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FRIEDBERG'S COMMODITY
AND CURRENCY COMMENTS
Prepared by Friedberg Mercantile Group
Safe For Capitalism?
In an impressive display of international cooperation and political resoluteness, multilateral agencies and the world's major central banks fashioned the third and, so far, the biggest bailout package in the continuing Asian crisis.
To tell the truth, their timing was impeccable. A wounded but stoic South Korea was allowed to bleed until it could no longer stand on its feet. Rebuffed in its attempt to obtain direct, bilateral help, the desperate Korean government found no escape but to submit to the IMF.
A war of nerves ensued, the Koreans prematurely announcing an agreement, and the IMF stalling, waiting for their complete capitulation on terms. In the end, the draconian conditions attached to the U.S.$57 billion loan represented and sought nothing less than a complete transformation of the Korean economy (see Chart 1).
Chart 1
Long On Objectives, Short On Deadlines
Republic of Korea: Summary of economic program
Macroeconomic Targets
–Maintain real GDP growth of about 3.0% in 1998, followed by recovery toward potential in 1999. GDP grew 6.0% in 1997.
–Narrow the current account deficit to below 1% of GDP in 1998 and 1999.
–Contain inflation at or below 5.0% in 1998. Inflation was 4.3% in 1997.
Monetary And Foreign Exchange Rate Policy
–Tighten monetary policy immediately to restore calm to markets.
–Increase money market rates temporarily to rise to a level that stabilizes the markets.
–Limit money growth in 1998 to a rate consistent with maintain inflation at 5% or less.
–Allow the exchange rate to float with intervention limited to smoothing operations.
Fiscal Policy
–Maintain tight fiscal policy in 1998 to fund the costs of restructuring the financial sector.
–Maintain at least a balanced budget by taking measures amounting to 1.5% of GDP to offset the impact of lower growth and costs of restructuring financial sector.
–Budget balance to be achieved by revenue and expenditure measures to be determined shortly. Measures may include widening corporate, income and value-added taxes and realigning expenditure policies.
Restructuring Financial Sector
–Government passage of revised Bank of Korea Act, providing for central bank independence with price stability its main mandate.
–Government passage of bill consolidating the supervision of banks, securities firms, insurance companies and financial services companies.
–Government passage of bill requiring corporate financial statements be prepared on consolidated basis and be certified by external auditors.
–Establish an exit strategy for troubled financial institutions including closures and mergers and acquisitions by domestic and foreign institutions.
–Clear principles on sharing of losses among equity holders and creditors will be established.
–Accelerate the disposal of nonperforming loans.
–Phase out present blanket guarantee to be replaced by a limited deposit insurance scheme.
–Establish a timetable for all banks to meet or exceed Basle standards and upgrade prudential standards to meet Basle core principles.
Any support to financial institutions will be given on strict conditions.
–All support to financial institutions, other than central bank liquidity credits, will be provided according to pre-established rules and recorded transparently.
–Strengthen accounting standards and disclosure rules to meet the international standards and audit financial statements of large financial institutions by internationally recognized firms.
–Increase manpower in the unit supervising merchants banks for effective supervision and proper handling of troubled backs.
–Accelerate schedule for allowing foreign entry into domestic financial sector, including allowing foreigners to establish bank subsidiaries and brokerage houses by mid-1998.
–Monitor borrowing and lending activities of overseas branches of Korean banks to ensure they are sound. Non-viable branches to be closed.
–Review Bank of Korea's international reserves management with intention of bringing it closer to international practice.
–Deposits of overseas branches of domestic banks will not be increased further, but gradually withdrawn as circumstances allow.
–Encourage financial institutions to improve their risk assessment and pricing procedure and the strengthen loan recovery, action in this area will be reviewed as part of prudential supervision.
Trade Liberalization
–Elimination of trade-related subsidies, under WTO commitments, under a timetable to be set at the first IMF review.
–Elimination of restrictive import licensing.
–Elimination of import diversification program restricting Japanese imports.
–Streamline import certification procedures and improve transparency.
Capital Account Liberalization
–Liberalization of foreign investment in the Korean equity market by increasing ceiling on aggregate ownership to 50% by end-1997 and 55% by end 1998.
–Allow foreign bank subsidiaries, seeking to purchase equity in domestic banks in excess of current 4.0% limit, to do so by mid-1998, provided acquisition contributes to efficiency and soundness of banking sector.
–Allow foreigners to purchase, without restriction, domestic money market instruments.
–Allow foreign investment, without restriction, in the domestic corporate bond market.
–Further reduce restrictions on foreign direct investment through simplification of procedures.
–Eliminate restrictions on foreign borrowings by corporations.
