A Narrative
Networked Economies, Stunted LivesSecond of four articles.
February 16, 1999
How U.S. Wooed Asia to Let Cash Flow In
By NICHOLAS D. KRISTOF with DAVID E. SANGER
They were serious men, prosperous and pinstriped, and they derided "the politics of class warfare" as they conducted a job interview with the young Governor from Arkansas.It was steak dinner in a private room of the "21" Club in June 1991, and the top Democratic executives on Wall Street were gathered at a round table to hold one of a series of meetings with Presidential aspirants in what an organizer called "an elegant cattle show." They were questioning a man with a meager salary but a silver tongue, and this was another show in which Gov. Bill Clinton charmed his way to a blue ribbon by impressing the executives with his willingness to embrace free trade and free markets.
"What was discussed was the need for the Democratic Party to have a new and much more forward-looking economic policy," Roger Altman, a leading investment banker and an organizer of the evening, recalled recently. "The Democratic Party needed to move into a new economic world."
Aides describe that evening as an important step in the business education of Clinton, who came to repeat and amplify the themes -- especially the need to move away from protectionism and push for more open markets in Asia and all over the world.
It was also the time that Clinton first met Robert E. Rubin, then the head of Goldman Sachs & Company, and although the initial encounter was cool, the two men eventually forged a close partnership that has left an enormous imprint on the global economy.
Clinton and Rubin, who became his Treasury Secretary in 1995, took the American passion for free trade and carried it further to press for freer movement of capital. Along the way they pushed harder to win opportunities for American banks, brokerages and insurance companies.
This drive for free movement of capital as well as goods was one factor in the long American-led boom in financial markets around the globe. Yet, in retrospect, Washington's policies also fostered vulnerabilities that are an underlying cause of the economic crisis that began in Thailand in July 1997, rippled through Asia and Russia, and is now shaking Brazil and Latin America.
Countries like Thailand and Russia and Brazil are in trouble today largely for internal reasons, including poor banking practices and speculation that soared out of control. But some economists also say that if those countries had weak foundations, it is partly because Washington helped supply the blueprints.
They argue that the Clinton Administration pushed too hard for financial liberalization and freer capital flows, allowing foreign money to stream into these countries and local money to move out. In many cases, foreign countries were happy to open up in this way because they thought it was the best road to economic development, but a wealth of evidence has shown that overhasty liberalization can lead to banking chaos and financial crises.
Even some former Administration officials acknowledge that they went too far. Mickey Kantor, the former trade representative and Commerce Secretary, now says that the United States was insufficiently aware of the kind of chaos that financial liberalization could provoke.
"It would be a legitimate criticism to say that we should have been more nuanced, more foresighted that this could happen," he said. Speaking of the risks of financial liberalization without modern banking and legal systems, he compared them to "building a skyscraper with no foundation."
Although the Clinton Administration always talked about financial liberalization as the best thing for other countries, it is also clear that it pushed for free capital flows in part because this was what its supporters in the banking industry wanted.
"Our financial services industry wanted into these markets," said Laura D'Andrea Tyson, the former chairwoman of President Clinton's Council of Economic Advisers and later head of the National Economic Council.
Ms. Tyson says she disagreed to some extent with the push and was concerned about "a tendency to do this as a blanket approach, regardless of the size of a country or the development of a country." Free capital flows, she worried, could overwhelm small countries or those with weak banking and legal systems, leading to a "run on a country."
This is not to say that American officials are primarily to blame for the crisis. Responsibility can be assigned all around: not only to Washington policy makers, but also to the officials and bankers in emerging-market countries who created the mess; to Western bankers and investors who blindly handed them money; to Western officials who hailed free capital flows and neglected to make them safer; to Western scholars and journalists who wrote paeans to emerging markets and the "Asian Century" -- and to the people who planned an empty city named Muang Thong Thani.
