China’s Immunity Gap
The Zero-COVID Strategy Leaves the Country Vulnerable to an Omicron Tsunami
Would the world need an International Monetary Fund today if it did not already exist? As the outlook for the world economy becomes increasingly gloomy, the answer is an urgent yes. After Russia defaulted on its debt in mid-August, interest rates in emerging markets have skyrocketed so high that half of the world economy is courting recession next year. But precisely this turbulence in global financial markets demonstrates why the world needs the IMF: no other organization can serve as lender of last resort to buffer extreme economic turmoil during market stress.
The IMF failed to stem the Russian collapse not because its reform package was flawed but because Russia's domestic woes -- combined with its sensitivity to the global slump in oil and commodity prices -- were too severe to prevent market panic. Had the $22 billion IMF package for Russia been as large as its $40 billion bailout of Mexico in 1995, investors would probably not have fled. Instead, Russia's fiscal position was so delicate that investors decided $22 billion was not enough to guarantee success.
Beyond Russia, however, the IMF has successfully tempered the Asian financial crisis. Indeed, the fund's performance in Asia has highlighted the three roles it needs to play in today's economy. First, the IMF offers macroeconomic policy advice that politicians can sell to voters as their own; although the fund remains heavily influenced by the United States and other G-7 countries, it still offers a semblance of autonomy that makes its policy proposals more politically acceptable for borrowers. Second, the IMF acts as a global lender of last resort during a liquidity crunch, similar to the role played by national central banks during domestic banking crises. In this capacity, the fund can step in when market panic prevents a troubled economy from receiving necessary credit. Third, the IMF promotes microeconomic reforms that might otherwise be politically unacceptable. Such reforms have generally helped promote noninflationary economic growth.
The Russian default was the third stage in the global financial contagion that began with the devaluation of the Thai baht in July 1997. In the first stage, Thailand's currency depreciation triggered a sudden collapse in other Asian exchange rates, causing a rash of bankruptcies among corporations and financial institutions that had borrowed heavily in U.S. dollars in the first half of the 1990s. In turn, the devaluations contributed to a slide in world commodity prices, leading currencies of other commodity producers such as Australia, Canada, New Zealand, Chile, and Mexico to plummet as well. During these two stages, Russia escaped a ruble devaluation thanks to previously pledged IMF support and investor demand for high-yield Russian Treasury bonds. But when the IMF failed to help sustain the ruble in the spring and early summer as it came under pressure from Russia's large budget deficit and first postcommunist trade deficit, investors panicked. The resulting capital flight out of Russia and other emerging markets produced a $2 trillion to $3 trillion decline in the value of global stock market capitalization and caused a correction in American fixed-income instruments and corporate bond markets so large that even sophisticated hedge funds like Long Term Capital were eventually hit.
With the Russian crisis threatening to spiral out of control, the IMF assembled a $22 billion package for Russia in July, over the objections of many of its own officials. The United States had to lobby the IMF to relax its conditions for lending to Russia on the grounds that Russia was "too nuclear to go bust." Following the IMF's announcement of the loan, however, events turned against the fund. The communist-dominated Duma refused to pass measures essential for reform, such as tax increases. In addition, the price of oil continued to slide as OPEC members failed to cap crude production, while the ongoing turmoil in Asia depressed commodity prices further and increased investor skittishness over emerging markets. New York hedge funds and Russian banks took advantage of the new IMF loan to withdraw from the market and take their dollars offshore. In the end, the IMF program failed to rescue the ruble and prevent a government default because investors decided that Russia was too expensive to save.
Russia's reformers might have been able to lay the groundwork for a more sound market economy, however, if the IMF had offered a package the size of its 1995 Mexico proposal. The Russian economy had begun to pick up, and direct foreign investment was poised to expand before the collapse in oil and commodity prices. A sustained upturn would have reduced the government deficit and increased public support for reform while supporting the ruble. But since the IMF package failed, Russia is now headed for hyperinflation and an economic collapse so severe that it threatens Russia's fledgling democracy. The events unfolding in Russia profoundly shock the Russian people, deal a blow to the reformers in other former Soviet republics, and crush investor confidence in all countries on its periphery. Perilously, the fate of Russia now rests on the shoulders of its increasingly fragile president and fragmented coalition government, out of the West's control.
