There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction – John Maynard Keynes
New York City, 22 September 1985. At the invitation of US Secretary of Treasury James Baker the Finance Minister of 5 economic super powers gathered together in the Plaza Hotel, Manhattan. The attendants of the meeting were Gerhard Stoltenberg of West Germany, Pierre Bérégovoy of France, Nigel Lawson of Britain, Noboru Takeshita of Japan and James Baker himself of United States. These men were gathered by Baker on this day with the objective of reaching an agreement to simultaneously push down the value of the US dollar against their respective currencies, particularly against the Japanese yen.
At that time Paul Volcker’s high interest rates had created an overvalued dollar that eroded US exports and consequently switched their trade balance from a surplus of $7 billion in 1981 to a deficit of $212 billion by 1985, mainly with Japan at the other end of the trade. Moreover, thanks to Ronald Reagan’s great financial deregulation, which was overseen by Milton Friedman, in the same period the federal government deficit also increased from $74 billion to $212 billion, a deficit that were only sustained by the willingness of the Japanese to put their surpluses in US Treasury Bond.
By then, Japan had risen to be the 2nd largest economy in the world, with the share of world trade up to more than 10%, which resulted to burgeoning trade surpluses and capital exports comparable with Britain in the 19th century. Income per capita was in the course of exceeding the US levels, its banks were the largest in the world in terms of both assets and market value, while Japan’s industrial companies dominated the world’s consumer electronics and other technology-focused industries.
This economic success story was the result of the adaptation of some form of Friedrich List’s economic theories, with decades of guarded financial sector by the ministry of finance, which ensured that cheap loans were channelled from the citizens’ thrifty savings to its highly leveraged corporations. Imports were restricted by a variety of measures by the Ministry of International Trade and Industry (MITI), while the government also implemented a fiscal policy that maintains a stable currency exchange rate that produces a continuous devaluation of the yen, thus making Japanese exports cheap especially compared with the US.
As they gain enormously from the trade with the US, the Japanese reinvested their trade surpluses to US financial instruments such as Treasury Notes and also began to invest their trade surpluses in other US assets, most famously by buying the icons of American capitalism such as New York’s Rockefeller Center and Hollywood’s Columbia pictures. But perhaps the most bizarre of all was Mitsui Corporation’s acquisition of the Exxon Building in Manhattan for a record price of $610 million, or $260 million above Exxon’s asking price so that Mitsui’s president can see his name in the Guinness Book of World Records.
But as Japan’s most important export market the US had a leverage towards Japan and was able to pressure them into changing their fiscal and monetary policy in order to increase yen’s value against the US dollar. This pressure was conducted in the midst of a growing resentment in the US for the “Japanese invasion” where angry auto-workers in Detroit destroyed Japanese cars in protest against their cheaper imports. There was also an accusation of dumping practices where manufactured goods sold in the US were cheaper than their price in Japan, while the New York Times warned that “today, forty years after the end of World War II, the Japanese are on the move again in one of history’s most brilliant commercial offensives, as they go about dismantling American industry.”
The culminating result of this pressure was the meeting on 22 September 1985 in Plaza hotel Manhattan, which eventually gave birth to the Plaza Accord, an agreement by the 5 finance ministers to simultaneously devalue the US dollar against their respective currencies.
Fast forward to 8 January 1998. In the heat of the Asian market crash Indonesians across the nation were panically clearing store shelves and gathering any food supply that they can find, in a fear of food shortages due to the continuous currency collapse. Up to then approximately $150 billion had fled the country, mostly to neighbouring Singapore, with rupiah plummeted close to Rp.10,000/dollar compared with around Rp.2,400/dollar just 7 months earlier. Demonstrations and riots were starting to take place (a rarity in President Soeharto’s dictatorship) with Human Rights Watch Asia reported that in the first 5 weeks of 1998 price riots, bomb threats and over two dozen demonstrations took place in the island of Java and quickly spread to other islands.
Meanwhile, the banking sector’s Non Performing Loans (NPL) had risen to 48.6%, and thus effectively triggered a domino effect from what began as a currency crisis in 1997 into a banking crisis and eventually to a fully-fledged economic crisis. By 1998 inflation soared to 77.6% and as the country that got hit the hardest Indonesia’s GDP fell by -13.1%, followed by second worse hit Thailand by -10.8% and third worse South Korea -6.7%.
Unemployment rate increased tenfold in Indonesia with poverty doubled, while unemployment increased threefold in Thailand and fourfold in South Korea, where urban poverty in South Korea almost tripled with nearly a quarter of the population falling into poverty. In addition, as the crisis created more victims and as governmental power weakened, in a manner similar with the rise of fascism in 1930s Europe, the rise of radical Islamic sects (back from fighting the Soviet Union in Afghanistan alongside CIA-sponsored Al Qaeda) and separatist movements also intensified in several South East Asian countries.
Just like Latin America in the 1980s, as the crisis worsened international credit dried-up for the battered region, and the governments were then forced to use their currency reserves to pay for imports, service their debt and cover losses in the private sector; adding a huge pressure to the economic instability. Understandably, the market responded with more panic, and thus in just 1 year $600 billion had disappeared from their stock exchanges, wealth that had taken decades to built.
The implementation of the Plaza Accord in 1985 did not directly cause the Asian market crash 1997. However, it did mark the end of the era of undervalued yen and mark the beginning of a rapid fundamental shift in the Japanese economy, which created a butterfly effect that would eventually lead South East Asia towards this catastrophic direction.
On the other side of the coin, a much bigger fundamental shift was occurring in the mid 1980s that created another string of butterfly effect that would lead to the Asian market crash. Intended to fight the stagflation effect from the Petrodollar Recycling in the late 1970s, the very high interest rates imposed by Paul Volcker to defend the dollar has subsequently caused the Third World Debt Crisis, where the World Bank estimated that between 1980 and 1986 repayment of dollar-denominated foreign debts for a group of 109 debtor countries bloated from $430 before the US interest rate hikes, to $658 billion with repayment of principal of $332 billion and interest payment alone of $326 billion.
As an effect, according to a study by Hans K. Rasmussen of Danish UNICEF, a massive transfer of wealth occurred in the early 1980s from the Third World countries primarily to the US. And for a lot of these countries that were unable to pay the bloated debts, they were forced to give away their sovereign control over their own economy in return for an “economic assistance” by the IMF and World Bank.
Moreover, the 1980s also witnessed the deteriorating economies in the member states of the Soviet Union – the root cause of revolutions that began in Poland in 1989 and eventually ended with the dissolvement of the Soviet Union by Mikhail Gorbachev in his speech on 25 December 1991. The end of Cold War completed the holy trinity for ‘Dollar Hegemony’, following the collapse of the Gold Standard and the creation of the Petrodollar system.
Subsequently, with Chicago School ideology fully installed in the Reagan administration and with IMF and World Bank controlled by the Washington Consensus, global-scale deregulations soon followed, with indebted countries and former communist states then converted to free-market capitalism and subscribed to US dollar as their reserve currency. As a result, the world economy and the entire global financial market system became heavily dependent on US dollar, and not surprisingly currency peg against the dollar then became the norm for a lot of currencies around the world. This made the US dollar the engine of the domination of the American Empire, and it gave the Fed chairman a tremendous power over the world economy, as the chairman controls the flow of the dollar.
Not missing from this trend were the currencies of South East Asian countries, which also pegged to the US dollar since their deregulation in the 1980s. With the implementation of the Plaza Accord the value of the pegged South East Asian currencies weakened alongside the dollar, and thus enhancing their export competitiveness. Not surprisingly, in the late 1980s and early 1990s this model looked strong and worked really well for the South East Asian economies, as stable dollar and cheap exports created some of the best economic growths in the world.
However, the boom of the 1980s in the US was about to end in a spectacular fashion, while the single Euro currency plan looked set to be implemented, at about the same time few politically-connected Asian Godfathers became increasingly powerful and wealthy in South East Asia. But before these events come to surface, the implementation of the Plaza Accord in 1985 first created a new trend in Japan.