High-Rise Ghost Town
uang Thong Thani rises up above barren fields on the edge of Bangkok, Thailand. It is a dazzling complex of two dozen huge gray-white buildings soaring nearly 30 stories high, and surrounded by streets lined with shops, town houses and detached homes. Walk closer and it feels eerie, for it is a ghost city.
Along one street of 100 houses, the windows are mere holes in the walls, and yards have weeds that grow as high as a person.
Muang Thong Thani was built during Thailand's boom as a product of free capital flows and financial liberalization. It was the great dream of Anant Kanjanapas.
One of 11 children born to an ethnic Chinese business tycoon in Thailand, Anant grew up with the wealth that his family had acquired through developing property and selling watches in Asia.
The family's Bangkok Land company began acquiring parcels of property near the airport, and they broke ground in 1990 on a megaproject to build a privately owned satellite city for Bangkok. Muang Thong Thani was to have a population of 700,000, bigger than Boston's.
"We have all intentions to develop Muang Thong Thani as a city, a complete city run by private-sector people," Anant said. "It was not a stroke of genius. It was logic."
The project was greeted enthusiastically, as all proposals were in the early 1990's, and Bangkok Land issued shares on the Thai Stock Exchange in 1992 to raise money. Its shares were hot, picked up by J. Mark Mobius, the emerging-markets guru, and by funds like the Thai International Fund and the Thai Euro Fund, which between them bought more than one million shares of Bangkok Land.
In Illinois, the state pension fund bought shares in both the Thai International Fund and the Thai Euro Fund, and that made Mary Jo Paoni, a secretary in Cantrall, Ill., a roundabout owner of a tiny part of Bangkok Land and Muang Thong Thani. Mrs. Paoni knew nothing of this, of course, and disapproves of the giddy investment sprees in Asia.
"When things are tough," she said, "you don't start spending like a drunken sailor. There are some people who take risks, but not us."
Bangkok Land also borrowed $2.4 billion from banks domestic and foreign. In that sense, some minute fraction of Mrs. Paoni's money might also have been channeled to the company as loans. Her money market account at A. G. Edwards went to buy commercial paper of major banks, and her pension fund also held stock in Bangkok Bank, which lent to Bangkok Land -- an illustration of the way in which globalization now gives just about everybody some tiny financial stake in everybody else.
Cash Controls Eased
ree movement of capital is nothing new, for it was the norm during most of Western history. At the beginning of this century, anyone could move money across borders without difficulty.
The Great Depression changed all that. Governments moved to control capital so as to avoid what they saw as the chaos of capital rushing out of countries and setting off financial crises.
A result was that most countries of the world (including the United States in the 1960's) limited the right of companies and citizens to buy foreign securities or invest overseas. People were often allowed to buy only small amounts of foreign currency.
Then, as memories of the Depression faded, the tide shifted again in the 1970's and '80's. Starting in the United States and Europe, it became fashionable to let money move freely, and the Reagan Administration began to push for free capital flows in other countries.
"Our task is to knock down barriers to trade and foreign investment and the free movement of capital," Ronald Reagan declared in 1985. George Bush described his Latin America program, the Enterprise for Americas Initiative, as a commitment to "free markets and to the free flow of capital, central to achieving economic growth and lasting prosperity."
The Clinton Administration inherited that agenda and amplified it. Previous administrations had pushed for financial liberalization principally in Japan, but under President Clinton it became a worldwide effort directed at all kinds of countries, even smaller ones much less able to absorb it than Japan.
"We pushed full steam ahead on all areas of liberalization, including financial," recalled Jeffrey E. Garten, a former senior Commerce Department official who is now dean of the Yale School of Management. "I never went on a trip when my brief didn't include either advice or congratulations on liberalization."
This push for financial liberalization reflected President Clinton's growing enthusiasm for markets and his desire to make the economy a centerpiece of his foreign policy. He created the National Economic Council as a counterpart to the National Security Council, and asked Rubin to be its first head. More broadly, this push was part of a global ideological shift in favor of free markets, as well as an increasing enthusiasm among developing countries themselves for lifting restrictions on the flow of money.
