Asia’s Currency Crisis: Problems and Prescriptions

Asia’s Currency Crisis: Problems and Prescriptions

Professor Merton H. Miller _*
to the Asia Society in
Hong Kong at the Conrad International Hotel

January 19, 1998

Speeches and Transcripts: 1998

The Current Southeast Asian Financial Crisis

I’m delighted to be here in one of my favorite cities, to see so many old friends, but I would like your permission to skip the pleasantries and get down to business since I have a long speech, and I know you have to get back to work. So let me just say that I’ve been asked to speak on the subject of the Southeast Asian financial crisis.

That is not easily handled in a brief speech. Too many countries are involved, each with their own special features. And worse yet, new developments are occurring almost daily. I fear that the doors will open and a message will come in saying, “Everything you’ve just said is wrong. Still another country has collapsed.” So the crisis, in other words, is an ongoing one.

Three Interrelated Risks

What we have been calling “the” crisis, moreover, is really three separate but closely interlinked crises, each corresponding to one of three classic financial risks. These interrelated crises should be thought of not as natural disasters like the Kobe earthquake, unexpectedly coming out of the blue, nor should they be though of as divine punishment for our over-indulgences as some people would like to interpret them. They are man-made, or should I say, institution-made disasters.

Until some fundamental changes are made in our financial institutions—I do not mean mere regulations—until these changes are made, I fear that we are in danger of more of the same in the years ahead.

Interest Rate Risk

The first of my three interrelated risks is interest rate risk, a risk that in principle, affects both lenders and borrowers, but which in the Southeast Asia crises has been falling mainly on borrowers. Borrowers are hit whenever interest rates rise unexpectedly—as I don’t need to emphasize here in Hong Kong. The hit is particularly bad when they are borrowing short-term and lending long-term as so many firms and banks throughout Southeast Asia were doing. The rise in interest rates then deals the borrowers a double blow: the value of their fixed-rate long-term assets declines, and, at the same time, the cost of renewing, or rolling over their short-term floating-rate borrowings increases.

The Double Currency Risk

The squeeze inflicted on Southeast Asian banks and firms by the rise in interest rates was painful, but hardly unprecedented. After all, borrowing short and lending long was precisely the source of the U.S. Savings and Loans crisis of the late 1970s and early 1980s. While the U.S. is certainly not immune from these maturity mismatches, the Southeast Asia maturity mismatches were magnified by a second risk factor. The Southeast Asian banks and firms were not simply borrowing short and lending long, but were borrowing short in one currency—typically the dollar or the yen—and lending in another, to wit the local currency. If, therefore, a country’s exchange rate falls substantially relative to the dollar, the cost of renewing or rolling over those short-term floating rate dollar or yen loans can become very high in local, real terms.

Painful as it might be for the borrowers to have to pay more interest on their short-term borrowings, many are wondering why the mere act of rolling over those loans should be causing such havoc. Why is the IMF flying in everywhere with bail-out packages—which are basically just devices for either rolling over or for extending the maturity of existing short-term loans—for borrowers who can no longer meet their original commitments? In domestic financial markets, after all, these incentives to restructure voluntarily after an unexpected shock normally work reasonably well. Voluntary workouts between the parties may require much hard bargaining—it may even, in some cases, require help from the courts to get the final package put together—but these voluntary restructurings occur all the time. Why then, do they seem unable to do the job currently in the international arena? Why do we have to keep calling in the IMF cavalry, as in the old cowboy movies?

The Japanese Credit Crunch Risk

The answer lies in the third, and in some ways, most important of the three risks that underlie the current crisis. It’s one thing to be borrowing short and buying, for instance, government bonds. What if you are borrowing short-term dollars to invest in over-built local real estate as in Thailand, or in steel mills and shipyards with no customers as in Korea? You’re not going to have much to offer your creditors as inducement to accept restructuring of their claims. The creditors are worrying not about restructuring your claims, but about whether you can survive at all!

