Mexico Redux? Making Sense of the Financial Crisis of 1997-98
Grabel, Ilene, Journal of Economic Issues
Beginning in May 1997, financial crisis swept across Southeast Asia and extended to Brazil and Russia. These events are notable because the crisis took investors and International Monetary Fund (IMF)-World Bank officials completely by surprise, and especially because they occurred after the IMF had implemented what were heralded as important safeguards, embodied in the "Special Information Dissemination Standard," following the events in Mexico in 1994-95.
My paper is motivated by the parallels in the conventional wisdom on the causes of the current and the earlier Mexican crises. In the Mexican case, what I elsewhere termed the "Mexican exceptionalism thesis" contends that the crisis was largely an aberration stemming from the country's "peculiarities" (viz., economic mismanagement, corruption, and instability) [Grabel 1996a, 1996b]. An interesting feature of the current crisis is the ubiquitous claim of exceptionalism that is again being invoked by neoclassical economists to explain these events. In the Southeast Asian cases, much is being made of the seemingly newly discovered - yet deeply rooted - patterns of corruption, real estate speculation, and misguided government policies.
My paper presents arguments against the exceptionalist explanations of the current crisis. I argue that the current crisis is principally a result of the failed neoliberal policy regime that embraces the ideology of free capital flows. In efforts to attract private foreign capital flows and as a consequence of domestic and international political pressures,(1) governments in emerging economies have over the last decade pursued programs of internal and external financial liberalization.(2) Liberalization created incentives and opportunities for the private sector in Southeast Asia to rely excessively on hard-currency denominated foreign loans, while also opening the economy to speculative inflows of portfolio investment. In the absence of sufficient foreign exchange reserves and mechanisms to control foreign capital flows, the reliance on these two types of private capital flows rendered these economies vulnerable to the self-reinforcing cycle of investor exit, currency depreciation, and financial crisis. I refer to the vulnerability to exit and currency risk as the "problem of increased risk potential." Once this increased risk potential was realized and the crisis emerged, governments found that they were unable to implement non-neoliberal economic policies insofar as the IMF explicitly precluded these alternatives. I call this the problem of "constrained policy autonomy." Paradoxically, the pursuit of further liberalization and of continued financial opening has introduced problems of greater risk potential to these economies and has also induced serious recessions. In concluding the paper, I offer some thoughts on the types of preventative measures that policymakers in emerging economies should consider in order that history not repeat itself (again).
Stylized Facts of the Crisis of 1997-98
During the late 1980s, inward portfolio investment to Southeast Asian (and other emerging) economies increased dramatically because of the opportunities presented by financial liberalization. These portfolio investment inflows helped fuel the boom in speculative activities across the region. Private lending to and within Southeast Asia also grew dramatically during this period, as increased international financial integration (made possible by financial liberalization) gave domestic banks and borrowers access to hard-currency denominated loans. This high degree of leveraging of the private sector was also made possible by the region's real estate boom, which inflated collateral values.
By mid-1996, the region began to show outward signs of difficulty. The decline in property and hence collateral values posed problems for the domestic banking industry. Moreover, as the Japanese economy's difficulties deepened, Japanese foreign direct investment (FDI) and lending slowed. At the same time, the dollar's appreciation after 1995 undermined the region's export competitiveness since its currencies were pegged to the dollar. Once investors became bullish on the United States after 1996, portfolio investors turned their attentions away from emerging economies in general and Southeast Asia in particular.
Once the first signs of trouble emerged in Thailand in May 1997, investor skittishness intensified. Initial currency and stock sell-offs fueled predictions that the stock market slide would continue and that the government would devalue or abandon the currency peg. When governments and central banks abandoned the peg, investors panicked, thereby triggering further stock and currency declines, portfolio investor exit, and debt distress. The governments of the Philippines, South Korea, Indonesia, Thailand, and later Brazil and Russia approached the IMF for assistance. The precondition for assistance was the agreement that governments implement radical neoliberal reform. Note that neoliberal reforms have proven to be a tough sell in Indonesia and Russia, much to the IMF's disappointment. Both of these countries have paid a price for their independence in terms of the denial of some portions of their IMF disbursements and the continued exit of foreign investors.
