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Braudel
Papers - Nº 19 , 1998
1. The game
Money, Greed, Technology is a new video game on an old
theme. In the monsoon season of 1997, a typhoon erupts in
the South China Sea, attacking the customs and artifacts
of organized society in an arc of prospering countries
stretching from Thailand, Malaysia and Indonesia
northward to Hong Kong, South Korea and Japan. This
typhoon is not a classic battering of land by nature. It
is a sudden, swirling, self-inflicted wrecking of
financial and political systems through complex
interactions of money, greed and technology unleashed in
the restless betting of assets accumulating wildly and
driven relentlessly to seek higher yields.
As the storm in Asia rose on the horizon, the Bank for
International Settlements (BIS), the central bank for
central banks, in Basle, Switzerland, reported that
"private capital flows to emerging markets exceeded
previous records by wide margins, with international bond
issues playing a prominent role. Were these surprising
developments the product of fundamental economic forces
or, rather, will they be reversed by such forces in the
future? One part of an honest answer is that we simply do
not know. Rapid technological change and deregulation,
which today profoundly affect all aspects of the global
economy, increasingly cloud our sense of what is possible
and reasonable."
Our video game is a complex affair, testing the tolerance
of existing technologies and our capacity for
imagination. The typhoon disguises an alien invasion. Our
way of life is threatened. Bleak and windy scenarios
prevail, auguring catastrophic outcomes. The bad guys are
going to win unless someone presses the right buttons,
zapping the bad guys without pity or hesitation. But who
are the bad guys? Shall we zap the emissaries of the
International Monetary Fund (IMF), those Shylocks of
world finance demanding rigid rules of internal order in
exchange for dollops of fresh money? Zap the foreign
bankers who lent so freely and foolishly and now, with
the diplomatic backing of rich countries, demand big fees
and extra interest to stretch repayment of their huge
loans? Zap the executives of foreign corporations moving
into the bankrupt paradise of Asian values to buy land,
buildings and companies on the cheap? Blow away Bangkok's
traffic jams and Kuala Lampur's pharaonic skyscrapers as
blights on civilization? Zap rioting Muslims, angry at
rising food prices, who burn down Chinese shops and
churches in remote towns of Java? Blow away the hordes of
poor immigrants from villages in Bangladesh, Burma,
Cambodia, Indonesia and the Philippines, fired suddenly
from jobs in factories, kitchens and construction sites
in Singapore, Malaysia, Indonesia, Korea and Thailand?
Blow away the blizzard of promissory notes issued by
failing companies that buries Korea's stock market and
banks in swirling drifts of bad debts? Zap the schemers,
masters of Crony Capitalism, businessmen whose dirty
deals with politicians wiped out decades of hard work and
sunk their countries beneath tidal waves of unpayable
obligations? What exciting, volatile truths shall our
laser beam destroy? Who are the bad guys and who is to
pay? This game has many moving targets. Bad guys can be
hard to identify because of confusion over who owes what
to whom. Both creditors and debtors hide their positions.
When Indonesia defaulted on $73 billion of private
foreign debt after its currency lost two-thirds of its
dollar value in three months, guesses on Indonesian debts
to Korean banks, themselves owing $66 billion in
short-term foreign loans, ranged from $2.5 billion to $25
billion. Who can zap the perennial menace of Colossal
Error? Our game demands discretion, ingenuity and a keen
sense of justice.
Our video game carries few new ideas, but poses some
basic questions. The central question of our time is
whether we have plunged into a breach with the past, a
basic discontinuity from the modernization of recent
centuries, reviving ancient fears of a plague of relapse.
Fear of relapse is driving a shift in the politics of
modern communities from a political economy of
entitlements, or acquired rights, to a political economy
of survival. The shift is only beginning and its
implications are coming slowly into view. In coming
decades, in many countries, from Russia and China to
Peru, from Brazil to Egypt to India and Nigeria, in
cities from New York to São Paulo to Budapest and
Bangkok, from St. Petersburg and Detroit to Jakarta and
Los Angeles, the main task of economic policy will be
regeneration.
Amid today's financial turbulence, Brazil is groping for
ways to fortify a new culture of low inflation and to
continue modernizing its public institutions. Since the
launching of the Real Plan in mid-1994, reducing annual
inflation from 5,115% in the previous 12 months to 4.7%
for all of 1997, Brazil has made modest, decent and
difficult progress toward enhancing the viability of
fiscal federalism, financial markets and the social
contract. However, political rigidities have slowed these
advances. The ground will give way under these efforts
only if Brazil fails to pursue them coherently, breeding
disillusion that could endanger political stability and
return Brazil to the pessimism and confusion of its
recent decades of chronic inflation. As Harold James
observes in his new history of the postwar international
monetary system, "a major problem is most easily
fixed if all those involved are convinced that they need
to act, and this conviction is most likely to be
generated by a sharp crisis."
Like Brazil's struggle against chronic inflation, the
Asian crisis is a test of institutions. This test
bestrides Asian countries embracing enormous differences
between them in wealth, economic structure, political
freedom, government policy and geography. It is hard to
compare Indonesia, an archipelago of 13,000 islands and
200 million people with a long history of colonialism and
dictatorial rule, with rich city-states like Hong Kong
and Singapore, a continental giant like China and an
economic superpower like Japan, used as a model for
state-directed industrialization in Korea and Malaysia.
The differences between these countries were blurred by
high economic growth rates in the recent past. Their
present difficulties are bred by failure of their
institutions to deal with the risks involved in sudden
increases in the scale of financial transactions.
Dramatizing these risks was the bankruptcy of Indonesia,
leading to a scale of political rioting unseen in Latin
America since the Bogotazo of 1948, triggered by
assassination of the Liberal leader Jorge Eliécer Gaitán, a key episode in aggravating endemic violence in
Colombia over the past half-century. Overshadowing
political convulsions is another question posed by the
Asian crisis: Given their huge burdens of unpaid foreign
and domestic debts, how many of these countries will be
able to maintain viable indigenous financial
institutions, interacting with the rest of the world
economy, over the next generation?
At the end of the 20th Century, mankind is struggling to
overcome the threat of institutional failure in managing
problems of scale. These problems of scale appear in the
proliferation of financial assets and information flows
as well as in the size of enterprises, cities and
nations. Sudden changes in the scale of human activity
breed institutional demands for applications of knowledge
in the form of capital-formation, adaptation, and
management. Institutional failure under pressures of
scale threatens relapse into more archaic forms of
civilization and mortality. Seeking humane outcomes, many
governments will seek to preserve civilized cooperation
in managing complex societies. Some communities will
sustain and speed their development, mastering higher
levels of knowledge and organization, while others sink
deeper into disease, violence and confusion. Brazil and
the stricken countries of Asia share these risks.
2. The Assets
What is seen today as an Asian crisis is merely a surface
disturbance of a much bigger problem: relentless and
uncontrolled proliferation of financial assets worldwide.
The heightened scale and efficiency of financial markets
has raised living standards, intensified international
exchange and created vast amounts of new wealth. But
money became too cheap and the rewards for risk too low.
The pace and secrecy of borrowing and lending bred
mistrust and dangerous information gaps. Delayed pressure
on creditors and borrowers led to changing expectations
embodied in devaluations, stock market crashes and
political casualties. The breakdown and reshuffling of
asset values in Asia came at a climax of global financial
expansion that has accelerated, despite a few brief
interruptions, throughout the postwar decades. By 1995
conventional financial assets in the core economies of
Europe, North America and Japan (bonds, equities, bank
assets and official reserves minus gold) had reached $73
trillion, or three times the total world product. In
early 1995 the BIS surveyed derivatives, the newest and
hottest game in financial markets, and calculated the
"notional" value of outstanding commitments
-that is, the assets generating the income streams being
swapped in derivatives contracts- at another $64
trillion. The combined value of derivatives and
conventional financial assets is now roughly five times
the world's total annual output of goods and services.
