because it forces government leaders and, importantly, business leaders to think about reality—to act with discipline and recognize that capital has a cost of fiscal discipline and management.
If the 1994 and the recent Asian crises have taught us anything, it is that the most competitive markets in the world are no longer for autos, steel, textiles, or technology; it is for capital. These capital flows are massive, measured in the trillions. They are unregulated, uncontrollable, and utterly unforgiving.
SHANNON CALLAN: I share with my colleagues concerns about the aftershocks of the Asian crisis. The first is the increased risk premium that we have seen take place in Latin America. The Brazilian government was in a particularly vulnerable position last October, having raised interest rates from 22 percent to about 43 percent, in reaction to the currency turmoil in Asia; and now recently has reduced interest rates to about 28 percent. So we are still living with a higher risk premium in the region, although it is lower than it was four or five months ago.
The focus instead, recently, has turned to the commodity market. There have been very sharp price declines in a number of key commodities in Latin America. Copper prices are down about 30 percent since July 1997. Crude oil prices, which from the middle of 1997 until the end of January 1998 had been down only 14 percent, are now down 30 percent, year over year. Likewise, coffee and soy prices are lower than they had been a year ago. These key commodities are important for the revenues they provide on the fiscal side of the government and for the foreign exchange revenues they provide. In fact, the dependence on commodity revenues for governments has not been noted enough in the markets. A lot of press has been given to Mexico, which receives 40 percent of fiscal revenues from the oil industry; but Venezuela also receives 50 to 60 percent of its revenues from the oil industry, and Colombia receives 20 percent.
This is the exogenous shock Enrique Sanchez mentioned that we are facing in Latin America. Oddly enough, Chile, a country that is often noted for its copper production, receives only 4 percent of its fiscal revenues from the copper industry. Instead, the impact is on the trade deficit. Sixty-two percent of Latin American exports are manufactured goods. Nevertheless, oil, agriculture, and mining still have a very strong impact on the trade deficit. Latin America will have a much larger trade deficit this year compared to a year ago. The current account deficit for the region as a whole is increasing from about 3 percent to about 4 percent.
This in turn has caused policymakers to take very orthodox policy steps. I applaud their action, although I question whether it is enough. Fiscal budgets today, in March 1998, are smaller than they were in October 1997. Across the board we have seen fiscal cuts; it is an election year. Are they enough? That is a key question to monitor this year. Second, interest rates have been raised in Brazil, Chile, and Venezuela in order to slow down economic growth so that these current account deficits do not get out of hand. Last, a few countries have allowed their currencies to depreciate instead of ardently sticking to a peg; the Mexican peso is down about 5 percent year-to-date, and the Colombian peso is down about 4.5 percent year-to-date. These kinds of managed devaluations are appropriate policy responses.
That is just touching briefly on the macroeconomic side. At TCW we spend most of our time looking at companies on the micro level. We travel to a region and meet with the management of companies on a regular basis. They see us several times a year, and we have been doing this for many years. Therefore, we have a chance to see firsthand the issues they are facing. These companies are large and well capitalized; they are not mom-and-pop companies. They are seeing a very vibrant economy, and an economy that is very much in transition.
In 1995—a year in which Latin America was devastated by the effects of the peso crisis, experienced zero GDP growth, and net capital contributions to the region diminished—corporate earnings growth in dollar terms was up 15 percent. Throughout the 1990s, Latin American corporate earnings growth has been very robust. Why is this occurring? There are structural changes occurring at the micro level, such as the folding of the informal sector into the formal sector of the economy, industry consolidation, enormous productivity gains, and the removal of the government from the economy. We tend to talk a lot about these issues when they occur, which was in the late 1980s and early 1990s, and then forget about them. But for those of us who visit companies regularly, talk with them about what they are doing with their cash flow, and see the transformation that takes place, it really is remarkable.
In terms of investment themes for our portfolios, industry consolidation is very important. I can go through example after example of cases. Privatization in Brazil this year is going to be a very big event. The Brazilian government has slated $55 to $60 billion asset sales this year and next year.
These are some of the more exciting issues that are taking place on the micro level that I think get forgotten. The key issue, though, is that these trends cannot continue endlessly. They need to be accompanied by additional reforms.
GUILLERMO FERNANDEZ: We at Colgate-Palmolive, like any other major consumer products company, face elections every day. The consumer will vote for us or against us, at the shelves. I wish politicians had the same type of test. The word "accountability" does not exist in Spanish. I do not think it exists in Portuguese, either. It takes at least two words to formulate the concept. This might be a license for taking a bit longer to demand that accountability becomes part of daily practice.
Being close to the marketplace, we are able to listen to it clearly. On a macroeconomic basis, even though there are many bright stars shining, we have not yet seen many of the good things that are happening percolating down to the masses. I have heard from many consumers who are struggling with unemployment or sub-employment how difficult it is to make ends meet. They talk about the famous external debt. To them it is not the external debt, it is the eternal debt.
In many Latin American nations, the economy is opening up. The public sector is fortunately shrinking, and protectionism and excessive regulations are rapidly diminishing. Macroeconomic performance indicators are encouraging, hyperinflation has been practically eliminated, and foreign investments are increasing. International reserves are growing; so is gross domestic product. However, many of these economic gains have not yet made a significant impact on the so-called microeconomy. Low wages, high unemployment, and numerous local small business bankruptcies remind us that the macroeconomic gains have not penetrated enough into day-to-day reality to significantly improve the economic lot of the majority of people.
We have not been able to complete the full transition from a closed economy and society to an open economy and society. We have an incipient open economy operating from a social-political platform that largely does not match it. The necessary democratization, modernization, and renewal of social and political institutions seems to move at a very slow pace. In order for economic reform to take permanent hold and become sustainable in the long term, its social-political foundation must advance in the same direction, be aligned, and move at the same tempo. Otherwise, any short-term setback to the new, more open economic system may cause permanent damage to it, lending credibility among the populace to the demagogic and populist policies of the past.
To translate macroeconomic gains into microeconomic well-being is perhaps one of the biggest challenges of the post-Cold War world. We have to ask whether economic reform can be successful without profound structural and social reform. Major reforms may only be possible if Latin American politicians are willing to apply the principles of economic opening to political institutions and the political process. In other words, will politicians have the courage to dismantle political empires and monopolies to give economic reform a fair chance of long-term success?
Simán Bolávar, the liberator of a good portion of Latin America, spoke 200 years ago about Latin American priorities for the region. He was asked, What are the highest priorities for the emerging Latin American nations of the time? Bolivar responded: Moral (morality or ethics) and luces (light, education, wisdom, and knowledge). I believe that Bolávar's words are more appropriate today than ever before.
FINLAY LEWIS: When President Clinton sits down in Santiago next month with his colleagues from the hemisphere's other 33 democracies, the overarching question is going to be, are these leaders going to be able to pull a rabbit out of a hat to avoid having this thing turning into a complete fiasco? Most of my colleagues in the media and I think it is that this is going to be just another very expensive and meaningless photo opportunity. After all, how can the leaders accomplish anything when Clinton is going to be going there lacking the unfettered authority that he needs to be able to complete trade negotiations? That is a fair question, and one that deserves an answer. In a way, this negotiation is too important to fail.
Let me explain the issue from two perspectives. First, Latin America has the most unequal distribution of income in the world. The richest 20 percent of households claim 60 percent of the income, while the poorest 40 percent take home only 10 percent of the income. The absolute numbers of Latin Americans and citizens of Caribbean nations living in poverty is higher than it ever has been before. In percentage terms the incidence of poverty from the 1980s is down slightly, from 41 percent to about 39 percent—hardly impressive.
The Washington consensus could be quite fragile. Patrick Durkin talked about the coupling of capital flows and economic performance. Trade is usually linked with investment, so it could be significant from that point of view in terms of social stability, economic performance, and so on in the region.
The second point is that demand is declining in Asia. Can the United States afford to ignore the Latin American market, where exports recently have been going up by about 20 percent, thanks to economic growth and the reduction of trade barriers? How does this affect the summit? A report released earlier this week by the Leadership Council for Inter American Summitry has a seemingly counterintuitive central recommendation, which is to accelerate the completion date for the negotiation of the free trade area of the Americas from 2005 to 2002. The Council's logic is that the more distant date encourages procrastination; that the Americans do not need the fast-track trade negotiation authority to begin a negotiation, only to complete it; and that the failure of fast track is, at best, a temporary glitch. I agree with the Council on all three counts.
The APEC Summit last November in Vancouver occurred only days after the defeat of fast track. The Asian leaders had come to that summit with their minds fully concentrated on the menacing dimensions of the crisis engulfing their region. They had every reason to go into a defensive crouch. After all, their economies were being victimized by what Bill Greider describes as the manic logic of global capitalism. If globalization can be said to have a split personality, those Asian leaders who thought they had gotten to know Dr. Jekyll were now making the acquaintance of Mr. Hyde. But instead of hunkering down before the storm, those leaders boldly advanced the APEC trade agenda by endorsing a sweeping program of trade liberalization across nine sectors of importance to the American economy, including chemicals and autos.
Why is that significant in terms of Santiago and the U.S. Congress? First, the narrow victory of NAFTA and the narrow defeat of fast track can be almost totally explained in terms of the collapse of the Democratic Center. Republican support in the House for both initiatives remained constant at about 70 percent. However, Democratic support went from 41 percent for NAFTA to about 21 percent for fast track.
Second, fast track was never presented as anything other than a theoretical, abstract matter of process, never as a question of real economic substance. This made it, as Fred Bergsten has said, "airy fairy." Those of us in the media who were covering that bill were unable to sell a story on the subject to our editors to save our souls. It was only when the editors began to see this as a story about a political power struggle did they say, "Oh, that's interesting."
Of course, it has to be acknowledged that Clinton's effort on behalf of his own bill was woefully inadequate; indeed it was inept. There was no risk to voting against fast track, and not much to be gained by voting for it—particularly if you were a Democrat, in view of the full-court lobbying press of the AFL-CIO against the bill.
If the U.S. government can get behind a forward-leaning trade agenda, it would bring into focus the practical lunch-bucket, cash-register advantages of trade with Latin America. The administration has a chance at the Santiago summit to get out of the political box in which it now finds itself. But accomplishing this is going to require some substantive changes in labor and environmental issues, and that could very well be the rub.
How does the Asian crisis affect all of this? Analysts who argue that the defeat of fast track signified that the United States was turning inward should perhaps look more closely at what is happening on Capitol Hill to the bill to replenish and strengthen the IMF. Because of the Asian financial crisis, that bill is about something really quite powerful: It is about the health of the American economy—jobs, if you will.
ABRAHAM LOWENTHAL: Let us talk about Brazil, the largest of the Latin American countries and the ninth largest economy in the world. Patrick Durkin predicted that by the second half of 1998, Brazil's position would be rising rapidly and it would be even better the following year. What is the basis for that statement, and does everyone agree with that projection?
