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.