Still, difficult as voluntary restructuring would be, private negotiating and contracting could do it in principle, except for one thing. The dollar and yen short-term loans to local borrowers are provided mainly by banks, especially—but by no means entirely-Japanese banks. The restructuring process would inevitably mean a big surge in loan losses and problem loans for the Japanese banks already staggering currently under their huge burden of bad loans. The overhang of bad loans in Japan has led already to a virtual freeze-up of normal bank lending operations there, and from there elsewhere in Asia. This “credit crunch” emanating from Japan and the Japanese policies for dealing with it are at the heart of the current Southeast Asian financial crises, crises that cannot be fully resolved until Japan, at long last, puts its house in order.

The Currency and Foreign Exchange Crises

Before turning to the credit quality and banking crises, however, let me digress and say a bit more about the currency and foreign exchange crises which have been receiving so much, perhaps too much, press attention.

The currency crisis, according to the conventional wisdom, started in Thailand as early as autumn of 1996. (Actually, as I’ll argue later, it really started elsewhere. But that can wait.) The point is that the Thailand baht, which was not rigidly pegged to the dollar as in Hong Kong but merely linked to the dollar—actually to a basket of world currencies in which the U.S. dollar was the dominant component—came under increasing pressure in the fall of 1996 from speculators and hedgers. The Bank of Thailand hoped to maintain the historical value of the baht out of fear of spooking foreign investors. The Bank tried to support the currency, but it eventually ran out of foreign currency reserves and in July of 1997, had to uncouple the link to the dollar and allow the baht to float. I should mention that in this context, the word “float” is a euphemism. Float implies an up-and-down movement, but when the baht was allowed to float it sank—it didn’t float. It dropped some 50% or more of its value relative to the U.S. dollar.

With the baht down so dramatically, the contagion quickly spread to Thailand’s neighbors and competitors: Malaysia, Indonesia, the Philippines, and most recently Korea. Singapore and Taiwan were also affected, though, like a strong boxer who takes a blow to the chin, their knees may have buckled a bit, but they didn’t go down. Their devaluations were minor. Hong Kong was even able to avoid a devaluation altogether because Hong Kong has wisely adopted a monetary and foreign exchange system that is so fundamentally different from that of the rest of Southeast Asia.

What was the Mistake?

When a currency like the baht loses fifty or sixty percent of its value virtually overnight, scapegoat-hunting becomes the order of the day—or as we say, there is a lot of finger-pointing going on. What did the Bank of Thailand do wrong? That question is particularly poignant because the Bank of Thailand was one of the most respected and honored elements of Thai life. Thailand had built up a strong reputation over the years for technical competence—all of the managers were trained economists—not at the University of Chicago, of course—and they had a well-deserved reputation for incorruptibility. And believe me, in Thailand, that was rare What was the mistake? If it wasn’t incompetence, and it wasn’t corruption, what was it?

The Bank of Thailand’s first mistake was the common one—the common mistake of trying to fight off the speculators by raising interest rates and tightening market liquidity. At first sight, that may indeed seem the natural way both to attract dollars from abroad and to discourage those pesky speculators. The higher rate would punish speculators by raising the cost of borrowing the currency to sell it short. But even though the cost looks horrendous—sometimes 100 percent or even 1000 percent on an annualized basis—it comes down to just a pin prick on a daily basis compared to what speculators hope to make from even a modest devaluation, let alone one of fifty or sixty percent.

Raising interest rates not only does not substantially discourage the speculators, but it can be shown to actually enrich those speculators who have already sold the currency short in the forward exchange market. There is nothing they want to hear more as a short, than that you are raising interest rates, because that is dollars in their pocket. That’s fine—I’m not the envious kind—let them get rich, but raising interest rates not only enriches them but it also impoverishes everybody else, as I needn’t emphasize here in Hong Kong. This is a very damaging policy to follow. It inflicts the pain on your own citizens, so many of whom , it will be recalled were borrowing short and lending long. The last thing in the world they are happy about is a rise in interest rates.