PATRICK DURKIN: The main events in Brazil that will be driving investment are two. First, valuations. If you look at some of the major companies in Brazil that have been the darlings for U.S. and European investment, those valuations have crossed markets; not only in Latin American but in other emerging markets, they look attractive. Second, Brazil is going through the largest privatization program in the world. Based on our activities in the country, it looks as if some of these privatizations are going to succeed. That will send a signal to the world that Brazil is serious. These are enormous amounts of capital, which are important to the budget and to the fiscal program for Brazil. Brazil has serious disequilibrium in the economy, and at the same time a bit of a carnival that is going to last longer than four days, and is going to involve the sale of $55-60 billion in assets. Brazil's privatization is going to be the sale of the world's eighth largest economy, including the entire telecommunications sector. That is a big sale.
Regarding the disequilibrium in the Brazilian economy, consumption is too high relative to its productive capacity. Some people say that means you need to devalue in order to reduce consumption. Or, you can simply have a period of lackluster growth where the consumer has a bit of a hit, and over time, investment grows and the productive capacity increases. Can Brazil do that when the real interest rates are at 20-25 percent? No, they can't. So, Brazil needs its assets sale.
ENRIQUE SANCHEZ: One of the most amazing changes that I have seen in Brazil is that until approximately five or six years ago, Brazil used to take three steps forward and four steps back. Over the past five years, Brazil has been taking four steps forward and only one step back. Turmoil in Brazil right now is probably temporary. Reforms take a long time to be passed in Brazil's congress because they apply democracy to the letter, and they have to go through seven different levels of approval in order to change their Constitution. I submit to you that the problem is temporary.
Yes, the risks are there. They are more severe today because they do not have degrees of freedom (i.e., room to maneuver) necessary to implement other cyclical restraints. That is the important point. How much more can they raise interest rates when they already have doubled them (to 44 percent), and when they have already induced the economy into a recession—a measure that was unthinkable even three or four years ago? They have done it intentionally in order to avoid a financial crisis. That reduces their policy options.
The positive point is that in Brazil, as well as in Mexico, the continuing pressures of the international environment today are causing the correct reactions.
ABRAHAM LOWENTHAL: Guillermo Fernandez suggested that the real question was whether political leaders would apply to the political system the same kind of commitment to openness as they have shown in reforming the economic sector. That is a central question in Mexico, as it seems to have no consensus opinion. There does seem to be consensus that the old rules of the political system—the system by which the president can appoint his successor, the quasi-imperial six-year presidency—are gone, but that they have not been replaced by a new set of rules. Do you agree? Whether you agree or not, what are the implications of political uncertainty for the Mexican economy and investment opportunity?
GUILLERMO FERNANDEZ: I believe that the old rules may have been thrown out but the spirit lingers on, because it is something deeply ingrained in Latin American culture. The big question is, what is going to happen in the year 2000 with an election that is going to be a crossroads one for Mexico?
I choose to be an optimist. I believe that Mexico is slowly learning and that it will tackle the political issue in due time. Whether this will happen at the 2000 election or if it will take longer is difficult to predict. Let's hope for the best.
ABRAHAM LOWENTHAL: In the next two or three years, partly around these election cycles, we are going to see more significant challenges in some countries to the market reforms that have gone forward—not fundamental attitudes, not complete reversal, but some real challenge to these rules—and this will be unexpected for some analysts as well as for some of our panelists today.
|Abraham F. Lowenthal, University of Southern California|
|Shannon Callan, TCW Group|
|Patrick Durkin, Donaldson Lufkin & Jenrette|
|Guillermo Fernandez, Colgate-Palmolive|
|Finlay Lewis, Copley News Service|
|Enrique P. Sanchez, Nations Bank|
|12:00 pm - 2:30 pm FRI 3/13|
|The Nobel Laureates|
|MICHAEL MILKEN: In 1981, when the major financial institutions in the United States were $1 trillion underwater, very few people were asking us to mark to market. If we had marked to market we would have found that all of our financial institutions had losses that were substantially more than their capital. Today we might ask for a market economy. We might ask for marking to the market. While it is easy to mark in the United States today, with interest rates of 5 to 6 percent, fixed income portfolios making gains, and a stock market at 8600, Asia is in a different cycle. How would you stand on this issue today?
MERTON MILLER: Well, I know at first sight it looks ridiculous. Here are these banks operating with depositors and withdrawals just about matched. Why do you bother to mark to market and call them insolvent? The problem is that in ignoring that, we let them feel that we don't have to worry about asset values. Then you wind up with something akin to the situation in Japan.
I've come reluctantly to the conclusion that we just can't live with this industry anymore. Banking is a 19th-century technology. It was very useful as a way of marshaling the savings of people who had only a limited number of other alternatives, but the industry itself is disaster-prone. Every few years, because of these ridiculous leverage ratios that it has, the industry becomes insolvent and gets bailed out. That creates a huge moral hazard problem, both among banks and regulators.
MICHAEL MILKEN: You're suggesting that if we marked to market in 1998, we would favor Western financial institutions because their assets for the most part are above water. Citibank, for example, has a market value of $62 billion today, versus $3 or $4 billion a decade ago. But if we had gone to marking to market in the latter part of the 1980s, institutions in Asia would have found that their assets were worth hundreds of billions of dollars more than book value and our Western financial institutions would have been underwater. Aren't you showing a little favoritism here?
MERTON MILLER: No, I would get rid of both of them. The point is I don't feel the institution of banking is viable in the modern age.
MICHAEL MILKEN: Are you suggesting that for financial institutions that are not serving as mortgage brokers (originating and selling loans) or for banks that are not serving as mortgage lenders (originating and selling loans), that the volatility is such that they can't operate in the traditional sense of an historical banking institution?
MERTON MILLER: They can′t operate with 4 or 5 percent capital. I don't think it's viable anymore. I would get rid of deposit insurance and the doctrine of too-big-to-fail and develop a whole new approach, one with a much more market-driven as opposed to a bank-driven type of capital market.
MICHAEL MILKEN: If we asked Asia to mark to market today, what would be its transition to a securitized bond market, a securitized mortgage market?
MERTON MILLER: Well, let me explain what would happen. There's a fear of bankruptcy in this country, but it is even greater in East Asia. But bankruptcy just means that everybody will take a step to the left, and some of the existing shareholders will drop off. That's it. Now we're going to get a whole new bunch of shareholders. That′s what the current shareholders in East Asia aren′t willing to accept.
HARRY MARKOWITZ: If the question is, should we mark to market right now and wipe everybody out who's underwater, clearly we don't want to wipe everybody out who is underwater. But think about the system we might like to move toward five to ten years from now. We'd want to mark to market then, because we as investors would like to have information about the companies we invest in. We will want to know whether the numbers we see are historical or current. So we would like to know what happens when you mark to market.
The next question is, if you do mark to market, and the book value is negative, what should you do about it? The problem is that there are assets that are not valued. Let's not worry about the banks; let's think about that insurance company. It has a client base. It's got contracts that aren't necessarily fully valued in this mark-to-market process. It has value as a going concern, which is not fully valued in this mark-to-market process. So, yes, I would like to see what the assets are worth, but I don't think that that insurance company should necessarily be put out of business given the current accounting, because it doesn′t really reflect the total value of the company.
MICHAEL MILKEN: This is a very interesting point. Let's talk about mark-to-market accounting. We want accurate data, we want to know what the facts are. We would suggest, and the work of Dr. Becker would suggest, that the most important assets on the balance sheet aren't even reflected--that includes human capital, management systems, and information systems. You wrote those off, they don't exist. Well, there is one industry in the United States, at least, where we do find human capital on the balance sheet, and that is professional sports.
In 1984 the Chicago Bulls had an attendance of 260,000. They drafted a young man named Michael Jordan in 1985 and that year they had an attendance of 650,000. They discovered that they could raise prices.
In 1986 they doubled the average ticket price to $30, and they still sold out. Today, as we're all well aware, the Chicago Bulls have won five of the last seven world titles. In the two years in which they did not win, Michael Jordan was playing baseball for all of one season and half the other. His contract is very valuable.
In 1979 or 1980 the Boston Celtics drafted a young man named Larry Bird. Once the proudest name in professional sports, the Boston Celtics had lost 29 games and won 53 games the season before. That very next season with Bird they won 61 games. By 1981 they had won the World Championship, which they repeated in 1984 and 1986. I think we've all seen that since Larry Bird retired the Boston Celtics have not been as successful. So one person made a tremendous difference.
GARY BECKER: On the point that has been raised about the valuation of human capital on the balance sheets, I think it's important that it be done. The value of the human capital in the U.S. economy in terms of education and training, particularly training, is very hard to get at. A very rough estimate, but I think in the right ballpark, suggests—when you look at the total capital in the United States—that roughly 75 percent of it is in the form of human capital.
It's not valued on any company's balance sheets that I know of. It's an intangible, but to most companies in the United States, it's absolutely crucial. The fact that we're not valuing it (not only in companies, but also in national income accounts) is an enormous oversight for any modern economy.
MICHAEL MILKEN: Well, let's take a quick look at a company that had a change in management. In 1983, the entire Disney enterprise was selling for $1.7 billion. Walt Disney had passed away in 1966, and for 17 years Disney stock had pretty much tracked the S&P 500. To give you a relative value, it would have taken three Disney′s in 1983 to equal one Universal.
In 1984, Michael Eisner, Jeffrey Katzenberg, Frank Wells, and the team came in. If you look at the performance of the company between 1984, when they arrived, and today, you will find that more than $24 billion in value relative to other industries in the group has been added. Today it would take seven Universals to make one Disney. This is a change in 15 years of 15 to 1, between two companies in the same industry.
We can also see this effect on companies such as Motorola and Kodak. When Kodak announced a new chief financial officer, in one day the stock went up $1 billion dollars. When the CEO announced he was resigning shortly thereafter, in one day the stock went down a $1.7 billion. When George Fisher was named the new head of Kodak with only two or three hours left in the trading day, the stock went up $1.6 billion; Motorola stock went down $300 million—almost a $2 billion change, caused by one person.
So although we can see the value of human capital, we don't find it on the balance sheet.
KENNETH ARROW: The question that hasn't been addressed is, who owns the human capital? These people are not owned by the company. They can dispose of their human capital as they will, and it's an interesting question why Michael Jordan, for example, didn't extract all the rent that he conveyed to the Chicago Bulls.
Obviously we can tell a complicated story: they were taking a chance on him, they developed him, and so forth. But it's not a simple matter saying that all the human capital is really in the hands of the company for whom the person works.
As we see, people move. Baseball, where we have gone to something of a market system, maybe illustrates this better than basketball.