The great Japanese Bubble
The Japanese called it Zaitech. It is a practice of financial engineering that was born since December 1980 when Japanese companies were allowed to account their investment with whichever higher between the book value or the market price, thus can easily hide their losses and forge their profits. The practice started to become a growing trend in Japan after their deregulation in 1984, when the ministry of finance permitted Japanese companies to operate special accounts for their shareholdings, known as Tokkin accounts, which allowed these companies to trade securities without paying tax on capital gains. Brokerage houses were also allowed (more precisely the government turned a blind eye) to set up services to manage special speculative accounts for companies, known as Eigyo Tokkin, where these brokerages offered a guaranteed of minimum return above the current rate of interest.
But it was not until 1985, immediately after the agreement at the Plaza Accord began to be implemented, when Zaitech practices began to widespread as a new trend. As agreed in the Plaza Accord, central banks committed over $10 billion to a dollar devaluation that would be implemented over several years period. The result was apparent, from 1985 to 1988 the dollar declined 20% against the German mark, 40% against the French franc and 50% against the Japanese yen, with yen strengthened from a high of ¥259 to under ¥150/USD, causing the purchasing power of the Japanese currency to increase and thus sparked the great Japanese shopping spree, from Louis Vuitton handbags to Van Gogh paintings.
The strengthening of the yen, however, also practically erased Japanese’s competitive edge in trading. And in response for the appreciating yen Japanese exporting companies began to compensate their declining profits and currency losses in sales by turning to Zaitech practices and speculation. The result was immediately transparent. Within the space of 3 years after the Plaza Accord the stocks in the Nikkei index in Tokyo rose by 300%, with nominal value of all the stocks listed in the exchange accounted for more than 42% of the world’s stock values. And within that period of time, the amount of capital invested in Tokkin funds grew from just under ¥9 trillion in 1985 to over ¥40 trillion ($300 billion) in 1989, at the height of the bubble. Total corporate gains from the Tokkin investment also increased from ¥240 billion in 1985 to ¥952 billion within just two years’ time.
Perhaps the most interesting part was during the same period ordinary operating profits from these corporations actually declined, but they compensated the decline by profiting from their Zaitech and speculative practices. In fact in some cases, the speculative activities became the main activity of their business. For example, a steel company named Hanwa raised over ¥4 trillion in the late 1980s from Zaitech, with their gains from speculative activities exceeded their profits from core business by 20 times.
While triggered by the Plaza Accord, this speculative environment was then further enhanced by the Bank of Japan, which during 1986 reduced interest rates in 4 occasions down to 3%, in order to stimulate the economy after the economic growth slipped below 2.5% due to the strengthening of yen, which made Japanese goods in international market became twice as expensive. However, as the price of imported goods became cheaper due to strong yen and since the price of oil was falling, the resulting fast monetary growth from the rate cut did not feed into consumer price inflation, but instead they fuel the rise of stock prices and most crucially land prices.
Indeed, despite the rising trend of stock market prices, according to Edward Chancellor in his brilliant book Devil Take the Hindmost the engine of the Japanese bubble was actually its property bubble. The Japanese government has a history of discouraging the sale of land and intentionally creates an illiquid property market, which actually stimulated land speculation. As an effect, land prices in Japan rose by 5000% between 1956 and 1986, with land prices only experienced a decline in 1974 alone, while consumer prices merely doubled. Therefore, understandably, acting on the belief that land prices could never fall Japanese banks had the tendency to provide loans with the collateral of land, instead of cash flows, making the rising value of land became the engine for credit creation for the entire Japanese economy.
In December 1987 representatives from the world’s central banks gathered in Basel, Switzerland, at a Bank for International Settlements meeting, to set new international standards for banking capital. Before this, Japanese banks had traditionally operated with a lower capital adequacy ratio compared with their foreign counterparts, since they were protected by the Ministry of Finance. However, foreign bankers complained about this unfair competitive advantage in global banking, and they demanded the Japanese banks to conform to the conventional level of banking capital, by raising their capital ratio to 8% by the spring of 1993.
However, an important concession was secured by the Japanese representatives at Basel. Under the cross-holding ownership system in Japan (the Keiretsu system), 45% of the unrealised gains on their share ownership on other companies could count for up to half of the required capital reserves. In other words, the banks’ ability to create credit became linked to the share price level in the Tokyo Stock Exchange, and thus indirectly to property prices, as the higher the stock prices the more inflated their capital and the more credit that the banks can lend, which were increasingly valued against property assets as collateral.
This was apparent towards the end of the 1980s, when lending activities against land and property increased, especially among the smaller companies. Total bank lending increased by ¥96 trillion between 1985 and March 1990, half of which went to small businesses that invested heavily in the property sector. The loosely-regulated consumer credit companies also increased property loans from ¥11 trillion in 1985 to ¥80 trillion by the end of 1989. On several occasions loans were provided for up to twice the collateral value of the property, while as the bubble heightened multi-generation hundred-years mortgages were issued to those who cannot afford to buy even a small apartment in central Tokyo.
Within this context, property values rose in tandem with the increase of stock market values, with Tokyo stock prices rose by around 40% annually and Tokyo real estate prices ballooned by 90% in some cases, reaching an astonishing heights that valued Tokyo real estate greater than that of the entire US real estate, with the grounds of Imperial Palace in Tokyo once valued to be worth more than the entire real estate value of Canada.
By 1988, the 10 largest banks in the world were all Japanese banks. And Japanese share prices increased 3 times faster than their corporate earnings (even after including the profits from Zaitech practices), with the Tokyo stock exchange flaunted some of the most overvalued share prices in history: services companies sold at an average of 112x earnings, textile sector at 103x, marine transportation at 176x, fishery and forestry at 319x, and even Japan Air Lines which in the process of privatisation was trading as over 400x annual earnings.
Moreover, the Japanese economic bubble was not only limited to Japan, as another new trend was increasingly spread to its South East Asian neighbours, namely globalisation. Due to growing trade friction with the US in the late 1980s and the steep rise in the value of yen thanks to the Plaza Accord, many Japanese exporting companies began to shift their production overseas, in the form of Foreign Direct Investment to their South East Asian neighbours, or as what to be known as the ‘yen bloc countries.’
This creation of international division of labour, with Japan as the central figure, was made in the midst of the end of the Cold War and during the time of the accelerating spread of globalisation. Trade volume for both exports and imports then increased between Japan and South East Asia, with Japanese companies export machinery and components to production facilities in South East Asia, and in return they import the finished goods back to Japan.
Hence, as the Japanese economy undergone a massive bubble the effect also spilled to South East Asia, as demand from Japan for finished goods kept on rising, helping to create what to be known as the Asian Tigers.
The protectionist roots
South East Asia has always been a strategically important part of the world trading system since the ancient times. Rich with wide range of commodities, it attracted many merchants and travellers into the region from Chinese, Indian and Arab merchants to European explorers such as Ferdinand Magellan, Marco Polo, and Christopher Columbus who accidentally landed in America while aiming to reach the Indies to pursue the supply of spices like nutmeg, pepper, cloves and ginger. First the Portuguese arrived, followed by the Spanish, the Dutch, the British and finally the French. Before long, European presence in South East Asia evolved into annexation of territories with the Dutch controlled the East Indies, the British controlled Malaya and Hong Kong, the French controlled the Indochina region and Spanish and US controlled the Philippines, leaving Thailand as the only country not colonised by the West.
By the late 1950s and 1960s most South East Asian countries had gained independence, and began to construct their economy that focuses on agriculture with an economic policy broadly known as Import Substitution Industrialisation (ISI). ISI is an economic model largely based on the thinking of 19th century German economist Friedrich List, which focuses on self-sufficiency through nationalisation, subsidising vital industries, increased taxation, micro-management of the supply of foreign exchange and highly protectionist trade policies that include high import tariff barrier.