"We were convinced we were moving with the stream," Garten said, "and that our job was to make the stream move faster."
"Wall Street was delighted that the broad trade agenda now included financial services," he added. Garten said he could not recall hearing any doubts expressed about the policy, either within the Administration or among officials overseas. Referring to Rubin, Kantor and the late Commerce Secretary Ron Brown, Garten said, "There wasn't a fiber in those three bodies -- or in mine -- that didn't want to press as a matter of policy for more open markets wherever you could make it happen."
"It's easy to see in retrospect that we probably pushed too far, too fast," he said, adding, "In retrospect, we overshot, and in retrospect there was a certain degree of arrogance."
The push for financial liberalization was directed at Asia in particular, largely because it was seen as a potential gold mine for American banks and brokerages. Neither Clinton nor Rubin had much experience in Asia -- Clinton as Governor had led trade delegations to promote Arkansas chickens and rice, and Rubin had done business in Japan for Goldman Sachs. But Clinton as President has worked hard to strengthen American ties with Asia, as well as his own.
The idea was to press Asia to ease its barriers to American goods and financial services, helping Fidelity sell mutual funds, Citibank sell checking accounts and American International Group sell insurance. Clinton's links to Asia caused embarrassment after they led to the campaign finance scandals of 1996, but fundamentally they reflected an appetite for business opportunities in Asian countries that had changed, as Clinton once put it, "from dominoes to dynamos."
His Cabinet approved a "big emerging markets" plan to identify 10 rising economic powers and push relentlessly to win business for American companies there. Under Brown, the Commerce Department even built what it called a war room, where computers tracked big contracts, and everyone from the C.I.A. to ambassadors to the President himself was called upon to help land deals.
The stakes could be huge. Japan had been the first target of pressure for financial liberalization, even under the Reagan Administration, and these days it is finally engaged in what it calls a "big bang" opening of its capital markets. The upshot is that American institutions are swarming into Tokyo and finally have a chance to manage a portion of the $10 trillion in Japanese personal savings. And when a big Japanese brokerage, Yamaichi Securities, collapsed 15 months ago, Merrill Lynch took over many of the branches -- an acquisition that would have been unthinkable just a few years earlier.
Real Estate Visionary
Anant, who is expert at playing official connections, was able to coax the Government into approving a convenient expressway exit, which made the area very accessible. He also managed to persuade the Thai Defense Department to move its headquarters and staff residences to Muang Thong Thani.
Critics cried foul, but Anant denies wrongdoing. During a 90-minute interview he was edgy, and at one point he seemed about to stalk out of the room. But then he calmed down and continued his spin.
"It makes sense to do this," he said. "But you need a lot of determination."
A result is that since the crash, Muang Thong Thani has everything but inhabitants. Bond Street is a mile-and-a-quarter strip of modern, window-lined buildings, but aside from a handful of colorful storefronts -- a bank, a restaurant, a pharmacy and a few others -- they are empty.
In the pharmacy at 11 Bond Street, Pornsawan Rakthanyakarn is fighting the ghostliness. A big Thai woman with a bouffant hair style, a brown flowered print dress and a diamond ring as large as her knuckle, she sits by the cash register, waiting for customers to come in and buy her Vaseline Intensive Care Lotion and Pond's Cold Cream.
Mrs. Pornsawan, a jeweler who hit it rich during Thailand's boom, heard about Muang Thong Thani on the grapevine. She inquired from the official sales agent and was told demand was so strong that she would have to pay a $27,000 surcharge per parcel of land.
That convinced her, and she ended up paying nearly $500,000 for a house and for the building that includes her shop.
"I'm upset with the salespeople here who cheated me," she said morosely. And she is trying to adjust. Originally she had planned to open a jewelry store, but when the economy crashed her son suggested that a pharmacy might bring more business. And she tries to raise money in other ways.