The magic of the market has its sorcerer's apprentice,
the hyperactive trader, a new kind of hero in the annals
of finance, sweating in the devil's kitchen amid vast
arrays of computer screens spawning the delights of
instant information: infinitesimal, fleeting spreads
within huge and sudden movements of financial assets,
creating flickering chances for quick trades. Completing
three years of 29% annual gains in stock prices and
hundreds of billions of dollars worth of corporate
takeovers and trillions of dollars in derivatives of
bewildering complexity, Wall Street was on a roll in
1997. At Goldman, Sachs, 190 partners took home bonuses
of at least $4 million each, with star performers and top
managers getting as much as $25 million, and 215 lower
level managing directors receiving an average of $1.5
million each. Dante classified avarice as a form of
incontinence. Gibbon called greed "an insatiate and
universal passion." Yet greed can be useful in
encouraging risk and innovation, although the Book of
Proverbs tells us: "He that is greedy of gain
troubles his own house." What can be dangerous about
greed is the feckless shifting of risk onto society,
subverting political systems and distorting the price of
risk and reward.
So far, the supply-driven financial expansion of our time
has accompanied declining inflation and fiscal
consolidation in the major countries, creating a stable
international environment. By 1994 the
institutionalization of savings in insurance companies
and pension and mutual funds in the rich countries had
amassed some $20 trillion in assets, of which only a
small portion poured into emerging markets at higher
yields. Yet this small portion is enough to flood the
institutional and management capacities of poorer
economies and to launch something akin to a video game of
attack and defense of vulnerable currencies leading to
the drama unfolding in East Asia since mid-1997.
Speculative attacks can surprise and overpower on several
fronts, while weapons of defense are few and usually are
used under severe constraints. Institutional investors,
with their huge hoards, are positioned well to mount
these attacks, together with highly leveraged hedge funds
and proprietary traders, by taking short positions
against weak currencies after capital flight has begun,
with leveraged bets worth five or 10 times their exposed
capital. The obvious targets are countries with
overvalued currencies, little exchange rate flexibility
for political or economic reasons, a weak financial
system and fiscal regime, big current account deficits,
lots of short-term foreign debt and limited international
reserves. On most of these counts, Brazil was a
prospective target for speculative attacks both before
and after outbreak of the Asian crisis.
The classic defense against these attacks is central bank
tightening of the domestic money supply, forward selling
of dollars, raising local interest rates and government
spending cuts. The defending central bank must act
quickly to raise the interest cost to speculators of
buying foreign currency to force a devaluation. As the
stakes rise, the battle becomes more intense and complex,
driving the central bank deeper into derivatives markets,
restricting foreign activity of commercial banks and
burdening the real economy with higher costs. A currency
can be attacked in either the spot or the forward market.
If no developed forward market exists, a new derivative,
NDF (non-deliverable forward) can be created as an
over-the-counter offshore contract, like those traded
heavily in Hong Kong and Singapore, to circumvent central
bank capital controls. NDF speculators bet on the future
price in dollars of the currency under attack and settle
their bets in dollars.
In October 1997 Hong Kong shares crashed, triggering an
international panic that devoured $10 billion of Brazil's
reserves within a week. In a successful defense, Brazil's
Central Bank decreed the world's highest real interest
rates, 40% above inflation, and sold $20 billion dollars
forward at the current exchange rate to shield its
currency, the real , from another attack. High interest
rates dampened domestic demand and sucked so many dollars
into the Brazilian economy that both reserves and
interest rates approached pre-crisis levels within four
months. "Never have so many dollars entered the
country," a banner headline exclaimed the newspaper
O Estado de S. Paulo as reserves approached a new record
of $75 billion, capitalizing mainly on hot money
exploiting the huge spread between Brazilian and
international interest rates. However, the security
provided by these $75 billion in reserves must be weighed
against $43 billion of annual interest paid by the
government, much of it from domestic debt sold to prevent
inflows of foreign capital from inflating the money
supply, and $36 billion in foreign short-term borrowing.
Asia's difficulties gave a healthy warning to the rest of
the world, suddenly reversing a steady fall in the price
of risk. According to the BIS, "the world financial
system seems to have shown greater resilience than during
the Mexican crisis in the early part of 1995. The risk
premia on Latin American and Eastern European countries
foreign currency debt retreated from their late October
peak and contagion to their currencies was muted....A
large number of investment and commercial banks appear to
have been taken by surprise by the virulence of the
financial turbulence, announcing heavy losses on their
proprietary trading operations," leading to a 30%
fall in international bond market issues in the last
quarter of 1997 and record levels of repayments.
Nevertheless, temporary and localized recoil from risk,
provoked by regional events in developing countries, is
unlikely to stall for long the growth, deepening,
specialization and diversification of financial activity.
Distortions and overvaluations always are adjusted.
Residual fear and instability are needed in financial
markets to contain herd behavior, which aggravates
overshooting and panics and makes episodes like the Asian
crisis more dangerous. Governmental action or inaction in
times of financial crisis often is guided by fear of the
unknown. Adjustments sometimes evoke the words of Joseph
Schumpeter who, during the Great Depression of the 1930s,
wrote that calculations based on inflated assets were
"swamped by the torrents of a process of
readjustment corresponding in magnitude to the extent of
the industrial revolution of the preceding 30 years.
People, for the most part, stood their ground firmly. But
that ground itself was about to give way." In
explaining the Asian crisis, U.S. Federal Reserve
Chairman Alan Greenspan alluded to Schumpeter's theory of
"creative destruction" as "an important
element of renewal in a dynamic market economy" that
needed, as Asian countries lacked, "an efficient
bankruptcy statute to aid in this process, including in
the case of cross-border defaults." Greenspan added:
"In an environment of weak financial systems, lax
supervisory regimes and vague guarantees about depositor
or creditor protection, bank runs have occurred in
several countries and reached crisis proportions in
Indonesia," breeding "a visceral, engulfing
fear. The exchange rate changes appear the consequences,
not of the accumulation of new knowledge of a
deterioration in fundamentals, but of its opposite: the
onset of uncertainties that destroy previous
understandings of the way the world works." The most
obvious danger is the proliferation of financial assets
that is unprecedented in speed, scope and scale. Here are
the main features of this expansion:
1. Reserves. The simplest indicator of
liquidity growth is the value of reserves in gold and
hard currency held by central banks. The postwar era
began with a "dollar shortage" that was ended
by the Marshall Plan and U.S. balance of payments
deficits. Reserves doubled in 1951-70, during the
"Golden Age" when the world economy grew at an
unsurpassed long-term annual rate of 5%. Since then,
economic growth slowed to 3% yearly but reserves
multiplied 12-fold. Since 1970 developing countries led
this increase, multiplying reserves 31 times, doubling
them in the 1990s, to exceed those of the rich countries
for the first time in 1997. Half of the $1.2 trillion in
net capital flows to emerging markets in 1990-96 went
into official reserves, 70% of them in Asia and 37% in
Latin America. As in the 1920s, many central banks
offered high interest rates in overvalued currencies to
attract and keep reserves. Short-term foreign credits and
surging Eurobond borrowing increased Brazil's hard
currency reserves from $10 billion in 1990 to $63 billion
on the eve of the Asia crisis, sixth-highest in the
world, as the lure of international interest-rate
arbitrage overcame the threat of chronic fiscal and
current account deficits.