Lack of Transparency

The most damaging mistake of the Bank of Thailand, however, was the concealment of facts about the true state of its foreign exchange holdings. Central bankers like to keep things like that secret—they like to hide what they’re doing—they pretend that they are just another trading firm like Goldman Sachs or Morgan Stanley. You don’t expect Morgan Stanley to tell you what its trading position is, so you don’t expect the Central bank to be honest with its owners. They believe the general public is too prone to panic to be trusted with such sensitive information, or they just naturally have the regulator’s mentality, which is “Don’t say anything to the public.” Anyway, lack of transparency is a long tradition of central banks not just in Thailand, of course, but in the U.S. and Japan as well and even, or particularly, by the International Monetary Fund. You figure out what they’re doing—they’re not going to tell you.

Speculators and the Forward Market

In the case of the Bank of Thailand, the deception was over the amount of dollars and foreign currency reserves the Bank had left for fighting off the speculators and maintaining the value of the baht. The Bank said, and the public believed, that those reserves were substantial. But the speculators knew better, because they know that the battles over the value of a currency are not fought in the spot market. The spot market is the simple market, which is a market that we can all understand. The speculators—including these days not just George Soros, but anybody who is hedging their foreign currency exposures—are actually operating in the forward market, not the spot market. And that is important because in the forward market, you don’t have to put your money up front, but only at maturity of the forward contract, which may be three or six months or more away.

Thus, the Bank of Thailand, which was fighting the speculators in the forward market by taking a long position to offset the speculator short positions, could, for a while at least, continue to show substantial amounts of foreign currency reserves on its books, even though the Bank had already committed those reserves in the forward market.

Losing the Mandate of Heaven

Central banks may not have to mark their positions to market daily in the forward market, but they can’t postpone collateral calls indefinitely. The truth must eventually come out. And come out it did, when the Bank finally had to admit its foreign reserves were mostly gone. That admission led, in turn to a massive run against the baht. I use the term advisedly: “run,” as in a bank run. You know what they are. I hope you don’t have to experience many of them here. This was a run, everybody was in a rush to get out, and it quickly swamped the additional liquidity that the IMF had brought in, which changed the terms of the battle from one of countering speculators to one of stemming widespread capital flight by the Thai people themselves.

With the deception by even the Bank of Thailand revealed, the remaining Thai institutions, financial and political, could not withstand the loss of confidence. To borrow a phrase from Chinese history, the Thai government and its institutions had lost the “mandate of heaven.” And in the process, what might otherwise have been a minor realignment of ten or fifteen percent turned into a major disaster.

Confidence in Hong Kong

The collapse of the currency in Thailand was followed by similar collapses and capital flight in Malaysia, Indonesia, the Philippines and most recently Korea, but not, as noted earlier, Taiwan and Singapore, and especially not Hong Kong, whose currency—at least up to the time of this writing—maintains exactly the same value it had before Southeast Asia’s financial crisis began. Why has Hong Kong been able to buck the tide? Because, so far, the people of Hong Kong have not lost confidence in their government and its promise to maintain the value of its currency—to maintain the value of so much of their life’s savings. This is an important point—as long as the public has confidence, mere speculators can have little impact, especially in the currency-board systems like that of Hong Kong, where nothing is supposed to distract the monetary authorities from their primary task of maintaining the peg.

Indeed, the only serious threat to the peg can come when the monetary authorities misunderstand their role and start applying the standard central bank techniques that failed so conspicuously in Thailand, notably raising domestic interest rates. As stressed earlier, that doesn’t hurt the speculators who have already sold short in the forward market. Thanks to the principle of interest rate parity, raising interest rates can be shown actually to help those who have been selling short. At the same time, it hurts everyone else.

The important point to remember is that, as long as the people of Hong Kong stay convinced that the peg will hold—and the currency board managers have ample ways other than interest rate increases to signal their determination to hold the peg—it will be maintained because confidence will set-up its own internal mechanisms for off-setting them. As the peg continues to hold, month after month, the speculators will simply find their wealth steadily being nibbled away by transaction costs. They will eventually tire of the game and look for easier targets.