What Went Wrong?
In the aftermath of the current crisis, a spurious "Asian exceptionalism" has emerged among neoclassical economists. Proponents of Asian exceptionalism assert that the crisis is an outcome of deeply rooted corruption and of the overregulation of the region's economies. But proponents of the corruption thesis have yet to explain how the corrupt ties that bound firms and governments throughout Southeast Asia led to crisis in 1997-98 while having led to high growth until that time. Moreover, if corruption and mismanagement were indeed widespread, why then were foreign investors and lenders (which neoclassical theory posits as rational) willing to commit vast resources to these economies for so long?
Some advocates of the corruption thesis argue that it was not the mere presence of corruption that caused the collapse, but rather it was the intensification of corruption that triggered the collapse. Granting this point, however, overlooks the policy choices that allowed corruption to intensify in some countries. In work on South Korea, for example, Ha-Joon Chang  has shown that corruption has in fact intensified because of the government's decision to curtail dramatically its regulation and coordination of the economy. Thus, to the extent that corruption has intensified, it is a consequence of the new liberalized climate, rather than being an outcome of overregulation.
Chang's argument regarding South Korea is also more generally applicable to the region. In the case of the region's economies, external and internal financial liberalization has created space not only for some types of corrupt activities, but also for the creation of bubble economies in which highly risky financial activities could flourish. Internal financial liberalization allowed domestic banks to become heavily involved in foreign operations and enabled them to engage in riskier domestic lending activities. In the broader context of the speculative booms throughout the region, higher rates of leveraging by the private sector became the norm. And while the region's economies have been characterized by high degrees of leveraging, during most of their high-growth periods, these leveraging rates became problematic in the new economic and regulatory context and in the context of global economic changes. Highly leveraged operations became problematic when it became difficult and expensive to rollover short-term foreign loans, particularly after January 1997 when U.S. banks and later foreign banks began to turn away from the region, when dramatic currency realignments set in after 1995, when governments stopped controlling firms' access to capital and coordinating their investments, and when the region's economies began to experience slower growth.
Exceptionalism (regarding corruption, tax evasion, crime, and non-payment of wages) is similarly problematic as a primary explanation of the recent investor exit from Russia. Given that these problems have been clearly apparent since the collapse of communism, one cannot invoke their discovery now to account for a sudden investor exit from the stock and government bond markets. The same is true in the case of Brazil, a favorite of international investors since the early 1990s, despite its clearly overvalued currency. It seems far more reasonable to attribute the recent exits from Russia and Brazil not to their exceptional features, but to a general emerging market contagion made possible by the policies of financial openness that these countries created via external financial liberalization. Let us now consider the manner in which the general arguments regarding the problems of constrained policy autonomy and increased risk potential are relevant to the current crisis. Prior to the current crisis, countries in Southeast Asia were not compelled to implement neoliberal policies in order to attract private capital flows. Given the status of the Southeast Asian economies, these governments did not risk repelling private capital by pursuing distinctly non-neoliberal strategies. Thus, there was no "ex-ante constraint" on policy autonomy. In countries such as Russia, Brazil, and Mexico, on the other hand, where investor pessimism or disinterest had to be overcome, the credibility of the government's commitment to neoliberal policy was critical to the attraction of private capital flows. For this reason, in countries that require "rehabilitation" in the eyes of investors, the range of macroeconomic policies is constrained by the overriding objective of attracting private capital flows.
The evidence on constrained policy autonomy following the crisis (what I term the "ex-post constraint on policy autonomy") is strong in the cases of all the countries involved in the current crisis (and Mexico following its crisis). Following the emergence of the crisis in each country, governments and central banks were compelled by the IMF to implement (or intensify in the case of Brazil) contractionary macroeconomic policies that would aggravate the consequences of the crisis for the majority of the population and lead to higher rates of loan defaults, bank distress, and a reduction in economic activity.(3)
Increased risk potential is also a feature of the current crisis. Prior to the crisis, the vast inflows of portfolio investment and the availability of relatively inexpensive hard-currency denominated loans obviously provided governments and the private sector with resources to which they otherwise might not have had access. However, the liquidity of this portfolio investment ensured that markets could be destabilized quickly once currencies and stock prices started to come under pressure. By relying on foreign loans (especially those that were short-term and repayable in hard currency), the private sector in Southeast Asia and the public sector in Brazil, Russia, and Mexico introduced increased risk to their economies. Once conventional wisdom grew pessimistic, these economies were rendered vulnerable to the costs of currency depreciations and lender/bondholder herding.