Although the human capital is there and should be accounted for in the national wealth, it is not necessarily corporate wealth.
GARY BECKER: I think Kenneth Arrowis raising a very relevant issue. The ownership, particularly of company-sponsored investments, or what we call specific capital in the jargon, is sort of jointly owned between the worker and the company. The valuation of that is very difficult. It really depends upon how much of that wealth workers can take with them when they change jobs. If they can take very little of it with them because it's embodied in the particular company they're working for, then it's really the company that owns it. If they can take all of it with them, then it's essentially the worker who owns it. Most cases are somewhere between those two extremes.
HARRY MARKOWITZ: This is similar to other areas: it's not the lines of computer code but the way in which they're put together that gives a program its value. So, one person, by himself, may be worth nothing; he's got to find an organization that he can make a contribution to.
MICHAEL MILKEN: Referring back to Dr. Miller's concept, Citibank, for example, even if it had no net worth, doesn't include all of its employees on its balance sheet. Its management system might have significant value with their relationships around the world, their teamwork, their processes, and their information systems.
HARRY MARKOWITZ: True. And somebody buying them would have paid for it. But let me ask you this. What's the value of the personal capital in the Japanese banks? Are there substantial economies of scale there that are worth preserving? I don't know. I don't think there's any evidence that there is.
MICHAEL MILKEN: Let's switch back to baseball for a moment. The owners of baseball have had a very difficult decade. They discovered that the first baseman they used to pay $100,000 now costs them $3 to 4 million on average. So they've had to pay 30 times more for that first baseman's talent. Peter McGowan, owner of the San Francisco Giants, a few years ago had to decide whether he should resign Clark and lose $15 million, or not resign him and only lose $10 million that year in running his business. This is a labor market where most of the value has flowed to the players.
Turning to the macro level, now, let's talk about immigration. In this decade, well over a few million people have left Russia for Israel or the United States. It's very difficult to put a value on the human capital that's moved. Your estimate in the United States of 75 percent would put some valuations of human capital close to $75 trillion. In dollar terms, we're talking about a movement of trillions of dollars in human capital that has flowed to the United States and Israel from Russia in recent years.
GARY BECKER: If you look at the balance sheet of a country like Russia, you can see a definite loss in capital. Of course, in a competitive system, people will get the value of their marginal contribution to the economy; the value of what they're contributing will flow to them.
Similarly, Michael Jordan's salary is an approximation of his contribution to his team. There is no question that the flow of human capital represents an increase in assets for Israel and the United States, in the example. When this large of a number of skilled people move, it is a loss to the national income of the countries they left. In their new country, Israel or the United States, they should be able to command in salary approximately the value they're adding, as individuals, to the economy.
MICHAEL MILKEN: So, for the United States, when we think about balance of payments, or trade, the influx of bright young people from around the world to attend our universities has obviously both brought human capital here and created more human capital for the world at large.
GARY BECKER: We have added to the supply of human capital. One of the great shames in U.S. immigration policy is that we don't have a much more flexible, freer policy of allowing in more immigrants, particularly more skilled immigrants.
Much has been discussed over the years about the U.S. educational system, K-12. Maybe it's not competitive with other countries around the world. The average number of days in school in Japan is 243 versus about 180 in the United States. By the time a student has graduated in Japan, he or she has gone to school the equivalent of four years longer than a student here in the United States.
Hong Kong and Taiwan also have more days of school. These countries are attempting to educate 100 percent of the population. Whether their educational system better prepares people for manufacturing jobs and other types of jobs is open to question.
However, when we look at the most recent test scores in math and science, we find the United States is near the bottom of the world. In fact, the average 13-year-old in Korea has math scores equivalent to the top 5 percent of students in the United States.
On the other hand, we find that the U.S. higher educational system is the leader in the world. There are more teachers teaching assistants, or administrators at the college level in the United States than there are college students in most other countries.
Is there a relationship between the stock market rate of return and educational levels? Hong Kong, which had the highest test scores in math in the last 30 years, also had the highest stock market performance in the last 20 years.
MICHAEL MILKEN: Are there two different educational systems? Do we have an educational system in many of the Asian and European countries that is really driven toward raising the level of the entire population? And do we have an educational system in our country that is really more focused on raising the level of the top 25 percent of our population? If so, what are the long-run implications?
KENNETH ARROW: The problem with evaluating an educational system, of course, is that the inputs are extremely complex and varied. As you know, those people have been attempting to estimate how the outcomes, however measured, are related to the input.
Elements in the social structure most strongly affect the outcome of education. Given this, while I think remedial and improvement possibilities are there, I don't think they are going to be easily achieved.
Americans have the ideology of universal education. If you look at, say, pre-World War II education in Europe, it was definitely a bifurcating system. A few students went to the gymnasium but a great number either did not finish secondary education at all or went to some secondary institution intended to lead to low-level jobs. That pattern has changed in those countries, and we might be moving in the opposite direction.
I think the problem of the U.S. educational system is largely the bottom 20 percent or so, where we're doing a very poor job. We're doing a reasonable job at the to 50 or 60 percent. Now you ask why in international comparisons of science and mathematics performance we do poorly.
I think the wrong comparisons are being made. We should be comparing people at the point of entry into the labor force. The United States puts a much larger fraction of people into various forms of higher education than any other country in the world. Some of these students don't get much math or science in high school, but they do better in college.
If we could compare U.S. students at the point of entry into the labor force with students from many other countries, I suspect the top 70 or 80 percent of our students would look much better than if we used math and science comparisons.
MICHAEL MILKEN: But isn't that suggesting that our students can't enter the labor force until they're 22, while other country's students can enter the labor force at age 17 or 18?
GARY BECKER: It's true we have a different philosophy. It may not be a good philosophy. Here, high school isn't that difficult, even for the top students, most of the time, but you work very hard at higher education. In Japan and many of the European countries, high school is as tough as can be, but then they rest when they're in college. Is their system better than ours? I'm not convinced it's a better system overall.
MERTON MILLER: I've been teaching both foreign and domestic students at the graduate level for many years. I think U.S. students, on the whole, do catch up by the time they get to graduate school.
The big difference is that the U.S. students have more alternatives to graduate education. Some of the East Asian and other students choose the academic track because they lack an alternative.
GARY BECKER: I want to come back to the point that the group that is being shortchanged in U.S. education is the bottom 20-25 percent. There are lots of reasons why this is occurring. It's not simply the school system, it's family structure, and so on. But the schools could do better. I think the only solution that has any hope of succeeding is to give these students the same kind of additional choice that middle class and upper class students have. They're facing what we call in economics a monopoly school structure. If we can improve this, it will make possible the chance of a significant number of people at the lower end making a much better contribution to the economy than they're able to make today.
MICHAEL MILKEN: Let's take a look at the differences in wages that has grown over the past 25 years. In 1975, the difference between wages in both absolute and relative terms between a college and a high school graduate were much narrower than today. The average 30 year old male today, in 1995 dollars, is only making two thirds, adjusted for inflation, of what he made in 1973. He's lost one third of his income. If we're in a state of relatively full employment, and we lack the human resources to increase our productivity, what is the solution that we put forth? And are we going to see social unrest in this country as we move forward into a stratified America?
GARY BECKER: This widening differential by schooling did start in the mid-1970s, and it's continued more or less into the 1990s, although it has somewhat since flattened.
If you look at individual earnings, particularly for males, there's been an enormous widening of the gap between the earnings of people at the high and low ends. What does that mean and what we can do about it? I think there's your question.
On the one hand, the answer is optimistic. It looks at the problem using financial concept. Rates of return on higher education have gone up in the United States, today they are higher than at any point in U.S. history—15 percent instead of the 9 percent we were accustomed to.
Also, since 1980, the fraction of high school graduates who have continued their education to some form of higher education has increased enormously. It's cut across every social and economic group. I think it's been a response to this great increase in the rate of returns. From that point of view, then, we have a great opportunity to enable people of modest means to continue their education beyond high school.
MICHAEL MILKEN: Let's broaden the subject a little here. Economics is now based on mathematics. Economics based on mathematical models is an exact science. Yet people are always asking why economists can't "get it right." Why can't you guys ever agree, and why doesn't it turn out the way you expected it to?
KENNETH ARROW: Mathematics is not a science, exact or otherwise. It's exact, but it's not a science. A science is substantive knowledge. Mathematics is a procedure. It's a very powerful procedure.
There is room for mathematics where somebody proposes a hypothesis to explain something. You then say, well, if you really believe that, you must also believe thus and such. The consequences therefore turn out to be rather remote from where you started.
But theory is always interpretation. In fact, the facts are interpretation. A 19th century philosopher of science once said that we see the world through a mask of theory. We need theory to see the facts, and we need facts to test the theory.
GARY BECKER: Mathematics has been a very useful tool, as Kenneth Arrow and Merton Miller said, in certain parts of economics. And we all use it. I'm not against the use of mathematics in economics. Nevertheless economics is a very imperfect science, and I think we have to recognize that. There are many things we don't know out there in the economic world, in the financial area, in the human capital area, and many others.
On the other hand, these are the things that economists can disagree about. Even so, there's a substantial body of opinion, among all economists, that is in substantial agreement. For example, conclusions about such questions as whether putting a tax on a good will lead to a rise in its price, and whether lowering a price will lead the consumer to buy more, will be similar among economists.
Additionally, economists, despite their imperfections, will generally do a lot better on an economic issue than somebody who's not trained as an economist.
HARRY MARKOWITZ: Let's talk about portfolio theory, which I'm not sure you would consider economics. There is a formula for the variances of the portfolio, which is a complex thing.
Now, people didn't need that formula to know they were supposed to diversify. If you look at Bartlett's Quotations, you find that the expression, "don't put all your eggs in one basket," comes from Cervantes' Don Quixote. And Shakespeare's Merchant of Venice says something similar. So who needs a theory?
Now if you're going to use your computers and your database to do an analysis of the value at risk for Citibank as a whole, you can't just tell your computers, "Don't put all you eggs in one basket." You have to have a theory. It just turns out this theory says that somebody has to estimate all these convariances. Mathematics doesn't, somebody does. And people argue back and forth about how you estimate the convariances. So, it's imprecise because people come up with different answers depending on how they estimate the covariance and variances. But at least it's focused the discussion on what it is that needs to be estimated.
MICHAEL MILKEN: If you could reflect back over the past, what might have been your largest surprise, economically speaking?
MERTON MILLER: The biggest surprise to me has been the rise of China from being nothing near a world power, hopelessly entrapped with communist ideology and a very low standard of living, to taking the first steps toward becoming a modern economy. And I must say, having been there in 1983, I was skeptical that it could. But I am now much more optimistic about it.
MICHAEL MILKEN: Dr. Markowitz, what would you say has been your greatest surprise?