2. Foreign exchange dealings. Daily
turnover in foreign exchange markets rose from about $200
billion in the mid-1980s to $1.2 trillion, or 20 times
the value of world trade in goods and services. Lured by
the rising value of the dollar against the deutsche mark
and the yen, investors poured nearly $1 trillion in net
capital inflows into the United States in 1995-96,
between four and five times the levels of the early
1990s. Many traders and hedge funds borrowed cheaply in
yen, then sold yen for dollars to buy U.S. treasury bills
and to finance other investments. Some of these dollars
were placed in developing countries, whose central banks
then used the dollars to buy U.S. treasury debt. Also,
international money markets increasingly use repurchase
agreements ("repos") for interbank funding,
with U.S. treasury securities the main form of
collateral. Central banks bought two-fifths of the $294
billion in foreign net purchases of U.S. treasury
securities in 1996 as Japan's reserves reached $216
billion, or $90 billion more than in 1994. Half of the
1996 central bank investments in U.S. government debt
came from developing countries trying to manage their
exchange rates amid huge and volatile capital flows.
3. International bank lending. Gross
cross-border bank lending quadrupled since 1992 while
international issues of bonds and notes by financial
institutions multiplied eight-fold, absorbing nearly
two-thirds of all net dealings. Analyzing the Asian
crisis in November 1997, the BIS found that "first
and foremost" was "the question of why the
evidence of growing economic and financial imbalances was
ignored for so long by the market....In contrast to the
Mexican crisis of 1995, which was heavily biased towards
public sector debt, the recent Southeast Asian currency
turmoil involved a wide spectrum of actors and
instruments," meaning that "it will be
increasingly difficult for official financial assistance
to insulate creditors and debtors from the adverse
consequences of poor investment decisions." As the
Asian panic spread, $93 billion in net capital inflows in
1996 to the countries most affected -Indonesia, the
Philippines, Malaysia, Korea and Thailand- became net
capital outflows of $12 billion, removing all chances of
orderly recovery.
4. Bonds. Foreign net purchases of
long-term U.S. government and corporate bonds reached a
new record 1996, 70% more than the previous high set in
1995. According to the IMF, "the United States is
playing the role of a global intermediary: it attracts
international capital by providing relatively safe,
liquid instruments (U.S. government and high-grade
corporate securities) at relatively high returns and then
reinvests them through international markets in less
liquid vehicles for higher returns." In proportion
to GDP, cross-border transactions in bonds and equities
by U.S. investors rose from 4% in 1975 to 35% in 1985 to
164% in 1996, while German activity mushroomed from 5% to
200% in the same span of years. Japan's international
financial dealings grew even faster, from 2% in 1975 to
156% in 1989 before falling to 60% by 1994 after collapse
of its domestic stock market and real estate bubble,
which erased more than $5 trillion in wealth, equivalent
to a year of national output. According to the BIS,
international financing through euronotes and bonds grew
much faster than domestic securities markets:
"Issuance of international debt was fueled by
investors searching for higher yields in a context of
ample global liquidity, further development of securitization, the migration of fund-raising activity
away from domestic markets and the appearance of new
borrowers. In their attempts to enhance returns,
international investors again showed a willingness to
move down the credit spectrum and explore new
niches," producing "the rapid increase in the
international issuance of lower-rated debt that...is now
being followed by a rise in the number of defaults."
Unlike loans, bonds "lack any mechanism for
achieving an agreed rescheduling," observed John
Williamson, a member of the Fernand Braudel Institute of
World Economics. "Ironically, it was precisely this
difficulty that made bonds popular with lenders during
the 1980s. While it was possible for distressed debtors
to maintain service on bonds when these were a minute
fraction of their total obligation, it will be impossible
to do the same if difficulties arise in a country with a
large proportion of its debt in the form of bonds. These
creditors are living in something of a fool's
paradise."
5. Short-term debt. The most dangerous
proliferation of assets is in short-term debt. Foreign
lending to both Asia and Latin America moved toward
shorter maturities and more credits to non-financial
companies instead of to banks and governments, especially
in Indonesia, Korea, Thailand, Brazil, Mexico, Chile and
Argentina, with short-term borrowing (maturities of less
than one year) far more prevalent in Asia than in Latin
America. Thailand's debt to foreign banks leaped from $29
billion in 1993 to $69 billion by mid-1997, 70% of which
was short-term.
Confusion and desperation over short-term foreign debts
in Korea, Indonesia and Thailand since mid-1997 evoke the
quagmire of short-term loans to Central and Eastern
Europe in the 1920s, after U.S. bankers poured money into
Germany to finance recycling of war debts and
reparations. The $200 million Dawes loan in 1924 began a
flood of high-interest, short-term loans on a scale that
was not understood until the Great Depression touched
bottom. In July 1931 the Creditanstalt, the 'Rothschilds'
Vienna bank and Austria's biggest, failed after the
French pulled their loans in protest against a planned
customs union between Germany and Austria. Half the
Creditanstalt's $145 million deposits were by foreigners.
By the time the Creditanstalt closed, the panic had
spread to Germany, which lost one-third of gold and
foreign exchange reserves in two months, forcing its
whole banking system to shut down. The BIS found that $10
billion of short-term debt was floating around the world,
with $5 billion in Central Europe, a much bigger share of
total international assets than the $212 billion in
developing country short-term debt discovered at the time
of the Mexico default in 1982 or today's Asia crisis. Fed
officials at first told President Herbert Hoover
(1929-33) that U.S. banks made only $500 million of these
short-term loans but Hoover, checking further, found that
the real amount "probably exceeded $1.7
billion," enough to destabilize some large U.S.
banks, blaming this on "artificially low interest
rates and expanded credit in the United States from
mid-1927 to mid-1929 at the urging of European bankers.
Some of our bankers had been yielding to sheer greed for
the 6% or 7% interest offered by banks in the European
panic area." Also, London bankers had borrowed
short-term in French francs at 2% and relent the funds,
changed into reichmarks, to German industry and local
governments at 8% in loans totaling $3.6 billion, more
than five times the gold reserve of the Bank of England.
As in Korea and Indonesia today, half of Germany's
foreign debt in 1931 was in short-term loans. Collapse of
the German financial system spread panic all over Eastern
Europe, shifting enormous pressure onto the gold standard
and British banks. In July 1931 Britain lost 19% of its
gold reserves. Withdrawals of foreign deposits from
London grew until Britain left the gold standard in
September. That event shook the world and shifted
pressure to the United States. While political conditions
now differ from those of Europe in the 1920s, the role of
short-term foreign loans in deepening the Depression
leads to worries about the impact of short-term debt
today. As Greenspan warned: "Short-term interbank
lending, especially cross-border, may turn out to be the
Achilles heel of an international financial system that
is subject to wide variations in financial
confidence." The Financial Times went further:
"If there is one lesson from the experience of the
last two decades, it is that banks are disastrous
vehicles for large-scale capital flows across frontiers.
The short-term money they provide is unsuitable for
finance of long-term investment; the expectation of help
from their home authorities makes them willing to take on
excessive risk; and their attempts to take their money
out impose intolerable pressure on exchange rates of the
capital importers. It would be far better for
international intermediation to be based, as a century
ago, on long-term finance: direct investment, portfolio
equity and long-term bonds."
6. Real estate speculation inflated
asset values in countries infected by the
"Dutch disease" as overvalued currencies drove
lending and investment into nontradeables, contributing
to bubbles and banking crises in Argentina, Chile,
Malaysia, Norway, Sweden, the United States, Britain and
Japan. In most countries real estate forms the bulk of
bank collateral, with real estate lending peaking at 37%
of all loans in Malaysia and 42% in the United States,
three or four times bank capital, before the collapse of
real estate prices a decade ago wiped out much of the
banking system's capital.