"Would you like to buy my diamond ring?" she asked hopefully. She held it out and suggested, "Five million baht?" That is about $137,000, more than a typical visitor might be expected to have on hand, but Mrs. Pornsawan pressed her case.
"That's a very good price!" she exclaimed.
The command center for free markets is the third floor of the United States Treasury, where Rubin and his deputy, Lawrence H. Summers, share a suite facing the Washington Monument. Rubin presides in a spacious office decorated with modern art and family photos -- just about all he sees of his family on weekdays, since his wife works in New York and he joins her each weekend.
At the other end of the suite is Summers's office, covered with photos of his son and twin daughters, and equipped with a small refrigerator stuffed with Diet Cokes. The two men are the closest of partners, and when Rubin is puzzled about something, he sometimes wanders over in his stocking feet to consult with Summers.
Historically Treasury has tended to stake out free-market positions, but Rubin stepped up the pace even further, for he showed an intuitive tilt toward the market based on his three decades as an investment banker.
"Bob comes from this very Wall Street view," said a senior Administration official. "He reflects that experience."
The 2 at Treasury
ithin the Clinton Administration, Rubin and Summers won increasing influence because of their skill at marrying international finance and foreign policy. Summers had been a prominent economics professor at Harvard, and Rubin had made a fortune on Wall Street, enabling him to take off on vacations with a fly-fishing rod that, as an aide joked, "probably costs more than your house."
For the most part, Rubin and Summers were not forcing financial liberalization down unwilling throats. Rather, Washington was leading more than pushing. The United States pressed for capital liberalization, recalled a former top Thai official, but he added that it was like pushing on an open door.
Within the Administration, there were occasional arguments about the virtues of free capital flows. Academic economists like Ms. Tyson and Joseph Stiglitz, former chairman of the Council of Economic Advisers, sometimes argued that Treasury was too dogmatic in insisting upon free flows.
One day in 1995, the National Economic Council called an interagency meeting in the ornate, high-ceilinged rooms of the Old Executive Office Building, next to the White House. Negotiations were under way with Chile over a free-trade agreement, and the topic of the meeting was whether as a condition of the deal the United States should force Chile to drop an innovative system that amounts to a tax on short-term capital inflows.
"The Treasury came in and said that Chile's controls had to go," recalled one participant, saying others had argued that "a sensible set of capital controls" was reasonable for small nations that could be devastated by a sudden outflow of money.
The issue never ultimately came to a head -- and Rubin and Summers say it never rose to their level -- because Congress did not pass the legislation needed to conclude a trade agreement with Chile. Still, there is considerable evidence that top Clinton Administration officials were involved in some efforts to seek freer capital flows, as when they pressed South Korea to liberalize its financial system.
After interagency discussions, the Administration dangled an attractive bait: if Korea gave in, it would be allowed to join the Organization for Economic Cooperation and Development, the club of industrialized nations.
"To enter the O.E.C.D.," recalled a senior official of the organization, "the Koreans agreed to liberalize faster than they had originally planned. They were concerned that if they went too fast, a number of their financial institutions would be unable to adapt."
The pressure on them is reflected in an internal three-page Treasury Department memorandum dated June 20, 1996. The memo lays out Treasury's negotiating position, listing "priority areas where Treasury is seeking further liberalization."
These included letting foreigners buy domestic Korean bonds; letting Korean companies borrow abroad both short term and long term, and letting foreigners buy Korean stocks more easily. Such steps would help Korean companies gain more access to foreign loans and investment, but they would also make Korea more vulnerable to precisely the kind of panicky outflow of capital that unfolded at the end of 1997.
Moreover, for all Washington's insistence that it emphasized building financial oversight, nowhere in the memo's three pages is there a hint that South Korea should improve its bank regulation or legal institutions, or take similar steps. Rather, the goal is clearly to use the O.E.C.D. as a way of prying open Korean markets -- in part to win business for American banks and brokerages.