Critics charge that the IMF's loans to Russia were imprudent and wasteful. Indeed, many in the IMF who opposed the July package agree. But the fund's miscalculation with Russia demonstrates the complexity of its mission. Russia still deserves Western assistance as a defeated but potentially dangerous nuclear power. The West, however, has yet to create an effective framework to aid a country whose political institutions are still reeling from 70 years of command economy mismanagement and a corrupt redistribution of state assets after communism's collapse. Tragically, the reformers who dominated the government in July did not have enough time to establish market credibility and challenge the iron grip of Russia's business oligarchs before the slump in oil and commodity prices. As a result, a new team has taken over that is deeply divided over policy and liable to print money to finance the budget. The resulting hyperinflation could either set the stage for the reformers to return or spark a nationalist backlash.
OPTIMISM IN ASIA
While Russia remains mired in crisis, the IMF can point to Asia as one area where it has helped. Critics charge that Asia's economic downturn proves the IMF is an ineffective Band-Aid or, even worse, a rescuer of undeserving bankers. But the truth is that Asia's private sector had accumulated so much dollar-denominated debt before the crisis that an economic slump was inevitable once exchange rate uncertainty provoked a flight of private capital. While Latin America's collapse in the 1980s resulted from large budget deficits and wasteful government expenditures, the Asian crisis stemmed from private-sector mismanagement. From 1990 to 1997, annual capital flows to developing countries expanded from $50 billion to $300 billion, with a large share going to Asia as direct investment, portfolio investment, and bank lending. The surplus global liquidity and low cost of borrowing encouraged reckless allocation of capital, including speculative real estate ventures (Thailand), ill-conceived industrial projects (South Korea), and crony capitalist networks that based investment decisions on political relationships rather than purely commercial criteria (Indonesia and Malaysia).
As the crisis deepened in 1997, the IMF was once again called to the rescue. With the Asian economies facing an impending liquidity crunch, the fund provided enough credit to prevent formal government defaults and maintain future access to capital markets. If South Korea, Thailand, and Indonesia had defaulted unilaterally, they would have lost access to loans for several years -- just as Mexico did after its 1982 default. Instead, South Korea and Thailand have maintained global market access, begun recapitalizing their economies, and rolled over a large volume of their existing bank loans. Thailand has attracted over $8 billion in foreign capital since March for bank equity recapitalization, buyouts of bankrupt companies, and sales of defaulted finance company loans. South Korea was able to sell government bonds in April that were only three to four percentage points over U.S. bond yields, while a few South Korean companies have started negotiations with foreign firms on potential asset sales. Mexico, by contrast, was not able to borrow for seven years after its default.
Indonesia is a tougher case. A few Indonesian companies, however, have been able to issue corporate bonds and obtain access to bank loans. While Indonesia still suffers from a liquidity crunch, one of its paper companies was able to sell Eurodollar bonds at an interest rate of about 12 percent in April, which would not have been possible after a formal default. As a result of its IMF agreement, Indonesia also has access to more humanitarian aid to feed its people and address rising unemployment. If the Habibie government establishes a credible democratic base, confidence should improve further and set the stage for a recovery for private capital flows in late 1999.