The Credit-Risk Crisis

But, enough of foreign exchange problems. Let me now turn to the third of the Southeast Asia crises, the one, I will argue, that served as the initiating trigger of the Southeast Asia crises in the first place; and the one that until solved, will keep the whole region from returning to its previous state of prosperity and high-growth. I refer, of course, to what I have been calling the “credit-risk” crisis.

Credit-risk is ever-present in financial markets, and is realized whenever borrowers cannot or will not repay their loans on the original terms. Normally, of course, these “bad loans” might seem of only local significance. But, in a properly regulated banking system, the rules would require banks to write those bad loans down to market value, taking the losses into income. Recognizing bad loan losses that way, however, erodes the bank’s capital ratios, and banks whose capital ratios are impaired, or close to it, cannot make new loans. They can thus no longer play their traditional—to use the old cliché—role of greasing the wheels of commerce. Banks that are capital-impaired can’t do that.

Banks in Denial

That scenario caused problems even in the United States, during the years 1988 to 1990, the years of the great credit crunch. But business firms and consumers in the U.S., for all their complaints about the drying up of bank credit did have plenty of alternatives to bank financing. That, unfortunately, is much less true of the firms and consumers in Southeast Asia who remain heavily dependent on bank financing. And because they are so dependent, many of the countries of the area have long been reluctant to force their banks to recognize and write off their bad loans. The governments and bank regulators in Southeast Asia feared and still fear that recognizing bad loans would impair the capital of their banks and lead to a liquidity freeze-up that would damage the economy severely because nobody could get any bank credit.

Nowhere has this refusal to recognize and write-off bad loans been more obstinate than in Japan, but Thailand, Korea and much of Southeast Asia share the same denial syndrome.

Economists of future generations, looking back on the late 1990s, will wonder how the banks and bank regulators of Japan and elsewhere in Asia were able to remain in denial for so long. In the case of countries like Malaysia, Indonesia and Korea, part of the answer is surely that the bad loans were not simply ordinary commercial loans gone sour. That wasn’t the whole of the problem. There were political loans reflecting the country’s “industrial policy.” Writing them off would have been a huge embarrassment to the governments involved to put it—mildly. In the case of Japan, the sense of urgency may have been further reduced by the seemingly endless store of bank capital represented by the unrealized capital gains on the stock of Japanese firms held by the banks. As the Nikkei 225 Average steadily sank, however, this cushion of capital reserve is drying right before your very eyes. And by the time, the average was flirting with 14,000, as it did in 1996, the cushion was effectively gone.

Low and Falling Value of the Yen

In an attempt to restore the Japanese bank capital, the lawyers who run the Japanese Ministry of Finance—and I use that term advisedly. They are not economists, although they are called the Ministers of Finance. They recruit each year a new crop of lawyers from the University of Tokyo Law School. They go up through the organization. The lawyers had a choice of strategies. They could have insisted that banks write off the bad loans and raise more outside capital. But that would have both damaged the existing stockholders and forced them—horror of horrors—to share their control with foreigners.

Instead, the Ministry of Finance—or MOF, as I like to call them—adopted another strategy which, unfortunately, destabilized the rest of Southeast Asia. In the middle of 1996, the Japanese opted for a strategy of driving down short-term interest rates. MOF’s hope, of course, was that Japanese banks would obtain thereby some low-cost, short-term funds that could be invested in higher yielding long-term securities, earning the carry—spread and adding it to their capital. As the profits from the carry, this upward—sloping structure, came in, more bad loans would be recognized and written off, and the viability of the system secured.