"These areas are all of interest to the U.S. financial services community," the memo reads.
In the end, Korea opened up the wrong way: it kept restrictions on long-term investments like buying Korean companies, but it dropped those on short-term money like bank loans, which could be pulled out quickly.
Then, in April 1997, Rubin headed a meeting in which finance ministers of the seven leading industrialized countries issued a statement "promoting freedom of capital flows" and urging that the International Monetary Fund charter be amended so that it could lead the charge for capital account liberalization.
Some Treasury officials now portray the effort to amend the charter as a fund initiative that they were not directly involved in, and indeed Britain was an early public backer of the idea. But a senior Treasury official acknowledges that the idea originated with American officials based in the fund who report to Treasury, and who consulted on the idea with members of the Administration. Indeed, in a speech delivered in March 1998, eight months after the crisis began, Summers reaffirmed his support of capital liberalization, although he cautioned that it could be phased in.
The records of the monetary fund -- which was in many ways an instrument of American policy -- also show that it was urging some countries in this direction already. In July 1996, the fund's executive board praised Indonesia's "open capital account" and, a few months later, "welcomed the recent acceleration of capital account liberalization" in South Korea.
Rubin argues now that it is wrong to suggest that the Clinton Administration was pushing for free capital flows while neglecting efforts to build modern financial and legal systems. As for pressing capital account liberalization, Mr. Rubin said his far greater concern was to strengthen banks, regulatory oversight and legal systems in other countries.
"Reducing capital controls was undoubtedly an objective of some of the things the Administration did," Rubin said. "But I never would have recollected it as a priority."
Still, he said the attempt to revise the monetary fund charter to promote capital liberalization was no longer a priority, and he hinted that this reflected changing views.
"As you go along," he said, "you adjust your position to reflect your experience."
Money Floods Asia
flood of capital poured into emerging markets in the early and mid-1990's, including $93 billion in 1996 alone into just five countries: Indonesia, Malaysia, the Philippines, South Korea and Thailand. Then there was a net outflow of $12 billion from those five countries in 1997. This turnabout, which was most evident in short-term loans, amounted to a financial hurricane, one that would harm any country in the world.
So while economists welcome free capital flows in principle, extensive scholarly work had clearly established the importance of "sequencing" -- meaning that countries should liberalize capital flows only after building up bank supervision and a legal infrastructure. A French scholar, Charles Wyplosz, of the Graduate Institute of International Studies in Geneva, concludes in an academic paper that "financial market liberalization is the best predictor of currency crisis."
Summers himself had emphasized the need for caution in financial deregulation in 1993, when he was still chief economist at the World Bank. He noted in a paper then that poor countries usually have "only quite limited bank supervision," adding, "As is true for nuclear power plants, free entry is not sensible in banking."
That scholarly emphasis on caution was drowned out in the rush to open financial markets. And one intrinsic problem was that while developing countries had a strong vested interest in opening up to foreign capital, to let money come in, they saw little benefit in building modern banking and legal institutions. Indeed, in some cases, top officials and their friends had a major stake in maintaining financial systems in which what counted above all was political connections.
"Financial liberalization was undertaken in countries that didn't have the infrastructure to support it," reflected Ricki R. Helfer, a leading international bank regulator and former chairwoman of the Federal Deposit Insurance Corporation. "That was one of the principal causes of the Asian crisis."
Given their backgrounds, Rubin and Summers were more aware of the risks than most others, and they did urge better regulation of international banking. For instance, at the 1995 meeting of the seven leading industrialized nations in Halifax, Nova Scotia, an American-led initiative called for improved financial regulation and data reporting for industrialized nations and eventually others as well.
Still, these steps to improve banking oversight were modest and proceeded slowly, while liberalization hurtled along. American officials pressed for oversight, but they continued to press harder, and certainly more effectively, for liberalization.