Shaky Japanese banks are stuck with boarded-up lots and
half-built apartment and office buildings, unsalable in
today's depressed market, that were taken as collateral
for defaulted real estate loans. Japanese investors who
bought luxury hotels, banks, office towers and golf
courses in the United States in the 1980s have been
selling $3-$5 billion of this property annually in the
mid-1990s. The flagship of Malaysia's real estate boom is
the 88-story Petronas Towers, billed as the world's
tallest building, an arresting creation of chrome and
plate-glass architecture, presiding over a building spree
in Kuala Lampur that would increase office space by 50%,
retail space by 90%, including 26 new shopping malls, and
the number of condominiums by 80%. Malaysia's Central
Bank tried to curb real estate lending in March 1997, but
not soon enough to avoid enormous oversupply and problems
for the banking system. Brazil escaped an Asian-style
real estate bubble because of high real interest rates
and low levels of bank lending to the private sector,
resulting from both chronic inflation and the rigors of
stabilization under the Real Plan.
7. Derivatives. "A derivative is
a bet, not an investment -a bet on the direction,
dimension, duration and speed of the changes in the value
of another financial instrument [mainly currencies,
interest rates and stock prices]," writes Martin
Mayer, a member of the Fernand Braudel Institute of World
Economics, in The Bankers: The Next Generation (1997).
The notional value of exchange-traded derivatives
contracts grew over the past decade at an annual rate of
32%. However, the market share of exchange-based deals
was overwhelmed by direct over-the-counter (OTC) sales by
financial institutions that grew at a 45% annual rate.
The IMF explained this buying and selling of risk in
terms of "an increased understanding by financial
and nonfinancial institutions of the capabilities these
instruments offer for repackaging and reengineering major
cyclical and balance-sheet risks, in tandem with
technological, analytical and numerical advances in
pricing and evaluating the risks of derivative
contracts." This reasoning supports technical
facility while overlooking basic questions about the
changing nature of credit and risk. The Asian crisis,
triggering big currency devaluations and stock market
losses, ruptured the mathematical premises for
calculating potential risks.Writing on derivatives in the
Asian crisis, Jan Kregel of the University of Bologna
argues that "it is precisely the role of most
derivative packages to mask the actual risk involved in
investment and to increase the difficulty of assessing
the final return on funds provided."
In the United States at the end of 1996, the top eight
banks alone generated 94% ($19 trillion) of all OTC outstandings. According to Mayer: "Something like a
fifth of the total 1993 profits of the largest American
dealers in such instruments -JPMorgan, Bankers Trust,
Chemical-Chase, Citibank, First Chicago, Bank of America,
Merrill Lynch, Salomon, Goldman Sachs, Bear Stearns,
Morgan Stanley- came from creating, selling and trading
the great zoo of futures, forwards, structured notes,
collateralized mortgage options, swaps, swaptions,
collars and so forth that carry the label
'derivatives'."
The danger of derivatives is that small sums of money can
be used to leverage big bets on interest rates,
currencies, commodities and shares, exposing players to
gains or losses that can multiply their original stake
hugely in periods of volatility. Potential losses can be
multiples of maximum gains. These bets emanate an aura of
complexity dressed in the mumbo-jumbo of high technology,
using computer-generated calculations based on advanced
mathematics, often custom-designed for each client,
giving the bank a big information advantage in each deal.
Some of the 'end users' whose risks were supposedly being
controlled by these instruments suffered losses of more
than a billion dollars each. The list includes Showa
Shell in Japan, Bank Negara in Malaysia, Barings in
Britain, Metallgesellschaft in Germany, Orange County in
California, Sumitomo and the New York branch of Japan's
Daiwa Bank. After Orange County filed for bankruptcy in
1994 with losses of more than $1.6 billion in risky
investments, mainly derivatives, Merril Lynch and Credit
Suisse First Boston paid $34 million to settle suits by
investors and the SEC. In March a Japanese beverage
company, Yakult Honsha, revealed $812 million in
derivatives losses in gambles to make up for stock market
losses after the "bubble economy" collapsed in
1989.
8. Foreign direct investment. Since the
mid-1980s, annual flows of foreign direct investment (FDI), the most stable and productive form of
asset-creation, multiplied four-fold, from $77 billion to
$349 billion in 1996. Total FDI inflows have doubled
worldwide since 1991-92. While trade in services is more
restricted than trade in goods, the fact that services is
the largest sector of the world economy has enabled it to
generate half of all FDI stock and nearly two-thirds of
FDI flows. Both trade and foreign investment are
concentrated in a few countries. UNCTAD's World
Investment Report 1996 shows that the 11 biggest host
countries (10 OECD members plus China) received
two-thirds of all FDI inflows and generated 78% of all
outflows in 1995, while the 100 least-favored countries
received less than 1%. The trend is toward more
concentration. Nearly 90% of the increase in FDI inflows
in 1995 went to developed countries, with their share
rising from 59% in 1994 to 65% in 1995, far exceeding
their portion of world output. The bulk of FDI growth
among developed countries is in mergers and acquisitions
(M&As), often for investment in new production
capacity. In 1995, U.S. companies spent $38 billion to
buy majority stock in cross-border M&As, or 90% of
the equity in FDI outflows from the United States, a
spillover from the domestic merger fever of the 1980s,
when $2 trillion was spent to buy 55,000 U.S. companies.
Of the $1.6 trillion in M&A deals worldwide in 1997,
45% were outside North America. Spurred by this surge of
M&A activity, Latin America received 11% of global
FDI in 1996, nearly triple its falling share of world
exports.
9. Stock markets. Until the typhoon
struck Asia, Brazil's stock market, trading mostly
non-voting shares in government-owned companies, rose 70%
in the first eight months of 1997. For all of 1997,
emerging Asia's stock markets lost 56% of their dollar
value and Japan's lost 30%, even as Wall Street stocks
gained 31% for the year, European bourses rose 24% and
shares in Brazil and Mexico, despite losses late in the
year, advanced by 35% and 51% respectively. Throughout
Asia, losses were concentrated in the last quarter of
1997, when stock markets in Bangkok, Jakarta, Kuala
Lumpur and Seoul fell by 29%-31%. Companies sank beneath
enormous burdens of debt, mostly short-term and in
dollars or yen, with chances of repayment receding as
local currencies lost value in the panic of each day or
week.
Emerging markets were riding the boom on Wall Street.
After seven years of steady growth and low inflation, the
United States has been enjoying an expanding sense of
what is possible and reasonable. In its 1997 report on
the U.S. economy, the Organization for Economic
Cooperation and Development (OECD) suspected "an
increased appetite for risk on the part of investors and
financial institutions," echoing Greenspan's warning
against "irrational exuberance" bred by one of
the biggest bull runs in stock market history. Since 1982
stock prices multiplied tenfold at a compound annual rate
of 16.5%, exceeded in speed only by the 29% yearly rises
in 1923-29 and in duration by the 10.5% annual growth
from 1942 to 1966.
Increased appetite for risk also could be seen in
shrinking yield spreads between U.S. Treasury debt and
emerging market bonds, which fell to new lows in early
1997, even after bank supervisors warned of risky
syndicated loans. The OECD observed that historical
experience shows that "an increased cyclical
willingness to bear risk is a hallmark of an expansion
nearing its end."
In the United States, mutual funds now manage nearly $5
trillion, reflecting higher stock market prices, compared
with only $62 billion in 1980 and $602 billion in 1990.
In 1970-97 the number of mutual funds multiplied from 361
to 6,500 and individual accounts from 11 million to 151
million. The $5 trillion in mutual funds equals
three-fifths of gross domestic product (GDP), more net
assets than those held by banks, pension funds or
insurance companies. More than half of the 96 million
U.S. households were believed to own shares, either
directly or through mutual funds, twice as many as in the
early 1980s, enabling the net worth of all households to
more than quadruple since 1985.