HARRY MARKOWITZ: Well, the greatest surprise and delight has that people use my theory.
MICHAEL MILKEN: Dr. Miller, a lot of the work you do is read by your peers, but the person on the street who is not an economist and doesn't have a mathematical background wonders what the economist's contribution is. Maybe you can follow up on that.
HARRY MARKOWITZ: Bill Sharpe, who shared our prize, is developing a web site at a level where the common man can learn about what this really means to him. Of course the common man is getting more and more into the market and he's getting more and more sophisticated.
GARY BECKER: I was attracted to the profession by my interest in social problems. I thought for a while of becoming a sociologist, but I found sociology too difficult, so I went into economics instead.
We haven't solved many of these social problems by a long shot: racial relations, education issues, pulling up people who come from poorer backgrounds, doing this not only in the United States but on a global basis. That spills over into issues related to economic growth, which is a problem that has fascinated economists for 200 years. We're not a perfect science, but people are struggling with it.
The diversity in incomes across the world is enormous. How do we get more countries to make the right policies with regard to education, free markets, and the like? How can they pull themselves up to a standard of living where the typical person has more than a very difficult life with few resources to spend? That to me is still a big challenge in economics.
I consider it a continuation of the problems that first attracted me into economics but that remain unsolved.
When I was a student at the University of Chicago, we learned to appreciate the value of free markets in a decentralized system. Nevertheless we saw the Communist world out there and it seemed to be doing remarkably successfully. The growth rates appeared to be good—some people said better than in the free world. The issue arose as to whether, as Khruschev said, they would eventually bury the United States (economically, not militarily). A lot of economists and others began to believe that a centralized economy could indeed manage and organize resources. Of course it doesn't have freedom and so is terrible from that point of view, but they can be more effective economic machines.
We didn't believe that at Chicago, but the evidence seemed to be going against us. A big and a very fortunate surprise was the unexpected and total collapse of the Communist world as an economic system.
So whatever it may be politically, China is no longer a communist economic system. There is not a single new nation that's forming today, no matter what they say their political philosophy is, that is looking to central planning as a guiding economic concept. To me, that's a great surprise, and a very gratifying one, because what I was being taught as a student turned out to be right.
KENNETH ARROW: In terms of the goals of economics and what it is that motivates us, I agree it is the large social problems. When I was young it was the Depression, the business cycle. Now, there's no point in assuming the business cycle has ended. So far we're doing remarkably well in this current period; whether it is the result of management or some conjunction of economic circumstances that we don't understand, I don't know.
Technology has raised a very interesting question. This is perhaps the added surprise. We have a remarkable retardation in the rate of productivity growth in the advanced countries. Gary BECKER quite properly talked about the remarkable successes in many of the developing countries. Their average rate of growth, if anything, is higher than that in the past. Yet the overall statistics seem to show that the advanced world is not growing. This is connected with the income distribution problem that we mentioned before.
Now it may be an optimistic view, but is this a digestion problem having to do with technology? People have drawn the parallel to the introduction of electricity. The first decade of the 20th century had one of the slowest rates of productivity increase ever. This could be due to the problem of absorbing the new technology, though this is a very vague statement. This is connected to the other interest behind a great deal of what I've done: a concern for communication the process of drawing inferences. My early training was as a statistician rather than an economist. I switched somewhat late in the game, and that's remained with me.
The idea of information flows, how people acquire information, how information flows from one person to another, has always been in the background. I think it is increasingly connected with the question of growth. Why are different countries so different in their ability to extract output from a given body of resources? Though this is an incentive question, among others it is also a knowledge question. Gary BECKER was very surprised that these knowledge differentials persist over long periods of time. It's gratifying to me to see that many countries, China for example, are in fact overcoming them.
MICHAEL MILKEN: One of the methods economists study is regressions, projections of the future based on the past. When we think about some of predictions made in the past, for example, that the price of oil would reach $100 dollars a barrel by 1983-84, and find today, even adjusted for inflation, that the price of gasoline is the lowest it's ever been in this century, we see they don't always prove to be accurate.
One of these areas is population. Many of us believed growing up that these population problems were in front of us. Today, in countries like Italy and 63 other nations in the world, populations are actually shrinking. Birthrates in some areas are varying between 1.0 and 1.7. Projecting these current numbers a generation or two, you find that Italy, for example, will lose a quarter of its population.
How do you account for such predictions? Are these surprises? Have you seen them many times before?
MERTON MILLER: Years ago, when I was first beginning to study economics, one of our books was called Problems of a Changing Population. It was the greatest work to date about population projection. But as I look back, even these "high" projections from the 1930s (you always had them in threes: low, high, and expected) were so far below the actual population that it makes you wonder whether population is even predictable.
I've heard all of these remarks about the decrease in population in Europe, and I believe them because I have no alternative model to use. But it wouldn't surprise me if they turned out to be terribly wrong. There is a large number of Albanians that want to migrate to Europe, and a myriad of other factors that cannot yet be accounted for. So, I think it's very difficult to make even something that seems as straightforward as population projections.
GARY BECKER: It's been surprisingly difficult to forecast populations, an area that I've worked a fair bit in, not too much in forecasting but the economic effects in relation to population. It seems as if all the population momentum is built in, but changes in fertility can have an enormous effect in a relatively short period of time, as can changes in the mortality rate. The earlier forecast missed both of these. People fortunately are living a lot longer than had been projected, and birthrates from the earlier forecast didn't come down as quickly as anticipated. Now, they've come down very rapidly.
A related problem, where I think economists have misled the public, concerns the consequences of population change. Ever since Thomas Robert Malthus published his first essay on population on 1798, the economic profession has seen negative consequences of population for growth on per capita income.
I think this has never been proven. I'm much more optimistic about that. If you look at the world from 1950 to 1990, we doubled the population and it was one of the periods of fastest per capita economic growth. There are very good reasons why rapidly growing and larger populations can be beneficial to per capita income of a country under many environments.
Therefore, these worldwide trends toward low fertility that we're seeing now in every advanced country may have important consequences for per capita income. I think the naive view of traditional economics (namely, that this will somehow be beneficial) is going to turn out to be wrong.
HARRY MARKOWITZ: May I generalize your observation? It's an uncertain world. You can't predict all sorts of things. I mean, your point was, if you could predict anything, it should be population, and even that you can't predict. Now what's the consequence of that? Traditionally, planning, both for business and government, was a process where you asked the experts to come up with a single prediction, and then you pretend like that prediction was true.
Now we understand better that you can't make just one prediction. You should predict a range and look for policies that are going to hold up over a range. Increasingly, businesses have faced up to the uncertainty in all their actions.
MICHAEL MILKEN: One of the areas we've not discussed yet is development in Africa. Dr. Markowitz, how would you develop a portfolio today to hedge the risk on development in Africa?
HARRY MARKOWITZ: Well, we don't have very good information about Africa. I haven't studied Africa, but I imagine the accounting systems aren't terribly great. So even if we got some numbers, we probably wouldn't believe them.
Before we can invest, we would like to see these countries develop good accounting systems, then put the resulting numbers in computerized databases. Their reward would be that if we like the numbers, we'll invest. Then, the capital flows that you were talking about will happen.
MERTON MILLER: I believe the remedy for Africa is the same as it is everywhere else. First of all, free up agriculture, get the government off the back of the farmers, cut out the other oppressive government interventions in the economy, and get rid of all those kleptocrats that are running the place. Why wouldn't the laws of economics apply in Africa just as they do everywhere else?
GARY BECKER: Absolutely right. People look at Africa and they try to invent a whole set of special conditions—colonialism and the like. Maybe that left some bad legacy in some of these countries, but the problem with Africa is just as Dr. Miller said. The fundamental problem is simply a series of bad governmental policies, a belief that government could micromanage the economy—partly because African nations became free during the period where it looked like the Russian model was the right model, and a lot of these nations copied it.
Getting rid of that model has been very difficult. Fortunately, the lesson is being learned in Africa. There is absolutely no reason why Africa couldn't join those nations of the past who also had dismal futures but now have a rapid economic growth.
I would be optimistic about Africa if government would get out of the hair of the individual businessmen and workers.
KENNETH ARROW: I think that's correct, but there is a fundamental problem that so far has not been addressed. Why haven't these countries moved in this direction? These countries are very artificial entities. There is no common history for the most part, except for having been ruled by some European country. If you look at the boundaries in Africa, there are a remarkable number of straight lines. They have no organic existence, I think this permits the kleptocracy, the military adventuresomeness and the like. This stems from a lack of any real unity.
Nigeria is but one example. In its north and south are two very, very different kinds of people. They have no countrywide linguistic identity and this is coupled with religious differences.
GARY BECKER: Indonesia is very diverse, Malaysia is diverse, and Taiwan was never an independent entity. It's always much more difficult to get rid of a highly bureaucratic environment than to establish it in the first place.
MICHAEL MILKEN: We can also say the United States is a very diverse country. Let's take a look at one other element here. Many U.S. universities were founded two or three centuries ago; they were here long before many of our urban problems arose. Some, like Yale University in New Haven, Connecticut, has produced a number of presidents. Many of the leading thinkers of the last few centuries were either educated or served as professors there, at the University of Chicago, the University of Pennsylvania, and others. When we focus on this issue, we see an unusual fact: many of our leading centers of knowledge are located in areas with some of the highest crime rates in the United States.
A little earlier in this decade, 6.7 percent of the U.S. population in New York City, New Haven, Philadelphia, Baltimore, Washington, D.C., Chicago, and Los Angeles experienced 21 percent of the violent crime. These cities also contain some of our greatest research facilities. Many of these institutions have endowments of $5-7 billion. Yale's endowment alone is more than $25,000 for every man, woman, and child that lives in New Haven. If our best thinkers are there, if young idealistic students with energy are going there, why have their host cities deteriorated over the centuries, and we haven't been able to correct this problem?
GARY BECKER: The most obvious reason is that universities are among the most durable of all institutions. They stay put and the neighborhoods around them deteriorate. The University of Chicago used to be in an upper middle-class neighborhood, a very rich neighborhood.
MICHAEL MILKEN: What was the cause of its deterioration? Was it the university itself?
GARY BECKER: Partly, probably, and housing getting older, and not being so useful in the modern environment. I think the bigger problem you're raising is twofold. One, crime is endemic in the United States. What can universities contribute to its elimination? Secondly, and more controversial, should universities be putting a significant part of their resources into trying to help their communities? Let me try to give two answers, starting with the second question.
I don't believe it would be the appropriate role of the University of Chicago to be spending its resources, which is $2 billion in assets or so, on trying to help the community around it, because that is not its purpose. Its purpose is to try to generate ideas, theories, and evidence that ultimately can help this problem not only in the area surrounding the University of Chicago but also in other urban areas throughout the world. It is partly incumbent on universities to be devoting some of their intellectual resources to worrying about issues like crime, broken families, and the like, and most of major universities, including the University of Chicago, are doing that.