A former senior Treasury official ruefully recalls arguments with Stiglitz, then in the White House as an adviser. Stiglitz was warning about the need for slower pacing of financial liberalization abroad, but nobody listened.
"I viewed 'pace' as an excuse by countries to keep their markets closed," the Treasury official said.
W. Bowman Cutter, who served as Rubin's deputy at the National Economic Council, said that all of the policy makers understood the risks and that in speeches "every one of them gave the qualifications -- that before you opened your markets to free flows of capital, you need to have the institutional strength to deal with it."
"Having said that," he added, "I think that we all missed the true importance and the difficulties created by the enormous growth of the amount of free cash floating around the world. In the speeches, we said the right things. But it was a question of where was the emphasis and where was the force."
In practice, liberalization frequently takes place without any improvement in bank supervision, and it is often accompanied by a rise in shady dealings. In 1996 Thailand's Justice Minister accused his fellow Cabinet members of taking $90 million in bribes in exchange for handing out banking licenses. And when the Bangkok Bank of Commerce, Thailand's ninth-largest bank, collapsed in 1996 it turned out that 47 percent of its assets were bad loans, many of them to associates of the bank's president.
Still, cronyism and corruption, while aggravating factors, were not necessary to touch off a crisis.
"The simple fact," said James Wolfensohn, president of the World Bank, "is that very sophisticated banks loaned to Indonesian companies, without any real knowledge of their financial condition, based on name, based on competition. So you have to say to yourself, would it have made any difference if they had known? Well, maybe, but they did go nuts."
Turning Point in '95
n 1995 governments did two things that would set up the emerging markets for trouble. What appeared to be a brilliant bailout of Mexico, led by Rubin and Summers, convinced investors that some countries were too strategically important to be allowed to fail. And then, when finance ministers from the Group of Seven industrialized countries gathered in Washington on April 24, 1995, they agreed to try to push up the value of the dollar against the Japanese yen.
The accord worked. The dollar rose smartly against the yen, easing the risk of a global crisis at that time.
But the pact also caused the rise of currencies like the Thai baht and the South Korean won, which were informally pegged to the dollar. Thailand and South Korea had already lost some competitiveness when China devalued its currency in 1994, and now they were tugged upward along with the dollar so that their exports became more expensive and even less competitive.
The upshot was that goods made there had more trouble competing abroad. Thai exports were stagnant in 1996 after having soared 23 percent in 1995, and the Thai current account deficit (a broad measure of the balance of trade) rose to 8 percent of gross national product in 1996, up from 2 percent in the late 1980's. Foreign currency reserves began to drain away to pay for the deficits, and the seeds of the crisis were sown.
As the money poured out, Thailand's deep structural problems became suddenly apparent to investors. Indeed, the countries with far stronger financial institutions weathered the storm much better -- the capital flight that devastated Thailand left Taiwan and Singapore with only mild damage. As a result, economists are still arguing about what combination of free capital flows and structural flaws truly spelled disaster.
One common vulnerability in many of the hardest-hit countries was that like Japan in the late 1980's, they had enjoyed speculative bubbles fueled by cheap credit.
The giddiness ended up creating havoc with the banking systems, for it resulted in what might be called the three excesses: excess borrowing, excess investment and excess capacity (meaning factories and equipment that are kept idle because of lower-than-expected demand).
These excesses were so widespread that their effects can be seen not just in the capital cities, but even in remote places like the Indonesian town of Mojokerto.
Salamet, a rickshaw driver who lives with his wife and three children on the edge of Mojokerto, always used to pay cash for purchases. But about five years ago, banks and finance companies began to pioneer a credit system even for the poorest people.
So Salamet and his wife, Yuti, bought furniture on installments. They paid for their son Dwi's school uniform on installments as well.
