Woes Dervied but Undiluted
s currencies and countries tumbled, another form of contagion began to take a toll on world economies: financial derivatives.
Originally called synthetic securities, derivatives are so named because they are derived from something else -- an underlying stock or bond. They can be as simple as an option to buy a stock, or they can be complex products involving multiple currencies, loans and bonds. In effect they are repackaged securities, stuck together like a complex work of financial Lego.
There is nothing inherently harmful about derivatives, and they can be very useful to protect against risks. But they can also be used to speculate. Their tremendous variety is reflected in the nicknames given to various kinds: the jellyroll; the iron butterfly; the condor; the knockout option; the total return swap; the Asian option.
These are jellyrolls that really sell. Western sales teams were active in Asia, and they often peddled complex financial products to customers who sometimes did not understand what they were getting into.
No one believes that derivatives actually caused the crisis. But although the point is bitterly contested by some investment bankers, a number of economists believe that once the crisis started, derivatives helped deepen it and infect other countries. They cite several mechanisms.
Rushing to the Exits
irst, derivatives made it easier to make high-risk bets on Asia, but these were not publicly reported. As a result, no one had any idea how much betting was going on.
"Derivatives enabled a lot of hot money to flow into Asia below the radar," said Frank Partnoy, a former derivatives salesman and now an assistant professor of law and finance at the University of San Diego.
Second, the riskiness creates a rush to cover bets when the market goes the wrong way, and this scramble sometimes causes wild market swings.
As Partnoy explained the scramble: "It's as if you're in a theater, and say there are 100 people and you have the rush-to-the-exit problem. With derivatives, it's as if without your knowing it, there are another 500 people in the theater, and you can't see them at first. But then when the rush to the exit starts, suddenly they drop from the ceiling. This makes the panic greater."
Third, derivatives increased the linkages from one country to the next. South Korea, in particular, invested in derivatives and other high-risk securities that were tied to Thailand, Russia, Indonesia and Latin America. South Koreans bought 40 percent of one Russian bond issue and almost all of a Colombian bond issue.
So when those countries soured, South Korean financial institutions were badly hit as well. Derivatives had allowed them high yields but also meant that they stood to lose far more than their principal.
"I think it is quite clear that derivatives are vectors of contagion," said Martin Mayer, a senior fellow at the Brookings Institution in Washington.
Why did derivatives flourish in Asia? One reason was that until the crisis, they were enormously profitable for everyone. Some Asian financial institutions now grumble about them, but until a couple of years ago Korean mutual funds managed to earn exceptionally high returns in part because of their derivative investments.
Moreover, American banks often made huge sums selling these products in Asia. Jan Kregel, who has researched the issue as a senior fellow at the Jerome Levy Economics Institute in Annandale-on-Hudson, N.Y., concludes that in the boom years of both Thailand and Indonesia, Western banks made incomparably more money selling derivatives than making loans, and that in any case much of the lending was linked to derivatives as well. Most of the major American banks -- Bankers Trust and Chase and J.P. Morgan and others -- were actively selling derivatives in Asia.
The problem was not that Westerners were fleecing Asians, for in Asia one of the biggest derivatives players was a Hong Kong investment bank, Peregrine Investments, run by a British former race-car driver named Philip Tose. Founded only in 1988, Peregrine came from nowhere to register an astonishing $25 billion in revenues in 1996.
Then, early last year, Peregrine returned to nowhere. It collapsed in a sea of debts in Indonesia and elsewhere, and the shock then rippled through Asia and around the world.
"It was a major local player," said Christopher Barlow, a finance expert at PricewaterhouseCoopers who is presiding over the liquidation of Peregrine. "A collapse like this causes shock waves in the system and damages confidence." Barlow said Peregrine had more than 2,000 creditors, with claims of more than $4 billion.
One of the losers was the Illinois state pension fund, which manages Mrs. Paoni's retirement money. The fund had bought $358,000 of Peregrine stock, all of it now worthless, although this had only an infinitesimal effect on Mrs. Paoni's holdings.
"Derivatives are like power tools," said Brian Lippey, managing director of Tokai Asia Ltd., an investment company in Hong Kong. "If you know how to use them, they're great. But if you don't know how to use them, you'll drill a hole in your head."
No Fares, No Food
n the Indonesian town of Mojokerto, high finance began to close in on Salamet, a rickshaw driver.
Salamet (who like many Indonesians uses only one name) cannot read, so he had not learned from the newspaper that the Thai baht had plummeted and the Hong Kong market had plunged. But he was shocked when Agus Santoso came home.
Santoso, a slight 40-year-old neighbor, too frail a man to make a decent ditch-digger, had been the talk of the town. He had managed to learn how to drive a car and had got a job driving new cars to dealerships all over Indonesia.
The job paid $400 a month, a colossal sum that had tongues wagging all over the neighborhood. Salamet had dreamed that he, too, might learn to drive a car and follow in Santoso's lead.
But cars and car parts are imported, so they began to soar in price as the Indonesian rupiah lost value. Indonesians stopped buying new cars, and Santoso was dismissed and moved back home.