ISI was a reasonable response to the end of colonialism. During the occupation, the colonial powers had structured these countries’ economy to heavily dependent on the export of low-value-added commodities to the ruling power, while in return they were forced to import a huge flow of finished manufactured goods back from the ruler at a higher price. In addition, tariff barriers were set very low, thus killing any chance for local industries to thrive, thus as a result these countries were forever stuck with exporting raw materials in order to pay for their expensive imported goods. Hence, for these newly-independent nations the adoption of ISI was arguably the best way to break out from the Mercantilism colonial model, through protecting their economies to nurture their “infant industries.”
The very term “infant industry” was first coined by the first US Secretary of Treasury Alexander Hamilton. On 5 December 1791 Hamilton submitted a report to the US congress about their new country’s manufactures, and proposed a program to stimulate the economy through developing its industries. The ideas of the report were principally rooted in the economic theories implemented by Queen Elizabeth I of England and by France’s Finance minister Jean-Baptiste Colbert (under the rule of King Louis XIV), and core to his ideas was the importance to protect the country’s “industries in their infancy” from foreign competition, in a then-backward country like the US, and nurture them until they could stand on their own feet. This made Hamilton the father of “infant industry” thinking that would later be further developed by Friedrich List, which was often mistaken as its originator.
In the report Hamilton, of the Federalist party, proposed several measures to protect the infant industries by using the likes of protective tariffs, government subsidies, import bans, export ban on vital raw materials, import liberalisation of industrial input and tariff rebates for it, prizes and patent rights for invention, regulation for product standards, development of transportation infrastructure and as briefly mentioned in part 1, financial infrastructure in a form of a national bank (in other words, all of the things that the contemporary Washington Consensus condemn. If Hamilton is a finance minister of a developing country today the IMF and World Bank would have denied any fund to his country and would be lobbying for him to be removed).
By implementing high tariffs, the US were acting against the advice of mainstream economists of the era such as Jean Baptiste Say and Adam Smith, and was constantly pressured by Britain to adopt free trade policies, with Adam Smith – whose book The Wealth of Nations appeared during the American Revolution in 1776 – commented that the US would make a big mistake if it protected its industry. However, in a different section of the book Adam Smith contradicted himself by declaring that only nations that have a manufacturing industry could ever win a war. Hamilton had read Wealth of Nations, and he based the industrial and commercial policy of the US with Smith’s declaration in mind, but leave out his theoretical claim about free trade.
The protectionist plan was also opposed internally, however, by populist Thomas Jefferson and James Madison, of the Democratic-Republican party, on the ground that it would lead to corruption (especially in the area of government subsidy) and would play favour to the industrialist North over the agrarian South. This would be the persistence problem for the economic policy of the US until the inevitable outbreak of the Civil War between the North vs. South. To put things in perspective, the US politics at the time were dominated by southern plantation owners that wanted to use the proceeds they earned from exporting agricultural products to import higher-quality European products at the cheapest possible price. Hence tariffs and nurturing an infant industry was not at their best interest. However both opposing sides did agree that manufacturing independence was vital for the country, but they strongly disagreed on how to obtain it.
After a lengthy debate, the average tariff on imported manufactured goods was indeed raised but only from around 5% to around 12.5%, which wasn’t high enough to support the infant industries and was only raised to generate income for the government. Hamilton resigned as the Secretary of Treasury in 1795 following a scandal on his extra-marital affair with a married woman, and in 1804 he died at the age of 50 in a pistol duel in New York, without seeing his proposal adopted in full. Had he lived for another decade he would have witnessed his ideas being fully implemented.
According to Cambridge economist Ha-Joon Chang, whom specialises on tariff and trade policies, in his book Bad Samaritans, when the war against Britain broke out in 1812 US Congress immediately raised the tariffs from the average of 12.5% up to 25%, interrupting the imports from Britain and Europe, and thus allowing the space for new local industries to emerge. Thanks to the pressure from this new group of industrialists, the tariff protection was further raised long after the war, notably after the Tariff of 1816 passed by Congress, to 35% by 1816 and up to 40% by 1820, reaching the protection level planned by Hamilton.
This irritated the South, and the North vs South tension was further escalated when the Tariff of 1828 was passed, which enhanced the protection for the industries in the North but at the expense of the agrarian South, in a form of higher import cost for goods they did not produce and affect the profitability of the British exporters, which in turn less able to import cottons from the South.
By the 1860s, 30-odd years after the Second Bank’s charter expired, the tariffs were very high that it successfully created an environment that nurtures American infant industries, and became the main reason for the period of prosperity that groom the likes of Thomas Alva Edison, Alexander Graham Bell, The Wright Brothers and Henry Ford; despite having no central bank at all. Key to this innovative period was the “American System” program created by Whig Party Senator Henry Clay – the speaker of the House 1811-1820 and 1823-25 and the ally of US Second Bank’s president Nicholas Biddle – whom heavily incorporated Alexander Hamilton’s protectionist ideas that was perfected by Friedrich List.
This led to the broke out of the Civil War. Ha-Joon Chang remarked in Kicking Away the Ladder that the Civil War, though it was fought on the issue of slavery, was arguably more intensely fought on the ground of tariff, as Abraham Lincoln was a protectionist president who adopted Henry Clay’s “American System” by raising tariffs to the highest level at the time in US history immediately after he got elected. Indeed, the South actually had more to fear and more to lose in the tariff issues than in abolishment of slavery, with slaves merely only functioned as the plantation workers while tariff could cause more direct impact to their exports. With this in mind, Chang concluded, the emancipation of the slaves in 1862 was arguably more of a strategic move to win the Civil War, rather than out of a moral conviction.
The industrialist North eventually won the Civil War, and the tariffs remained high at 40-50%, the highest in the world, until the World War I broke out in 1913. This high tariff environment was the context that prompted economic historian Paul Bairoch to describe the US as “the mother country and bastion of modern protectionism.”
Moreover, despite their constant pressure towards the US to adapt free-trade policies, Britain was enjoying a period of economic prosperity ironically also thanks to the protectionist policies, which was installed in the late 15th century and early 16th century by Henry VII. From the 1st Tudor monarch Henry VII until the last under the House of Tudor Elizabeth I, Britain implemented protectionism subsidies, government-sponsored industrial espionage, distribution of monopoly rights, and other interventionist means to nurture and develop their woollen manufacturing industry – Europe’s high-tech industry at the time.
Before the Tudor’s rule, Europe’s textile manufacturing industry was centred in Bruges, Ghent and Ypres, in the Low Countries (present-day Netherlands and Belgium), with Britain relying only on their exports of raw wool to finance their imports. But then Henry VII came to power after seizing the King of England crown from Richard III at the battle of Bosworth Field, and he began to implement a form of ISI in 1489. At first King Henry VII increased the tax on export of raw wool, he even banned the export of unfinished cloth for coarse pieces above certain market value, to encourage domestic wool processing industry in substitute for just exporting the raw material. He then also sent royal missions to identify locations suitable for woollen manufacturing in the country as well as recruited skilled workers from the Low Countries.
However, at first his protectionist and interventionist policies were not successfully implemented as when the export duties were first raised it became immediately clear that Britain did not have the proper capacity and sufficient equipment to process all the raw materials into cloth, and their textile industry was not yet established or was not matured enough to handle the volume of wool to be processed. This was a major lesson learned, a sober reminder that protectionism – just like liberalisation, austerity and privatisation – if implemented too early when the economic infrastructure is not ready, could cause disastrous consequences.
It was not until 1578, during Elizabeth I’s reign (1558-1603), that the British textile industry finally had sufficient processing capacity and had become mature enough to be able to cope with a ban on raw wool exports. Once the export ban was in place, it drove competing manufacturers in the Low Countries, who became deprived of wool raw materials from Britain, to ruin. Textile manufacturing then became Britain’s top exporting industry, and it provided the majority of the export earnings to finance a large quantity of import of food and raw materials that fed the Industrial Revolution.