And, now we can put our fingers on the real culprit for the financial crises in Southeast Asia: the low and falling value of the yen. A matter of deliberate policy by the Manager of the Japanese economy. One is tempted to say the Japanese government, but who are they? So it was the Ministers of Finance. The low and falling value of the yen was the problem not because it led to increased Japanese export surpluses in the U.S., as President Clinton would insist because it worsens our balance of trade with Japanese. That is indeed an annoyance for him, not for me—maybe for the United States automobile manufacturers. But the real trouble with their policy is on the other side of the coin of a falling yen, namely a rising dollar. Thailand and the other countries in Southeast Asia had linked their currencies to the dollar. As the yen fell, the dollar rose. Currencies linked to the dollar, therefore, inevitably seemed overvalued, and, as the balance of payments deteriorated, they seemed ripe for speculator attack, particularly so after a new Asian Tiger, mainland China, began to enter the export markets in a big way. All of this pressure on their balance of payments.

Conclusion: Hong Kong

So much for my three interlinked crises. Where do we go from here? The answers will vary substantially over the region.

For Hong Kong, for example, the answer is simple. The Hong Kong banks unlike the banks of Japan and Korea are among the strongest, best managed and most honestly regulated in the whole world. The Hong Kong currency board, moreover, eliminates the need for a central bank and the mischief such central banks can cause—always with the best intentions, of course. It’s just that you can’t hope to maintain both the internal and external value of currency at the same time. You have to choose one or the other. The United States, under the leadership of Alan Greenspan, has chosen to maintain the domestic value of the currency, allowing its external value to float. An indeed Greenspan has succeeded. Prices in the U.S. have been remarkably stable over the last five years.

Hong Kong, has wisely, in my opinion, adopted the opposite strategy of maintaining a stable foreign exchange value for its currency by firmly pegging it to the U.S. dollar. Exporters—in Hong Kong’s case that includes the local tourist industry— will of course always be clamoring for devaluation’s. But the citizens of Hong Kong should remember that if they choose to lower the peg—and I hope they will not—any gains will be temporary. Other countries will simply match the cuts. Not only that, import prices will quickly adjust leaving the exporters no better off competitively.

If you look only at exports, you don’t see the fact that you are also making imports much more explosive, as they are learning in Korea and other places. Make import prices more expensive, eventually the workers realize that in the long run you don’t gain by devaluation’s. A phrase I always use is, “If devaluation’s could make a country rich, Argentina would be the richest country in the world.” So, Hong Kong would not gain as a result of losing the peg, but it would lose its priceless reputation as an island of financial stability in a sea of chaos gone forever. Once you lose it, you’ve lost it.

Other Southeast Asian Banks

For those countries with weak banking systems, which includes most of Southeast Asia except for Hong Kong, and possibly Singapore and Taiwan, a more rational system of bad loan recognition must be developed which in turn means huge amounts of new capital must be pumped in to make the banks capable of playing their role in the savings/investment process. The countries must recognize, however, that the needed capital can come only from one source: foreigners. And that those foreigners will be unwilling to put their capital in without substantially more control over the management of that capital than many locals are willing to give up to outsiders. They are still laughing in Wall Street about Thailand’s offer to allow foreigners to take major stakes in their banks and businesses—but for no more than five years!

Such steps to shape up the local banks, though urgent, represent short-term solutions at best. Improve banking institutions, yes. Any bankers present? Good—they’re all out at the other meeting. But recognize that banking itself is disaster-prone, 19th Century technology. We’ve studied these problems for years. A way of endowing both bankers and regulators with the fight incentives both to finance industry and to avoid catastrophic collapses—we haven’t solved that problem. It’s unsolved now, nor will it ever be, I’m afraid, given the moral hazards posed by the absurdly high leverage ratios in banking, by deposit insurance, by the doctrine of “too big to fail,” and by the increasing likelihood that the IMF—at least until it runs out of money—always stands ready in the wings to bail out bad banks and bad creditors generally.