The Asian typhoon has revived solemn and urgent words of
warning. "We are past the stage of denial,"
warned Alfred Ho, associate director of Ivesco Asia in
Hong Kong after prices of Asian currencies and stock
markets, with few exceptions, collapsed in the last
quarter of 1997. "We are at the stage of
bankruptcies -and jail sentences. When the currency moves
10% a day, a company's liabilities go up 10% a day. At
these levels of interest and currency rates, everyone is
bankrupt. No legitimate businesses can function."
Words like these have been spoken many times before.
Writing in 1934 on The Great Depression, the British
economist Lionel Robbins warned: "We eschew the
sharp purge. We prefer the lingering disease. Everywhere,
in the money market, in the commodity markets and in the
broad field of company finance and public indebtedness,
the efforts of central banks and governments have been
directed to propping up bad business positions."
Six decades later, as the Asian crisis intensified in the
final weeks of 1997, Greenspan urged that "companies
should be allowed to default, private investors should
take their losses, and government policies should be
directed toward laying the macroeconomic groundwork and
structural foundations for renewed expansion; new growth
opportunities must be allowed to emerge. Similarly, in
providing any international financial assistance, we need
to be mindful of the desirability of minimizing the
impression that international authorities stand ready to
guarantee the external liabilities of sovereign
governments or failed domestic businesses. To do
otherwise could lead to distorted investments and could
ultimately unbalance the world financial system."
Time and time again, in many nations, two complications
blocked obedience to these sound principles. First,
financial institutions and their public regulators never
learned to deal systematically with the problem of
overshooting, embodied in the metabolism of all markets.
Second, political considerations get in the way and seem
to rule most of their decisions. Political considerations
drove big bailout operations of recent years in many
countries. Political and economic logic are in danger of
colliding again today.
3. Brazil and
Korea
Modernization in Brazil and Korea is threatened by misuse
of financial resources that we may call deranged economic
transfers. These financial problems are surface features
of deeper institutional difficulties, with common
elements reaching across cultural and geographical
distances. These distances and common institutional
difficulties join, at the same crossroads of crisis and
time, a relatively self-sufficient continental nation of
170 million people, covering half of South America's land
mass, with an ancient "hermit kingdom" of East
Asia that since World War II and the Korean War emerged
from isolation and colonial submission to become the
world's 11th-ranking exporter. Despite its spectacular
success as an export platform, Korea has only begun to
emerge from cultural isolation over the past decade.
Japanese and Korean ideals of ethnic purity contrast
sharply with the polyglot diversity of peoples within the
Chinese empire and with Brazil's experience in the New
World.
Brazil's peculiar regionalism gave it one of the world's
most decentralized federations, in which state governors
wield power in national politics with little
accountability, much in the way that Korea's chaebols (a
Korean adaptation of the Japanese word zaibatsu, meaning
conglomerates) wield economic power. In both countries
the private sector was dominated by family firms, which
received huge government transfers. In 1983, in the worst
phase of Latin America's debt crisis, the World Bank
called Brazil "a transfer economy to distinguish it
from the market and centrally planned economies." In
1982 transfers to individuals and businesses, including
government corporations and the cost of financial
subsidies, totaled 17% of GDP. Only 16% of the loan
portfolios of the Central Bank and the Bank of Brazil
carried positive real interest rates, while the
liabilities of these institutions were high real interest
obligations absorbing 78% of their resources. For
decades, Korea threw money at privileged private
companies as military governments drove the family-run
chaebols into "strategic" areas of activity
-shipbuilding, machine tools, steel, chemicals,
semiconductors, car-making and construction- and then
bailed them out of financial difficulties after being
rewarded by gigantic expansion of manufactured exports.
While government support of the chaebols may declined
recently as the chaebols became more powerful with
greater acess to private loans, these credits embody
massive transfers of resources from households to the
corporate sector, which has failed to recover its capital
costs. In 1997 the top five chaebols absorbed 15% of all
bank credit. The Korea Development Institute estimated
corporate debts, foreign and domestic, including
operating and foreign exchange losses, at $650 billion at
the end of 1997. According to the McKinsey Global
Institute, "while Korean companies recorded profits
on an accounting basis, they were destroying value since
the profits generated were lower than the cost of
financing the capital investments (i.e., Korean companies
suffered from extremely low capital productivity)."
In most of the world, transfer economies are sinking
under the stress of fiscal burdens, political conflict
and international competition. Large-scale fiscal
transfers are common to nearly all modern economies.
These transfers become deranged, as weapons of
self-destruction, when they grow to rival market
mechanisms, when they develop a life of their own, when
their scale can no longer be controlled without injuring
or destroying important niches within the community.
Brazil and Korea are not alone in spawning deranged
economic transfers, driven by perverse incentives, but
have carried them much further than most countries.
Korea's antiquity as a unified state goes back 1,200
years, its independence broken only by brief conquests by
the Mongols in the 13th Century and the Japanese in this
century. A stranger to large-scale warfare, Brazil is a
more recent creature of Europe's mercantile capitalism,
based on plantation agriculture and extractive
industries, its culture shaped by slavery and European
immigration. The floating world of Brazilian inflation
was animated by a fantasy of infinite expansion, peculiar
to the frontier societies of the Western Hemisphere. The
returns to labor remained low because of weak political
and economic organization over a vast national territory
and meager investment in infrastructure and human
capital. Yet the promise of the frontier remained vibrant
in view of Brazil's cornucopia of natural resources and
its experience as the world's fastest-growing national
economy for most of the past 120 years. Brazil is a
cosmopolitan society while Korea, despite its spectacular
recent development, is struggling now with inbred and
xenophobic culture developed in response to periodic
incursions by more powerful neighboring civilizations.
Fear of foreign dominance has shaped Korean resistance to
foreign investment and to foreign investors' purchase of
land. Memories persist of Japanese property seizures and
of farmers being forced off their land when Japan ruled
Korea as a colony (1910-45). By 1918 the Japanese owned
40% of Korea's land area. Only now are bans on foreign
land ownership, under a law passed in 1948, being relaxed
under terms of $58 billion bailout pact with the IMF in
late 1997, which commits Korea to open its economy to
foreign investment.
Brazilian experience knows nothing like Korea's love-hate
dependence on Japan. The interface between these two
peoples arises from the mists of ancient history and
legend. Southern Japan probably was peopled by stone-age
migrations from Korea. As late as the 15th Century Korea
exported advanced products to Japan (pottery, cotton
thread, textiles) in exchange for raw materials (copper
and sulphur) amid the tumult of military invasions and
endemic piracy. Park Chung Hee, South Korea's military
dictator (1961-79), was trained at Japanese military
schools. His Heavy and Chemical Industries drive,
mobilizing and financing the chaebol to industrialize
Korea, was modeled after similar drive of Japan's
military regimes of the 1930s. In the postwar decades
Korea became dependent on Japanese loans and capital
goods to modernize its economy. "We now are seeing a
generational change," said Professor Woo Tack Kim of
Hallym University (Seoul). "The old politicians,
bureaucrats and military, educated in Japanese colonial
schools, are moving out. Younger people, with an
American-style, schooling, are moving in. Korean
bureaucrats did nothing to solve the mess in our
financial system because they copied Japanese
bureaucrats, who also did nothing to solve their own
financial mess. One thing the Asian crisis may prove is
that the Japanese model no longer is good for us."
Despite political instability in recent decades, Brazil
and Korea have developed strong international ambitions
and a new vocation for democracy. In both countries
military rule ended in the mid-1980s in the face of
popular clamor for free elections, but in Brazil
democratization was planned and executed by its military
rulers over a 10-year period. Both now struggle to emerge
from the cultural and economic models of state-driven
industrial development that flourished under decades of
anti-communist military rule. These statist models were
more fashionable worldwide in the 1960s and 1970s than
they are today, producing high growth rates that citizens
of both countries took for granted.