Indeed, by implementing ISI Henry VII and his successors in the House of Tudor had transformed Britain from a relatively poor country into the wealthy Britain which would become the British Empire. By 1860 Britain produced 20% of world’s manufacturing output, and in 1870 it accounted for 46% of world trade in manufactured goods (For a comparison, China as at 2007 produces only around 17% of world manufacturing output, even though everything seems to be made in China). It was only then – 84 years since the publication of Wealth of Nations, after British industries had become mature, and when Britain was at their economic prime – that Britain finally implemented free trade policies.
Britain had long preached free trade and tried to force it to the world, in the same manner as the Washington Consensus are presently doing, even way before themselves implement it. But once they finally implement free trade, more pressurr was given to the world and especially to the US to adopt free trade policies, in which Ulysses Grant – a Civil War hero and US President in 1868-1876 – famously remarked that “within 200 years, when America has gotten out of protection all that it can offer, it too will adopt free trade.” The US did finally adopt free trade after World War II, but they did so after US’ industries were already matured (analogically speaking, as if the industries are already a grown man with a college degree, and no longer a fragile baby needed nurture and care from his parents) and its supremacy was unchallenged.
However, Ha-Joon Chang remarks “the US has never practised free trade to the same degree as Britain did during its free trade period (1860 to 1932), [as] it has never had a zero-tariff regime like Britain.” Moreover, despite lowering its tariffs the US government still uses non-tariff protectionist measures, namely R&D subsidy. Between 1950s and mid-1990s US federal government funding for R&D accounted for 50-70%, way above the average 20% implemented by “big government” countries like Korea and Japan, ensuring US’ technological lead in key industries such as life sciences, aerospace, semiconductors, computers and the internet.
Nevertheless, despite still using protectionism, just like Britain in 1860s the US then began to preach about free trade and forced it to the world, for their trade benefit, only this time they did so ever successfully through the Washington Consensus and the Dollar Hegemony.
At the end of World War II, South East Asian countries such as Indonesia and Thailand, and East Asian countries like South Korea and Taiwan were similarly poor. But today South Korea and Taiwan have a GDP per capita of around $20,000 while Indonesia and Thailand report GDP per capita of only $3000 and $5000 respectively. This huge wealth gap, according to Joe Studwell in his book How Asia Works, is determined by the consistent set of interventions implemented by the governments.
In the book, Studwell highlighted that there are 3 critical intervention stages that governments can implement to speed up economic development: 1. To maximise economic output from agriculture, which employs a vast majority of people in poor countries 2. To direct entrepreneurs and investments towards manufacturing, which make the most effective use of limited productive skills of the work force of a developing economy, and create value in factories by working with machines that can be easily purchased on the world market 3. To intervene the financial sectors to channel their capital on intensive small scale agriculture and on manufacturing development.
After World War II the success stories of East Asian countries of Japan, Korea, Taiwan and China were all thanks to the full implementation of all of these stages. First, they radically restructured their agriculture sector as a highly-labour intensive household farming, which, despite only generate tiny gains per person employed, make use of all available labour and pushes up yield and output to the highest possible levels. Then East Asian governments focused their modernisation efforts on manufacturing, and further enhanced their technological upgrading through subsidies that were only given to firms based on certain standard of export performance, which along with export discipline had created the pace of industrialisation to a level never been seen before. And finally, East Asian countries made their financial systems slaves to these two reforms. As a result, these interventions have produced the quickest progressions from poverty to wealth that the world has ever seen in East Asia.
Among these East Asian countries, the fastest growing story was South Korea. As described in the book 13 Bankers, since the wreckage of the Korean War in the 1950s South Korea had managed to turn their country around from a country poorer than India into an economic powerhouse where they became a member of Organization for Economic Cooperation and Development (OECD), the club of the advanced industrialised countries, by early 1990s. In the process they managed to dramatically reduce poverty, increase income per capital by eightfold, achieve universal literacy and tremendously successful in closing the technology gap. South Korean government also ran highly efficient steel factories (a counter argument that denies Chicago School’s assumption that governments aren’t capable of running an enterprise), while its conglomerates such as Samsung, Daewoo and Hyundai were equally successful in producing goods known all over the world.
By contrast, South East Asian countries started off with the same ambitions and equal endowments after the end of World War II, but have not followed the same policies, resulted a fast growth for a period of time but with unsustainable progress. By the 1980s as their population significantly growing, the governments in South East Asia conducted an economic reform and replaced their ISI policy with Export Oriented Industrialisation (EOI) policy, where they shifted their economic focus to labour-intensive manufacturing with comparative advantage of cheap labour.
Just like South Korea the South East Asian countries also implemented protectionist policies and planned their path to liberalisation slowly and carefully. As described by Naomi Klein in The Shock Doctrine and Joseph Stiglitz in Globalization and its Discontents, they kept vital sectors like energy and transportation in the hand of the government, they prohibit foreigners to own land and buying out national companies, they also had high import tariff barrier and blocked many imports from North America, Europe and Japan, as they built up their own domestic market. As in the Washington Consensus model, trade was important, but the focus was more to enhance exports not removing barriers for imports. Trade was eventually liberalised, but only after the fundamentals were strong for the local companies. In other words, these were economic success story mirroring what Britain did under the House of Tudor and what the US did in the late 19th century, and almost none of the model that the Washington Consensus were preaching.
However, just like in many other low-income countries in the past half-century, the economic development was dominated by a small group of elitist with personal ties to the ruling family, which traded business favours with political support and financing. According to Joe Studwell in his other book the Asian Godfathers this system are identified as “crony capitalist” in the Philippines, “Pariah capitalist” in Thailand, “Ali Baba operations” in Malaysia where businesses fronted by the more ethnically accepted Malays (Ali) but actually run by Chinese (Baba), and “Cukong operations” in Indonesia, in which a Cukong is a person described as politically beholden for his commercial success and had to pay politicians and military for their share of the success.
Despite having different names, their activities were all the same: with the so-called Godfathers as the beneficiaries, carefully-planned privatisations were conducted without tenders and deregulation merely substituted state monopolies with cartels of Godfathers. Hence, the performance-determined subsidies imposed by the East Asian countries was not implemented by South East Asian governments, but instead protectionism measures were channelled to the politically-connected and not necessarily the best manufacturing firms that meet the minimum standards, a fatal flaw that prevent them to nurture globally-competitive companies.
Furthermore, with the exclusive relationship with the President/Prime Minister and his family, these Godfathers built mega factories, won concessions to construction works, gained monopoly access to raw materials and received leniency on regulations while alienating their competitors. But perhaps most crucially, especially in Indonesia where the practice was rampant, these Godfathers founded many banks that stored a growing domestic savings rate, which, as a proportion of GDP, the growing savings rate can be as high as 30% in Hong Kong and Indonesia and more than 45% in Singapore. As a benchmark, in the mid 1960s savings rate in South East Asia was at par with Latin America, but by early 1990s it was 20% higher, thanks to the rise of manufacturing jobs that allure people to enter the labour force and earn wages, and thus allow more people to save an increasing proportion of their income.
With a complete disregard on the 3rd stage of intervention on financial sector (that channels funding only to the best firms for the agriculture and manufacturing reforms), these banks then lend most of their funds back to related Godfathers’ businesses. This inefficient form of manufacturing reform led a Japanese economist Yoshihara Kunio to warn in the 1980s that South East Asian countries risked to becoming a “technology-less” developing nations, which was what exactly happened when their investment funds dried up in mid 1990s.
Nevertheless, between 1986 and 1995, with their currencies pegged to the undervalued US dollar, South East Asia was in cloud nine, with the average export growth rose by 4-10% per year, and with average GDP growth of 8-10% a year in Indonesia, Malaysia and Thailand, compared with 6-8% in the period after 1960. In Thailand alone exports jumped from $9 billion in 1986 to $57 billion in 1995, while manufacturing’s share of exports in Malaysia increased from 12% in 1970 to 74% in 1993. This success story was lauded as an Asian Miracle, and earned them the nickname of the Asian Tigers.