Meat and rice soared in price, and people in Mojokerto began to cut back to two meals a day. The poor began to walk instead of taking rickshaw rides, and Salamet's earnings fell by half, to less than $1 a day.
It is still unclear how severe the impact has been across the region, and the last few months have seen a statistical battle, as international organizations and aid agencies have issued a flood of reports offering widely divergent portraits of Asia in crisis. Invariably, the bleakest assessments have tended to get the most attention.
In Indonesia, for example, estimates by the government and some aid agencies have suggested that the proportion of people living in poverty has risen to 40 percent or even 50 percent. But three carefully prepared World Bank reports released in January suggest that the increase has been much more modest, to 13.8 percent in 1998 from 11 percent in 1997.
As the World Bank sees it, "Rather than the universal devastation in poverty, employment, education and health so widely predicted and repeated in the media," the reality is increased poverty and a rising number of school dropouts, but not on the scale that aid agencies had suggested.
Still, although the scale is uncertain, everyone agrees that the crisis has left millions of people in great distress. And in Salamet's extended family, there is no doubt that life has taken a turn for the worse, even if it is difficult to measure.
Salamet took his wife, Yuti, and their baby daughter to visit his in-laws in a village near Mojokerto, and there they sat down beside a hut to chat. No food was served, for there was none.
The matriarch, Sambirah, who does not know her age but appears to be in her 80s, cradled her great-granddaughter in gnarled arms so frail that they seemed to rattle in the breeze, and for a moment her rheumy eyes glowed with pride. Mrs. Sambirah's pale mouth turned up at the corners, revealing two yellowed teeth, tusks emerging from an expanse of gum.
Then the tusks disappeared, and Mrs. Sambirah's eyes clouded. She sighed and described how she now pawns her sarongs so that the children do not starve.
"I can put up with it if I don't eat," she said. "But the children aren't used to it. They cry and cry."
Pulp Facts, Pulp Fiction
cross the globe, on the 22nd story of a skyscraper in Rio de Janeiro, Carlos Aguiar began to feel Indonesia's pain.
Aguiar, 53, president and chief executive of a pulp and paper company called Aracruz Cellulose SA, is solid and plain-speaking. His hair is neatly parted on the side; his manner suggests a waltz rather than a samba. He worked his way up through the business, and his heart is not in Rio but 375 miles north in the company town of Aracruz, where most company timber plantations and pulp mills are.
"Asia was seen as a great market", said the Brazilian paper tycoon Carlos Aguiar, "Everybody was betting on them."
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Mrs. Paoni is among those with a stake in Aracruz. Her state pension fund bought into the Brinson Emerging Markets Fund, which in turn owned 102,000 shares of Aracruz preferred stock.
Many investors picked up Aracruz, for the paper industry was doing well in the mid-1990s and investment analysts were recommending the stock. But a problem was developing behind the scenes: Asian companies were building a quantity of enormous paper mills in Indonesia and other countries, dramatically increasing worldwide output. Global pulp capacity has soared to 35 million tons, from 25 million tons in 1990.
"Everybody saw Asia as being this great market," Aguiar said morosely. "China, India, they have enormous populations, and everybody was betting on them. That was why the Indonesians built these giant factories, because they were expecting that paper use in China would go from 17 kilos a person now, to 30, then to 100. It didn't happen."
On top of the glut, the devaluations in Asia meant that Indonesian companies lowered their prices. So the price of Aracruz pulp dropped to $420 a ton recently from $850 a ton at its peak in 1995.
Pulp offered simply one example of a global slump in commodity prices. The world abruptly found itself bedeviled by excess capacity just as demand slumped, and so markets were awash with Russian steel, Chilean copper, American grain, Colombian coffee and Saudi oil.
Astonishingly, after one of the great booms in economic history, commodity prices on average are still 12 percent lower than the average in 1990. Metals on average now cost just two-thirds as much as eight years ago. After adjusting for inflation, oil costs less than it has for 25 years, since before the 1973 oil shock.
Debt Addict Seeks Rx
alling commodity prices were making ripples around the world. They were especially brutal to Russia, whose main export is oil and gas, with the upshot that Russia's economy was falling apart.
Nobody much noticed at first. As with Asia a year earlier, it was too easy to be dazzled by the black Mercedes-Benzes, the diamond rings and the crowded discos. In 1997, Russia's stock market performed the best in the world, rising 149 percent in dollar terms, according to the calculations of the International Finance Corp.
At GUM department store, Solomatin, the chairman, had been equally optimistic. He had sunk GUM's entire nest egg of liquid assets -- then worth $33 million -- into the stock and bond markets. It had seemed a good deal, for the bonds were paying interest rates of 100 percent or more.
But behind the scenes Russia's economy was showing severe strains, and many of them were unrelated to the Asian crisis. Tax collection was abysmal, government budget deficits were growing, short-term debt was rising and President Boris Yeltsin's health seemed to be fading.
Asian countries had had problems with private debts, but Russia's problems were a bit different: the government itself was addicted to debt. And with one-third of government revenues coming from taxes on oil and gas that were steadily falling in price, it was difficult to foresee an improvement.