In Brazil and Korea, banks formed part of the support
system for goods industries that were heavily protected
from international competition. Both countries tried
financial liberalization in recent years, with Brazil
going much further. Their experience shows how hard it is
to free credit markets without also freeing goods
markets. Commercial banks in Korea were privatized in
1957, renationalized by President Park in 1961 and then
reprivatized in the early 1980s, with the government
controlling appointment of all bank presidents until
1993. The kind, direction and rates of bank lending fell
under Japanese-style "window guidance" by
government, which steered loans to big companies while
depriving individual savers of credit for housing
mortgages and personal loans, giving banks little chance
to gain experience in credit evaluation. Liberalization
of this system took place in small steps in the 1980s and
early 1990s. While by the mid-1990s turnover on the
Korean stock market was sixth-highest in the world,
foreigners still were restricted to 15% ownership of
Korean companies at the time the currency and stocks
crashed in late 1997. As in Korea, the bulk of the assets
of Brazilian banks are loans by government financial
institutions. However, despite the domination of credit
markets by huge public banks, and the waste and
disorganization perpetuated by multi-billion dollar
bailouts, Brazil's banking system embraces a wider
variety of institutions: from big and profitable private
banks, like Bradesco and Itaú, with national branch
networks, to investment banks and medium-size commercial
and regional banks to state government banks that serve
as political cash boxes and are rescued recurrently from
collapse by the Central Bank. Moreover, financial
liberalization moved in step with trade liberalization.
The opening of the foreign exchange market in the late
1980s, and of local capital markets to foreign portfolio
investment, was followed by freeing of goods imports in
the early 1990s. Foreign banks were allowed to buy
Brazilian banks to avoid closure in the banking crisis of
the mid-1990s. High interest rates attracted huge capital
inflows. Reserves multiplied. The inflows also bred a
boom in a stock market mainly trading non-voting shares
in government corporations. The price of shares in Telebrás, the federal telecoms monopoly which accounts
for half of the capitalization of the São Paulo stock
market, soared from $2 in 1991 to $150 on the eve of the
October crash provoked by the Asian crisis.
By then, globalization of financial markets had gone so
far that Korean banks and companies held 15% of the $36
billion in outstanding Brazilian Brady bonds, a
heavily-traded debt instrument, partly backed by U.S.
Treasury securities in renegotiating developing countries
debts to foreign banks. Korean investment banks and
brokers were running over 100 offshore investment funds,
of which some 40 had derivatives business with JPMorgan.
Of JPMorgan's $3.4 billion total exposure to Korea, $2
billion was in derivatives contracts. JPMorgan's suit
against a Korean counterparty to a "notional"
$250 million currency swap derivative claimed a real loss
of $189 million. When the Koreans dumped their Brazilian
Bradies on Wall Street to get dollars to pay their own
debts, the price of these bonds crashed. After borrowing
heavily to buy Bradies upon receiving inside information
that the government would drive up prices by buying its
own debt, Brazilian banks dumped their own Bradies to
raise dollars to meet their commitments following the
Hong Kong crash. Their heavy losses forced Brazil's
leading investment bank, Banco Garantia, to negotiate its
sale to a foreign institution.
Nevertheless, Brazil benefited hugely from the global
proliferation of financial assets in the 1990s. As this
swelling peaked, more private foreign money poured into
Latin America and Asia in 1996 alone than in the entire
decade of the 1980s. At the climax of this expansion, two
Brazilian officials told how their government used
surging world liquidity in the 1990s to enable the Real
Plan to drastically reduce annual inflation. "Our
strategy was to use the moment of extreme international
liquidity to advance in disindexing the economy,
improving our fiscal accounts and restructuring
production," wrote José Roberto Mendonça de Barros
and Lídia Goldenstein. "The advantage of using
international liquidity made possible a less traumatic
fiscal adjustment. We gained time to adjust little by
little while productive restructuring advanced, allowing
us to return to higher growth rates and, consequently,
absorption of deeper adjustments by the society." In
the 1990s, they added, Brazil's productive restructuring
was pushed forward by three "competitive
shocks": (1) an export drive to overcome domestic
recession; (2) opening the economy to imports to compete
with domestic production bred by protected
import-substitution programs of the past; (3)
privatization of state-owned mining, transportation,
electricity and telecommunications industries, raising
foreign direct investment to new levels. The Real Plan
also abolished the culture of indexation that perpetuated
chronic inflation. Since 1990, annual gross inflows of
foreign capital rose from $5.4 billion to $129 billion.
Over the past two years gross flows doubled and foreign
direct investment (FDI) multiplied five-fold to $17
billion, three times its share of poorer countries'
exports. In 1996 Professor Celso Martone of the
University of São Paulo viewed the process more
skeptically:
What the Real Plan essentially did, besides changing the
name of Brazil's currency, was to use foreign money
instead of inflation to finance government deficits.
Favorable conditions in the world economy, especially the
emerging markets boom of the early 1990s, made funds
available to enable Brazil's government to replace the
domestic inflation tax with foreign savings as the
primary source of financing its deficits. The current
account deficit in the balance of payments and the fiscal
deficit today amount to the same share of GDP. Two policy
tools have been used to produce the shift in government
funding: the exchange rate and domestic interest rates.
The exchange rate policy tries to keep the rate of
inflation low by linking domestic prices to world prices,
while monetary policy maintains very high real domestic
interest rates to attract enough foreign capital to
finance the current account deficit. Over the past two
years, however, there has been no public sector
adjustment to eliminate the deficit and end the danger of
resurging chronic inflation.
Never has a country emerged from decades of chronic
inflation so painlessly as Brazil since the launching of
the Real Plan in July 1994, thanks to these huge inflows
of foreign capital. The Real Plan is Brazil's eighth try
at economic stabilization since two decades of military
rule ended in 1985. During this period 13 Finance
Ministers and 15 Central Bank Presidents succeeded each
other as the currency changed names six times. Like other
economists who prepared the Real Plan while President
Fernando Henrique Cardoso (FHC) was Finance Minister in
1993-94, Edmar Bacha has become an investment banker.
During the crisis he logged onto the Internet every
afternoon to read the next day's Korea Herald so he could
tell executives from Merrill Lynch and Fidelity
Investments where Brazil is headed. "I get very
worried on days when the Koreans don't seem as worried as
I am," Bacha said. "Let's face it, if Korea or
Indonesia goes and Japan is hit, then who cares about
fiscal adjustment in Brazil or anywhere else? Everyone's
out of here and into United States Treasury Bills."
Until recently, comparisons with Korea inspired shame and
envy among Brazilians:
• Infant mortality of 44 per 1,000 live births in
Brazil, against only 10 per 1,000 in Korea.
• Only 31% of Brazilian adolescents enrolled in
secondary school, with high failure rates, against 92% of
Koreans.
• Annual inflation of 5,115% in Brazil as recently
as mid-1994, against only 5% in Korea. In the early
1990s, Korea ran general government surpluses averaging
2.7% of GDP, against Brazil's deficits exceeding 50% of
GDP as governments printed money to keep the economy
moving on the treadmill of chronic inflation. Korea's
wage bill at all levels of government since 1970 was 15%
of total spending, against 60% in Brazil.
• Brazil's income distribution is the worst recorded
by the World Bank, with the richest 10% of the population
taking 51% of all income and the poorest 20% only 2%,
while Korea's richest tenth absorb 28% and the poorest
fifth get 12%.
• Since 1980, Brazil's economy has grown at an
annual average rate of only 2.7%, while Korea's has grown
by nearly 9%. Korea's per capita income multiplied from
$150 in 1964 to $10,600 in 1996.