Salamet used to rent his rickshaw, a dilapidated contraption that looks like a love seat being pushed by a bicycle. But as the neighborhood prospered, Salamet dreamed of moving up in the world. He borrowed from the bank and bought a banged-up secondhand rickshaw with a red seat, promising to pay the equivalent of $4 a month for 14 months. He thought he would be able to earn the monthly payment in just a few days on his rickshaw, and so it seemed the perfect investment.
As it turned out, he bought in at the peak of the rickshaw bubble.
A decade ago, the area had about 100 rickshaws, and each of the drivers could earn about twice as much as a farm worker. But the advent of rickshaw financing, coupled with the general enthusiasm for moving up in the world, led to an explosion of rickshaws. Now there are 300.
"These days there are more rickshaws than the area can support," grumbled Rutiati, a 37-year-old woman who is a rickshaw agent, arranging financing for Salamet and others in the neighborhood. "There are more rickshaws than passengers."
Salamet and Mrs. Yuti (who like many Indonesians use only one name) have a plan to overcome the family's difficulties.
"I figure I'll start a little shop in front of our house here," Mrs. Yuti explained, beaming. "It seems it's a good way to make money on the side. And if we're hungry, we can always eat the shop's food."
The problem is that the neighborhood is also suffering from a shop boom. Banks in Mojokerto began lending to households wanting to open stores in their living rooms, and all the cheap credit and optimism in Mojokerto led to the same problem locally as around the world.
The number of shops in the neighborhood soared to 20, from 3. The banks in Mojokerto are scrambling to recover the loans they made to stores, but it seems the banks miscalculated when they assumed that the groceries would remain as collateral. Borrowers have taken the collateral and eaten it.
Asia Follows Japan
Then prices steadily tumbled, leading to an $8 trillion decline in financial assets and to Japan's continuing troubles today. This recession meant that Japanese banks had few good lending opportunities at home, and so they began lending elsewhere in Asia -- and since yen interest rates were extremely low, the loans were alluring to borrowers.
Thus began the "carry trade," which was initially highly profitable but ultimately catastrophic. It took many forms, but typically financial institutions would borrow yen at 2 percent interest rates, convert the proceeds into Thai baht, and reap the differential: baht deposit rates were about 10 percent.
Meanwhile, Japanese manufacturing companies also began building factories all over Asia. Between 1986 and 1996, Japanese private investment in Asia added industrial potential equivalent to three Frances.
All this was in many ways wonderful for Asia, resulting in an investment boom and low interest rates. But the deluge of cheap loans and foreign investment resulted, not surprisingly, in a huge increase in capacity to make everything from steel to paper to cars. The world now has the ability to manufacture 60 million cars a year, even though there is demand for about 44 million.
A few alarm bells went off. Citicorp has a Windows on Risk committee, a group of senior executives who meet regularly to discuss problems that may erupt in the future, and in May 1996 the committee invited Paul Krugman, an economist at the Massachusetts Institute of Technology, to a conference room in Citicorp Tower to give his views.
"Krugman said he thought the Asian model was running out of steam," recalled William R. Rhodes, vice chairman of Citicorp. "He told us that after 10 years of unsurpassed growth, the boom in Asia was over, and the area was going to face some major adjustments."
"I think he was the person who triggered the concern for us," Rhodes said. "We started to adjust our exposure accordingly."
Rhodes was particularly sensitive to credit risks, because in the early and mid-1980's, he was the point man for the Western banking system in dealing with the Latin American debt crisis. A fluent Spanish speaker, Rhodes had worked in Latin America and had seen the conventional wisdom about the region's prospects suddenly transformed almost overnight in August 1982, when Mexico missed a debt payment and the crisis began.
It was because of those memories that American banks were generally more careful in the 1990's in Asia than they had been in the 1970's in Latin America. American banks were comparatively cautious about their borrowers in places like Bangkok and Moscow, while European banks developed a reputation for being willing to lend to just about anybody with a business card.
Assigning Blame
o what were the causes of the crisis?
