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feldstein, part 2 of 2
What Korea needed was coordinated action by creditor banks to
restructure its short-term debts, lengthening their maturity and
providing additional temporary credits to help meet the interest
obligations. The creditors should have preferred this course to
having the borrowers default on their loans, just as the
creditors
did 15 years earlier in their negotiations with the Latin
American
debtors. The rate of interest required to attract such long-term
foreign lending on a voluntary basis-and thereby avoid a
withdrawal of private lending to other emerging-market
countries-was about four percentage points above the interest
rate
on U.S. Treasury bonds and therefore well within what Korea could
finance by its exports. During November the interest rate on
ten-year dollar bonds issued by the government-backed Korea
Development Bank varied between two percent and four percent
above
the interest rate on U.S. Treasury bonds. Even a four percent
premium on a completely restructured Korean foreign debt would
have been equal to only about one percent of Korea's GDP and
about
four percent of its exports. The IMF could have helped by
providing a temporary bridge loan and then organizing the banks
into a negotiating group. (In fact, the IMF did just that in late
December with the help of the national central banks after its
original plan had failed.)
Instead, the IMF organized a pool of $57 billion from official
sources-the IMF, the World Bank, the U.S. and Japanese
governments, and others-to lend to Korea so that its private
corporate borrowers could meet their foreign currency obligations
to U.S., Japanese, and European banks. In exchange for those
funds, the IMF demanded a fundamental overhaul of the Korean
economy and a contractionary macroeconomic policy of higher
taxes,
reduced spending, and high interest rates.
The IMF's program emphasized eight structural problems of the
Korean economy that it said had to be changed. Foreign investors
are not able to acquire Korean businesses by purchasing their
shares or to own majority stakes in Korean businesses. Korea's
domestic financial markets are not fully open to foreign banks
and
insurance companies. Imports of some industrial products are
still
restricted, especially Japanese cars. Korean banks do not apply
good Western banking standards of credit evaluation but follow
what might be called the Japanese development model, in which the
government guides banks to lend to favored industries in exchange
for an implicit guarantee of the loans. The Bank of Korea is not
independent and does not have price stability as its only goal.
The corporate structure involves large conglomerates (the
chaebols) with an extremely wide range of activities and opaque
financial accounts. Korean corporations generally have very high
debt-to-capital ratios that make them risky debtors for domestic
and foreign lenders. Finally, Korean labor laws make layoffs very
difficult and provide strong impediments to the flow of workers
between firms.
The IMF said that it would provide credit only as Korea altered
these central features of its economy. It predicted that economic
growth in 1998 would be only half the 1997 level and that the
unemployment rate would double. These conditions would be
exacerbated by the IMF's requirement for high interest rates and
for tighter fiscal policy to reduce the budget deficit between
1997 and 1998. Many private observers estimated that the adverse
effects on output and employment would be substantially worse.
EVALUATING THE STRATEGY
The fundamental issue is the appropriate role for an
international
agency and its technical staff in dealing with sovereign
countries
that come to it for assistance. It is important to remember that
the IMF cannot initiate programs but develops a program for a
member country only when that country seeks help. The country is
then the IMF's client or patient, but not its ward. The
legitimate
political institutions of the country should determine the
nation's economic structure and the nature of its institutions. A
nation's desperate need for short-term financial help does not
give the IMF the moral right to substitute its technical
judgments
for the outcomes of the nation's political process.
The IMF should provide the technical advice and the limited
financial assistance necessary to deal with a funding crisis and
to place a country in a situation that makes a relapse unlikely.
It should not use the opportunity to impose other economic
changes
that, however helpful they may be, are not necessary to deal with
the balance-of-payments problem and are the proper responsibility
of the country's own political system.
In deciding whether to insist on any particular reform, the IMF
should ask three questions: Is this reform really needed to
restore the country's access to international capital markets? Is
this a technical matter that does not interfere unnecessarily
with
the proper jurisdiction of a sovereign government? If the
policies
to be changed are also practiced in the major industrial
economies
of Europe, would the IMF think it appropriate to force similar
changes in those countries if they were subject to a fund
program?
The IMF is justified in requiring a change in a client country's
national policy only if the answer to all three questions is yes.
The Korean case illustrates the need for this test very well.
Although many of the structural reforms that the IMF included in
its early-December program for Korea would probably improve the
long-term performance of the Korean economy, they are not needed
for Korea to gain access to capital markets. They are also among
the most politically sensitive issues: labor market rules,
regulations of corporate structure and governance, government-
business relations, and international trade. The specific
policies
that the IMF insists must be changed are not so different from
those in the major countries of Europe: labor market rules that
cause 12 percent unemployment, corporate ownership structures
that
give banks and governments controlling interests in industrial
companies, state subsidies to inefficient and loss-making
industries, and trade barriers that restrict Japanese auto
imports
to a trickle and block foreign purchases of industrial companies.