Southeast Asia and China must look ahead ultimately not just to reforming the banks, but insist to reducing dependence on banks as suppliers of capital to industry, partly by shrinking the banking industry itself, but even more, by steadily expanding the number and variety of market alternatives to bank loans—everything from leasing to junk bonds, which, after all, are really just liquid, negotiable commercial loans. You need a vast set of alternative ways of raising money. Here as so often in economic life, we must rely on the principles of decentralization and diversification—in this case diversification of financing alternatives—and not on the presumed superior judgments of large banks and their regulators for directing society’s capital to its must productive uses. If, therefore, the current crisis has done nothing more than discredit the Japanese and Korean models of development, then perhaps someday we can look back and say that the episode—painful as it has been and still is to live through—at least it’s nevertheless been worthwhile.

Questions & Answers

Professor Miller also answered several questions from the audience:

You mentioned earlier that capital flight has not happened in Hong Kong because people still have confidence in the system. Do you think this confidence is well-placed or not? Secondly, you mentioned that the monetary authority has ample ways to maintain stability other than hiking up interest rates. Can you share with us, in general, what these are?

Let me break these up. First on the subject of confidence, I thought confidence was being maintained until I read this morning’s paper, which reported a poll which suggested that confidence is slipping. My own feeling is, that as long as interest rates are up where they are—14% or something like that—confidence is going to be hard to maintain, because they shouldn’t be that high. If the LIBOR rate is 5%, the Hong Kong rate—“HIBOR”—should be five plus a little bit more. I would say five, but apparently there is a little teensy bit of historical currency risk.

Is the confidence misplaced? Well, it depends! If they insist on raising interest rates, I’m afraid it is. I am arguing that they shouldn’t—they don’t have to do that. In a situation like this, when you still have a very large level of support for the currency, what you need to do is somehow signal to the world that, when it comes to maintaining the peg, you are really serious. We have kind of a crass expression in the States when this comes up. One way to show you’re serious is to “put your money where your mouth is.” If Hong Kong will offer the public the equivalent of insurance policies for the maintenance of the peg with the understanding that if it sells these insurance policies and then breaks the peg, it’s going to take a hit—then the public will be inclined to say that they must be serious, because they have put their money on the line.

That is the same advice incidentally, I’ve given in China on the subject of the renminbi. If you expect people to believe you, you’ve got to adopt these bond techniques of making your intentions known by, in effect, using the modern power of derivative, shall we say, to offer insurance to the public. Then the public insurance will take care of itself.

Do you think that the currency board system is functioning in a self-correcting way or that Hong Kong is playing with an independent monetary policy at the moment?

I hesitate to deal specifically—I am not here to discuss personalities. I wanted to talk about where we go from here. My father always used to say to me when I was in a battle with my cousins, he said, “Don’t tell me who struck John. What do we do from here on out?” That’s my burden. Never mind who was responsible for what—and I don’t even care to speculate about that.

The question is, what should the HKMA do now? I think the answer is fairly straightforward. They should try this other approach. If they’ve got a better approach, I would like to hear it, but I haven’t heard it yet. They should offer the public this reassurance. If the public is worried that their houses are going to burn down, they’ll hire firemen and so on. They’ll also sell you fire insurance, and then you can relax a little bit—at least, you may lose your house, but you won’t lose your wealth.

In the case of the Hong Kong Monetary Authority, if they would offer to the public these insurance policies, and you could buy one and then not have to worry about any possible devaluation—you not only don’t have to worry about the devaluation but you now could take an aggressive anti-devaluation stand. If enough people did that at the same time—it’s just the paradoxes of information economics—there wouldn’t be anything to worry about. If they offered to sell the insurance policies, and everybody took the attitude that “If they’re willing to sell them, there’s not much of a crisis so why bother to buy them?” that would still be fine. That’s a victory too. So, I call them insurance policies, but what’s actually involved is certain kinds of derivative instruments known as structured nodes, or whatever you want to call them. What it amounts to is insurance policies.

I think you said in the introduction that you have just come down from China. You made a very eloquent argument against devaluation here. Even the Chinese government has been saying that they are not going to devalue. Are you confident in that? Six months down the road when we are talking labor problems?