There are two main camps in the academic battleground. One, led by Jeffrey Sachs of Harvard University, argues that the crisis was essentially a panic, in which investors rushed for the exits because everybody else was rushing for the exits. The other, initially led by Krugman of M.I.T., argues that the hardest-hit countries had fundamental weaknesses that sealed their fates.
Still, there is general agreement that there were both structural problems and a panic, even if there is a critical dispute about their relative importance. The most common view is that several key factors worked together to set the stage.
The countries had severe internal vulnerabilities. These included weak banking and legal systems, overvalued currencies, and mountains of short-term loans in dollars and other foreign currencies. And investors delivered the coup de grâce, panicking and frantically pulling their money, so that currencies plummeted and capital dried up in these countries.
The banking system was frail because of several built-in flaws.
First, Asian companies borrowed too much from banks. In the United States, companies tend to raise money on the stock and bond markets, and only 22 percent of corporate debt is held by banks. But in Asia, 80 percent of corporate borrowing is from banks, much of it in short-term loans.
Second, companies borrowed for the short term but invested in long-term projects like hotel construction. This was risky because if the banks did not renew the loans and instead asked for repayment, the money would be sunk in half-completed buildings.
Third, companies and banks borrowed in dollars and yen even though the returns would be in baht and other local currencies. This seemed safe as long as Thailand maintained its currency peg of 25 baht to the dollar. But if it devalued to 50 baht (which had seemed inconceivable but eventually happened), borrowers were devastated.
Suppose a developer borrowed $1 million, converted it to 25 million baht, and began to construct a hotel with an expected value of 40 million baht. When the crisis hit, the hotel's value fell to only 15 million baht, but the devaluation meant that the developer had to pay back 50 million baht. In country after country, these kinds of calculations spelled bankruptcy.
Moreover, Asian banks often lent money on the basis of connections or government instruction, without much credit analysis. In South Korea, by some estimates, half of bank lending was made at the direction of Government officials.
So, even before the crisis hit in July 1997, nonperforming loans (those that borrowers are not repaying) made up 15 percent or more of total loans in Indonesia, South Korea, Thailand and Malaysia. That compares with just under 1 percent in the United States.
This financial scaffolding was fragile enough, but then it was forced higher and higher because of speculation that inflated land and stock prices in most of Asia.
In Asia in the early 1990's, property prices soared into the stratosphere, such that in 1994 a parking space in Hong Kong sold for $517,000. Scholars have long noted a dangerous spiral whereby inflated property prices became inflated collateral for inflated loans, which further inflate property prices and start the cycle along again, until the whole edifice collapses.
By 1997, according to one ranking, the three most expensive rental locations for retail stores were 57th Street in New York, Causeway Bay in Hong Kong and GUM department store in Moscow. The crisis has sent prices plummeting in Hong Kong and Moscow, as New York remains unfazed, the costliest retailing location in the world.
In an economy that is all speculative froth, even the stupidest investments tend to pay off initially, so one result was a lot of foolish investments.
"Investors wanted to hear a good story to buy your shares," recalled Vichit Surapongchai, president of Radanasin Bank in Thailand. "It was like the tail wagging the dog. Because you wanted your shares to make a lot of money, you tried to think of what projects you should invest in. There was less viability of projects to start with."
The intellectual trend has changed in every way since the crisis began. Emerging markets are now seen as risks, not opportunities. And the ethos that drove the wave of investment in small countries -- the triumphalism of free markets for capital as well as for goods -- has abated. Now it is fashionable to talk about the dangers of unregulated free capital flows and the need for caution in opening them up. One result is that although the United States economy is so far unscathed, American credibility is not.
As Seichi Kondo, a senior Japanese Foreign Ministry official, puts it, "Washington wasn't the major source of the crisis, but it added considerably to the worsening of the situation. If they haven't learned lessons, if they still think it was Asian values that prolonged the crisis, then I have to blame Americans. But I think the United States has learned a lot from the crisis."
"Of course," he added pointedly, "the learning cost has been very expensive for Asian countries."