If we can make an important contribution to understanding what generates crime and how can we reduce it, this would be a far more important contribution than it could make by spending some of its limited endowment in trying to help the area that immediately surrounds the University of Chicago. I think it is making that contribution.
MICHAEL MILKEN: The great findings and discoveries of economics and other disciplines are used by society effectively. Modern portfolio theory, such as that Dr. Markowitz has been developing, is used throughout the world. For a person who has a well-diversified portfolio, the 1 or 2 percent loss he will sustain in the Asian markets will be more than made up by gains from other pieces. This is so only because technology now allows capital to flow around the world, thus spreading our risk.
It is this financial technology and theories such as those developed by the four individuals here that has built the supply line that has allowed countries to flourish. These factors have also contributed to the elimination of the concentration of economic and industrial power and have allowed entrepreneurs to flourish. I believe this technology and new financial understanding eventually will bring a period of growth that will spread across Europe, Russia, and quite possibly Asia, and will thus enhance growth throughout the rest of the world.
|Michael R. Milken, Milken Institute|
|Kenneth J. Arrow, Stanford University|
|Gary S. Becker, University of Chicago|
|Harry M. Markowitz, Harry Markowitz Company|
|Merton H. Miller, University of Chicago|
|10:00 pm - 12:00 pm FRI 3/13|
|United States, Europe, and Russia|
|ROBERT HUNTER: The United States, Europe, Russia: one success story, one in the process of becoming a critical success, and one huge question mark. In fact, of all the countries we are discussing at this conference, the biggest unknown factor to affect our destiny in the early 21st century will be what happens in Russia politically, economically, and strategically.
Just 50 years ago, five countries in Europe came together and reached out to the United States, asking for our strategic commitment. This led to the creation of NATO, which underpinned the Marshall Plan, and created the basis for the most extraordinary economic advance in European history.
The United States Senate will soon vote on NATO expansion, which will bring three countries of Central Europe into NATO. This will create stability in the heartland of the Continent, the source of the three great wars of this century; and it will underpin the European Union's and others efforts for security, in its broadest sense. These steps, backed by U.S. power, purpose, economic skill, and engagement, will form the basis for economic advance there and will confirm the United States as a European power. With expansion, NATO and the European Union will need to reach out to Russia, drawing it out of its 80-year self-imposed isolation, and help it, like Germany after 1946 rather than Germany after 1919, to play a constructive role in the outside world.
In parallel fashion, the European Union is marching toward the twin goals of deepening and widening its reach, in particular deepening the prevalence of its monetary unit, the euro. Critical countries are now meeting the key targets to be able to use the euro next year.
The political and economic solidarity of the European Union, at least for the core countries, is moving forward, and at the same time is broadening, reaching out into Central Europe and Russia, more deeply even than the United States, and taking in new members.
Meanwhile, Europe and the United States have been stepping up to the most serious fighting in Europe since World War II, in Bosnia, for 815 days now. They are demonstrating that all of our countries take seriously what is happening in Central Europe and beyond and are prepared to help provide the stability necessary to make this a place for trade, aid, and investment.
Together, the United States and Europe, unlike any other region we have talked about, have been working in concert in numerous areas—strategically, politically, institutionally; and remarkably, the United States and European Union have not gone their separate ways after the end of the Cold War but have continued to work in the same direction. The great economic schism did not occur.
This is not a one-sided relationship in trade, investment, and ownership. This is a balanced relationship. These countries on both sides of the Atlantic are all stable and democratic. This offers with extraordinary possibilities for the 21st century for this country, across Europe, and deep into Russia, building on great human capital resources, including the best-trained workforce overall.
The important questions are, to what extent will continuing economic growth in the West be critical to the political development of Central Europe and Russia? Can the non-British countries in the European Union adapt fast enough and will they be able to keep up with the pace of American transformation? Will the integration of Europe bring all of its countries together, or will there be disillusion or differences within the Union, putting a halt to its development?
As the European Union moves forward, will it be able to continue to look outward and work with the United States, or will it turn inward? Will we be able to strike an adequate balance between Central Europe and Russia? Indeed, will these two areas of Europe, Central Europe and Russia, be able to take the needed internal steps, to enable outsiders to act in their countries effectively, so that true cooperation can be created and economic benefits can be cultivated? Will developments in Russia continue to provide the strategic and political basis to move this forward? Will we have the political leadership in the 21st century, most critically in Russia, that can make any of this happen?
We have a formidable list of challenges, but if we can overcome them, there are some great possibilities.
JEFFREY FRANKEL: The U.S. strategy for dealing with the East Asian crisis includes supporting reform programs in specific countries, and providing temporary financing where it is needed, conditioned on reform programs for those countries.
Public finance is not a substitute for private finance. Rather, it is a catalyst or complement to restoring confidence in the markets. The IMF (International Monetary Fund) is key to this process; it is the central provider of public funds and is the monitor of conditionality. It is critical that Congress approves what the administration has asked for: $3.5 billion for the new arrangements to borrow, and $14.5 billion for the regular capital increase for the IMF.
Some claim that private financial markets work just fine if left by themselves. They see no market failure and no need for the government to be involved in any way. However, this recent Asian crisis shows that financial markets do not work very well, and that we have made a mistake encouraging East Asian countries to open up to global capital markets; we are making a mistake now in encouraging them to continue to do that.
There are three reasons why financing cannot be left to private markets alone. First is the risk of financial contagion. The current disruption originated in Thailand and spread to the rest of East Asia. There is still some danger that it may spread further.
Second is the effect on U.S. net exports. The 1997 current account deficit was just released yesterday. It is going to be worse this year. We are going to lose net exports to East Asia. However, this should not impact U.S. output or employment too adversely. The economy is very strong, we have a lot of momentum and can withstand this easily. The Council of Economic Advisers' forecast for the growth rate in 1998 is 2 percent, the same as it was a year ago. We knew we had to slow down one way or another, now we have some idea how. However, when large trade deficits are registered this year, particularly large bilateral deficits vis-á-vis the East Asian countries, this may have adverse political implications. There could be some sort of protectionist or isolationist backlash, which would be a very bad thing.
Third, we have to stay involved because of geopolitics. It is in our interest to maintain economic success in East Asia, because stability and prosperity in that region are important both for the region's own sake and for the example it sets for the rest of the world.
As far as our interests in the region are concerned, Thailand and Korea both are U.S. military allies; Indonesia is a potential source of instability. As regards the implications for the rest of the world, a truly major development of the last 10 or 20 years has been the adoption of the capitalist system by many parts of the world that hadn't previously welcomed it. The failure of the Soviet Union was one reason why countries chose this route, but it was also encouraged by the great success of the East Asian countries and the favorable example they set. These are all reasons why the public sector cannot walk away from East Asia.
Financial markets do not work perfectly. The idealized, efficient-markets paradigm is a bit overdone. Markets' successive swings of optimism and pessimism, as well as contagion, might lead one to conclude that we should have let countries maintain their barriers to international capital flows and that we should not encourage them to liberalize more now. One can explain some of the contagion by competitive devaluations, but not all of it. Still we are better off with modern financial markets than without.
Some say we are financing too much and some say we are not financing enough. One virtue of all these critiques is that everyone in Washington now has learned the meaning of the concept of moral hazard. This is good, it is a useful concept, one that every public policymaker should know, and it has a lot of applications for this discussion.
The point is that if the effects of this crisis are cushioned, the incentives for borrowers and lenders to be careful in the future are reduced. This can be exaggerated. It is a simple principle of economics that actions generate offsetting actions somewhere else. This does not mean that we should not try to moderate the effects of a crisis.
None of these countries would voluntarily go through what they are going through now. Each is hurt badly by this. Mexico suffered a big adverse effect on its standard of living in the 1980s, and again after 1994; East Asians are doing that now. As for investors, security investors have taken huge hits in terms of reduced prices of securities and exchange rates. It does not mean that moral hazard is not there at all, but there is a danger of exaggerating it.
Some argue that there is too much exchange rate flexibility in the programs, and some argue that there is not enough. This echoes the debate following the December 1994 peso crisis, where there were many op-eds and members of Congress saying that a serious mistake was made in exchange rate policy. It almost looked like a consensus, until you listened more carefully and saw that half the people were saying that Mexico should have devalued earlier, and the other half were saying that they should not have devalued at all. Something of that sort has happened in East Asia as well.
The central point is that neither pure floating, nor a currency board, nor any other exchange-rate arrangement is a panacea. The policy problems are complex. What constitutes good macroeconomic policy cannot be written down easily. A lot that can be said about it, but all the problems cannot be solved with just a wave of the currency wand. That said, I think it is true that Thailand became overvalued and that it helped trigger the crisis. Then current account deficit became too large. Things would have been better if they had listened to some of the IMF's advice and adopted more exchange rate flexibility earlier.
Some say there is too much macroeconomic austerity in these programs, and some say there is not enough. Macroeconomic retrenchment is not the central aspect of the IMF's programs in this case. The austerity that is there—the reductions in the standard of living—is a consequence of the crisis and of the loss of confidence. It is not a consequence of policies that the IMF decided to impose per se.
Interest rates inevitably will increase when there is capital flight in a crisis like this in order to reassure investors and bring capital back in. Some of the targets the IMF laid out for the budget deficits early on proved to be overly optimistic, along with some of the growth rates. They have been modified accordingly. This is not unusual. If the crisis turns out to be greater than expected, and the fall in GNP (gross national product) and currency is greater than expected, fiscal deficits must be modified accordingly.
Some claim that there is too much structural reform as part of these programs, and some claim that there is not enough. It is true that these programs are not the same old cookie-cutter macro austerity programs that the IMF is said to have applied most often before. There is more emphasis on structural reform than on macro austerity. That is appropriate, partly because these countries have historically fallen to macroeconomic policies. The IMF has evolved with the times, and it is appropriate that it do so. After 1973, the IMF switched its emphasis toward currency problems of developing countries. After the debt crisis of 1982 it changed again—it evolved with the times. After 1989 and the fall of the Berlin Wall, it became involved in the transition economies and delved into structural issues that it previously had not had much to do with.
It is entirely appropriate that the IMF now get more involved in the structure of Asian financial systems, because that is what is appropriate to the circumstance. It is right to push for increased transparency and supervision, for loosening banking relationships, for undoing some of the directive lending and connective lending that goes on so much in East Asia, for improving corporate governance, and for opening up the financial markets. The most important kind of moral hazard here is that which exists between the government in each East Asian country and the banks, financial institutions, and corporations that have been borrowing and spending money and been allocating it based less on market incentives than on a drive for maximizing market share and along lines of personal relationships. This is an historic opportunity to change all that and move in the right direction.