That’s a very good point. I have discussed it with the Vice Premier. He has announced that the value of the renminbi will hold. I said, “Mr. Vice Premier, you’ve got to remember that people don’t automatically believe what a public official says.” I gave him an example, which he really relished. Remember the case of the Mexican President, who said in 1982, “I will defend the peso like a dog.” That was on Thursday. On Saturday, they devalued. Of course, everywhere this President went whereafter, everybody would bark at him.

So I said, “You ought to recognize that, if you put your money where your mouth is, if you issue these securities with these structured note securities, not only are you showing that you’re serious by putting the state’s money at risk, but...,”— at this point his eyes perked up, “you can make a couple hundred million bucks. If you know that you are not going to devalue and you are selling devaluation insurance, in the U.S. you’d be arrested for dealing in inside information.” Anyway, they are thinking of it.

I said, “Actually, you don’t even have to do it. You just have to announce that you are thinking of doing it.” That may be enough, but I would feel better if they actually did it. I’ve sent some memos to them to show them how it can be done.

Elsewhere I’ve heard you say that the IMF may be focusing on the wrong thing, namely on structural reform issues, when they should be focusing in liquidity. Just now, I heard you mention that a lot of the problems with Southeast Asia are structural. So how do you square these comments?

Originally, the IMF was meant as a source of short-term liquidity. Like every other government agency, they try to expand their mission. One of the things they are involved in now is structural reform. Why the IMF should be the one to do it, I don’t know. I actually have looked at the structural reforms they have suggested for Korea—they’re perfectly good. I just wish the Koreans had had the sense to adopt them voluntarily anyway.

If the IMF is going around with this “do-gooder” attitude, saying, “all right, if you want $8 billion, you have to do this, that, and the other thing,” I suppose one shouldn’t take account of perfection. Anything that cleans some of the cesspools, the better—know matter how they do it. Even so, I personally am very worried that when you have this joint kind of mission, both to preserve local liquidity and to structure reform, that you are not going to do either job very well. So I am not a great fan of the IMF.

Talking about the Hong Kong dollar peg situation again, my understanding of the currency board is that the central tenet is that interest rate arbitrage was self-adjusting in a currency board system, whereby the interest rates went up when you had more money coming in and so that interest rate rise was actually only temporary. By your suggestion that we don’t need to use interest rates, are you suggesting that the central tenet of currency board theory is flawed in and of itself?

What I’m saying is, if you look at interest rates now, they are 14%. You would think, off hand, what an interest rate arbitrage opportunity you have. If you borrow U.S. dollars at 5%, you can make 14% once you convert it into Hong Kong dollars—if the peg holds. But if you’re worried about whether the peg will hold, then that 800 base-point spread is a measure of the risk that you will be taking. When I call it, “my suggestion”—please, it was developed originally by the very good economists that you have here in Hong Kong. Hong Kong is unlike the other countries in Southeast Asia: Hong Kong has plenty of good economists, and they have developed this solution of recognizing the psychological side of things with insurance policies, or “puts” they would call them. I would call them structured notes. So, it’s not just my suggestion—it’s a feeling that that premium won’t go down automatically. It won’t go down because people are losing confidence in the permanence of that peg. So they’ve go to do something—sort of slap the market in the face—to make it clear that they are serious about this. Once they do, then the mechanism, as you describe, will work.

You mention that part of the regional currencies is attributable to the loss in value of the yen through time. It seems that the Japanese economy is in a severe case of doldrums right now, with continually declining GDP. So it looks like it’s a real good possibility that the yen is going to continue to slide in value through time. Can anything be done to stop the loss in value of the yen? It seems to be a very important thing with respect to the local, regional currencies.

That’s a very good question. Normally, in past years, I’ve always taken the attitude that if the Japanese want to commit slow, harikiri, well, I deplore it, but it’s their business. The problem with the Japanese mismanagement of their economy—I know of no other way to characterize what’s been going on over there for the last seven years—the trouble is that the mismanagement of their economy has these externalities that are effecting everybody else.