Then the Asian typhoon struck. "We're in big
trouble," President-elect Kim Dae Jung told heads of
the top chaebols . "We went on a spending spree on
borrowed money, and we've only ourselves to blame for the
mess." Korea's $100 billion in short-term debts at
the end of 1997 were 25 times its official reserves,
which evaporated after its Central Bank lent its own hard
currency recklessly to finance overseas expansion of the chaebols. The 1998 renegotiation of short-term debt of
Korean banks excluded $40 billion in foreign loans owed
by the chaebols. Overseas subsidiaries of Korean firms
owe $50 billion.
Brazil has some big local business groups, but nothing
like Korea's chaebols. In 1992, the chaebols embraced 78
groups and their 1,056 subsidiaries, linked both by
ownership and a maze of cross-guarantees of debts by
companies within the same group. The top five groups had
an average of 42 subsidiaries (including four non-bank
financial companies) operating in 30 industries. The top
four chaebols -LG, Hyundai, Samsung and Daewoo- generated
60% of the sales and 78% of profits of the 30 biggest
groups, whose debts rose to 519% of equity in 1997. The chaebols' huge debts became entrenched in Korea's
political economy since the 1960s. Some Korean economists
find that cross-shareholding between firms in the same
chaebol is "imaginary capital," which would
make realistic debt-equity ratios even higher than the
alarming levels currently reported. Daewoo became the
biggest foreign corporate investor from developing
countries when the Asian typhoon struck, leaving it with
debts of $3 billion, or six times equity.
Korea was the golden boy of the debt crisis of the 1980s.
In January 1980, three months after the assassination of
President Park and 28 months before Mexico's default,
Korea launched a drastic stabilization effort that
embraced a 20% currency devaluation, tight money, a 60%
rise in gasoline prices, commitment to a flexible
exchange rate and a $600 million balance of payments loan
from the IMF. By 1983, thanks mainly to fast growth of
manufactured exports, Korea cut its current account
deficit by three-fourths. Creditors were ecstatic.
JPMorgan announced: "Korea's achievements in
adapting its economy to the turbulent world of the 1980s
exemplify the benefits that can flow from an
outward-looking, market-oriented strategy for economic
adjustment and development similar to that now being
urged on many other developing countries."
As critics in the U.S. press and Congress insisted that
the IMF rescue loans to Asian countries should not simply
cover a bailout of foreign banks, JPMorgan sued Korean
banks and brokers for $480 million in New York courts
after declaring $589 million in loans and derivatives in
Indonesia, Korea and Thailand as non-performing assets.
Some two-thirds of Korea's foreign debt were loans to
local banks by foreign banks, $55 billion of which were
short-term, posing big risks for major U.S., Japanese and
European banks. Aside from Korea's huge foreign arrears,
its companies are struggling with some $300 billion in
domestic debt, mostly short-term. Korean banks are left
with $52 billion in government-ordered policy loans to
favored companies on their books, 56% of which are
non-performing. The Korean and Brazilian banking crises
of 1995-98 confirm the findings of Andrew Sheng of the
Hong Kong Monetary Authority, in a study of bank failures
in many countries since the 1970s, arguing that "the
unwillingness of governments to allow banks to fail for
fear of systemic failure (bank capital is negative systemwide) has meant that implicit and explicit
government guarantees exist for almost all banking
liabilities. Consequently, a central problem of the
global banking system is that, irrespective of public and
private ownership of banks, commercial bank losses in
excess of capital have become de facto quasi-fiscal
deficits."
After signing agreement with the IMF in late 1997, Korea
is trying to become the Comeback Kid of the Asian crisis.
Korea's foreign debt of $187 billion is nearly the same
share of GDP as in 1980. With surprising realism and
decisiveness, President-elect Kim, a veteran leftist
politician who survived imprisonment and attempts by
military regimes to kill him, hired former high-level
U.S. officials to advise in rescheduling $24 billion in
short-term loans to Korean banks at lower interest rates
than foreign banks demanded, in exchange for government
guarantees. In the first quarter of 1998, Korea ran an
$8.6 billion trade surplus, thanks to shrinking imports,
against Brazil's continuing trade deficits, as Korean
reserves recovered to a two-year high of $32 billion from
a low of $4 billion in December. In April Korea's
government sold $4 billion in junk-rated global bonds, at
lower interest spreads above U.S. Treasuries than Brazil
was able to borrow a week earlier, in the opening shot in
Korea's drive to tell $9 billion in bonds during 1998. To
open its economy, trying to overcome a widespread sense
of failure and resentment sometimes bordering on
xenophobia, the government scrapped limits on foreign
ownership of Korean stocks, ordered more transparent and
consolidated financial statements by companies and sent
missions abroad to attract foreign investment, targeting
222 overseas companies, and plans.
As foreign investors looked for bargains in Korea, its
citizens won sympathy in late 1997 as television screens
around the world showed them lining up to sell $2 billion
worth of gold jewelry, exported as bars to back the local
currency. As the currency wilted, domestic prices jumped.
Flour rose by 60% and cooking oil by 56%. Factories
lacked basic raw materials such as aluminum, cotton,
hides, scrap iron and copper. Hospitals lacked imported
vaccines and X-ray film. University students, unable to
pay tuition, left their studies to join the army. Before
his inauguration in February, Kim persuaded Korea's
militant unions to accept changes in labor laws that
would enable failing or merging firms to fire one million
workers if Congress strengthens the social safety net.
But union militancy revived as manufacturing job losses
rose sharply in early 1998, partially offset as in Brazil
by growth in informal services. Open unemployment rose
from 2.3% in October 1997 to 6.7% in March 1998 and could
rise to 10% by the end of the year. The number of
suicides rose by 36% in the first quarter of 1998 over
the same period last year. As in Lima during the economic
collapse of the late 1980s, jobless youths stole sewer
caps to sell as junk. Robberies in Seoul rose 45%, their
numbers swollen by older housewives shoplifting in
supermarkets and burglaries by laid-off workers, dubbed
as "IMF survival crimes" by the press.
Pessimism deepened after an initial recovery in early
1998. Officially 13,971 firms went bankrupt during 1997,
among them eight big chaebols with combined debts of $21
billion. The Korean Institute of Finance says that
another 50,000 firms will fold in 1998, with a new surge
of bankruptcies expected to start in August. "We're
headed for the full meltdown of the financial
sector," said Stephen Marvin, research director at
Seoul's Ssangyong Investment & Securities.
"There will be nationalization of the banking
system." So far, however, most bankrupt firms
continue operating in limbo, with the four bankruptcy
court judges in Seoul swamped by a flood of cases as
banks, carrying $91 billion in bad debts and worried
about providing for losses, pumped another $1.5 billion
into 11 troubled firms. Meanwhile, the three firms
controlling two-thirds of Korea's $100 billion in trust
funds lost $2.6 billion and may have secretly diverted
another $10 billion into their own accounts. Bankruptcy
of some of Korea's most reputable firms made banks
increasingly reluctant to discount promissory notes,
traditionally a much-abused form of business payment. The
Encyclopedia Britannica in 1910 reported that promissory
notes "have long existed in Korea":
They took the form of a piece of paper about an inch
broad and five to eight inches long, on which was written
the sum, the date of payment and the name of the payer
and payee, with their seals; the paper was then torn down
its length, and one half given to each party. The debtor
was obliged to pay the amount of the debt to any person
who presented the missing half of the bill. The readiness
with which they were accepted led to over-issue, and,
consequently, financial crises.
