BostonGlobe. Perils of a fast buck
boston.com
Asia and Russia enthusiastically welcomed Western investors
but the quick deposit and withdrawal of that 'hot money'
shattered their fragile markets
By Kimberly Blanton, Globe Staff, 09/06/98
It moved through the world's financial markets with the power of a
tsunami.
International investors pulled their money out, causing the collapse of
fragile currencies in Southeast Asia, then Russia, Eastern Europe, and
Latin America. One after another, stock markets followed them down.
Last week, the West awoke to the seemingly remote crisis that had been
unfolding for more than a year. The mighty Dow Jones industrial average
slid 512 points Monday - its second-largest point decline ever. There
was talk of a chill in this country's eight-year economic expansion - or,
worse, a global depression.
The troubles cascading from Bangkok to Moscow to Caracas are not
the first to hit the world's ''emerging'' economies. In the early 1980s, a
debt bomb exploded in Latin America, where governments were unable
to repay loans to US banks. But the financial meltdown in Asia - and
now Russia - is worse than any ever experienced, economists say.
What distinguishes it is the role played by the modern system of financial
markets. Emerging economies, none more than Asia's, embraced
capitalism and opened their doors to Western investors and lenders.
Total equity investments and loans to 29 emerging countries surged to a
peak of $305 billion in 1996. As financial markets became more fluid
and intertwined, big-money institutions like mutual funds and banks
moved billions into emerging economies.
Now that fluidity is the very reason for the dimensions of the current
global crisis.
''The markets are so small relative to the money these big institutions can
put in,'' said William White, chief economist of the Bank for International
Settlements in Basle, Switzerland, which acts as a central bank for the
world's central banks. The flows of money, he said, ''cause inflation on
the way in, fueling a bubble, and havoc on the way out as people head
for the exits.''
The ability of financial institutions to move money around the globe with
lightning speed is ''the way the modern system tends to work,'' said
Philip Suttle, chief international economist for J.P. Morgan & Co. in New
York.
The economic turmoil of developing countries has boomeranged on the
industrial world. Troubles in Asia's once up-and-coming countries have
played a big role in weakening Japan's economy, the world's
second-biggest. And much of the volatility has been blamed on
Americans and Europeans, who have sustained huge losses on their
activities in Asia, That has sparked a backlash in countries like Malaysia,
which slapped on currency controls and tightened restrictions on foreign
investors.
The sea change in world financial markets is a major distinction between
today's crisis in Asia and the Latin America debt crisis 15 years ago.
Throughout Asia, unprecedented steps were taken in the early 1990s to
liberalize financial markets by loosening restrictions on foreign investors.
More open economies thrived, as governments had hoped they would.
Real estate prices in countries like Hong Kong surged to new heights.
Trade flowed more freely.
The new investors were not just speculators, the wild men of Wall Street
who place big bets in currency markets. They were also conservative
pension funds, high-risk hedge funds for wealthy individuals, and New
York's most prestigious banks and investment houses. Even mutual fund
investors joined the craze: Between 1995 and 1997, fund assets in
emerging markets nearly doubled to $24 billion.
When these investors pulled out, the downturn was breathtaking.
In Hong Kong's stock market, the Hang Seng index shed one-quarter of
its value in just four days in October. The volume of trading in Thailand's
stock market plunged from $1 billion a day at its peak to under $20
million now. Stock markets in Indonesia and Malaysia lost half of their
value in eight months.
Premier companies were flattened. Matahari, Indonesia's biggest
department store, was ''over-owned'' by investors, said Edward
Bozaan, president of Waterford Partners, a New York firm that invests
in troubled emerging markets. During rioting in the country early this year,
stores burned, pushing Matahari's stock value to a penny a share.
Investors, as a result, should be able to cash out of Matahari's stock
''sometime into the next century,'' Bozaan said.
The boom - and bust - in Asian stock markets parallels the flood - and
withdrawal - of international capital into and out of the region.
In just two years, the amount of new equity and loans flowing into five
emerging countries in Asia - South Korea, Indonesia, Malaysia, Thailand,
and the Philippines - more than doubled to $97 billion in 1996, according
to the Institute of International Finance in Washington, which tracks
lending and investments in emerging markets.
Some countries' stock markets doubled in the final three months of 1994.
That attracted more investors, some of whom had portfolios bigger than
the capitalization of a single Asian country's stock market. Share prices
shot up further.
The collapse on July 2, 1997, of Thailand's currency, the baht, triggered
an exodus of $12 billion in capital from Asia's developing economies in
1997. Currencies plunged. The ensuing capital flight and tumbling stock
markets sparked another round of currency devaluations in early 1998.
As money fled Asia, some investors moved to new opportunities - in
Russia. The value of its fledgling stock market soared to ludicrous
heights. As Russia's economy unraveled, stocks lost most of their value.
The investment fund of international speculator, George Soros, sacrificed
$2 billion in Russia, mostly in the stock market.
''It's almost as if money was bouncing from place to place,'' said J.P.
Morgan's Suttle. ''When Asia came under pressure that money flowed to
other parts of the world, Russia and also Latin America.''
The West was not spared. Stocks of European companies and banks,
heavy investors in Russia and Asia, were battered. Resource-rich
countries such as Venezuela and Canada, hit by plunging commodities
prices, are struggling to shore up their currencies.