Economic openness also introduced increased risk into the economies involved in the current crisis. When U.S. interest rates rose in February 1995, investors began to exit Mexico during that country's crisis. The same dynamic obtained in the current crisis when economic circumstances changed in the United States and Japan in 1996-97. Insofar as the bailouts stipulate greater financial openness on the part of afflicted economies, these economies are rendered more vulnerable to the risk of being destabilized by changes in external conditions or by a cycle of investor and lender flight followed by currency depreciation and financial crisis. Financial openness also increases the likelihood of a cross-border contagion. Given that during panics investors and lenders come to see emerging economies in an undifferentiated fashion - the "guilt by association" of the tequila effect or the Asian flu - cross-border contagion among emerging economies becomes inevitable.
Preventing a Repeat of Recent History (Again)
Capital controls deserve serious consideration, as James Crotty and Gerald Epstein have argued [1996, 1999]. Capital controls can augment other government initiatives to secure sustained, stable economic development, rather than the speculative profits associated with unregulated portfolio investment flows. Capital controls reduce the ability of investors to flee whenever a government pursues a policy of which they disapprove; in this sense, controls augment policy autonomy and state capacity. More germane to the discussion here, they also reduce macroeconomic instability by damping flows.
One type of capital control that represents an extremely promising direction for policy is that employed today in Chile and Colombia (often referred to as the "Chilean model"). This model balances the need for capital with the need to protect the economy from instability. In Colombia, foreign investors are free to engage in (less liquid) direct investment but are precluded from purchasing debt instruments and corporate equity. As a consequence, foreign capital is much less able to flee Colombia en masse. In Chile, foreign investors may engage in portfolio investment, but they must keep their cash in the country for at least one year. To the surprise of many neoclassical economists, Chile has not only succeeded in securing large portfolio investment inflows, but has also remained largely unaffected by the Asian flu.
The Chilean model also offers lessons on discouraging the kinds of private sector borrowing that contributed significantly to the current crisis. Up until a few months ago, the Chilean government tried to discourage borrowers from taking on short-term foreign loans by imposing a reserve requirement tax on loans with a maturity of less than one year. Borrowers who took on such loans were required to deposit 30 percent of their loan proceeds in a non-interest bearing account for a number of months. This measure proved beneficial to Chile in terms of reducing the risk potential of foreign borrowing, and it deserves wide consideration elsewhere. It is disappointing to note that the Central Bank in October 1998 reduced the reserve requirement tax from 30 percent to zero percent (though the authority to restore the tax has been retained). The decision to reduce the tax was made because the country experienced a drastic reduction in private capital inflows following events in Asia and in order to accede to the complaints of the Chilean business community. The fact that the Chilean government has sought to weaken its controls precisely at the time they are needed most is obviously a poor decision and is one that demonstrates George DeMartino's  point regarding the difficulties of one country pursuing an independent path in a neoliberal world.
Finally, it would also be advisable for governments in emerging economies to consider designing measures that might indicate (to them and to investors) whether they are vulnerable to a crisis triggered by investor exit or a currency collapse. Let me suggest three such indicators that might serve as "ex-ante circuit breakers"; these circuit breakers would be tripped when a country faces high levels of risk of currency depreciation and investor/lender flight. As a country approached the danger range, measures might be put in place to curb imports, slow the pace of foreign borrowing, slow the entry and exit of portfolio investment, or limit the fluctuation of the domestic currency. There would have to be, say, three sets of thresholds for these indicators - for emerging economies at the lowest, medium, and highest levels of development.