Although I agree that opening financial markets should be emphasized, I am not saying that in countries where financial markets are relatively primitive, where domestic reform is needed and where adequate prudential supervision must be strengthened, that it is good to open up to the full force of global capital movements before getting domestic financial markets in order. The domestic side should be developed parallel to the international opening. These countries need to undertake domestic financial and other structural reforms, as well as strengthen their prudential supervision, and do this all in the proper sequence and proper balance with opening up to world financial markets.
HOWARD BERMAN: In the U.S. Congress, we had essentially 50 years of bipartisan and congressional executive agreement about the central thrust of American foreign policy. It was shaped by the Cold War and America's interest in it, and while we argued on the fringes about Central America and Vietnam, there was a fundamental agreement about what policies we needed.
Since the collapse of the Soviet Union and the massive changes in the world economy—globalization included—we are now seeing both new strains emerge and conflicts that had been submerged for most of the previous 50 years developing. These strains cross political parties; they are shaped by geographic and ideological factors that do not necessarily follow the historical political party alignments in Congress. On both sides of the aisle one sees a growing neoisolationism—it is almost a repeat of the reaction at the end of World War I. Strong forces in both political parties want the United States to turn inward; they do not quite understand or share any sense of what role we can play and are fearful of the risks of internationalism, intervention, and involvement in the world. Alongside this neoisolationism there is also—particularly among Democrats, but not exclusively—a rise in protectionism. Both the new isolationism and protectionism are manifested in a variety of debates, whether the topic is NATO expansion, the IMF, or China; the fast track debate is developing around the IMF quota increase and new authority for borrowing requests from the administration.
Other factors also play a part. There is a devoted group of free marketeers in Congress who are suspicious of government generally, and multilateral institutions specifically, be it the UN or the IMF. They think that the economic crisis in Asia should be dealt with through market forces and not through the intervention of these kinds of institutions.
Among Democrats more particularly, there is a belief that each of these issues is an avenue to promote certain values which many of them feel are fundamental—for example the rights of labor to organize, or governmental regulation of environmental hazards. But we cannot as a Congress just develop an agenda around these issues and promote it, because we have no jurisdiction over the policies in other countries.
Overlying all of this is the fact that the Republican leadership of the House of Representatives has replaced the sign that was in President Clinton's campaign office, "It's the Economy, Stupid," with a new sign: "It's Abortion, Stupid." The abortion debate permeates every single major international economic and geopolitical issue that comes up right now. The reason the abortion issue has been transferred there is because the Republicans realized that when they tried to make that an issue in the context of domestic policies, resulting in the shutdown of the federal government and a massive reaction against the new Republican leadership in Congress, they lost tremendous political capital. So now they want to transfer the abortion issue to issues they think are fundamentally not popular with the American people, such as paying the arrearages of the UN, or supporting what they say is an $18 billion commitment to the IMF. In fact, it is a paper commitment only, as a result of our arcane budget rules; it has nothing to do with deficits. It is not an outlay program as such; we get certain claims on the IMF by virtue of increasing our quota there, so the IMF issue is not a real budget issue.
Still, it is not perceived as a popular issue for the American people, so it becomes a vehicle through which politicians can push their pro-life, anti-abortion, anti-choice agenda. At the moment, that is probably the biggest threat to quick action by the Congress on the IMF issue.
I am optimistic, though. I think at the end of the day, the IMF quota increase will pass and the abortion issue will be sorted out in some other fashion.
JAMES FLANIGAN: The biggest countries in Western Europe have unemployment rates of 12 percent. In a former time you could say, well, Germany likes to have 12 percent unemployment because it keeps those who have jobs in jobs, they are taxed, and they pay the benefits for those who do not have jobs. And France has a vast state machine, and they like it that way.
But today you cannot like it that way. The pattern of the leading companies of Western Europe is to move elsewhere. They desperately want to get into the global capital markets, so they are listing their stock on the New York Stock Exchange. They are moving plants to the United States, of all places. They are moving to Eastern Europe. There may have been a former model in industry where Eastern Europe was akin to the poor countries of the world, the Hungarys and Polands and Czechoslovakias, as a place of cheap labor. But there really are not any more cheap labor plants. If you put a plant in Eastern Europe, and you are a company like Siemens or Daewoo of Korea, you put up a state-of-the-art plant, turning out efficient goods so that those goods will be competitive in Western Europe.
I do not believe the 15-nation European Union is going to become a protectionist bloc. It may have toyed with that idea, but its unemployment, its need to modernize its economies, and its need to join the global economy argues against all of that. The models of Eastern Europe, the progress of people there, and the NATO expansion, all coalesce. You will see a larger, growing economy there.
In May 1998, under the aegis of the Frank Russell Co. of Tacoma, Washington, 20 of the top pension funds in the United States, including some corporations like GE Capital, are going to Russia. They are looking for investment opportunities and probably will find them, because we are seeing in Hungary, Czechoslovakia, Poland, that when a state-run organization is reformed and privatized, there is an immediate burst of productivity. Of course, more needs to happen. In the nations of Asia there was an immediate burst of productivity when the farm boys came into the factories; now, it is time for the next step. In the future, we are going to see a greatly expanding economy.
JONATHAN FRANCIS: One cannot really address Europe's economic issues without talking about economic and monetary union in Europe.
First, will economic and monetary union (EMU) indeed take place? It looks like a virtual certainty. In early May of 1998, the ministers in Europe will meet to decide and announce the countries that will participate in the first round of monetary union. It will be a broad monetary union of 11 countries which will include not only Germany and France but also Italy, Spain, and a host of the smaller countries. We have premised our work and our thinking now on the fact that monetary union will happen in Europe, and we are trying to understand the implications of that.
Second, will the euro, the new single currency, be weak or strong? There are three ways of answering that, reflecting three of the major participants in the euro markets in Europe. One is from the viewpoint of the official reserve managers, the bankers of the central banks involved. Will the creation of the euro trigger a significant change in the desired composition of their foreign currency reserves?
Another answer is from the viewpoint of the investment firms that play the role of private sector asset and liability managers. The introduction of the euro will create a large liquid financial market in Europe; foreign exchange risk in that market, because of the single currency, will be eliminated. This is part and parcel of the plan that the authorities have for EMU: to create this type of financial market and provide the basis for an increased role of capital markets as opposed to credit markets on the allocation of capital in Europe. The argument is that this will attract investors to diversify their assets into Europe, or to build their assets in Europe at the expense of assets elsewhere in the world. That will put upward pressure on the euro.
The longer-run position of the euro, at least in terms of the dollar exchange rate, relates more to the evolution of the net international investment position of the third major participant, the United States. The United States has been running a current account deficit for many years now. It has moved from the position of a substantial international creditor to, by some measures, the largest international debtor in the world. That has been consistent over time with the gradual erosion in the value of the dollar. Therefore, the strength or weakness of the euro partly depends on the fiscal and international position of the United States.
What is the prospect for the long-run stability of the euro or European monetary union? Economists discuss this along three lines. First is the flexibility of labor markets. In this new economic and monetary union, will labor be flexible enough to move from areas in which there are no jobs to areas in which there are jobs?
Second is the vulnerability of the EMU to asymmetric shocks, which refers to a situation when something happens in one part of the European Union that does not impact the economy of the rest of it. Can and how will policy react to such shocks? The evidence is that the countries in Europe are susceptible to these asymmetric shocks to a marginal but greater degree than are the states of the United States. How government and governmental structures are going to contend with these eventualities is as yet unknown.
Third is the fiscal flexibility of the monetary union. The central budget deficits for the economic union are all 1.5 percent of GDP (gross domestic product). In the United States that figure is just above 10 percent. So there are not a lot of resources at the central level to deal with these shocks. Many of those funds are already tied up in the common agriculture program or in other structural programs. There is virtually nothing in the kitty. For instance, if we had the equivalent of a Northridge earthquake in Europe, there simply would not be enough resources at the central level to be able to shift them very quickly to the Californias of Europe to help with the adjustment and rebuilding process. That will create a whole series of economic and financial strains.
What does this new economic unit look like compared to the United States and Japan? The United States has a population of about 263 million; Japan's population is 125 million. This new unit of 11 countries will have a population of 287 million, larger than the United States. Gross domestic product, if valued at 1991 purchasing power parity rates in the United States, was $7.5 trillion. Japan's would be $2.5 trillion, and the European Union's would be $5.8 trillion. So it is a large unit, certainly larger than Japan. Average GDP growth over the period 1990-96 in the United States had been 2 percent, Japan's was 1.7 percent; and the European Union's was 1.9 percent. The inflation rate in the United States was about 2.7 percent; Japan's was less than 1 percent, and Europe's was at 3.5 percent until recently. Now inflation in most of these countries is solidly below 2 percent.
The unemployment rate is also very different among these countries. Over the same time period, the unemployment rate in the United States was 6.3 percent, and Japan's was 2.6 percent; but in the EU-11, it was 10.6 percent. Public debt as a share of GDP was 62 percent in the United States, 71 percent in Japan, and 71 percent in the European Union.
The United States runs a trade deficit 1.6 percent of GDP. Japan has a big trade surplus of 2.5 percent of GDP. The trade balance for the EU-11 over this period was a modest deficit. If you look at the current account including services, and bring it up to date, you will see close to a surplus of about 1 percent of GDP today. The national savings rate in the United States was just on the high side of 15 percent; in Japan, it was 33 percent. In the 11 countries of the European Union, it was somewhere between these, at 20 percent.
The U.S. stock market capitalization of GDP is over 100 percent. But Europe has typically had a stock market capitalization of about half of that of the United States, or Japan, so there is plenty of room for development and expansion for Europe's stock markets.
Outstanding domestic debt is at $11.7 trillion for the United States, just over $5 trillion for Japan, and just over $7 trillion for the European Union. We are looking for the evolution of bond markets in Europe. As the exchange risk is eliminated and as governments move to rely more upon financial markets rather than credit markets, we are looking for a substantial increase in activity both on the equity side and in the fixed-income markets going ahead-a very exciting prospect.
JOHN LIPSKY: There are three simultaneous developments in economic performance, policy, and financial markets that have the prospect of being revolutionary. One is the unexpectedly favorable recent performance of the U.S. economy, which has come to be called the Goldilocks economy. The performance of the U.S. economy in the past few years has been far better than conventional wisdom either would have predicted or even held possible. We have to ask whether this performance has been good luck or good policy, whether it is temporary or sustainable, and what implications it might have for future prospects.
Second, we are on the verge of a revolution in European economic organization: that is, the impending implementation of monetary union by the creation of a single currency managed by a new European central bank, and the eventual enlargement of the single currency both eastward and westward.
