Asian financial crisis

Japan and the World Economy 10 (1998) 355±358

Asian ®nancial crisis Merton Miller* University of Chicago, 1011E. 58th Street, Chicago IL 60637, USA

I have some comments about the Japanese part of the crisis but I want to save them for last. The Southeast Asia crisis is really several crises. They are interlocking and related, and the worst part of it is that they are still ongoing. I had the feeling as I was lecturing in Southeast Asia a few weeks ago that while I was on the platform the doors might burst open and a messenger would come running in saying, ``It's all wrong, it's all changed.'' So subject to the problem that the crisis is still ongoing, let me talk mainly about what to do from here on in. I cannot resist saying one or two things about the origins of this crisis, however. In particular, I want to say something about the Thailand situation ± a very painful subject for me since I have so many friends in Thailand and have spent so much time there over the years. Basically, as I see it, the Thais made three mistakes. The ®rst one, in the fall of 1996, was deciding to ®ght to support the value of the baht. At the time, they had about $37 billion of reserves, and a better strategy ± I believe, looking back now ± might have been to recognize that the Thai baht had become overvalued for reasons that I shall explain later. Given the overvaluation, the best thing at that point may have been to take a once-and-for-all devaluation of 10±15% while they still had $37 billion to back it up. Instead, they decided to ®ght off the inevitable. The second mistake, it seems to me, was to do it in the classical way by raising interest rates and draining local liquidity to make it hard ± they thought ± for the speculators to speculate against the Thai baht. But the problem with that strategy is that while speculators like George Soros get a lot of the publicity, the really huge volume of transactions in the foreign exchange markets are by traders, Thai traders who have dollar liabilities. (But, I will call them all speculators because that is the way the press likes it.) These speculators seek to protect themselves in the forward market, not the spot market. They hedge against a devaluation by selling the Thai baht short in the forward market. If the Thai Central Bank then raises the local interest rates, the interest rate parity theorem tells us that those speculators who have already sold short will be enriched, not hurt. At the same time that the speculators were shorting the baht, the Bank of Thailand was ®ghting them by going long in the forward exchange market. The trouble is that the forward * Corresponding author. 0922-1425/98/$19.00 # 1998 Elsevier Science B.V. All rights reserved. PII S0922-1425(98)00035-8

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M. Miller / Japan and the World Economy 10 (1998) 355±358

exchange market is different from a spot market. If you take a position in the forward market, you do not have to settle up on the day you take a position. It is 3 months or 6 months before you actually have to put the money up. So the Bank of Thailand could show on its books it still had some $37 billion, even though it had, in effect, committed a substantial amount of that reserve in long positions in the (weakening) forward market. Now you can get away with that for a while, but sooner or later the dealers are going to demand settlement or ask for more collateral. As the interest rates were rising and the forward foreign exchange rate was falling, the amounts the Bank of Thailand owed the dealers was growing. And then, the Bank made what I regard as its most fundamental error. They did not disclose the true extent of their off-balance sheet commitments. They kept reassuring the public with: ``Oh, we have got plenty of reserves. Look at our books. $30 billion'' ± not pointing out that in the forward market they had big losses and big debts. When the truth came out there was a terrible shock. Suddenly, people in Thailand realized that there were no reserves left. The Bank of Thailand had gambled them away. And this was a terrible blow for a number of reasons. For one thing, the Bank of Thailand had always been held in high esteem there. The Bank of Thailand was one of the few parts of Thai life that was believed to be incorruptible. Not only that, but the managers of the Thai Central Bank were all American-trained economists ± I might say at places like Yale, Harvard and Berkeley, however, not at The University of Chicago. But they were widely respected as competent technocrats, raising the question: how did it happen that this part of Thai life, believed to be so competent and not corrupt, could botch matters so badly? But botch it they did, and once the public realized that most of the reserves had been frittered away, you got the equivalent of a bank run. And I mean literally a bank run. The problem in Thailand was suddenly transformed from a modest exchange-rate adjustment, which might have been 10±15%, as happened in Singapore, into full-scale capital ¯ight. To describe it, I must use a phrase that I know that the Chinese in the audience will understand. The Thai governmental institutions had lost the mandate of heaven. The public simply no longer had con®dence in the Thai government or its institutions, and they tried to get their wealth out of the country as fast as possible. From Thailand, the panic and loss of con®dence in the currency spread throughout the rest of Asia very quickly. The ¯ight to safety was on. A sad tale indeed, but the question is what do they do now to restore con®dence and get back on their long-term growth paths? Here I think we have to take a different attitude depending upon which country is involved. I want to start with Hong Kong because I think in some ways that it is the simplest case. Basically, for Hong Kong my recommended solution is, ``Don't do anything.'' Hong Kong is in reasonable shape, in the sense that it has strong banks, its economy is sound, the people have not lost con®dence in the government and the Hong Kong people have made the right decision about how to manage their monetary policy. We in the U.S. have taken the position that the Federal Reserve will maintain the internal value of the dollar and let the external value ¯oat. In Hong Kong they have adopted the opposite strategy: they have tied ± and I do not mean just wishful thinking tied ± the value of the Hong Kong dollar to the U.S. dollar by means of a currency board.

