13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (9 page)

The premise was that the crisis had not occurred because Korea was too exposed to volatile flows of short-term foreign capital, but because it was not open enough to foreign direct investment, including in the financial sector. To many observers, it looked like the IMF and the United States were taking advantage of the crisis to push forward their program of global financial liberalization.
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While every crisis is unique, Korea was in many ways typical of the experiences of emerging markets in the 1990s. Large, well-connected companies expanded rapidly by taking on large amounts of cheap debt, unconstrained by the forces that should prevent irresponsible corporate behavior in a capitalist economy; outside shareholders had little influence over powerful founders, and creditors lent money freely, assuming that the leading chaebol were too important for the government to let them go bankrupt.
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Even though state-owned banks nominally controlled the flow of capital, tight relationships between the private sector and the government meant that the chaebol felt they had little to fear. Political factors played an important role in the economic crisis.

This central role of politics is common to many emerging market crises. Political connections were even more crucial in Indonesia, where the late President Suharto could never be mistaken for Thomas Jefferson. Under no possible interpretation was Suharto interested in protecting citizens against the power of the government. Instead, his goals were some combination of maintaining order, improving the economic welfare of ordinary people, and enriching his own inner circle.

Suharto adopted neither a communist-style planned economy nor an “anything goes” free market system. Instead, he cultivated a small group of private businesspeople whose family businesses became the backbone of the economy. Aided by the president and his family, who opened doors for their friends (and shut them for their competitors), these entrepreneurs built factories, developed cities, and learned how to export raw materials, agricultural products, and simple manufactured items to the rest of the world. As in many other low-income countries in the past half-century, economic development was dominated by a small economic elite defined by their personal ties to the ruling family, which traded favors for both political support and cold, hard cash—a pattern known as “crony capitalism.”
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For example, Indofood became one of the largest conglomerates in the country, largely because of a longtime personal friendship between its founder, Liem Sioe Liong, and Suharto.
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Suharto’s wife, Siti Hartinah Suharto, known as Madame Tien, was involved in so many business deals that she was referred to by critics as “Madame Tien Percent” for her alleged fees.
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Suharto’s children also cut themselves into many major deals; his daughter was involved in the largest taxi company, one son tried to build cars, and another son was a financial entrepreneur.
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For a long time, the system worked reasonably well. Annual income per capita grew from $1,235 in 1970, just after Suharto came to power, to just over $4,545 by 1997.
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Indonesia was still a poor country with pervasive poverty, but thirty years of economic growth had created higher standards of living for millions of people. The country was regarded as a development success story by the World Bank and by foreign investors, who supplied much of the capital needed to build factories, roads, and apartment buildings. Everyone knew that the flow of capital was controlled by Suharto’s family and friends, but this was actually attractive to investors, who quite reasonably thought it safer to lend money to people with strong political connections. The increasing availability of foreign capital fueled economic growth.

But easy money also fueled overinvestment and increasing risktaking, especially by well-connected businesspeople who assumed they would be bailed out by their powerful friends if things turned out badly. And over time, success in business became less a question of innovation and sound management than of using political connections to obtain government favors and subsidies. The result was an economic boom that could be sustained only by ever-increasing amounts of foreign debt, which came crashing down in 1997.

Russia provided a different example of the dangers created by a well-connected economic elite with easy access to foreign capital. With the collapse of communism after 1991, many former Soviet republics attempted to build capitalist economies with independent private sectors. In Russia, with its vast reserves of oil and gas, privatization of state enterprises provided a direct route to creating the major companies that would be the foundation of the economy. The reformers in the government of President Boris Yeltsin initially planned to create companies with a large number of relatively small shareholders. But in 1995, with Yeltsin facing a difficult reelection campaign the next year, they allowed a small group of powerful businessmen to buy large stakes in major state enterprises cheaply; in return, the businessmen provided crucial financial and media support to Yeltsin during the campaign. This was the creation of the Russian oligarchs, who dominated the economy in the 1990s.
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The new power of the oligarchs, however, did not translate into strong economic growth or fiscal stability for the government, whose tax revenues depended heavily on the volatile price of oil. Needing to keep social spending at a reasonable level to avoid widespread protests, the IMF (and the United States) encouraged the Russian government to open up the country to capital so that foreigners could lend enough money to bridge the government into more prosperous times—the idea being that Russia could pay back those loans with future economic growth.
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Private capital could also help restructure the oil and gas industry, develop new fields, and fund other productive investment projects that had been neglected under communism—even if the entire enterprise had a pungent whiff of corruption.

However, Russia’s fragile economy was vulnerable to the financial crisis that began in Asia in 1997. The resulting slowdown in global economic growth caused drops in the prices of the commodities that Russia exported, notably oil, hurting both company profits and government tax revenues. By mid-1998, both the government and the private sector were in serious trouble because they had large short-term debts to global banks and foreign investors—and those debts were magnified by the falling value of the ruble. Even an emergency IMF loan in July 1998 could not bail the government out of its problems, and in August Russia was forced to default on its foreign debts, causing massive capital flight out of the country.
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NOT ENOUGH LIFEBOATS

Financial crises, at least in emerging markets, have political roots. Although severe crises are generally preceded by a large buildup of debt, that appetite for debt is the product of political factors, most often including close relationships between the economic and political elites.