Third is Asia's transformation from the miraculous age of the 1980s to what I would call "unbalanced Asia." In the 1990s, Japan has struggled with being mired in structural problems and weak growth. At the same time, China has been in transformation, while the "tiger" economies are struggling with the maturation of their long period of very rapid growth.
The Asian crisis from this perspective is potentially important. It represents the first generalized crisis of confidence in a world of securitized finance. And, contrary to the conventional wisdom that the trigger of the financial problems was a withdrawal of external capital, the root cause was capital flight. The crisis was important not only for the challenges it presents for Asia but also for the potential systemic threat it represented. After all, it drew in the world's second largest economy, Japan, and it is affecting what is arguably the world's third largest economy, China, as well as other countries in Asia.
The crisis has raised the broader issue of the adequacy of our international institutional framework. In the postwar era, every period of economic and financial crisis has resulted in an acceleration of reform. There are lots of reasons for optimism, and, if reform is sustained, the end result will be positive.
But there is one central mystery: Why did the crisis spread so quickly throughout Asia? The answer is the 1990s trend toward regionalization; conventional wisdom is that the 1990s has been the decade of globalization. The data tell us otherwise: It has in fact been a decade of regionalization. Trade, capital flows, and investment flows all have grown more rapidly within regions than between regions. Financial institutions may have become globalized; but transactions growth in fact has been more rapid regionally than interregionally. Thus, typical views about the diversification of risk and other issues may have been clouded by this confusion.
We also could look at the Asian crisis from a slightly different perspective. One of the problems in achieving stabilization in Asia is that the Asian countries at this time lack a clear model for reform. It is not certain where they are headed, or want to head, in terms of systemic reform.
Europe, in broad terms, has a model of reform. The European Union countries have adopted market-oriented measures that will be far-reaching in the coming years. East European countries by and large are attempting to adapt to West European standards. Although there is a model for reform, implementing it has been a struggle because vested interests are going to be affected adversely, and they are not particularly anxious for this to happen.
In the United States and in the Western hemisphere more broadly, not only is there a consensus model of reform (referred to earlier as the Washington consensus) but that model has had more success in the 1990s than almost anyone expected. Thus, a key question is whether the U.S. Goldilocks economy can be sustained. If it can, the implications for the rest of the world, for Europe, Russia, and Asia, will be extremely positive.
My answer to the question of whether Goldilocks can be sustained is a real economist's one: No and yes. No, in the sense that my Chase Research colleagues and I titled our 1998 U.S. economic and financial outlook, "Goodbye, Goldilocks."
What do we mean? We think there is ample reason to expect a significant slowdown in U.S. GDP growth this year to a pace of about 1-1.5 percent. In broad terms, we think a slowdown in consumption growth, deterioration in the trade deficit, and slowing inventory accumulation will each reduce U.S. economic growth by about 1 percent this year.
At the same time, however, consumer price inflation is likely to fall in 1998. In fact, it is likely to be about 1 to 1.5 percent. This is certainly not a consensus view. If we are right, the Federal Reserve will have ample justification to lower short-term interest rates by 50 to 100 basis points. Long-term interest rates should fall to a 5-6 percent range on a sustained basis, perhaps by the end of the year falling to the lower part of the band. Despite low rates, we think the dollar is going to remain strong.
If Goldilocks is not going to be sustained in 1998, then what is the good news—the "yes" part of my answer? With both inflation and infation expectations falling, the U.S. finally has closed the door on what is likely to be called the "great Inflation of the 1970s." We are resurrecting productivity growth from the slowdown that began with the oil price shock in 1973.
If that occurs—if the combination of anti-inflationary, credible monetary policy, broad-scale economic deregulation, and reasonable fiscal balances are sustained—there is a good case that U.S. growth rates in the future are going to be sustainably higher than they have been over the past 20 years. And if we can simply sustain an increase of even a half a percent per year in productivity growth in the United States, then long-term problems like social security and others will look very different than they do today.
In Europe, there has been more progress toward reform than most people think. There tends to be a negative view about this in the United States, particularly on the process of EMU. In Russia, there has been more progress on fiscal reforms so far than most people understand.
DAVID MALPASS: It is easy to be complacent right now about what is going on. The United States is expecting job growth, a growing economy, low inflation, and growing consumption. The Republican Party is complacent in seeing that their best avenue toward election in late 1998 is to spend more money on mass transit in various parts of the country through its major transportation bill. A sign of complacency is President Clinton's easy idea that all of the budget surplus should be saved for social security. This is a very convenient policy idea, because it means there does not need to be any legislation.
Even Asia's crisis is viewed by some as a benefit for the United States. A whole region of the world is collapsing, and it is good for us because it slows our inflation rate a little bit.
There have been reasons why optimism has been appropriate. Michael Milken has pointed out that, in the 1980s, market price was below replacement cost for many companies, so you could buy and be quite comfortable with what you were getting for value. Then by the 1990s, a lot of the developing countries expanded rapidly, using pegged exchange rates to borrow a lot of money and create growth in both Asia and in Latin America. So, it is easy to be optimistic. Now there are some red flags.
Alan Greenspan has mentioned three concerns. Irrational exuberance was one. Then, in his most recent testimony, he said the real interest rate tightening that occurred in 1997 was not inadvertent. So, after his irrational exuberance speech, U.S. real interest rates began going through the roof and remained there; his statement that it was not inadvertent had some meaning. Then he has also pointed that those who buy stocks may regret it 12 to 18 months from now. Thus there is some reason for caution in this environment.
I also see several tensions in the world right now: First, the U.S. government is paying more for money than the Italian government, the Spanish government, and others in Europe. And we are paying much more than the Japanese government, which is supposedly going through a crisis. There must be some resolution of the interest rate differentials.
Second, we have some of the same tensions in the U.S. economy with very narrow spreads on assets that may turn out to be risky. Much of the financial engineering that has gone on very rapidly in the 1990s may come under some kind of pressure.
Third, we should expect heavy pressure on corporate earnings in 1998. Fourth, there is severe tension in the world over floating exchange-rate systems. Europe is going to one exchange rate, the euro, while we are pushing poor countries toward floating exchange-rate systems that have no history of working. That is creating tension between the rich and poor. The rich countries get to have stable exchange rates, while the poor countries are supposed to have unstable exchange rates.
Fifth, of course, it is tense in Japan right now with a severe credit crunch and in Southeast Asia with a growing recession, one that is much deeper than what people are letting on. There is also a lot of rapid change in China but I think it will work out for the best.
How is the United States reacting to this? As big winners in the world environment, we are not being very responsible winners. We are looking at Asia's problems as a benefit because we are going to be able to buy their goods and assets cheaply. That is often heard in the United States.
Japan runs a giant fiscal deficit and has a giant national debt. The U.S. government has had the audacity to tell Japan to spend more money and to berate it in the G-7 forum for not doing enough on the fiscal accounts. Japan is not doing as well as it should, and should find a way to fix it, but fiscal stimulus is a dead end for the Japanese economy. Yet it is the only measure the United States has been hammering them over the head with. Japan needs a new monetary policy and is not moving in that direction.
Another way U.S. policy misuses its winner status is with the Washington consensus. The Washington consensus is the idea that poor countries should try to have floating exchange rates and have labor rates low enough to be able to export their way out of problems. So we see the IMF in Southeast Asia prescribing demand adjustment programs. But if you adjust the demand of an Indonesian who earns a thousand dollars a year, what are you doing? You are telling him that he must eat less rice, because that is really what you can do with a thousand dollars per capita. Indonesia is now going down to $500 or $400 per capita.
The Washington consensus has not really addressed exchange rates, which are at the core of all of the success stories in recent years. Argentina had a hugely successful economic policy with no IMF program and no Washington consensus. In fact, Argentina's program was initially opposed. Brazil's plan is a huge success in terms of the poor people of Brazil who finally are experiencing a rising per capita income—without an IMF program, or support from the international consensus.
The point is, Southeast Asia's per capita incomes are going down by 25-50 percent this year. That is not a victory and is a real setback for democratic capitalism.
I am very skeptical about whether reforms in Southeast Asia will be accelerated. In Mexico, for example, after their devaluation and in conjunction with huge international support, they pulled petrochemical privatizations completely off the table—a huge setback for reform.
Complacency is easy for us because the United States is in a winning position. But the way we are using that victory may not get us closer to free market capitalism, democratic capitalism, or higher per capita incomes in other parts of the world.
MUSTAFA MOHATAREM: It is almost impossible for me to be pessimistic. In General Motors' biggest revenue region, the United States, we are seeing a seventh year of fairly strong economic growth. We expect that to continue. Industry wide American sales have been well over 15 million units during the last four years and we are expecting a fifth.
We hear a lot about the adverse trade impact, but there is a concept in economics called "terms of trade," and right now we are receiving two favorable terms-of-trade shocks. One is the Asian crisis, which is bad for those countries, but which increases our purchasing power.
But more important in offsetting what is going on in Asia is the significant drop in oil prices. That is going to offset any adverse trade impact on our trade dollars. Added to this is the fact that Canada and Mexico, our two largest export markets, are now growing very strongly.
The UK, Canada, Australia, New Zealand, and the United States are all performing better than expected. They all have the same things in common: fairly advanced financial systems, domestic deregulation, open trade, and fiscal restraint.
Now Europe seems set to join that group. We are beginning to see a broad-based economic recovery under way in Europe. We hear a lot about unemployment rates and how the rate of growth in Europe is insufficient to create jobs; but in 1993-94, the U.S. economic recovery was also called the jobless recovery.
We are also optimistic about Russia, and just announced a significant investment there. We are learning our lessons from what we did in Poland, what was formerly East Germany, and Hungary. General Motors started building cars in Eastern Germany the day after the wall came down. Now we have a very large plant in Hungary; our most efficient plant in the world is located in what was formerly East Germany. Hopefully by the end of the year we will have a brand new plant in Poland.
I am optimistic about Russia despite economic data that report very little growth because sales of consumer durables, including autos, are rising very rapidly. This suggests a serious measurement problem, that economic growth in Russia is not being reported.
One concern is excess capacity in the auto industry. Some economists claimed that there was 20 million units of excess capacity in the worldwide auto industry of about 80 million units. That is a 75 percent capacity utilization rate. But that has, by and large, been the history of the industry. So, the problem in an aggregated sense is not severe; in fact, it is probably not a problem. From the U.S. perspective, the capacity utilization rate is almost at an all-time high. But in Japan and Korea is where the problem really rests.
I was criticized in Asia for saying last year that what the Koreans were doing was irrational. Korea was building capacity of about five times their domestic demand, expecting that they would sell that capacity all around the world. At the same time they could not enter the Japanese market, the largest market in their region, and China—the second largest market—had almost explicit prohibitions against imports from Korea. So they expected to build capacity and sell in the United States and Europe without establishing a quality or brand image. Now that capacity is a noose around all the Korean auto companies' necks. One of the companies announced last week that they were going to put another $1.2 billion into the Ukraine.