"I think the main reason for our crisis was not the Asian crisis," said Sergei Kiriyenko, who at 37 became Russian prime minister last spring. "It was that for years we had expenses higher than revenues."
More broadly, in contrast with Asia and Latin America, where markets were deeply rooted, Russia had only the flimsiest attachment to market principles and was being savaged by corruption and organized crime. Russia's top prosecutor, Yuri Skuratov, estimates that half of all Russia's commercial banks are mob-controlled and that criminals control about half of the gross national product.
Even as Russia's economy was quietly disintegrating, public support from the United States, Germany and other countries bolstered the impression that, as one economist put it, Russia was "too nuclear to go bust."
In July 1998, the Clinton administration pushed the monetary fund for a major bailout, even though officials worried privately about whether it would work. In the end the fund worked out a $17.1-billion deal.
Perhaps Americans did not fully notice the crisis developing, but Russians did -- and their behavior undermines the notion that around the world it was only Western investment bankers who took poor locals to the cleaners. In Russia it was more the other way around. Russian capital flight steadily averaged $1 billion per month for the last three years, moving to places like Britain and Switzerland, which Russians felt they could trust. The first $4.8 billion installment of the fund bailout quickly disappeared as Russian oligarchs cashed out their rubles and took their money out of Russia.
As Charles Dallara of the Institute of International Finance in Washington described it, "So in a broad sense, you had the West, the IMF, Western banks and Western governments pouring money in the front door, and a select group of Russian citizens taking it out the back door."
Meanwhile, the Russian legislature balked at many of the required reforms. Investors panicked, and on Aug. 17, computer screens flashed the bad news: the bailout had collapsed, and Russia stopped propping up the ruble and defaulted on domestic bonds. Overnight, the bonds were virtually worthless, and stocks fell from dollars to pennies.
Still, Rubin says he has no regrets about the July bailout. "I'd do the same thing again," he said. "Given the stake we had in an economically viable Russia, it was a risk worth taking. It had a realistic chance."
GUM, which had been seeking listings on overseas stock exchanges, sent despondent faxes that day to its investment banker friends, postponing those plans indefinitely. The crisis sent the ruble tumbling to more than 18 to the dollar from 6, and so in effect all the imports in GUM (and most of the inventory is imported) tripled in price just as Russian consumers were losing their jobs.
The shock waves from the Russian default were felt around the world, partly because they shattered the assumption of an international safety net. The United States and the monetary fund had wanted to save Russia, and their failure sobered investors, sending them scurrying once more away from risk.
After the Russian crisis, the upheavals in international markets nearly destroyed Long-Term Capital Management, the most glamorous of America's hedge funds. More than a year earlier, the hedge funds had helped to trigger the financial crisis in Thailand, setting in motion a chain reaction that ultimately came back to take Long-Term Capital to the brink of collapse.
Long-Term Capital tumbled for the same reasons that Thailand did. American financiers may like to think of themselves as a world apart from Thai bankers, but there was a certain symmetry in what went wrong.
Thailand and Long-Term Capital were both victims of their own successes, which bred hubris and carelessness toward risks. They also both borrowed more money than they should have, and got into trouble when their bets went wrong. And, to be fair, both had a certain amount of bad luck.
On When to Bail Out
he Russian default sideswiped Brazil, which for a time lost money from foreign reserves at the rate of $1 billion a day. So when Brazil wobbled, the United States braced itself. In November 1998, the Brazilian government agreed to a $41.3-billion bailout package from the fund, which Clinton arranged early, while Brazil was still solvent.
For the United States it was a remarkable turnaround. A bit more than a year earlier, the Clinton administration had refused to contribute money to the Thai bailout and had prevented Japan from distributing aid. This time, Clinton himself led the intervention and the United States came up with $5 billion of the package.
Yet it was a bad bet. Despite widespread recognition that the Brazilian currency, the real, was overvalued, Washington made essentially the same mistake as it had in Russia: it trusted the legislators to quickly pass reforms that would reassure investors. Again the markets won, and in January Brazil was forced to float the real.
The collapse of the currency in turn forced Brazil to raise interest rates to try to attract foreign money -- the pattern that had occurred a year earlier in Indonesia or South Korea. And the high interest rates, in turn, are depressing Brazil's economy and casting a shadow over Argentina, Mexico and all of Latin America.
At Aracruz, Aguiar has solemnly watched the stock price fall, from $22 a share in the summer of 1997 to $11.81 on Tuesday. Over the years, he has taken desperate measures to compete globally, trimming Aracruz's work force by nearly two-thirds, cutting back on health and dental benefits, and turning to a cheaper contractor to run the company cafeteria. Just since the crisis hit in the fall, he has pared staffing another 10 percent, and he prays it will be enough.
On the other end of the globe, in the third floor boardroom of GUM, Solomatin has a grand view of Red Square -- and a terrible view of his company's future.
All the company's plans are on hold; the money in defaulted bonds is locked up; all the stock is now worth only $36 million, about the cost of the inventory.
That makes GUM a candidate for a takeover by a foreign company, and two European companies are said to have been eyeing it. But Solomatin sounds skeptical.
"Who would take us over?" he asked. "Investor fear of Russia is so great that nobody would consider buying us." |