Two indicators of currency risk might be given by the ratio of official reserves to total short-term external obligations (the sum of accumulated foreign portfolio investment and short-term hard-currency foreign borrowing) and the ratio of official reserves to the current account deficit. A simple indicator of vulnerability to a lender withdrawal would be the ratio of official reserves to private and public foreign-currency denominated debt (with short-term obligations receiving greater weighting in the calculation). The vulnerability to portfolio investor exit could be measured by the ratio of total accumulated foreign portfolio investment to gross domestic capital formation. If a large proportion of domestic capital formation were financed by inward portfolio investment, this would provide an indication of the country's vulnerability to a reversal of those flows and its excessive reliance on a particularly liquid type of capital flow. As a country approached the danger range, new capital inflows would have to "wait at the gate" until domestic capital formation increased by a certain level. These indices are preliminary in nature; I plan to engage in further research on them in the future.
1. For example, the South Korean government of President Kim Young Sam pursued liberalization (especially regarding the capital account) in order to gain entrance to the Organization for Economic Cooperation and Development (OECD). These efforts proved successful; South Korea was admitted to the OECD in 1996.
2. There are many heterodox analyses of the causes of the current crisis; see, for example, the work of Burkett and Hart-Lansberg , Chang , Crotty , Dymski , Grabel , and Wade and Veneroso .
3. Two caveats should be noted here. First, the power of the IMF to dictate policy is not absolute as the Russian and the Indonesian cases make clear. But resistance to the IMF can be costly, as noted above. Second, crisis not only empowers external actors like the IMF and the United States to push for neoliberal reforms, it also empowers those interest groups that have long pushed for neoliberal reform. Backed by IMF sanctions, neoliberals are sometimes able to take advantage of the crisis to push for reforms that were not politically possible in earlier periods.
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Chang, Ha-Joon. "Korea: The Misunderstood Crisis." World Development 26, no. 8 (1998): 1555-61.
Crotty, James. "The Korean Crisis." Mimeo. Department of Economics, University of Massachusetts, Amherst, 1998.
Crotty, James, and Gerald Epstein. "In Defence of Capital Controls." In Are There Alternatives? Socialist Register 1996, edited by Leo Panitch, 118-49. London: Merlin Press, 1996.
-----. "A Defense of Capital Controls in Light of the Asian Financial Crisis." Paper presented at the annual meeting of the Association for Evolutionary Economics, January 3-5, 1999.
DeMartino, George. "Global Neoliberalism, Policy Autonomy, and International Competitive Dynamics." Paper presented at the annual meeting of the Association for Evolutionary Economics, January 3-5, 1999.
Dymski, Gary. "A Spatialized Minsky Approach to Asset Bubbles and Financial Crisis." Mimeo. Department of Economics, University of California-Riverside, 1998. Grabel, Ilene. 'Marketing the Third World: The Contradictions of Portfolio Investment in the Global Economy." World Development 24, no. 11 (1996a): 1761-76.
-----. "Stock Markets, Rentier Interest, and the Current Mexican Crisis." Journal of Economic Issues 30, no. 2 (1996b): 443-49.
-----. "Rejecting Exceptionalism: Reinterpreting the Asian Financial Crises." In Global Instability and World Economic Governance, edited by Jonathan Michie and John Grieve Smith, 37-67. London: Routledge Press, 1999.
Wade, Robert, and Frank Veneroso. "The Asian Crisis: The High Debt Model Versus the Wall Street-Treasury-IMF Complex." New Left Review (1998): 3-23.
Ilene Grabel is Visiting Postdoctoral Fellow, Kellogg Institute for International Studies, University of Notre Dame, and Associate Professor of International Finance, Graduate School of International Studies. University of Denver. The author wishes to thank the Kellogg Institute for its support of her research on the Asian financial crisis. This research has benefited from the reactions of participants at the session on "International Financial Crises" at the AFEE 1999 conference, the Kellogg Institute for International Studies, and at the conference on "Global Instability and World Economic Governance," Cambridge University, May 13, 1998. I also thank Paul Burkett, James Crotty, and George DeMartino for their immensely helpful reactions to related work. This paper was presented at the annual meeting of the Association for Evolutionary Economics. New York City, New York, January 3-5, 1999.…