Trust foreigners over Indians

July 2 marked the tenth anniversary of the Asian financial crisis, which flattened most Asian economies in 1997-99. China and India suffered, but survived intact.

Today, Asian countries have adopted new policies — discussed below — to ensure that 1997 never happens again. Some of these new policies are wise, others are unwarranted overreactions.

Do not run large current account deficits of 7%-8% of GDP. Many Asian countries ran big deficits for long periods. But 1997 exposed the catastrophic risk involved. India was always prudent: its current account deficit was only 1.5% of GDP in 1997-98.

Discourage short-term foreign loans. In early 1997, short-term loans were ballooning in every crisis country with nobody taking notice.

When short-term lenders refused to roll over their loans, the consequent dollar outflow emptied many Asian treasuries. India and China had very limited short-term loans in 1997, and were not discomfited.
Institute strong bank oversight. Thailand’s banks in the mid-1990s borrowed massively from abroad at low interest rates to lend at higher rates locally.

This financed a housing bubble, which burst just as the forex reserves were crashing. The Thai baht fell, raising the local value of foreign loans, so banks that had borrowed abroad went technically bust. Indian banks in 1997 could not indulge in foreign adventures: they were bound hand and foot by RBI red tape. Lesson: we need financial liberalisation, combined with firm but not crippling RBI oversight.

Discourage high corporate leverage. In Korea, the chaeobol became giant conglomerates using huge debt-equity ratios. Leverage turned into catastrophe in 1997 because many chaebols now had large foreign loans, whose local value skyrocketed after devaluation. Daewoo, the second biggest chaebol, went bust. Indian companies also had high debt-equity ratios in 1997 but very little in foreign loans.

Today, thanks to Sebi, prudent bank lending, and the thumbs down given by the stock market to high leverage, excessive debt-equity ratios have largely disappeared in India.

Improve corporate governance. In 1997, many Asian companies went bust without warning because their books had been cooked for so long that only the owners knew the truth. Indian balance sheets were also regarded as dubious in 1997, but less so than in south-east Asia. Since 1997, Sebi and financial markets have greatly improved corporate governance and balance sheet credibility in India.

Avoid fixed exchange rates. Many Asian countries in 1997 pegged their currencies to the dollar. This tended to make their currencies overvalued, exacerbating trade deficits. It insured foreign lenders against currency risk, and so encouraged excessive inflows in search of high interest rates. Today, virtually all Asian countries have managed floats. Even China is devaluing slowly.

In India, the RBI intervenes often but fitfully to prevent excessive rupee appreciation. This has created enough uncertainty to encourage traders and financiers hedge their forex risks.

Run current account surpluses. This new policy of most Asian countries is an overreaction to 1997, not sound policy. Developing countries should invest more than they save, and hence run a modest deficit. India gets high marks on this score: its current account deficit is only 1.1% of GDP.

Build huge foreign exchange reserves for safety. This again is an overreaction to 1997, not good policy. Countries need prudential reserves. But China’s forex reserves are approaching $1.5 trillion, and other developing countries (including OPEC) have as much again. This far exceeds any reasonable prudential limit. The counterpart of Asian surpluses is a huge US trade deficit. This paradoxical pattern is sustainable for some time, but one day the dollar will crash, wiping out a good chunk of Third World forex reserves. India should go slow on further forex accumulation.

Discourage high inflows of foreign capital. After 1997, Asians worry that large inflows raise the risk of large subsequent outflows. This was one reason why Thailand imposed capital controls on inflows this year. China curbs inflows into its stock markets. In fact, countries should distinguish between four sorts of inflows.

Foreign direct investment in the form of factories poses no risk of capital flight: factories cannot leave during a panic. Foreign portfolio investment in stocks and bonds is widely but wrongly thought to be volatile. In theory, foreign institutional investors (FIIs) can sell shares and leave during a panic.

But in a panic, share prices plummet and there are no volume buyers. FIIs can exit only by selling at ridiculously depressed prices, so they would rather stay put. This explains why FII portfolio inflows into India remained positive right through the Asian crisis, except for a small outflow in 1998. Lesson: encourage rather than fear FII inflows. The third category of inflows is long-term loans. These cannot suddenly flow out in a panic, but can mean a steady outflow to the extent old loans mature and are not rolled over. Finally, we have short-term loans which will indeed flow out fast during a panic. Lesson: discourage short-term loans, but encourage FDI and FII inflows.

Focus capital controls on citizens rather than foreigners. India gave total freedom of exit to FDI and FII during the Asian financial crisis, but few exited. However, India did not allow its own citizens to exit from rupees into dollars. That policy was a success. Foreign exchange reserves can cushion capital flight by foreigners during a panic. But no amount of reserves can protect against citizens trying to convert their entire liquid savings into dollars. That will bust any treasury.

Today, the RBI is easing capital controls on Indians and encouraging them to invest abroad, to ease the pressure on rising reserves. But this policy can and should be reversed if another crisis strikes. The great lesson of 1997 was that you can trust FIIs to stay put in a panic, but not your own citizens. The hottest of hot money is not that of foreigners, but of citizens.


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