''These are the risks people don't anticipate when putting 10 percent of
their (401)k in an emerging markets fund,'' said Jamie Coleman, a senior
foreign exchange analyst for Thomson Global Markets, a Boston
consulting firm.
In hindsight, Western economists and investment specialists say, Asian
markets were simply unprepared to handle the ''hot money'' pouring in.
Emerging markets typically are marked by weak regulation and bad
accounting practices that conceal a company's true financial condition,
making it difficult for outside investors to accurately assess risk. In
Malaysia, for example, there are no credible rating agencies, said Phil
Wellons, deputy director of the Program on International Financial
Systems at the Harvard Law School.
''In the early '90s, these stock markets had a sort of casino quality to
them, with taxi drivers taking an hour off to watch the screen in the
broker's office or housewives going in,'' Wellons said. ''What I find
appalling is that [foreign] investors knew this.''
But now, the near-breakdown of financial markets has created a
backlash from some Asian leaders threatening to reverse free-market
reforms put in place over a decade. ''The free market has failed and
failed disastrously,'' Malaysian Prime Minister Mahathir Mohamad said
last week when he announced capital controls.
Authorities in Hong Kong, departing from their trademark free-market
philosophy, recently used the city-state's ample foreign reserves to
intervene in markets and outfox speculators ravaging their dollar. The
government ''had to do something,'' said David Tsui, director of the US
office for Hong Kong's trade ministry, defending the moves. ''Once these
speculators have departed, we will move out of this in an orderly
fashion.''
As stock and currency markets shook, an earthquake rumbled under the
surface. Commercial banks in Europe, Japan and, to a lesser degree, in
the United States hold billions in bad loans to troubled Asian companies
and Russian enterprises. These loans are an even greater, if less visible,
threat than the plunging markets.
As banks stepped up their Asian lending during the early 1990s, they
were hailed as essential to the region's transformation to free markets.
Over the past year, it has become evident to international banking
specialists they repeated the mistake made in Latin America in the 1970s,
when US banks lent more than $200 billion to governments in the region.
The International Monetary Fund estimates, conservatively, that problem
loans in emerging Asian economies total $266 billion. Japanese banks,
according to some estimates, provided nearly one-third of the loans that
funded the business and building boom of its neighbors. Lending to
emerging Asian economies is a large chunk of the astounding $1 trillion in
bad loans piling up in Japan's banking system.
Banks were eager to make loans to Asia's emerging markets because
governments there encouraged it to fuel economic growth. In South
Korea, banks borrowed money from foreign banks and in turn lent to
domestic companies. Loans were not always wise. ''We now have steel
mills financed with 90-day loans,'' said White, of the Bank for
International Settlements.
Aside from magnitude, the Asian debt crisis differs from Latin America's
troubles in another significant way - which could slow its resolution. Latin
America's borrowers were primarily governments. A consortium of
banks and US government officials was formed to meet with Mexico,
Brazil, and Argentina to hammer out overarching repayment schedules
with each.
Asia's debt may be much more difficult to clean up, international
economists said, because it consists of millions of loans to private
enterprises or banks - making it impossible to reach an overall solution.
The plunge in currencies worsened a debt crisis already in the works in
Asian economies that were slowing down. When currencies fell,
companies could not repay US-dollar or yen-denominated loans in their
own countries' currency. Banks halted their lending, wreaking further
havoc on fragile markets.
South Korea, for example, had borrowed heavily from Western and
Japanese banks in the two years running up to its currency crisis. The
rapid pullout by international banks accelerated a plunge in the won late
last year.
The resolution of debt problems has been slow in South Korea - a
harbinger of what other countries face. The auction of Korea's
third-largest auto maker, Kia, collapsed last week amid bickering among
creditors, including Ford Motor and Hyundai, seeking to buy Kia.
''One of the lessons I take away from this is that developing
sophisticated markets takes time,'' said Donald Mathieson, chief of the
emerging markets research group at the IMF.
Russia's financial markets were the latest to demonstrate their inability to
withstand the international money invasion - and subsequent withdrawal.
High-interest government bonds, known as GKOs, were a magnet for
Russian banks seeking better returns than could be earned from
low-yielding US Treasury securities - GKO yields once topped 200
percent. Hedge funds and foreign banks from Europe, the United States,
and South Korea, followed them in and played the GKO market.
The short-term GKOs were ultimately a powerful destabilizing force in
Russian financial markets. As economic reforms stalled and the ruble slid,
political and financial instability spread. Desperate to do something, the
government, unable to repay the GKOs, simultaneously devalued its
currency and defaulted on $40 billion in ruble-denominated debt on Aug.
17. Financial institutions were left holding paper worth a fraction of what
they paid for it.
Evidence has grown of the intricate ties between the West's financial
giants and the players in Russia. Citicorp, which was hurt by Latin
America's woes in the 1980s, said last week it would lose about $200
million on customers who invested in Russia and were caught short when
the ruble fell.
For emerging economies, international economists and bank regulators
see one way out: a cleanup of the bad loans so that banks can again lend
money for business expansion.
But, said Nicholas Perna, chief economist for Fleet Financial Group Inc.,
it is unclear who will lead the effort, ''There's no organization like the Fed
or the [Federal Deposit Insurance Corp.] that can parachute in and
isolate the problem,'' Perna said. ''That's part of the problem.''
This story ran on page E01 of the Boston Globe on 09/06/98.
c Copyright 1998 Globe Newspaper Company.
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