Caging The Bankers

The present international financial crisis is not, yet, the most serious since the second world war. If _ a big if _ the Asian turmoil halts here, the post-1982 debt crisis in Latin America will remain the more devastating.

But the current crisis is more worrying, for at least two reasons. First, the countries of east Asia had been uniquely successful in securing a broadly shared rise in living standards. Second, the disaster cannot be explained by fiscal or monetary profligacy. What had been an outstandingly successful private-sector route to economic development now seems blocked.

Conventional wisdom suggests the lesson is that east Asians should become as western as possible as quickly as possible. This is the philosophy underlying the programmes of the International Monetary Fund. Yet the cardinal east Asian mistake could well be not that they liberalised too little, but rather that they liberalised too much and, above all, too imprudently.

What has erupted in east Asia is, it now appears, a dire mixture of currency, corporate and banking crises. A helpful perspective on the origins of such crises can be derived from two unpublished papers. The first is by Frank Veneroso, a financial consultant, and Robert Wade, a professor at Brown University. They argue that Asias high-debt model of economic development is not an insanity, but a logical consequence of the structure of their economies and the aspirations for rapid economic growth.

These economies have high savings rates _ around a third of gross domestic product _ and very high rates of economic growth.

Much of the savings are generated by the household sector, but are needed by fast- growing businesses. Banks are the intermediaries. They provide a safe home for household savings. But the result is high levels of leverage compared with countries where slower-growing companies are better able to finance investment out of retained earnings.

This system has generated very high rates of economic growth over a long period. Yet the financial structure it has produced, with high ratios of bank liabilities to GDP and of debt to corporate equity, is inherently risky. To manage these risks, it has three safety mechanisms: the long-term relations between companies and banks, which turn debt into quasi-equity; the constraints on the ability of depositors to take their money out of the domestic banking system; and the power of fiscally prudent governments to tax.

In another paper, Paul Krugman of the Massachusetts Institute of Technology argues that if a banks owners know they will capture the gains from a successful investment, but can walk away from losses, they have an incentive to choose the investment that will give the highest return in the best of all possible worlds. This Prof Krugman calls the Pangloss value, after the character in Voltaires Candide. What happens if Dr Pangloss is wrong? Disaster.

One mistake east Asians have made is to tolerate a shift in lending from manufacturing, which is exposed to international discipline, towards property development, where the bank-driven asset price bubbles Prof Krugman describes are a far greater threat. But the impact of this error has been multiplied by the involvement of foreign lenders, with no commitment to support debtors through bad times.

Short-term foreign borrowing, property bubbles, or both, have played central roles in all the east Asian financial crises, including that in Japan. But short-term foreign borrowing is particularly problematic, because the domestic lender of last resort is then unable to help.

So far at least, IMF programmes have failed to halt the spiral. The reaction of outsiders to the continuing failure is captured perfectly in the massive downgrading of South Koreas sovereign debt.

With hindsight, it is evident that east Asian governments made big errors. The core of the mistake was to permit, even encourage, short-term foreign borrowing and exacerbate the calamity by fixing exchange rates and tolerating runaway property lending

The immediate question is how they can hope to escape from their predicament. The challenge is huge, partly because of the heavy debt overhangs, both domestic and foreign, under which their economies now labour.

At present, however, they have no effective institutional means to turn debt into equity on the required scale or to transfer future savings from the household sector to companies, other than through banks.

In time, the needed securities markets may emerge. But, with old mechanisms destroyed, it could take years to create new ones.

The big difficulty, however, concerns short-term borrowing. What the east Asian crisis demonstrates is that governments will not allow financial systems to implode. Bank borrowing, if big and general enough, is likely to become sovereign borrowing.

At the least, there is an overwhelming case for permanent prudential regulation of foreign borrowing, particularly short-term borrowing, by commercial banks.

Prudential control over short-term foreign currency borrowing by institutions underpinned by the state is inescapable. The crisis shows, once again, that banks fall into this category _ they are part of the public sector. Unregulated flows of short-term international capital are a licence to rack up losses at the expense of taxpayers.

If banks are not to be reformed, they must be more securely caged.