So the irrationality continues, and that is the one reservation we have about the IMF plan. Bailing out the Koreans may slow down some of the necessary adjustments. Unfortunately, the depreciation of the yen, which contributed to Asian's problems, also has made it less likely that Japan will truly reform. Because once again, they see that what worked in the past is working in the present. The Nikkei is down roughly two-thirds from its peak in 1989. Yet if you look at the stock prices of some of the major Japanese exporters, such as Toyota and Honda, they are above their 1989 peak. Therefore, these companies, which carry considerable political influence in Japan, have no incentive to push for change. So if I am a pessimist about anything, it is about Japan. However, when I look at the rest of the world, there is every reason to be very optimistic.
ARNOLD NACHMANOFF: Economic recovery is under way in Russia. It may be fragile, and it is based on consumption, but we anticipate growth this year, perhaps 1-2 percent; next year, 4 percent. We have to put this in context: this country has not seen any positive growth since the fall of communism.
Russia can avoid a balance-of-payments crisis as it experiences this economic recovery and the reform process will continue despite political uncertainties. The question now in Russia is not whether reform will occur but at what pace and with what emphasis.
However there are still some real risks, which could create another crisis of confidence. First, there is the risk of capital outflow, investor avoidance generated from some developments in Asia or elsewhere in the world. Second, key commodity prices may undergo a sustained period of decline. Russia depends on oil, gas, and metals for about 65 percent of its export earnings. The third risk is of some internal political crisis occurring.
Russia may avoid a balance-of-payments crisis because, first, the current account is in surplus, although that surplus may gradually shift over to deficit as a result of the economic recovery. Second, Russia has gross foreign exchange reserves of about $16 billion. That is about 2.5 months worth of imports. It is not a great position, but there was a fall during the initial part of the Asian crisis that stabilized after the central bank took protective measures, and the level of reserves may be increasing since the IMF agreement. Third, Russia has a relatively manageable level of foreign debt—about 30 percent of GDP—and a manageable level of debt service since two restructuring agreements with the Paris Club and the London Club—about a 16 percent debt service ratio. Finally, Russian banks are much smaller relative to the economy than the banks in the Asian countries are, and they are not excessively exposed either internationally or to the private sector.
Certainly, there was contagion from Asia. There was currency pressure, but in late 1997 and early 1998 the central bank showed its determination to defend the exchange rate, taking a series of measures helpful in stabilizing the situation. These included increasing the refinancing rate, adjusting reserve requirements on foreign deposits, and creating a more flexible exchange-rate mechanism.
In trade, Russia is not very vulnerable to Asia. Most of its exports flow to Europe, the United States, and the other CIS countries. Negative effects will be indirect; that is, they will occur only if there is a slowdown in Europe, the United States, or other countries that could affect Russia's export markets. Certainly the opportunity to increase exports to Asia is quite limited now.
Why expect that the economic reform process will continue? There is political uncertainty, but the two leaders of the reform team, Chubais and Nemtsov, are still in place, although Chubais's influence may be waning. But, we are seeing the evolution of a more consensual approach between the executive and the legislature. The confrontational style of Chubais in some ways has been counterproductive. The approach of developing political accommodation in some of these programs may pay off. It will slow the process, but may make it more sustainable.
Evidence that this is working is that the legislature passed the 1998 federal budget recently, and it appears likely that a revised tax code will be passed later this year. The budget may still be somewhat unrealistic and the tax code is not perfect, but these are moves in the right direction. There is a political consensus that reform should continue. If Yeltsin becomes fully incapacitated and a presidential election is held before scheduled in the year 2000, the leading candidates are likely to be Prime Minister Chernomyrdin and the mayor of Moscow, Yuri Luzhkov, neither of whom would wish to radically alter the basic thrust of economic reform or to obstruct foreign investment.
The key issue to watch in the near term is whether the government will have the will and the ability to reduce expenditures, improve tax collection, maintain control over the fiscal deficit, avoid loosening monetary policy, and raise more money through privatizations. Over the longer term, similar to some of the Asian countries, the key issues will be corporate governance and structural reforms, which are needed to deal with cronyism, corruption, and the establishment of a sound legal framework for investment.
THOMAS THORNHILL: Technology is helping drive growth in the world economy. The deployment of technology is also leading to changes in business practices and organizational structures. The combination of technology deployment with labor flexibility, which we have in the United States and not in Europe, is part of what is driving productivity here. It is the deployment of technology in combination with changes in business practices and organizational structures that is driving improvements in productivity that fuel growth.
The technology sector represents a little more than 6 percent of GDP. It is second only to health care. It is the largest employer in the United States, about 35 percent larger than automotive industry. It contributed about 28 percent of the growth in GDP in 1997. From 1993 to 1997, it has contributed more than 20 percent of the growth, even though it is only about 6 percent of GDP. We think it will grow from about $750 billion in worldwide revenue to about $1.3 trillion between 1997 and the year 2000. That is about a 21 percent growth rate, significantly faster than any other individual sector that is anything close to this scale.
Several sectors in technology—software, Internet, and IT (information technology) services—have not been affected at all by the crisis in Asia. Even broad international companies are okay; Oracle, for example, just reported that revenue was up 27 percent year-over-year for the quarter. Even though Asia is weaker, this is being offset by growth in the United States and Europe. However, in the wireless sector there was very large capital growth in Korea in particular. Korea accounted for a good percentage of sales for Motorola, Nokia, and Erickson. Wireless sales in this region have declined rapidly.
An interesting company to look at is Dell Computer. Less than 8 percent of its sales go into Asia, but 65-70 percent of its cost of goods sold come out of that region. So, Dell is a net beneficiary relative to what is happening in Asia.
On the other hand, a sector that is being impacted is semiconductor capital equipment manufacturing. A large part of the growth in that sector for the last several years occurred because there was cheap capital being deployed in that sector in Southeast Asia and Korea. We will likely see revenues in that sector down this year. Korea will probably reduce its capital expenditures in that area by at least 50 percent. The earnings that we projected for these companies are down 40 percent from what we had projected prior to this becoming an issue. The fact that Southeast Asian and Korean companies will not be continuing the pace of capital expenditure has implications for U.S. semiconductor companies. Because this is such a capital-intensive industry and because the capacity ages so rapidly, U.S. companies will shift the balance back toward manufacturers outside of that region.
ROBERT HUNTER: What is going to be the most important thing in the region that includes the United States, Europe, and Russia that will determine whether we have a positive or negative forecast for the year 2010?
ARNOLD NACHMANOFF: Maintenance of an open global trading system.
JAMES FLANIGAN: The continued immigration of people into Europe, even into northern Europe, Russia, and the United States. Because the older population in all of these places will need people to do the work and serve them.
JOHN LIPSKY: Liberalization of European financial markets.
DAVID MALPASS: Europe's interplay between the euro and socialism. That will impact on whether the euro has far-reaching effects without significantly changing labor mobility, fiscal deficits, and so on.
MUSTAFA MOHATAREM: How seriously Europe and United States take their commitments to the Kyoto Protocol on reducing carbon dioxide emissions.
HOWARD BERMAN: Political stability: avoiding the calamitous theoretical possibilities in places like Russia and particularly China. What the proliferation of weapons of mass destruction means in terms of world stability.
THOMAS THORNHILL: Labor flexibility and education. If anything is going to slow down the deployment of technology which improves productivity, it is probably education. We do not have the kind of talent pool that we need to keep the deployment growing.
JONATHAN FRANCIS: Political stability in Europe. This push toward EMU has strained the political fabric. It does not have a lot of broad support at this stage, so it is important to get the average European involved and behind this process.
ROBERT HUNTER: What one thing do you want the United States government to get right between now and 2010, if it does not get anything else right?
DAVID MALPASS: Stable currencies are the only workable system, so it would be very helpful if President Clinton and Secretary Rubin explained that there was no benefit in having Brazil, China, and Russia devalue, and that the United States would work with the world to try to find a workable long-term price stability model that is now lacking.
Congressman Berman asserted that we are entering a protectionist, pull-in-our-horns period. We cannot do that. We are the leader of the world, so American policy and leadership will have to assert itself properly in the period between now and 2010. It is vital for the world.
JEFFREY FRANKEL: I agree. There is a risk that countries in Asia or elsewhere might pull back from trade, investment, and internationalism, in response to the current crisis. I am optimistic that they won't, but it would be really remarkable if the United States pulled back at a time when our economy has been so successful.
To the extent we are shying away from doing the little things that are necessary for us to sustain global leadership, whether it is paying our arrears to the UN or the IMF legislation or passing fast track, it is remarkable in the eyes of the rest of the world that we are so uncertain about just these minimal necessary trappings of a world leader.
JONATHAN FRANCIS: Mayor Riordan made reference to the performance of the education system here in the city of Los Angeles and his frustration with his attempts to reform it. In the longer term, that's a very serious issue, not only for Los Angeles, but for the country as a whole.
MUSTAFA MOHATAREM: We also have to focus on how the United States handles the emergence of China as both an economic and political power in Asia.
JOHN LIPSKY: The formal codification of capital market liberalization through the inclusion of capital account convertibility as part of the IMF's Articles of Agreement would be important and positive.
ARNOLD NACHMANOFF: Our political leadership and our institutional structure need to better manage our role in a global world. We have to learn to build coalitions and alliances and be sensitive to the fact that although we are the world's military superpower, we can only exercise our power within very serious restraints. We have to build these coalitions in a multilateral world.
THOMAS THORNHILL: If we are going to focus on the U.S. economy and government, it would be policies that are aimed toward more rational tax policy, something that is focused more on the formation of capital and business, rather than hindering them. Labor and capital are the critical variables for growth. The key issue for labor is education to build a talented labor pool. The second issue would be fiscal and tax policies that facilitate capital formation and investment.
ROBERT HUNTER: The United States has to continue its global leadership role to help provide the political stability and the economic leadership so these things can work. Also, people in the private sector need to lean on the government, on the executive branch and Congress, to make sure that we do not become isolationist and continue to be outward-looking, and that we make the investments in the human capital that are going to give us the capacity in the next generation to do what we have done in the past.
I thank this panel for a fantastic presentation.
|Robert E. Hunter, Former U.S. Ambassador to NATO, 1993-98|
|Howard L. Berman, U.S. House of Representatives|
|Jonathan H. Francis, Putnam Investments|
|Jeffrey A. Frankel, Council of Economic Advisers|
|John P. Lipsky, Chase Manhattan|
|David Malpass, Bear Stearns|
|G. Mustafa Mohatarem, General Motors|
|Arnold Nachmanoff, Oxford analytica|
|Thomas A. Thornhill III, NationsBanc Montgomery Securities|