Some economists argue that countries and investors may take excessive risks knowing the IMF will come to their rescue -- the "moral hazard" critique. But this argument is unrealistic. First, the absence of a lender of last resort could result in political turmoil so grave as to outweigh any short-term financial consequences. Without a buffer of credit, a developing country's financial crisis could spin out of control and lead to political and economic chaos. Second, the suffering that a country in crisis endures is already so severe that risk-prone parties quickly learn their lesson without lectures about moral hazard from well-meaning economists. Third, IMF credit is necessary when the behavior of the market takes an inexplicable turn. The Asia crisis is a prime example: capital flows in the private sector expanded and contracted quickly enough to produce debilitating economic instability. Private investors today are driven by the same mixture of greed and fear that has characterized capitalism throughout history. In times of crisis, market irrationality often prevents a country from overcoming a severe tightening of credit. Finally, critics often exaggerate moral hazard risk by confusing the causes of a crisis. IMF reforms are generally preceded, not followed, by slumping market value of companies and eroded market confidence in bank loans.
Critics often charge that the 1995 Mexican bailout encouraged reckless lending to Asia. In fact, banks continued to lend to Asia after 1995 because they did not perceive it as vulnerable to the same problems as Mexico. The peso came under pressure from a current account deficit, political instability, and a strong dollar bolstered by high U.S. interest rates. Asia, in contrast, depended far more on seemingly safe forms of capital flows such as bank loans and foreign direct investment. Ironically, American banks were far more cautious in Asia than their European or Japanese counterparts and will therefore have to write off fewer losses; the Latin American experience in the 1980s taught them to adopt more discriminating lending policies than French and German banks eagerly entering emerging market lending for the first time.
SCYLLA AND CHARYBDIS
Moral hazard aside, the IMF has miscalculated at times. In Asia, the IMF fumbled in sequencing its reform programs. In Indonesia, for example, it proposed shutting down several corrupt banks with links to the Suharto family before the country had established a system of deposit insurance. The prospect of a major bank collapse stunned the population and sparked a massive withdrawal of deposits, causing the central bank to intervene to stabilize the financial system. This intervention greatly eroded confidence in the currency and helped push Indonesia's inflation rate to 50-60 percent this summer from 6-7 percent a year ago. The reform program was sound, but the timing was disastrous.
Another complication that the IMF failed to foresee was that some Asian leaders took advantage of IMF lending to engage in large-scale capital flight on their own. Suharto's friends and children exported several billion dollars from Indonesia during late 1997 as the political and economic crisis worsened. Faced with such large capital outflows, international lenders have a much harder task in stabilizing the currency and protecting the local financial system. Ironically, one major beneficiary of such capital flight is the United States, the world's largest capital market and the holder of the leading currency. It is no accident that the massive expansion of IMF lending to Asia and Russia during the past year was matched by a bull market on Wall Street.
Faced with these challenges, what is the IMF to do? Its basic role is inherently controversial. It has to demand that borrowers accept fiscal and monetary austerity to regain investor confidence, but runs the risk that fiscal restraint might coincide with a private sector debt crisis. In turn, the government of the borrowing country must struggle to achieve its budget targets without imposing socially disruptive cuts in public expenditure. If social unrest spins out of control, as it did in Indonesia, the IMF must back down to prevent a complete social and political collapse. Indonesia, for example, will soon have a deficit equal to ten percent of GDP -- sharply higher than the balanced budget the IMF had demanded in January. South Korea will also have to relax its fiscal target to create a social safety net for unemployed workers.
Another potential minefield for the IMF is the question of banking reform. The fund is theoretically not supposed to intrude on private sector contracts when drawing up reform proposals. If faced with an overleveraged private sector rather than a bloated public sector, however, a reform program will not work unless bankers provide debt rescheduling up front. The failure of the first two IMF programs in Indonesia to stabilize the rupiah illustrates how difficult it is for any program to restore confidence when the major problem is private sector debt. The fund imposed many attractive and overdue microeconomic reforms on the Suharto government, but they failed to stabilize the currency because the country's corporate sector had such massive dollar liabilities that it could not service the debt without loan rescheduling or a rupiah revaluation. More encouragingly, the IMF was able to stabilize the Korean won because the U.S. Treasury and Federal Reserve lobbied the commercial banks to roll over existing loans.