Moreover, in this booming period the lack of government efficiency in nurturing export discipline and channelling funding to firms that meet the export standard was somewhat compensated by the huge flows of FDI that went into South East Asia. Among those who came to set up an FDI in these countries, Japanese companies were the biggest investors in the region, which implemented a system of division of labour with South East Asia undertook the manufacturing part of their system. As mentioned before, as the Japanese economy undergone a massive bubble, the effect of the great Japanese bubble also spilled to South East Asia as demand from Japan for finished goods kept on rising, thus became one of the driving forces of the phenomenal economic growth enjoyed by the Asian Tigers.
However, judging an economic progress by growth rate alone had proven to be misleading, as Brazil had managed to grow more than 7% a year in the 1960s and 1970s only to crumbled after the Latin American debt crisis in early 1980s. The sudden collapse of the Brazilian economy exposed the bitter truth that too much of Brazil’s earlier growth had been generated from debt that did not channelled into a more productive and competitive economy. With this realisation, the growth of the Asian Tigers under the crony capitalism environment can be considered fragile, although unlike Brazil South East Asia was not flushed with debts. But this, as we shall see, will soon change.
With the Asian Miracle in full effect, Western and Japanese banks and corporations increasingly demand more than just access of FDI for low-cost manufacturing in the region, and desired the access to the booming consumer markets and the right to acquire the best of South East Asian corporations. Various pressures were thrown to the South East Asian governments to open up their controlled financial markets and to free capital flows in the interest of “level playing fields” as well as easing regulation for foreign capital lending.
The argument for “level playing field” was first mentioned by US president Ronald Reagan, where in the Uruguay round of General Agreement on Tariff and Trade (GATT) in 1986 he called for “new and more liberal agreements with our trading partners – agreement under which they would fully open their markets and treat American products as they treat their own.” Understandably, developing countries resisted at the time, and thus the GATT trade talks that started in the Uruguayan city of Punta del Este in 1986 stalled until the talk in Marrakech in 1994. The concluding result of this trade talks was the transformation of GATT into the World Trade Organisation (WTO), an organisation that became part of the Washington Consensus.
Critical to the new WTO was the adoption of the principle of a ‘single undertaking’, which required all members to sign up to all agreement. While in GATT countries could pick and choose the agreements that they want and did not want, in the ‘single undertaking’ principle all members (except for the poorest countries) had to conform by the same rules, where, true to neoliberalism principles, all of the members had to reduce tariffs, give up import quotas, give up export subsidies and also abolish most domestic subsidies.
The ‘single undertaking’ policy might look fair at first, but it actually favour developed countries at the expense of developing countries. For example, as described by Ha-Joon Chang, WTO requires all countries to reduce tariff quite substantially in proportional terms, but this means that in absolute terms developing countries will ended up reducing their tariffs a lot more than developed countries since they started off having higher tariff in the first place. For instance, before the WTO agreement India’s average tariff rate was 71% and after WTO they were required to cut around 55% of tariffs down to 32%. Similarly, the US tariffs also cut by 55%, but it was a cut from 7% down to only 3%. If translated to money, an imported goods to India that formerly cost $171 would now only cost $132 – a fall of 23% in consumer price that would dramatically alter consumer behaviour. Meanwhile in the US a $107 worth of imported goods would have only fallen to $103, a price difference of 4%, which most consumers will hardly notice.
In addition, although developed countries have low ‘average’ tariffs, they tend to disproportionately protect products that developing countries export, such as textile and garment. This means that developing countries will still face higher tariffs when exporting to developed countries. As Oxfam report highlighted “the overall import tax rate for the USA is 1.6%. That rate rises steeply for a large number of developing countries: average import taxes range from around four per cent for India and Peru, to seven per cent for Nicaragua, and as much as 14-15 per cent for Bangladesh, Cambodia and Nepal.” As a result, in 2002 India paid more tariffs to the US than Britain did, even though Indian economy was less than one-third that of Britain, while Bangladesh paid nearly as much tariffs to the US as France, although the size of its economy was only 3% that of France.
In the mid 1990s, under pressure from the IMF and the newly created WTO acting on behalf of the banks and corporations, the Asian Tigers eventually agreed to split the difference to create a ‘level playing field’: they would maintain the protectionist model, but would lift barriers to their financial sectors and allow a surge of currency trading, paper investing and overseas borrowing by local businesses.
Consequently, this gave the Tigers’ economies further exposure towards the vagaries of global market. With their respective currencies pegged to US dollar, as their respective central banks maintained high interest rates their currency peg to the US dollar meant that at the same value of currency local businesses can access cheaper funds from lower interest rates environment such as in the US and Japan. As a result, with the newly eased regulation for cross-border borrowing, local businesses began to borrow heavily from foreign banks (with the ratio of private-sector-debt to total-national-debt increased from 12.6% in 1980 and 29% in 1990, to a whopping 81% by 1998) and thus flooded their respective countries with foreign dollars, which made way to luxury real estate, local stock markets and other assets, creating the environment for speculative bubble.
The businesses got more incentives to borrow from US banks in the first half of the 1990s when Fed Chairman Alan Greenspan cut US interest rates from 9% in May 1989 to 5.75% by July 1991 to then-historical-low of 3% in September 1992 where he controversially held them for the next 15 months. In addition, the rate cut also effectively devalued the price of US dollar and made US exports cheaper, thus, with currency peg to the dollar, the Tigers’ exports also improved accordingly.
However, the effects of the rate cut on the Tigers’ economy were by all means fortunate consequences. Alan Greenspan cut interest rates to fight off recession caused by the Savings & Loans crisis, the spectacular ending for the great financial deregulation of the 1980s and its subsequent decade of greed. The crisis was rooted in 1982 when the Reagan administration deregulated Savings & Loans companies and effectively allowed them to make risky investments using their depositors’ money, which contributed to the stock market boom of the 1980s. However, by the end of the decade hundreds of these Savings & Loans companies had failed, and between 1985 and 1992 more than 2000 banks collapse, hundreds of people were arrested for fraud and more than $100 billion eventually spent to bailout the financial system.
One of the worse cases of fraud was conducted by Charles Keating, who in 1985 – when the federal regulators began to investigate him – paid an economist $40,000 to defend him and wrote a letter to the regulators praising Keating’s sound business plans and expertise, and concluded that he saw no risk in how Keating invest his customers’ money. The economist that Keating hired was Alan Greenspan, and Charles keating was found guilty and went to prison shortly afterwards.
It was in this context that Alan Greenspan – since then appointed as the Fed’s Chairman by Reagan in 1987 – cut interest rates from 9% in May 1989 to 3% in September 1992, which also affect interest rates across the board. Consequently, Greenspan’s rate cuts caused rates drop for bank savings, corporate bonds, convertible bonds and T-bills, while the rate cut also provided investors with cheap money to invest in higher yielding investments in stocks. Investors then were given a simple choice: stick with the declining yield of the bond market or participate in the rising yield of the stock market. Hence, according to the book Greenspan’s Bubble, the aggressive rate cut by Greenspan had massively over stimulate the stock markets, and lay the foundation for the stock market mania of the 1990s and particularly the hype over the new trend of tech stocks, which created what became known as the Dot.com Bubble.
Meanwhile, in late 1989 Japan’s Finance Ministry tried to stop their ever expanding bubble by sharply raised interest rates. But the action backfired as the bursting of the bubble ironically became the very trigger to the inevitable crash of the stock market (a long continuous crash like the dot.com crash rather than like the October 1987 one day crash), with many of their banks suddenly loaded with bad debts. The crash then followed by overall debt crisis, where a budget surplus of 2.4% in 1991 turned into a deficit of -4.3% by 1996 and -10% later on by 1998, with the national debt to GDP ratio reaching 100%. Consequently, Japanese government had to bailout banks and inject massive fund to corporations seen as too big to fail, which practically made these corporations zombie corporations, and marked the 1990s as Japan’s Lost Decade.