Corporate Governance And Structure
–Improve transparency of corporate balance sheets through independent external audits, fuller disclosure and provision of consolidated statements for business conglomerates.
–No government intervention in bank management and lending decisions.
–Any remaining “directed lending” to be further reduced further in 1998.
–No government subsidies or tax privileges to bail out individual corporations.
–Maintain the “real name” system in financial transactions, although with some possible revisions.
–Take measures to reduce the high debt-to-equity ratio of corporations and develop capital markets to reduce share of bank financing by corporations.
–Take measures to change the system of mutual payment guarantees within conglomerates to reduce the risk it involves.
Labor Market Reform
–Strengthen capacity of new Employment Insurance System to help redeploy labour in parallel with furhter steps to improve labor market flexibility.
Disclosure Of Information
–Regularly publish data on foreign exchange reserves, including the composition of reserves and net forward position with a two-week delay initially.
–Publish data twice yearly on financial institutions, including nonperforming loans, capital adequacy, ownership structure and affiliations.
The objective–to deregulate and liberalize the world's sixth largest economy–was more than meritorious. Taking a leaf from President Woodrow Wilson's famous address to Congress in April 1917 that the world must be made safe for democracy, the czars of world finance intended to make the whole of Asia–and South Korea in particular–safe for capitalism. Good intentions aside, we wonder if that was the best alternative.
While not exactly a Treaty of Versailles, one can't help but fear that in the eyes of this hard-working and nationalistic nation, the U.S. Secretary of Treasury and his cohorts practiced a rough-and-tumble form of economic imperialism. We have yet to see if Western conditionality will work in Asia.
Was there a better alternative? We believe that, indeed, there was: Allow Korea–and Thailand and Indonesia–to find their own way. This would have meant the renegotiation and rescheduling of the international debt, or default in the extreme. If the reckless creditors were not reasonable, they would risk losing it all. Chances are that losses would have been shared between local debtors, governments, and international creditors. Instead, the IMF deal bailed out most of the creditors, shifting the entire onus of the adjustment on to the debtors–or at least that is the way the humiliated debtors will come to see it. (We too see it that way, although we appreciate something that the Koreans, the Indonesians, and the Thais don't: the quid pro quo obtained).
In prying open their economies and markets, the IMF opened the way for foreign investors, banks among them, to scoop up distressed assets, enterprises, and financial institutions–or at least that is the way the debtors will see it (we too see it that way, although we understand–and they won't–that foreign capital is, on balance, positive for a country). In short, it would have been better for the debtors to find their own way out.
Perhaps, in a fit of self-enlightenment, they would have found the correct answers. Perhaps, not. Life would have gone on, and we would not have risked the potential outbreak of nationalism. There is, however, another reason why the non-interventionist alternative was preferable. It is called moral hazard.
Coming just three years after the Mexican debacle, the saviors should have known that their 1995 bailout effort was the efficient and formal cause (in the Aristotelian sense) of the 1997 Asian crisis.
Having lost the fear of losing through default, international investors and lenders, primarily the latter, piled into emerging markets. In their view, they collected free money in the form of excess returns. Even as spreads narrowed and equity multiples soared, the game was worth playing simply because the players could not lose. International banks, financial institutions, and investors can now act safe in the knowledge that the IMF & Co. will provide a safety net to protect them from some, or even most, of their losses.
The risks are increased by such moral hazard–reason enough to allow one or all of the stressed debtors to default. The Southeast Asian bailout is certain, as night follows day, to cause another, and probably bigger, financial crisis in the near future–surely less than three years away.
Finally, there is the question of responsibility for the financial mess in which almost one third of the world's GDP finds itself and, which, as it spreads, threatens to engulf the entire globe in an economic debacle. Ultimate responsibility lies not with the “failed” policies of the Asian countries or of Brazil or Russia, but with the bankrupting policies of the U.S. Federal Reserve, which for the past 15 years has created excessive quantities of money and credit. Regretfully, this monetary inflation did not inflate domestic prices. Instead, it was exported to the rest of the globe and inflated assets from Manila to Kuala Lumpur, from Shanghai to Seoul, from Moscow to Sao Paulo. And it continues to be created under the specious argument that consumer prices are still moderating, that Asia is in a deflation (that bubble is burst, but new ones are expanding), that the price of gold indicates that the Fed, if anything, is too tight (see our counter-argument on this point in our discussion on gold).
Until the Fed owns up to the real problem–the discretionary management of its own balance sheet–financial booms and busts of ever greater amplitude will be with us for a long time. We may have made the world safe for capitalism, for now. But not for long.
December 7, 1997Friedberg Mercantile Group
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