In the end, the magnitude of the global market collapse after the Russian default illustrated how badly the market had misjudged Russian credit and the capacity of the IMF and the U.S. Treasury to intervene effectively. Their inability to save Russia demonstrated the limits of their power and caused investors to reassess risk all around the world. Countries such as Brazil and Venezuela had to hike interest rates immediately to discount the risk of immediate default. The resulting rise in borrowing costs was so severe that a Latin American recession will be unavoidable in 1999.
DON'T GET CHEAP
The IMF's critics, including Republican members of Congress, charge that its only mission is to rescue bankers from their own foolishness and encourage reckless lending to countries undeserving of international support. Other commentators lambaste the IMF's assistance to countries under authoritarian regimes, such as Suharto's Indonesia, and see IMF funds as nothing more than financial aid for dictators. But these critics fail to grasp the larger historical implications. If Russia does revert back to authoritarian rule and a command economy, historians will say that the West lost Russia because it was not prepared to spend enough to ensure its successful transition into a market economy. The United States stands right in the middle of this debate, having used the IMF since the Cold War as a proxy agency for American foreign policy. Whether with Mexico in 1995 or Asia in 1997, the United States has decisively shaped the IMF agenda, calling for the liberalization of trade and investment in countries that would otherwise resist implementation of these policies through bilateral channels. As Deputy Treasury Secretary Lawrence Summers said in February, "The IMF has done more to promote America's trade and investment agenda in Korea than 30 years of bilateral trade talks."
The Clinton administration has asked Congress to provide over $18 billion in new IMF funding to help expand its total capital to $280 billion, but the House continues to refuse. If America fails to provide its share, the IMF will have to find other means of funding, such as borrowing in commercial paper and bond markets or greater contributions from other members, that would inevitably reduce U.S. influence. Last autumn Eisuke Sakakibara, Japan's vice minister of finance, proposed creating an Asian monetary fund to bolster the resources available to the region's troubled countries. The U.S. Treasury rejected that idea because it feared it would establish an institution that could compete with the IMF -- and thus weaken American control. Congress must decide whether America wants to pay the cost of leadership.
Great economic crises do not occur in political vacuums. In the 1930s, depression led to global war and cost millions of lives. In Indonesia today, the streets of Jakarta have already seen bloodshed and attacks on ethnic Chinese. While China has mostly stayed aloof so far, it has formally indicated its concern to the Indonesian government. If civil war were to break out in Indonesia, it would disrupt the 40 percent of the globe's shipping -- including energy supplies for Japan and electronic goods for the entire world -- that passes through its waters. The economic crisis may strengthen the hand of extremist Islamic parties and pose new foreign policy problems for the United States. In short, the consequences of an Indonesian collapse would be so grave that IMF intervention should be classified as financial peacekeeping, not just economic assistance.
The great difference between today's economy and the emergence of the modern market economy a century ago is the speed and frequency with which money moves across borders. As the shocks following the Russian default have shown, economists still cannot fully comprehend the consequences of a global financial system that can move capital so quickly and cheaply. The viability of such a system remains in doubt. But despite these differences, today's debate recalls many issues that first emerged in the arguments over the establishment of the U.S. Federal Reserve in 1914. Due to its longstanding populist tradition and skepticism over central banks, the United States was one of the last industrialized nations to establish a national central bank. But those doubts vanished. Central banks are now widely seen as necessary in supervising banking systems and providing liquidity during crises. A consensus has also emerged that the world requires better financial supervision, increased transparency, and improved corporate disclosure and governance. True, less agreement exists over whether the global economy needs an institution comparable to a global central bank to promote such reforms and offer liquidity during periods of crisis. As a consequence of Bretton Woods, however, the IMF has evolved into an institution that assumes some basic functions of a global central bank without provoking needless debate about whether the world needs a global currency or political union. As the Asian crisis has demonstrated, it still has much to learn from the revolution in technology and financial behavior in recent years. But in 1998, the IMF remains the best solution in an imperfect world. If the IMF did not exist, governments would be frantically debating today whether to establish such an organization.