In the midst of this chaos, the Japanese government implemented a near zero-interest-rate policy to stimulate the economy (a practice also implemented by Fed chairman Ben Bernanke to stimulate the US economy since the 2008 crash). The ultra-low Japanese interest rates encouraged a practice called carry trade, i.e. investors borrowing the cheap yen and invest it in other places that give higher return, such as the high-yielding investments like US tech stocks thus also played a significant role in creating the dot com bubble. While in return these surging bubble economies created a robust demand for Japanese goods, where ultra-low interest rates subsequently made yen to weaken, and thus making Japanese exports cheaper once again.
This low Japanese interest-rate became a blessing in disguise for South East Asian borrowers, as it provided cheap Japanese money that were borrowed heavily by local Tiger businesses, thus also played a significant role in creating the Asian Miracle bubble. With the entire Tigers’ currencies pegged to the US dollar, and with huge presence of Japanese FDI in the region for their export manufacturing sector as well as heavy borrowings from Japanese banks, the USD/JPY rate became the key determining factor for the fate of South East Asian economy. For example, when the yen was strong (and the dollar is weak, hence the local currency is cheap) the textile, electronics, automotive and petrochemical exports that Japanese corporations manufactured in South East Asia were more lucratively priced for export.
Hence in the early 1990s when Alan Greenspan cut interest rates, the Tigers’ economies not only enjoying their peg to the weakened dollar but also the strengthening of yen, where the corporations exporting its good to Japan made more profits. But this also raised a serious question, what will happen if the USD/JPY rate shifted to stronger dollar/weaker yen? Not surprisingly nobody commented on this anomaly, as it was in a good period. But it wasn’t long until this shift occurred.
The first sign of trouble appeared in January 1994 in the Japanese bond market. With their economy already in the Lost Decade, the yield in 10-year Japanese government bond had plunged to a historic low of 3%. But then, bond buying in Japanese credit market ran out of steam, with some investors moved from bonds into stocks in a possible speculation of an economic recovery, with bond yield unexpectedly jumped to 3.4%. Some big US investment banks that had bought heavily into the Japanese market suddenly found themselves unable to cut their bonds exposure, as there was no willing buyers, and thus were forced to dump their US Treasury holdings to cover their losses in Japan.
By that time, the euro currency project had gathered political steam and was on the process of becoming a single currency by 1999 and with notes and coins to begin circulation by 2002. As the euro project was on the process of converging various currencies and bonds towards a single currency and interest rates, a type of trade called convergence trade became the dominant theme in European foreign exchange and fixed income market. Convergence trade works by taking long positions on currencies and bonds that will rise in value towards the single euro, such as weaker economies of Spain and Italy, and taking short positions on currencies and bonds that will decrease in value towards the single euro, such as stronger economies of Germany and France.
However, in practice, to hedge their long European government bonds positions from currency depreciation, many US hedge funds, banks and other financial institutions did not actually short the stronger euro zone currencies and bonds such as German mark or French franc, but instead they shorted the Japanese yen. According to Tom Steffanci, head of Fidelity Investments’ bond operations, investors figured that with Japan in their Lost Decade the yen was due for a sharp drop against the dollar, and the profits that they might earn from shorting the yen would far exceed what they could make by hedging their bonds in the issuing countries.
But then after a continuous trade frictions especially since the late 1980s, trade talks between US president Bill Clinton and Japanese prime minister Morihiro Hosokawa collapse, with the US immediately imposing trade sanctions on Japan. While the sudden jump in Japanese bond’s yield to 3.4% prompted investors to dump their US Treasury holdings, the trade friction caused the yen to soar close to 100 to the dollar and unravelled currency traders’ hedging positions. This in return, prompted them to start selling their hedging bets in long European bonds positions that were already disturbed by European trade frictions and the bundesbank’s reluctance to slash German interest rates due to high inflation in their country as an effect of West-East German unification.
And then came the biggest blow that triggered the bond market rout. In February 1994 Fed Chairman Alan Greenspan raised the overnight US interest from 3% to 3.25%, which surprised the market, and began a series of rate hikes that ended the era of easy money in the early 1990s. It was a surprise move that caught the market off guard because it was implemented in the face of buoyant economy, with the US economy had recovered from the S&L recession, real GDP grew at an annual rate of 4.1% the highest growth rate since 1984, inflation dropped to only 2.6% the lowest since 1986, while unemployment rate declined to 6.7% by January 1994.
Greenspan reasoning was with the economy booming he became concerned about a potential increase in inflation. Hence to prevent the economy from being overheated and to slow the economy down to a sustainable growth rate Greenspan raised interest rates 7 times from 3.25% in February 1994 to 6% by February 1995.
Date (Interest Rate): 4 Feb 1994 (3.25%). 22 Mar 1994 (3.50%). 18 Apr 1994 (3.75%). 17 May 1994 (4.25%). 16 Aug 1994 (4.75%). 15 Nov 1994 (5.50%). 1 Feb 1995 (6.00%)
Given the sizeable leveraged positions that had been built up in the low interest rates environment in the early 1990s, this unforeseen trend reversal subsequently create a great bond market massacre, where global bond traders were caught in rate miscalculation and trapped in inverse effect of the falling market. Richard Noble, then a bond strategist at Salomon Brothers, commented “leveraged players said they could not afford to be in a falling market and that was the trigger for the sell-off.”
3 months after the first hike, the 10-year US Treasury notes yield moved from 5.87% to 7.11%, while European bonds also began to unravel. The sell-off was further compounded as leveraged positions were unwound and margins were called, created a vicious cycle of forced selling. Caught in the middle of bond and currency losses, investors started dumping whatever they could to keep the margin calls at bay, which mean dumping their European bonds, high-yielding Latin debt and US Treasuries. “They’re all scrambling to get liquid,” said Chicago Board of Trade Chairman Patrick H. Arbor, “this thing is of cascading proportions.”
This, as a consequence, caused long-term interest rate to soar and put further pressure on bond positions. 30-year US Treasury rates rose from 6.2% at the beginning of the year to 7.75% in mid-September, with Fortune magazine estimated that more than $600 billion has been wiped off the value of the US bonds. Worldwide decline in bond values have also erased around $1.5 trillion, with economies like England and Italy, who are still in the aftermath of a recession, and former Soviet East European countries face the threat of rising long-term interest rates.
Moreover, the global bond rout also spread to the derivatives market where companies such as P&G and Gibson Greetings suffered major losses as their hedging positions went against them. And by December 1994 Orange County, California, the wealthiest county in the US at the time, filed for bankruptcy as interest rate derivative structure imploded, and became the biggest municipal bankruptcy in recorded US history, which subsequently extended the effect of Greenspan’s surprise rate hike to a meltdown in the municipal bond market.
Furthermore, the first 10 months of 1994 where Greenspan increased the fed funds rate by 83% from 3% at the beginning of the year to 5.5% by November 1994, also saw the value of US dollar increased in value by 15%. And this steep rise made it difficult for countries to maintain its currency peg to the dollar, especially for Mexico.
1994 was presidential election year for Mexico and the incumbent president Carlos Salinas de Gortari – whom was in the last term of his sexenio (6-year administration) – implemented a high spending splurge amounted to 7% of GDP current account deficit to create a temporary and artificial period of low inflation and prosperous high growth, to boost his party’s chance of winning the election. To finance the spending splurge Salinas issued a tesobonos, a short-term (90+ days) dual-currency treasury bond that paid redemption in Mexican pesos but paid the USD/peso currency rate at maturity.
During the election campaign, presidential candidate Luis Donaldo Colosio was assassinated in March 1994 and the assassination further deepening Mexico’s political risk especially after an uprising broke in Chiapas since January. The uprising in the southern Mexican state of Chiapas began on 1 January 1994, on the same day the North American Free Trade Agreement (NAFTA) came into effect. The uprising was conducted by the Zapatista Army of National Liberation (EZLN), a group inspired by Emiliano Zapata’s revolution of 1910-1919, whom was fighting for the preserverance of Article 27 in the Mexican constitution, in which Indian communal land holdings were protected from sale or privatisation.