The downward spiral that occurred in Korea, Indonesia, Russia, and other countries hit by the 1997–1998 crisis was remarkably steep. When foreign credit disappears, economic paralysis ensues; the government is forced to use its own foreign currency reserves to pay for imports, service debt, and cover losses in the private sector. If the country cannot right itself before defaulting on its own government debts, it risks becoming an economic pariah.

As the currency collapses, companies default on their debts, and unemployment rises sharply, the reality on the ground becomes nasty. Leading businesspeople—often selected for their personal relationships or political skills rather than their management ability—focus on saving their most prized possessions. Facing shorter time horizons, executives care less about the long-term value of their firms and more about their friends and themselves. As George Akerlof and Paul Romer wrote in their classic paper on “looting,” businesspeople will profit from bankrupting their own firms when “poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.”
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In Russia, as in most emerging market crises, there was a sharp increase in “tunneling”—borderline illegal ways for managers and controlling shareholders to transfer wealth from their businesses to their personal accounts.
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Boris Fyodorov, a former Russian minister of finance who struggled against corruption and the abuse of authority, argued that confusion only helps the powerful;
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when there are complicated government bailout schemes, multiple exchange rates, or high inflation, it becomes difficult to monitor the real market prices of assets and protect the value of firms.
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In the extreme confusion caused by a crisis, insiders can take the money (or other valuables) and run, leaving banks, industrial firms, and other entities to collapse. Alternatively, confusion means that government officials have extraordinary discretion to save firms or let them fail. Describing an earlier financial crisis, Carlos Diaz-Alejandro wrote,

[T]he ad hoc actions undertaken during 1982–83 in Chile to handle the domestic and external financial crisis carry with them an enormous potential for arbitrary wealth redistribution.… Faith in orderly judicial proceedings to clear up debts and claims on assets appeared to be quite low; stories abounded of debtors fleeing the country, and of petty and grand financial chicanery going unpunished.
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From a macroeconomic perspective, the government needs to restore the confidence of foreign investors. Large government deficits (Russia) require cuts in government spending and higher taxes; large private sector debts (Korea and Indonesia) need to be rescheduled; and to attract capital, interest rates need to be higher, even though this hurts the local economy.

But responding to crises also has a political dimension. The IMF is ready to lend money, but only if it (along with its backers among the major industrial countries) believes that the government has sufficient political will to sustain the policies necessary to stabilize the situation; in the case of Indonesia, for example, this involved cutting back on the cozy relationships with economic elites that helped produce the crisis.
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This means less use of national reserves to cover the local private sector’s debts, less bailout money for the banking system, and fewer subsidies all around. Essentially, the government needs to choose whom to save; it has to squeeze at least some of the oligarchs. Of course, this is rarely the strategy of choice among emerging market rulers, whose reflex is to protect their old friends when the going gets rough—it can be tough to find new supporters in the middle of a crisis—even coming up with innovative forms of subsidies, such as guaranteeing the debts of private companies. In some instances, rulers prefer, at least in the short term, to inflict pain on the working class through layoffs, reduced government services, and higher taxes, on the assumption that big private businesses produced the original boom and can also drive the recovery.

Eventually, however, at least some within the elite have to lose out, both because there aren’t enough foreign currency reserves to cover everyone’s debts and because external lenders (first among them the IMF) demand some sign that the excessive risk-taking that produced the crisis is being punished. In both Thailand and Indonesia in 1997, the real fight was over which powerful families would lose their banks. In Thailand, the issue was handled relatively smoothly; more than fifty Thai “finance houses” (lightly regulated financial intermediaries) were shut down and some of the country’s largest banks were taken over by the government. In Indonesia, however, the question was whether the parliamentary government would close the banking operations belonging to one of President Suharto’s sons. In the struggle that ensued, the son’s bank first lost its license to operate, but then appeared to have obtained another license with the suspected aid of the presidential palace; in the end, local officials did not have sufficient political will or power to stand up to the ruling family, undermining IMF (and U.S.) support and deepening the economic crisis.
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In Korea, the confrontation was between the government and the largest chaebol, some of which had quite blatantly broken the law. After a series of showdowns—in which Daewoo threatened to default and political forces rallied to its assistance—the government won, and the hugely powerful Daewoo group went through bankruptcy and restructuring.

It is unheard of that all the oligarchs lose out, since the government can easily claim that they are essential to the domestic economy; some typically become even more powerful by absorbing their rivals, as happened in Korea, where Hyundai acquired the failing Kia. As the oligarchs in Yeltsin’s Russia found out in 1998, it’s a game of musical chairs; the post-crash government has enough foreign exchange reserves to help some big companies pay their debts, but not all of them. Usually the biggest of the big—the top chaebol, Suharto’s close business allies (under the protection of Bacharuddin Jusuf Habibie, who succeeded Suharto as president), and the large Russian natural resource companies (such as Gazprom)—survive and prosper thanks to generous bailouts and other forms of government support. It’s their smaller competitors who are cut adrift, while ordinary people suffer through government “austerity measures.” Of course, the “dispossessed” oligarchs fight back, calling in political favors or even trying subversion—including calling up their contacts in the American foreign policy establishment, as the Ukrainians did with some success in the late 1990s.
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But the aftermath of an emerging market crisis typically leads to a shakeout of the oligarchy, with political power concentrated in a smaller number of hands.