On the day that Korea's financial troubles became world
news, Brazilian newspapers inconspicuously reported that
the Senate in Brasília approved a $44 billion federal
loan to rescue the state government of São Paulo from
its spiraling debt to Banespa (State Bank of São Paulo),
which was racing neck-and-neck with France's Crédit
Lyonnais for the Grand Prize of becoming the biggest
failure in the history of world banking. (See "King
Kong in Brazil: State bankruptcies and bank
failures," Braudel Papers. No. 15 [1996].) Banespa
and Crédit Lyonnais were bailed out a huge cost to
taxpayers by their national governments. While the IMF
was mobilizing $118 billion to rescue Korea, Thailand and
Indonesia from their debts, Brazil was showing the world
that it needed no help from the IMF because its transfer
economy had spawned a more generous and less complaining
IMF of its own. In 1995-97 Brazil's federal authorities
mobilized some $150-$200 billion, or from one-fifth to
one-quarter of a year's GDP, to contract public debt to
sterilize the monetary impact of inflows of reserves and
to bail out failed banks and bankrupt state governments.
While deranged economic transfers in Korea were embodied
in overinvestment that proved wasteful and
self-destructive, the transfer economy in Brazil bred
huge burdens of fiscal parasitism leading to chronic underinvestment. After long delays and tortuous
negotiations, under pressures bred by the Asian crisis,
Congress amended the populist 1988 Constitution,
curtailing social security and public employment
entitlements to save most of the public sector from
bankruptcy. These reforms are watered-down versions of
government proposals to be tested in their fiscal effect
by years of political negotiation. Pension reform has
stalled in Congress and constitutional changes curtailing
job security for public employees still must be
implemented by ordinary legislation. The payrolls of most
state governments absorb more than 70% of total spending,
but several governors announced their refusal to use
their new powers to dismiss employees. The Cardoso
government is carrying out a huge program of privatizing
public enterprises to improve efficiency of basic
infrastructure, increase savings and foreign investment
and reduce the cost of doing business in Brazil.
Privatization provided federal and state governments with
$50 billion of windfall revenues since 1991, with another
$50 billion expected for 1998-99. However, much of this
money is being used by some state governments to finance
election campaigns instead of reducing public debt on
which the government pays heavy interest charges. Albert
Fishlow of the Council on Foreign Relations, a veteran
analyst of Brazil's economy, argues that the success or
failure of the Real Plan hinges on the use or misuse of
privatization revenues. "The government will succeed
if, in an election year, it manages to use privatization
income to reduce its debt," Fishlow adds, enabling
the economy to generate more savings and investment.
"Brazil has maintained the same savings rate for 40
years. Without an increase, Brazil will not grow."
But the privatization program, one of the biggest ever
attempted, has run into trouble, while the public deficit
surged to 6.5% of GDP in early 1998 and is expected to
rise to 8% despite a 27% increase in tax revenues passed
by Congress as part of a new stabilization package
responding to the Asian crisis. "Spending has risen
in all areas, as if the government has lost the will to
control its outlays," said Raul Velloso, a leading
fiscal analyst. These public deficits exclude increases
in off-budget outlays by government banks such as the
National Bank for Economic and Social Development (BNDES)
and the Caixa Econômica Federal (CEF) during the
election campaign. Meanwhile, the privatization program
has become increasingly dependent on government pension
funds and loans to purchasers from the BNDES to sell
state corporations at inflated prices, creating another
form of fiscal parasitism. The broader scope and weight
of fiscal parasitism can be illustrated by two more
examples:
• Federal transfers to states and municipalities
rose enormously under Brazil's 1988 Constitution. A
tripling of municipalities' share of public spending led
to creation of some 1,328 new municípios to harvest
these transfers. Nearly all this new money went to hire
new local employees. The legislative and judicial
branches of federal and state governments, guaranteed
"autonomy" by the Constitution, gave themselves
generous salary increases and pensions, while teachers,
who are one-third of all public employees, continued to
earn the lowest pay as the quality of schooling fell.
States and municipalities hired aggressively, with people
with less than four years of schooling generating nearly
half the increase. "The public administration
clearly tended to pay its poorly qualified employees much
better than the private sector and did the opposite with
its best-trained people," a study by the
government's economic research institute (IPEA) reported.
While the number of public employees in Brazil is low
compared with rich countries, it is high in many
communities depending on central government transfers,
salaries and pensions for survival. Of Brazil's 5,507 municípios, 95% derive less than 20% of their spending
from local taxes. This dependence on transfers shaped
Brazilian political culture and gave it its extraordinary
resilience. Over the past decade, it also spawned growing
public debts that threaten to bankrupt the government and
to end economic stabilization.
• Public pensions in Brazil absorb 12% of GDP, about
the same as in most of Europe, a big burden for a young
population, roughly equal to all federal tax revenues.
With nearly half of the labor force informally employed,
its pool of contributors is shrinking. The average
retirement age has been 49 years for length of service
(nominally 30 years). Early retirees (16% of all
pensioners) get 37% of all social security spending.
Young retirees will receive pensions for more years than
they worked. Public employee pensions absorb 40% of
spending at all levels of government.
Pensioners form two classes: plebes and nobles. The
plebes are 87% of the retirees, most of whom retire at
age 60 with a monthly social security payment of roughly
$120, equal to the minimum wage. The nobles are the other
13%, getting one-third of all benefits as members of
politically influential professions, who can retire under
"special regimes" as early as ages 45 or 50,
with monthly pensions that can run from $7,000 to $20,000
or more, beyond the dreams of all but the wealthiest
retirees in the United States or Europe. Many officials
accumulate several pensions during their careers. Some
100,000 retired public employees get monthly pensions
exceeding $8,000. In Minas Gerais, one of Brazil's
biggest and wealthiest states, a rush to retirement,
prompted by fear of change in the social security laws,
expanded the ranks of pensioners by 49% over the past
five years. The state's pension burden embraces 27 police
colonels and 19 treasury inspectors for each colonel and
inspector on now active duty. Monthly pensions for police
colonels can run to more than $20,000. Falsified work
histories and disability claims breed widespread fraud to
obtain benefits. One gang of lawyers, judges and social
security officials looted the system of $531 million in
fraudulent disability claims in 1988-91. Evasion of
social security payroll taxes is 40% of contributions
owed, with many private firms and public agencies keeping
salary deductions for themselves. President Cardoso
called those who retire before age 50 "bums in a
country of poor people" who "enrich themselves
on social security." Under the proposed
constitutional amendment, workers still could retire
under a monthly pension ceiling of $12,700 that Social
Security Minister Reinhold Stephanes, himself a pensioner
since age 46, called "too high. The ideal would be
something between $5,000 and $6,000, as in any other
country in the world."
Fiscal parasitism in Brazil grows from rapid expansion of
the political system in recent decades. In the 19th
Century, democracy was practiced only at the top of the
pyramid. Endemic violence and fraud plagued elections. In
1872, only one million of nine million Brazilians were
eligible to vote and only 20,006 did so. The historian
Steven Topik observed: "The total of federal, state
and local employees in 1920 was about 200,000. That
equaled the number of votes necessary to win the 1919
presidential election." However, in the half-century
since 1945 the electorate has grown 17-fold, from 5.9
million to 100 million. Despite flaws in the political
system that developed since the end of military rule in
1985, there have been few reported cases of violence and
fraud. But the costs of competition and the number of
insiders and minor political parties multiplied. Until
1994, the political system's deformities were financed by
chronic inflation. Now they are being funded mainly by
foreign money.
Korea's chaebols and Brazil's state governors share
common dependence on deranged economic transfers. Neither
in Brazil nor in Korea can government funding of their
bad debts last much longer. The Asian crisis may or may
not curtail proliferation of financial assets worldwide.
But it is forcing debtor countries into political
decisions and institutional changes that they have
avoided so far. As we shall see in the second part of
this essay, to appear next issue of Braudel Papers, the
need for new political decisions and institutional
changes is casting a shadow over the future of Japan.
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U.S. AND WORLD ECONOMY