Under NAFTA, however, with trade liberalisation installed between Canada-US-Mexico, Article 27 was considered as a barrier for investment, hence Indian farmers would be threatened with the loss of their remaining lands, with the passage of NAFTA allowed corporations to buy their sacred land and use it to produce exports. This also put a strain on local merchants and farmers who had to compete with multinational corporations. Moreover, on the other hand local industry would also be destroyed as cheap imports (substitutes) from US and Canada would flood the liberalised and unprotected Mexican market. Hence, on the same day NAFTA was passed, EZLN in effect came out against trade liberalisation and attack the local and national government in protest.
These attacks, alongside the assassination of Luis Donaldo Collosio and a crisis of confidence on the rotten banking sector have made the country risk premium on Mexican bonds high. And with their peso pegged to the dollar, the higher risk premium gave pressure to the fixed exchange rate, while Mexico lacked the sufficient amount of foreign reserve to maintain the currency peg level in the increasingly high US interest rate. Hence, when Greenspan hiked the interest rates the Mexican government had no other option than to devalue the peso, and this action prompted investors to cash out from the country and thus further raising the risk premium.
This forced the Mexican government to take action, either by raising their interest rates and choke its own economic growth or let their currency further dwindle and risk capital outflow. The government settled on a poor mix of the two, with the central bank approving an immediate 12.7% devaluation in the peso. Hence the inevitable happens, on 20 December 1994 the Mexican peso crashed. Without the central bank’s support, the peso collapse through its trading band, dropping from 3.46 pesos to 3.92 pesos to the dollar in just 2 minutes. And in the space of 1 week, under a floating regime, the peso crashed from 4 pesos to 7.2 pesos to the dollar. The Mexican stock market also collapse alongside the currency, and panic spread to Mexico’s South American neighbours and created a crash that was to be known since as the Tequila Effect.
With the global bond massacre and the Tequila Effect were in full downward effect, the international mood became anxious. And before long panic also broke out to foreign exchanges market and stock markets in Asia, especially after the US dollar appreciated by more than 50% between April 1995 and January 1997. Due to their own respective currency peg towards the US dollars, South East Asian currencies also appreciated, and thus slowly eroded their competitive advantage and gave a serious threat towards the managed exchange rates systems.
By this point, the structures of South East Asian economies were too fragile, with ever expanding current account deficits. And while the switch towards a stronger dollar / weaker yen made these countries’ exports uncompetitive and can no longer deliver surpluses that would compensate for their domestic weaknesses, the rise of mighty China as a serious competitor for low-cost manufacturing states after Deng Xiao Ping’s reform in late 1980s – which once again emulated the economic formula used by the likes of Britain, the US and Japan – gave the biggest blow to date.
And then towards the middle of 1997, in response of global financial pressure, Japanese banks were finally forced to increase their reserve requirements, something that they previously managed to avoid, and in response these banks became less incline to roll over short-term debts. For many South East Asian businesses that have borrowed heavily from Japanese banks since the liberalisation of cross-border borrowing, this drying up of liquidity – compounded by a sudden rally in yen in May 1997 – was a recipe for disaster. They suddenly have to pay up their dollar-denominated debts using the income that they generated in their local currencies, with dollar getting more expensive by the day, thus became the 2nd determining factor after US rate hikes that trigger the Asian Market Crash.
With the threat of liquidity dry out, many Western banks then became afraid to roll over debts to South East Asian companies, in a fear of default. And their decision to back off became a self-fulfilling prophecy that made the defaults inevitable.
To make matter worse, with Japanese liquidity dry out and the continuous rise on the value of US dollar, speculative attacks became frequent on South East Asian currencies, with speculators believe that currency devaluation will eventually take place, considering the alarmingly low foreign exchange reserve that these central banks have left to support their currency peg. This is where the likes of George Soros and Julian Robertson stepped in and gave pressure to the dollar peg, with them believing that the central banks would eventually forfeited from the pressure, un-peg their currencies to the dollar and let it devalue to a devastating effect.
In summer 1997 the speculators’ prophecy came true. By June market pressure on the currency peg was so big that the Thai central bank almost ran out of foreign exchange reserves, and inevitably on 2 July they finally admit defeat and gave up the dollar peg altogether and let the baht to float. The currency devaluation news triggered more panic and dropped the value of the baht even more by -20% against US dollar, and spread a panic-selling pressure on other South East Asian currencies.
Foreign fund managers then wanted to get out from the local stock markets as quickly as possible, and crashing the stock and bond markets by doing so. Foreign banks tried to limit their exposure by calling in their short-term loans, while in response the local borrowers were then scrambling to buy US dollars to cover their borrowing positions, which add fuel to the fire and led to systemic sell-off pressure for these currencies. Within the next 3 months the dollar peg in Indonesian rupiah, Malaysian ringgit and Philippine peso will all follow suit the Thai baht and be abandoned, with Indonesian rupiah – where local corporations had foreign exchange borrowings up to $80 billion versus central bank forex reserve of only $20 billion – being the hardest hit.
Just like in the collapse of the British pound in 1992, currency speculators like George Soros kept on shorting the South East Asian currencies, which prompted Malaysian Prime Minister Mahathir Mohamad to publicly blame Soros as the main cause of the crash in an annual IMF meeting on September. However, an IMF inquiry after the crisis found little evidence that hedge funds and other leveraged investors had a significant role on the currency collapse in the region. In fact, as we shall see, capital flight was to be a much bigger problem than currency speculation, which the IMF themselves had a huge role in creating it.
On the brink of a complete economic meltdown the 3 most hard-hit countries of Indonesia, Thailand and South Korea all then seek desperate help to the IMF, with Thailand eventually granted a $17 billion loan, Indonesia with $40 billion and South Korea with a then-record $57 billion. However, in an unmistakably Washington Consensus manner the IMF grant these loans with the conditions of wide ranging Chicago School reforms, under the name of Structural Adjustment Program (SAP).
In Thailand, in exchange for IMF loan the Thai government had to impose murderous tax hikes and close down 56 ailing finance companies, thus destroying 30,000 while-collar jobs. In South Korea the government was forced to expedite financial reforms and open its financial market, on top of mass layoffs required to get the IMF loans. In Indonesia SAP included postponing 15 major government-subsidised projects, eliminating the government’s monopolies and state subsidies (which instantly increased prices for basic food staples by as high as 80%), and closing 16 financially insolvent banks.
Moreover, according to Joe Studwell in Asian Godfathers, in the special case of Indonesia, when president Soeharto signed the first letter of intent with the IMF for the loan the condition imposed to Indonesia included the dismantling of his network of godfather cronies, which marked the beginning of the end game for Soeharto. This included the dismantling of Bob Hasan’s Plywood cartel, Liem Sioe Liong’s Bogasari flour mining monopoly, and even Soeharto’s own son Tommy Soeharto’s clove import monopoly for kretek cigarettes.
Among the 16 insolvent banks forced to shut down, Bambang Soeharto’s bank Andromeda and a bank controlled by Soeharto’s half-brother Probosutedjo were amongst them. This was a fundamental shift for Indonesia, because for 3 decades Soeharto had managed to create a relatively stable economy that heavily rely on his flow of corruption and his network of cronies. Thus it is not an exaggeration to say that he WAS the economy, and therefore the dismantling of his corrupt regime made the economic foundation of the country even more fragile.
To make matter worse, the IMF bailout money provided the Asian Tigers with the means to temporarily sustain their exchange rate at an unsustainable level. And the Godfathers took advantage of this situation to convert their money into dollars at the favourable exchange rate, and whisk them out from the country, thus created a capital flight, most of which went to neighbouring tax havens of Singapore and Hong Kong. To illustrate the big capital flight problem, on the onset of the crisis $200 billion of Indonesian capital was in Singapore alone, compared with Indonesian GDP of $350 billion.
