Raghuram Rajan was a good economist, and as professor in Chicago, had been active in the public debates on the global economy. His move to the International Monetary Fund gave me a chance to reflect about global crises in this column published in the Telegraph on 12 August 2003.
How far away is the next crisis?
One of the questions Raghuram Rajan will have to focus on, as International Monetary Fund’s new chief economist, is how far the next major payments crisis is, and what the Fund can do to prevent it – and if it occurs, to limit and shorten it.
The 1980s saw a string of meltdowns. They were a hangover of the oil crises of the 1970s. The massive rises in oil prices brought enormous revenues to the oil producing countries for which they could find no immediate use. So they parked them in banks in New York and London. The bankers in turn lent out the money to developing countries. One by one, they failed to repay it. When I went to Argentina in 1990, inflation was running at 350 per cent a year. Property prices were quoted in dollars; many Argentines had no doubt parked their savings abroad. To tame the inflation, Argentina introduced a currency board. In other words, it decreed that it would not issue any local currency which was not backed by a dollar in its foreign exchange reserve. The total volume of currency could increase only if dollars flowed into the Argentine central bank; and that could happen only if Argentina exported more than it imported, or if someone abroad was prepared to lend money to Argentinians. Inflation was stopped in its tracks, exports recovered, and many abroad were emboldened to lend to Argentinians.
Therein lay Argentina’s undoing. Each unit of local currency had a corresponding dollar sitting in the central bank’s assets and could be exchanged for a dollar. But the debt did not have such dollars backing them. When foreigners began to withdraw their loans, the central bank could not release dollars to pay them, and Argentina went under. The banks went bankrupt and closed doors; people could not get their deposits out and starved. Argentines surrounded their President’s palace and started banging on pots and pans; the President ran away in a helicopter. It was quite some time before anyone could be persuaded to take on his job.
The Indian crisis of 1991 was also an offshoot of the oil crises. By the early 1980s lenders of petro-dollars had run out of borrowers – one by one, they were all in trouble. After 1985, when Rajiv Gandhi took over, India looked pristine by comparison; so international banks – mainly Japanese ones – poured money into Indian public enterprises which had an implicit sovereign guarantee from the government of India. Soon India did not have the foreign exchange to service the loans. NRIs were the first to stumble on to the impending crisis. They pulled out their deposits, and India went bankrupt.
The 1990s saw some other spectacular payments crises: Mexico and Russia had them, and in 1997 and 1998, all the Southeast Asian countries had crises of varying severity. Russia and Mexico had relatively straightforward crises. After the Russian communist regime fell, the Americans decided to support the successor regime. They asked their own as well as international financial institutions – principally International Monetary Fund – to pour money into Russia. But the Russian economy was in a shambles. It was full of monopolies, and each had a secure market within a closed economy. Once the economy opened up, many lost their markets and went under. Their bankruptcy had a domino effect, and they took others with them. So the country took a long time to recover, and in the meanwhile, many lenders to it lost their money – just as they had done when the communists murdered the Czar and staged a coup in 1917.
Mexico appointed a finance minister in the early 1990s who had excellent connections with New York banks. He introduced a policy of steady, precise devaluation of the currency at a fixed rate per week. Since the exchange rate could be predicted for any number of years ahead, exchange risk disappeared. The finance minister also ensured that Mexican interest rates were high enough to reward foreign lenders well. So money poured in from New York, Mexico became overindebted and failed to repay its debts.
The East Asian crisis was a bit different. East Asian economies grew rapidly enough to provide a home for large inflows of foreign investment. Their industries were profitable enough to reward the investment well. Their exports grew rapidly enough to instill confidence amongst foreign investors. But a lot of the foreign money went into banks, which in turn lent it to real estate developers. When a surplus of real estate developed, the developers could no longer repay their debts. The Banks reneged on their foreign debts; even when the central banks did not run out of money, foreign loans were dishonoured because the borrowers went bankrupt. And as in Argentina, when banks failed, ordinary depositors lost their money.
Since 1998, however, there has been no crisis worth the name. Even the badly hit East Asian countries have recovered. Is that just luck? Or has there been an improvement in world financial architecture? What I understand from Benu Schneider, a figure of some authority in global finance, is that a number of attempts have been made since the East Asian crisis to prevent crises. The first was the Financial Stability Forum set up in February 1999 by the finance ministers and central bank governors of G7. It identified 60 standards, of which G7 selected 12, falling in three groups, as essential. The first group related to transparency in fiscal, monetary and financial policy and data dissemination. The second related to business ailments and their treatment or prevention – accounting and auditing, payment and settlement, money laundering, insolvency, and corporate governance. The third related to financial regulation – supervision of banking , securities and insurance. Various international institutions were identified to oversee the standards. International Monetary Fund has been preparing Reports on the Observance of Standards and Codes (ROSCs) since 1999. Although it has prepared over 53 reports, the frequency and the number are too low to cover the world adequately. The resources required to increase the coverage of the reports adequately are quite unlikely to be devoted to them.
Besides, it is not clear at all that the application of these standards will make the world less prone to crisis. The reports are prepared jointly by the Fund and the reporting countries; it is always possible that the information the latter provide will have a bias. Transparency means the release of abundant timely information. Even the volume of information being released now is so large that market players are liable to be unable to distinguish between important signals and noise. If they get the signals right, herd behaviour can magnify the impact of signals and hasten a crisis.
The biggest drawback of officially agreed and administered standards is that if a country is heading towards a crisis, it is in the interest of its government to conceal that fact. It will begin to camouflage information, enter transactions that would hide and postpone the crisis, delay release of information, and in various ways mislead its creditors and the international community. This is why international investors do not depend on ROSCs or other official reports; they look to reports from brokers and rating agencies.
It is therefore unlikely that any international cooperative effort will succeed in predicting or preventing crises. But for now, as long as the US runs big payments deficits, we need not worry; other countries will find it easy to acquire high dollar reserves and will avoid a crisis. Long live the US deficits.