Imposing detailed economic prescriptions on legitimate
governments
would remain questionable even if economists were unanimous about
the best way to reform the countries' economic policies. In
practice, however, there are substantial disagreements about what
should be done. Even when there has been near unanimity about the
appropriate economic policies, the consensus has changed
radically. After all, the IMF was created to defend and manage a
fixed exchange-rate system that is now regarded as economically
inappropriate and practically unworkable. Similarly, for a long
time the advice to developing countries that came from the World
Bank, the IMF's sister institution, and from leading academic
specialists emphasized national plans for government-managed
industrial development. The official and very influential U.N.
Economic Commission for Latin America preached the virtues of
protectionist policies to block industrial imports in order to
encourage countries to develop their own manufacturing
industries.
Now the consensus of professional economists and international
agencies calls for the opposite policies: flexible exchange
rates,
market-determined economic development, and free trade.
Today, there is nothing like unanimity about the appropriate
policies for Korea or Southeast Asia. Korea's outstanding
performance combining persistently high growth, low inflation,
and
low unemployment suggests that the current structure of the
Korean
economy may now be well suited to Korea's stage of economic and
political development and to Korean cultural values stressing
thrift, self-sacrifice, patriotism, and worker solidarity. Even
if
it were desirable for Korea to shift toward labor, goods, and
capital markets more like those of the United States, it may be
best to evolve in that direction more gradually and with fewer
shocks to existing businesses. Unless the reforms could only be
done under the duress of an IMF program or are specifically
needed
to end the liquidity problem, making the transition in the midst
of a currency crisis would be very poor timing.
The short-term macroeconomic policies that the IMF prescribed for
Korea are equally controversial. The program calls for the
traditional IMF prescription of budget deficit reduction (by
raising taxes and cutting government spending) and a tighter
monetary policy (higher interest rates and less credit
availability), which together depress growth and raise
unemployment. But why should Korea be required to raise taxes and
cut spending to lower its 1998 budget deficit when its national
savings rate is already one of the highest in the world, when its
1998 budget deficit will rise temporarily because of the
policy-induced recession, and when the combination of higher
private savings and reduced business investment are already
freeing up the resources needed to raise exports and shrink the
current account deficit?
Under the IMF plan, the interest rate on won loans is now about
30
percent, while inflation is only 5 percent. Because of the high
debt typical of most Korean companies, this enormously high real
interest rate of 25 percent puts all of them at risk of
bankruptcy. Why should Korea be forced to cause widespread
bankruptcies by tightening credit when inflation is very low,
when
the rollover of bank loans and the demand for the won depend more
on confidence than on Korean won interest rates, when the
failures
will reduce the prospect of loan repayment, and when a further
fall in the won is an alternative to high interest rates as a way
to attract won-denominated deposits? Although a falling won would
increase the risk of bankruptcies among Korean companies with
large dollar debts, the overall damage would be less extensive
than the bankruptcies caused by very high won interest rates that
would hurt every Korean company. Finally, why should Korea create
a credit crunch that will cause even more corporate failures by
enforcing the international capital standards for Korean banks
when the Japanese government has just announced that it will not
enforce those rules for Japanese banks in order to avoid a credit
crunch in Japan?
ENCOURAGING EXCESSIVE RISK
The IMF faces a serious dilemma whenever it deals with a country
that cannot meet its obligation to foreign creditors. The IMF can
encourage those creditors to roll over existing loans and provide
new credit by promising them that they will be repaid in full.
That type of guarantee was implicit in the IMF's $57 billion
credit package for Korea. But promising creditors that they will
not lose in the current crisis also encourages those lenders and
others to take excessive future risks. Banks that expect loans to
be guaranteed by governments do not look as carefully as they
should at the underlying commercial credit risks. And when banks
believe that the availability of dollars to meet foreign exchange
obligations will be guaranteed by the IMF, they will not look
carefully at the foreign exchange risk of the debtor countries.
There is no perfect solution to this "moral hazard" problem. In
principle, the IMF and the Korean government should provide the
guarantees needed to keep current creditors engaged while
swearing
that it is the last time that such guarantees will be provided.
Although there may be no way to make such a promise persuasively,
the IMF may have encouraged future lenders too much by the speed
with which it took control-without waiting for lenders and
borrowers to begin direct negotiations with each other. The call
by IMF Managing Director Michel Camdessus for member governments
to provide an additional $60 billion in IMF resources, on top of
the $100 billion increase requested last September, just after
announcing the Korean program in December also encourages banks
and other lenders to believe they will be bailed out in the
future.