In addition, once it got in the governments’ hand, the majority of the IMF bailout money were mostly channelled back to the ailing Godfather entities and to bribe several central bank officials and parliament members that stand within the money flow. In Indonesia, where the practice was most scandalous, this was to be known as the BLBI scandal, where 48 failing banks were privatised by the government and then re-sold back to the owners at a much cheaper price. This scandal involved many of the high ranking government officials and parliament members, which are still powerful and politically-connected across all parties, and thus making them immune from prosecution till this day.
Nevertheless, these problems were not a concern for IMF, as according to Joseph Stiglitz in his book Globalization and its Discontents, from IMF’s point of view much of the money was intended to enable the countries to provide dollars to local banks and companies that had borrowed from Western banks, to repay their loans. In other words, it was more of a bailout to the Western banks – so the lenders did not have to face the full consequences of making bad loans – than to help the national economy.
Upon the intensification of the crisis in 1998, SAP also dictated the Indonesian central bank to raise interest rates up to a whopping 65%, thus destroying weak banks and already struggling domestic corporations. The IMF Managing Director Michel Camdessus then argued that to reverse currency depreciation the currency has to be more attractive, hence their move of raising the interest rates to “restore confidence in the currency” regardless of the catastrophic consequences. This differ greatly from the thinking of John Maynard Keynes when he masterminded the birth of IMF, in which the organisation was created to exactly deal with these kind of economic crises with the formula of increasing government spending, propping up major companies and LOWERING interest rates (something that the US is currently conducting to tackle its economic problems).
Not surprisingly, the IMF crisis management met by fierce protests from the people, with anti-IMF and anti-neoliberalism protests began to appear in the streets of Jakarta, Bangkok and Seoul, and eventually gave way to political changes in the region. Thai Prime Minister General Chavalit Yongchaiyudh was the first victim of political reform caused by the crisis as he was forced to resign amid pressure from many political movements. 1 month later, in a Presidential election South Korean President Kim Young Sam was defeated by Kim Dae Jung, the first ever President elected from the opposition party.
In Indonesia political reformation began with student protests demanding the resignation of President Soeharto after he was “re-elected” on 11 March 1998 for the 7th time and appointed the most bizarre cabinet members, including appointing Soeharto’s crony Bob Hasan as the minister of trade and industry and Soeharto’s daughter Tutut Soeharto as minister for social services. The protest was further enhanced when on 5 May Soeharto implemented an IMF-imposed fuel-subsidy-cut, which spiked the fuel price in the country by 70% and transportation fares by similar amount. But none of the protests made a significant impact on Soeharto’s grip on power, that is until on 14 May 1998 the national troops open fire to a peaceful protest in a university and killed 6 students, which sparked a full-blown riot and looting across the country, a deadly event that eventually forced Soeharto to finally resign on 20 May 1998 after 32 years in power.
In retrospect, the IMF money not only helped the likes of Soeharto to safeguard their cronies’ wealth, but it also bailed out the Western lenders, leaving the overall economy in a more fragile state. Moreover, through SAP the IMF actually exacerbated the downturns with the excessive rapid financial and capital market liberalisation and government deregulations, which became one of the main causes that drag the region into a full-blown crisis. But this was by all means not a naïve mistake in IMF’s part, as the dismantling of the last remaining barriers towards free market was indeed deliberate.
As soon as the crisis began, a surprising number of financial professionals and political leaders stepped forward with a unified message: don’t help Asia. For instance, Milton Friedman made a rare appearance on CNN and declared that he oppose any kind of bailout, and opined that the market should be left to correct itself. This view was echoed by George Shultz, a board member at the brokerage house Charles Schwab and Friedman’s colleague at the right-wing Hoover Institution, and also echoed by Walter Wriston, a former head of Citibank and Friedman’s old friend. Even Bill Clinton downplayed the economic catastrophe as “a few little glitches in the road” at an APEC summit on November 1997.
Their intentions were clear. Alan Greenspan stated that the crisis is “a very dramatic event towards a consensus of the type of market system which we have in this country” and that it is “likely to accelerate the dismantling in many Asian countries of the remnants of a system with large elements of government-directed investment.” Robert J. Pelosky, a global strategist at Morgan Stanley, then elaborates this view by saying “what we need now in Asia is more bad news. Bad news is needed to keep stimulating the adjustment process.” Pelosky reasoned that if the crisis was left to worsen, all local companies would eventually have to go bankrupt or sell themselves at rock bottom prices to foreign companies, both of which are beneficial for the likes of Morgan Stanley. And that was exactly what they did.
Together with Treasury Secretary Robert Rubin and Deputy Treasury Secretary Larry Summers, Alan Greenspan then ensured that his prophecy will come true, by pushing forward their neoliberal agenda both directly and indirectly through the IMF in the form of SAP. As a result, according to Naomi Klein in her book the Shock Doctrine, with the SAP exaggerated the crisis and thus making Asian companies more desperate to sell at lower prices, pretty much everything in Asia was now up for sale.
The Wall Street Journal captured the moment by running an article with the headline of “Wall Street Scavenging in Asia-Pacific” two months after the IMF conclude its final agreement with South Korea. Coca-cola bought a South Korean packaging company. Nissan bought one of Indonesia’s largest car companies. General Electric obtained a controlling stake in South Korea’s LG. Motorola obtained full control over South Korea’s Appeal Telecom. While Britain’s Powergen bought LG Energy, an electricity-and-gas company.
Furthermore, Carlyle became a major shareholder in one of South Korea’s largest banks, as well as snapping up Daewoo’s telecom division and Ssangyong Information and Communication (one of South Korea’s largest high-tech firms). JP Morgan obtained a stake in Kia Motors. AIG bought Bangkok Investment for a fraction of its worth. Merrill Lynch bought Thailand’s largest securities firm and Japan’s Yamaichi Securities. While Travelers Group and Salomon Smith Barney bought several companies in South Korea including their largest textile companies. Interestingly, at the time the chair of Salomon Smith Barney’s International Advisory Board, which provides advice on mergers and acquisitions to the company, was Donald Rumsfeld, with Dick Cheney was also on the board.
Former US undersecretary of commerce, Jeffrey Garten, predicted that when the IMF was finished “there is going to be a significantly different Asia, and it will be an Asia in which American firms have achieved much deeper penetration, much greater access.” And he was right, although it was not only American firms that have achieved much deeper penetration and greater access. Bechtel got the contract to privatise the water and systems in eastern Manila and to build an oil refinery in Sulawesi, Indonesia. British Telecom obtained a large stake in Malaysia’s and South Korea’s postal service. Indonesia’s water systems were split between France’s Lyonnaise des Eaux and Britain’s Thames Water. Bell Canada purchased a piece of South Korea’s telecom Hansol. While New York-based energy giant Sithe obtained a large stake in Cogeneration, Thailand’s public gas company.
Other big multinational companies who got a piece of the Asian distressed companies included Nestle, Hewlett-Packard, Seagram’s, Interbrew and Novartis, Ericsson, Tesco and Carefour. These mergers and acquisitions by foreign multinational corporations (MNCs) were intended to snap up the entire apparatus, workforce, customer base and brand value that were built over decades, only to be break apart, downsized, or even completely shut down in order to eliminate competition for these MNCs’ imports. Samsung was broken up and sold for parts: General Electric got its lighting division, SC Johnson & Son its pharmaceutical arm, while Volvo got its heavy industry division. A few years later, Daewoo’s once mighty car manufacturing division, which was valued at $6 billion, was sold off to GM for just $400 million.
All in all, in the span of 20 months, there were approximately 186 big mergers and acquisitions of companies in Indonesia, Thailand, Malaysia, the Philippines and South Korea. And the trio of Alan Greenspan, Robert Rubin and Larry Summers were praised as some kind of a cult hero, and were immortalised on the cover of Time magazine as the “Committee to Save the World.”
To be continued in Part 3: the conclusion