M. Miller / Japan and the World Economy 10 (1998) 355±358

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Now, should that tie be kept or should the Hong Kong dollar too be allowed to ¯oat (i.e., drop like the currencies in the rest of Southeast Asia)? There was a lot of agitation in Hong Kong to abandon the peg when I was there a couple of weeks ago. Exporters, of course, always want you to devalue the exchange rate. But everyone else, too, suddenly started to wonder whether perhaps the Hong Kong Monetary Authority no longer had the will and the power to hold this peg. Their concerns on that score trace to Joseph Yam, the man running the Hong Kong Monetary Authority, who had the misfortune of being named `Central Banker of the Year' by Euromoney Magazine. What is ironic about that award is that he is not really a Central Banker. He is supposed to be just a ¯unky. If you understand how a currency board works, it is like an ATM machine. It is on automatic pilot. But Mr. Yam was so ¯attered by being called a central banker, that he started to act like one. He squeezed local liquidity and raised the Hong Kong interest rate to 30% ± which looks huge on an annual basis. However, when you break it down into how much it is per day, it really is a very small amount. And the speculators ± again I use the term advisedly ± are more than willing to pay this little amount for the right to gamble on a major devaluation. Even one of 5±10% will do, let alone the 50±60% or more then being experienced elsewhere. So what Joseph Yam did was only to spook the Hong Kong people by his policy of raising the interest rates and tightening the market liquidity to defeat the speculators. He did not hurt the speculators, of course, who as I said were already short in the forward market. The more he raised interest rates, the more money they made! But he almost killed Hong Kong, because when you push interest rates so high that they become mainly the premium of a devaluation, you will inevitably knock down the stock market as well as the real estate market and all interest-sensitive prices. The people of Hong Kong suffered the Yaminduced fall in asset prices, but mistakenly came to believe that it was somehow the inevitable price that Hong Kong has to pay in order to maintain its peg. Redemption via suffering in the IMF fashion. Now, I argued there and will argue again that suffering is not necessary. There were ways to defend the Hong Kong peg that did not involve raising interest rates and incurring the attendant economic costs of the recession that ultra-tight money produces. I discussed these ways at great length in both Hong Kong and in mainland China. They amount to harnessing the power of modern derivatives. The Hong Kong Monetary Authority need simply announce it was selling a structured note, as we call it in the derivatives trade, which has a put component on the exchange rate built into it. If the Hong Kong Monetary Authority started to sell those puts then the policy would combine not only derivatives but modern signaling theory as well. It would be saying: ``we are putting our money with our mouth is.'' We are doing so by issuing these securities, because if we do devalue, it is going to hurt the Hong Kong Monetary Authority. That makes the pledge not to devalue more believable. And once the fear of a major devaluation is gone, the interest rates in Hong Kong would fall back to their normal level. But while the Hong Kong case is easy, what is to be done about the rest of Southeast Asia? How is con®dence to be restored in Thailand, Indonesia, Malaysia, the Philippines and Korea? To answer, I believe we must ®rst ask how Thailand got into the mess that triggered all the devaluations and fears of devaluation in the ®rst place? Why did the baht seem overvalued all of a sudden? I believe, I am sorry to say, that the problem can be traced ultimately to Japan. What happened was ± and we have bankers here to prove it ± the

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M. Miller / Japan and the World Economy 10 (1998) 355±358

Japanese banks were in a rather dif®cult situation with bad loans. What do you do when you have bad loans? Well, the lawyers who run the Ministry of Finance (MOF, my favorite target) felt they faced several unpleasant options. If they forced the banks to recognize those bad loans, the banks would have been out of capital compliance. MOF did not want to do that! As an individual bank, of course, you always get back into capital compliance, by shrinking ± by reducing your assets and your liabilities and then the capital you have will meet the capital requirements. But MOF did not want to do that either. Another alternative was to bring in more capital. Where are you going to get it? From abroad! But that was the most frightening prospect of all for MOF. So what did they do? They adopted a strategy that we in the U.S., alas, have also used in the past, with equally bad results, although of a different kind. MOF lowered short-term interest rates. They drove short-term interest rates down to levels we have not seen since the 1930s in this country. They hoped to generate what we call a term-structure play. They said: Well, if you lower the short term rates, and the Japanese banks invest long-term both in Japan and elsewhere, they will earn a pro®t on the spread. They will use that pro®t as a way of writing off the bad loans. The trouble with this strategy is that it destabilized the rest of Asia! If the interest rate in Japan goes down, the value of the yen also falls. And that creates problems. Not what you think from reading the Washington papers that ``gee, there will be a Japanese trade surplus with the U.S.'' Forget that! That may be an embarrassment to the Administration, but it is of no great economic consequence. But when the yen falls, what is the other side of the coin? The dollar rises! The countries in Southeast Asia ± Thailand in particular ± had linked themselves to the dollar, so that as the yen fell and the dollar rose they started to suffer balance-of-payments problems, the kind that alerted the speculators to move in to attack. So while our hosts will not like this, and maybe they will not invite me back next year, I feel compelled to say that Southeast Asia is not going to recover until Japan gets its act in order. That means, on the one hand, ending the policy of driving down interest rates and the value of the yen, and, on the other, bringing in substantial amounts of new equity capital for the banks. When a banking system is out of capital compliance or close to being out of capital compliance, it freezes. It cannot ful®ll its obligations for greasing the wheels of industry. Or let me put it a little differently. Thanks to MOF and the weak banking system it supervises, Japan and all of Southeast Asia is suffering an old-fashioned `credit crunch' of massive proportions. Restoring bank capital, however, and getting bank credit ¯owing again is only the immediate short-run solution for Japan. (That plus abandoning the rigid resistance of MOF to lowering marginal tax rates.) In the longer run, Japan and all Southeast Asia must learn to develop capital markets, so they can reduce their current and very large dependence on banks. Perhaps we can talk about that next year.