At the same time, the message to emerging-market countries sent
by
painful and comprehensive reform programs was that they should
avoid calling in the IMF. Malaysia is now doing just that, even
though its conditions are roughly similar to those of Thailand
and
Indonesia. More generally, the tough program conditions make it
difficult to get a country to work with the IMF until it is
absolutely necessary. The IMF appears like the painful dentist of
the old days: just as patients postponed visits until their teeth
had to be pulled, the countries with problems wait too long to
seek technical advice and modest amounts of financial help.
The desire to keep out of the IMF's hands will also cause
emerging-market economies to accumulate large foreign currency
reserves. A clear lesson of 1997 was that countries with large
reserves could not be successfully attacked by financial markets.
Hong Kong, Singapore, Taiwan, and China all have very large
reserves, and all emerged relatively unscathed. A country can
accumulate such reserves by running a trade surplus and saving
the
resulting foreign exchange. It would be unfortunate if developing
countries that should be using their export earnings to finance
imports of new plants and equipment use their scarce foreign
exchange instead to accumulate financial assets.
When the foreign exchange crisis hit Korea, the primary need was
to persuade foreign creditors to continue to lend by rolling over
existing loans as they came due. The key to achieving such credit
without an IMF guarantee of outstanding loans was to persuade
lenders that Korea's lack of adequate foreign exchange reserves
was a temporary shortage, not permanent insolvency. By
emphasizing
the structural and institutional problems of the Korean economy,
the fund's program and rhetoric gave the opposite impression.
Lenders who listened to the IMF could not be blamed for
concluding
that Korea would be unable to service its debts unless its
economy
had a total overhaul. Given the magnitude of the prescribed
changes, lenders might well be skeptical about whether Korea
would
actually deliver the required changes, regardless of what
legislation it enacted. Even the $57 billion IMF pool did not
promote confidence in Korea's ability to pay since the IMF
emphasized that the money would be released only as Korea proved
that it was conforming to the IMF program. Unsurprisingly, after
the program was announced, the bond rating agencies downgraded
Korean debt to junk bond status.
As a result, by late December Korea's reserves were almost gone,
shrinking at a rate of $1 billion a day. The U.S. government and
the IMF recognized that the original strategy had failed and
agreed to accelerate $10 billion of the committed loans as a
bridge to prevent a default. More important, the U.S. Federal
Reserve and the other major central banks called in the leading
commercial banks and urged them to create a coordinated program
of
short-term loan rollovers and longer-term debt restructuring. The
banks agreed to roll over the loans coming due immediately, and
the crisis was averted. The banks are now meeting with the Korean
government to develop plans for longer-term restructuring. The
situation in Korea might have been much better and the current
deep crisis avoided had such negotiations begun much earlier.
Several features of the IMF plan are replays of the policies that
Japan and the United States have long been trying to get Korea to
adopt. These included accelerating the previously agreed upon
reductions of trade barriers to specific Japanese products and
opening capital markets so that foreign investors can have
majority ownership of Korean firms, engage in hostile takeovers
opposed by local management, and expand direct participation in
banking and other financial services. Although greater
competition
from manufactured imports and more foreign ownership could in
principle help the Korean economy, Koreans and others saw this
aspect of the plan as an abuse of IMF power to force Korea at a
time of weakness to accept trade and investment policies it had
previously rejected.
The IMF would be more effective in its actions and more
legitimate
in the eyes of emerging-market countries if it pursued the less
ambitious goal of maintaining countries' access to global capital
markets and international bank lending. Its experts should focus
on determining whether the troubled country's problem is one of
short-term liquidity and, if so, should emphasize that in its
advice and assistance. The IMF should eschew the temptation to
use
currency crises as an opportunity to force fundamental structural
and institutional reforms on countries, however useful they may
be
in the long term, unless they are absolutely necessary to revive
access to international funds. It should strongly resist the
pressure from the United States, Japan, and other major countries
to make their trade and investment agenda part of the IMF funding
conditions.
The IMF should remember that the borrowers and the lending
bankers
or bondholders should bear primary responsibility for resolving
the problems that arise when countries or their corporations
cannot meet their international debt obligations. The IMF should
provide technical assistance on how the debtors can improve their
current account balances and increase their foreign exchange. It
should act as a monitor of the success that the country is making
in moving toward self-sustainable liquidity, providing its own
funds as an indication of its confidence in the country's
progress
rather than as a bailout of international lenders and domestic
borrowers. If the IMF can focus its attention on this narrower
agenda, it can devote more of its scarce staff talent to the
problem of crisis prevention. The IMF should work with countries
that have not yet reached a currency crisis in order to prevent
the large current account deficits or the excess short-term debts
that could later precipitate a crisis. If the fund is seen more
as
a client-focused and supportive organization than as the imposer
of painful contractions and radical economic reforms, it is
likely
to find that countries will be more willing to invite its
assistance when it can be most helpful.
Martin Feldstein is Professor of Economics at Harvard University
and President of the National Bureau of Economic Research.
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