Will they ever get their act together? I don’t know. I vary. I’m quite pessimistic about them, because, as I say, they have no government. They have nobody there who is willing to take charge. They talk about Big Bangs, but—with the Chinese New Year coming up—I assure you that the Japanese Big Bang is like a very small fire cracker.

They are not serious. Their internal politics has paralyzed them to the point where they cannot take the steps that have to be taken. Whether, something will come that will resolve it, I don’t know. I hope so, because we are all in for a long, hard summer.

Can the United States do anything to help?

Where is General MacArthur when we really need him? I don’t know. The United States has problems of its own. I don’t think it’s that simple. I don’t think that they listen to us. Everybody knows—I’ve talked to many Japanese administrators and economists—everybody in Japan knows what should be done. There’s no doubt about it. It’s simple economics. But how are you going to do it? How are you going to get the governmental will to do the necessary things. Let’s hope that Hong Kong can develop the will power to do what has to be done, let alone a country like Japan.

You mention that Hong Kong has ample ways of maintaining stability should they choose to use them. There are countries within the region for whom the issue is not so much maintaining stability as regaining it. What would your advice be to the authorities or perhaps the central bank in Thailand or perhaps more importantly to Indonesia?

Get rid of Suharto, is one. I don’t know. I only give advice to countries that invite me. I don’t know. It is a very difficult question. I’m not sure there is any easy solution until such time as the Japanese economy starts moving again, and the area as a whole starts going up. Once you have the kind of rut that they have in Indonesia, with its capital flight, with a complete loss of confidence in the governmental institutions—as I said, they have lost the mandate of heaven.

How do you regain the mandate of heaven? I am still reading Chinese history to see if I can find out how a reverse occurs. There are many cases where you lose it, but there aren’t many too many where you regain it once it’s lost. I don’t know, it’s a difficult situation, and I don’t want to give the idea that there is any easy solution.

Hong Kong, I think, is lucky because they wisely chose the currency board approach, and it is a sustainable approach if its properly implemented.

Other countries—one thing I’m going to tell them, if they ever recover, is, “Why don’t you put in a currency board? Your own central banks will cause you nothing but trouble.”

One of the problems in Southeast Asia is over-borrowing and over-investment, because people in these countries essentially believe that the exchange rate systems would hold forever. With the public insurance idea that you have suggested, do you see a similar sort of moral hazard issue arising?

I don’t know. I don’t think so. I think this system is simple and straight-forward. I don’t see any serious problems with it. If people think that there are some, I wish they would let me know. The objections that I have heard from certain people—I won’t say that there are more than that—but the objections that I have heard do not seem very cogent. I think that at this point of Hong Kong’s development, I’m tempted to say, “Well, you got any better ideas?” You should at least try this, because it is low-cost, doesn’t have any obvious moral hazards that I can see, and in my opinion it will work.

I do not have a closed mind. If somebody has a better solution, tell me what it is. Don’t tell me raising interest rates, though—that won’t do it.

We all agree that, on average, many of the banking systems around are bankrupt. The banks have negative equity. One of the solutions is to open the doors to foreign banks to take some stake in that. Most of the countries in Asia are just coming out of a long period of colonial oppression, and, understandably, they don’t want foreigners in again. Pretty good examples are Malaysia or Singapore. Can we solve the problem in an elegant way?

Yes. I think the elegant way is simply this: you don’t want foreigners, then suffer. We have a saying in the U.S., “You have to pay for your thrills.” If they are so determined to keep out foreigners, then they are going to have to shrink in world-size down to a country that they can support on the basis of their own internal resources. Don’t expect foreigners to put in money—particularly after what’s happened recently—why they ever did it in the first place is unclear to me—but don’t expect foreigners to put in money with the understanding that the local people will manage it any way they want. It ain’t gonna happen.

*: Merton H. Miller is the Robert R. McCormick Distinguished Service Professor Emeritus of Finance at the University of Chicago and was awarded the Nobel Memorial Prize in Economic Science in 1990. Back.