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Strategies & Market Trends : India Coffee House -- Ignore unavailable to you. Want to Upgrade?

To: Mohan Marette who wrote (3083)	10/24/1998 12:14:00 PM
From: Mohan Marette	Respond to of 12475

The Tyranny of Orthodoxy Source:Far Eastern Economic Review. By Rajiv Lall October 29, 1998 The International Monetary Fund and U.S. Treasury would have us believe that their orthodox prescriptions for Thailand and Korea are working their magic. Their claim is that high interest rates were needed in each case to stop the flight of capital, and the subsequent run on the currency. Now that currency stabilization has been achieved, they suggest, rates can be cut and we can look forward to a relatively quick recovery. This is false propaganda. The reality is that the hike in interest rates did not stem the outflow of private capital. In both countries, exchange-rate stabilization has been achieved only by accumulating huge surpluses on the current account of the balance of payments. In effect, the programmes have bailed out foreign creditors by deploying official funds to facilitate the latter's exit, and have only built up foreign-exchange reserves by killing domestic economic activity and import demand. I would go further. Far from calming frayed nerves, the IMF's initial policy mix of tight monetary policy and tight fiscal policy actually accentuated the flight of foreign capital. The collapse of domestic demand has had a devastating impact on the cash flow of many previously healthy companies, driving an unnecessarily large number of smaller firms into bankruptcy. This, in turn, has deteriorated bank balance sheets, and has made foreign creditors even more reluctant to maintain their exposure to weakened domestic financial institutions. The resulting credit squeeze has inflicted gratuitous damage to the real economy and greatly complicated the process of recovery. If success for any adjustment programme is about minimizing output loss and equitable burden sharing, the orthodox efforts of Thailand and Korea have been dismal failures. But all that is history; the priority today is to reflate. Thailand and Korea cannot rely on external demand. They must kick-start domestic demand for which the orthodox prescription is fiscal expansion and interest rate cuts. But these measures will not suffice. While public spending may cushion the shock of the recession, it will not turn these economies around. Rate cuts may revive demand for credit to some extent, but they will not solve the problem of the stock of debt outstanding. Today, the breakdown in financial intermediation is a much larger problem than weak domestic demand. The fact is that even banks that have liquidity are not lending because their equity base is impaired. Given the general state of the economy, they have become extremely cautious with respect to new lending. To the extent that they do have loanable funds, banks prefer to invest in riskless assets or lend only to the bluest of the blue chips. All other companies are being abandoned. It is thus critical to get the banks to lend again. But this will not happen until the capital structures of both the banks and most of their clients are improved. Here again, Thailand and Korea have both been victim to the tyranny of orthodox thinking. Public ownership of banks is supposed to be bad, so both governments have been reluctant to commit public funds towards recapitalizing the banks. Moral hazard is bad and so the aim is to force debt resolution through U.S.-style corporate restructuring--sacking staff and selling assets, for instance--and bankruptcy. The reality--as both governments have been discovering--is that it is hard to raise private capital to fix the banks. What's more, neither country has the necessary legal and institutional infrastructure to make bankruptcy proceedings work in the near future. So what must be done? First, governments must take more aggressive steps to recapitalize the banks using public funds. We have already seen the creeping nationalization of Thai and Korean banks. The process should be accelerated and extended to all institutions that have little hope of attracting additional private capital. In each country though, there will be two or three core institutions that should be able to raise private capital, albeit not without some form of public assistance--in the form of loss sharing, for example. These institutions should be identified and assistance made available promptly. Second, governments should contemplate generalized debt relief for corporations aimed at improving the capacity of borrowers to repay the banks. Such relief could take the form of across-the-board coverage for exchange-rate losses and debt rescheduling at lower interest rates. Third, in addition to deficit spending and interest-rate cuts, corporations and consumers should get tax relief. Given the systemic nature of problems, socializing the bulk of losses through a combination of debt and tax relief and government-led recapitalization of the banks is not an inappropriate way of sharing the burden of adjustment. It penalizes the shareholders of imprudent banks, it does not let debtors entirely off the hook, and it provides the hope of containing unemployment. The orthodox prescription would only delay recovery and raise the eventual cost to the taxpayer. Rajiv Lall is the Hong Kong-based executive director of E.M. Warburg Pincus & Co., an investment firm.