SUNS #4345 Tuesday 15 December 1998



FINANCE: CRISIS DUE TO UNDER-REGULATED, OVER-LIQUID INTERN'L MARKETS

Geneva, 11 Dec (Chakravarthi Raghavan) -- The crisis, beginning with the devaluation of the Thai baht in July 1997, hitting the 'miracle' economies of Asia, and now enveloping the world, is due to market failures which are endogenous to the under-regulated, over-liquid international financial markets.

This is the broad conclusion of a number of, admittedly non-mainstream economists, in articles in the November Special Issue of the Cambridge Journal of Economics (CJE) devoted to the Asian crisis.

The journal carries some eleven articles, with an introductory overview, from 17 economists (who have contributed individually and jointly) on the overall issue of the Asian model and/or country
specific assessments.
The cutoff date for contributions the issue was June-July 1998, and thus do not take account of the developments on the world financial markets after the Russian moratorium in August and the Malaysian decision in September reinvoking capital controls and making its currency non-convertible.

Most, if not all of the articles in the CJE, reject the simplistic attempts (of the IMF, US Treasury and others) to blame the crisis on the "cronyism" of the Asian economic model and governance -- political and economic structures and non-transparent corporate governance and corruption.

Some of these ills were there in the countries affected, but are also prevalent in the much-advocated US and other western models, and there is abundant evidence of "cronyism" in IMF bailouts, says Chalmers Johnson, of the Japan Policy research Institute (Cardiff, California).

[The Johnson article as others in the journal have been sent in by July, before the spectacular US Federal Reserve orchestrated rescue of the Long Term Capital Management Fund, which a number of articles (by orthodox and non-orthodox critics) have identified as a spectacular case of "crony" capitalism in the West.]

Prof. Jan Kregel (Professor at the Bologna University, now working at UNCTAD) in his paper 'Derivatives and Global Capital flows: Applications to Asia', suggests that the several puzzling facets of the Asian crisis are all linked to the characteristics of derivative contracts used to provide lending to Asia.

He explains how many of these over-the-counter (OTC) structured credit derivative packages, created by global investment banks, have provided the means for professionally managed institutional investment funds (including many public funds) to circumvent statutory requirements on
the type of investments they can make, and thus enabling such funds to invest and earn higher incomes on more risky funds abroad.

Kregel argues that the predominance of bank lending, and of short-term nature of such flows, and their volatility, to a region that had previously relied on foreign direct investments, is linked to the OTC structured derivatives used in attempts to circumvent the particular prudential regulations of countries (home and host) and provide banks with low-risk, high commission incomes.

The incentives behind such contracts, Kregel points out, provide little support for the common belief in the self-regulating nature of private capital markets in terms of risk assessment or their ability to
allocate capital efficiently. And the fact that developed country banks and regulators had difficulty in foreseeing the risks involved in the derivatives positions used suggests that the crisis was not completely due to the inability of emerging markets bankers and regulators to provide acceptable risk management, Kregel adds.

Robert Wade, in his article, "From 'miracle' to 'cronyism'," argues that while the Great Asian slump has been caused both by the build-up of vulnerabilities in the real economy of the countries and the normal workings of the under-regulated national and international financial markets, a strategy of escape from the crisis, requires reintroduction by the countries concerned to adopt expansionary policies, take control over short-term capital movements including through reintroduction of capital controls, and create an Asian Financial Facility to end the region being a dependency of the IMF.

In analysing the East Asia crisis, and the explanations about the East Asia model being one of "crony capitalism", Johnson underlines that throughout the region the crisis was caused more by under-regulation than corruption or other side effects of overly-close relationships between business and the government. Only Japan which since its bubble economy began to deflate in 1989 and 1990, fits the "crony capitalism" description, by continuing to protect its structurally corrupt and sometimes gangster-ridden firms.

And by perpetuating its cosy Cold War relationship with the US, instead of adjusting painfully to a global economy, Japan remains essentially a protectorate of the US, not fully in charge of its government or destiny, Johnson argues.

But crony capitalism is not confined to Japan. The US strong economic performance during the 1990s, the US academic argues, "coincided with the biggest outbreak of American crony capitalism, since the arrival of the military-industrial complex in the 1950s" and yet no one is proposing a total restructuring of the American economy on the ground that the Lippo Bank of Jakarta tried to buy influence in Washington or the sale of ambassadorships.

"If crony capitalism brought down East Asia, why has it not similarly affected the United States, where it seems to be endemic?" asks Johnson.

On the various explanations, Johnson argues that if one were to accept the explanation that the East Asian crisis is essentially a financial problem (of liquidity crunch) and not one in the real economy, then the answer to the crisis is to stop the IMF before it turns a problem into a disaster and implement some elementary controls on capital movements - such as a 2-3 percent tax on short-term loans, and government regulations to favour FDI over purchases of shares and stocks, and a regulatory regime to inhibit short-term investments and discourages local businesses from accumulating big debts in foreign currencies.

But if the explanation of the crises lies in the "over-capacity", of TNCs investing in the region to take advantage of cheaper labour, the US should then use its full American market power to raise the wages of workers in places where the transnational corporations are investing, so that the workers can purchase the new products more or less on par with employed American workers.

But if the explanation that the buildup of overcapacity was due to US Cold war strategies in the Far East -- with Japan, Korea, Taiwan, Hong Kong, Singapore, Thailand and the Philippines becoming outposts of American capitalism and protectorates assured of unrestricted access to the US market -- then the solution lies in the Americans finally letting the Cold War end, he adds.

Only by cutting its apron strings to the US can the Japanese political system be energised, and the region can see a renewed burst of growth and prosperity. "If not, global recession is a serious possibility."

Lance Taylor, of the New School for Social Research (New York), in his paper argues that external financial crises are not caused by an alert private sector taking advantage of the public sector's foolish actions such as running an unsustainable fiscal deficit or creating moral hazards.

Rather they are best described as private sectors, both domestic and foreign, acting to make destabilising short-term profits when policy and circumstances provide the preconditions and the regulatory authorities acquiesce.

The solution lies in restructuring the international financial arrangements, he argues.
Firstly, recent experiences demonstrate that global macroeconomic financial system is not well understood. An immediate recommendation is for humility on the part of institutional players. There is no reason to force all countries into the same regulatory mould. "International institutions should wholeheartedly support whatever capital market, trade, and investment regimes that any nation, after due consultation, chooses to put into place."

Second, international agencies should support national regulatory initiatives. If national regulators are made more aware of what is happening in their countries, perhaps they can take prudent steps to avoid a pro-cyclical bias in their decisions.

Third, since the IMF seems unlikely to receive large additional sums of money to make it a (conditional) lender of last resort, but remain a signaller to other sources of finance such as central banks and the BIS, this should leave room for regional cooperation such as Japan's proposal for an Asian bail-out fund which died as a result of vigorous opposition from the US government and the IMF.

Fourth,, there should be specific changes in international regulatory practices, for example, of the Basle capital adequacy rations, so as to permit a 20% as opposed to 100% backing for loans to non-OECD countries for maturities of only three months or less, as opposed to the current one year or more. This would reduce incentives to banks to concentrate on short-term lending to developing countries.

Finally, says Taylor, there should be an independent external body with power to assess the IMF's actions.

"More transparency, especially in the relationship between the US government and the Fund, and independent evaluations of the IMF are sorely needed in the light of its largely unsuccessful  economy-building enterprises in post-socialist nations and now East Asia."