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Journal of International Relations and Development
Volume 2, No. 3 (September 1999)
National Policy and Currency Crises in a World of Global Finance
By Shah M. Tarzi
*
Introduction
Financial globalisation, also referred to as the globalisation of money and finance, 1 is perhaps the most significant expression of the transcendence of national territorial space. As a result of rapid increases in telecommunication and computer-based information technologies and products, and the new instruments and risk management techniques they have made possible, a dramatic expansion in global financial flows within and across countries has emerged. As a consequence, an ever wider range of international firms are able to manage their financial and currency risk exposure more effectively, thus enabling them to concentrate on managing the economic risks associated with their primary business. Dramatic gains in communications and information technologies have enabled financial markets to develop and use complex financial instruments such as put and call options, interest rate swaps, or ‘short positions’.
New technologies have made it possible to deploy complex financial instruments and techniques, and in the process have strengthened interdependence among markets and market participants, both within and across national boundaries. The recent financial turmoil in Hong Kong, South Korea, Taiwan, Thailand, Singapore, Malaysia and Indonesia, and the turmoil in the European exchange rate mechanism (ERM) in 1992, confirm that there is a contagion effect associated with the globalisation of financial markets. That is, in a world of global financial mobility, a disturbance in one market segment or one country may be transmitted to other segments of the market and to reverberate with astonishing rapidity throughout the world economy.
Many of these global financial flows are based on world-wide portfolio investing. However, in terms of global economic fundamentals, such flows of capital are part of the global economic architecture that supports the efficient international movements of goods and services. Integrated financial markets facilitate the flow of trading, direct investment, thereby creating new opportunities for developing profitable financial products (Lee 1997).
In the high technology financial markets of the 1990s, the link between money and territory has loosened due to the borderless cyberspace of banking computers, the free electronic cross flows of national currency, the globalisation of medium and short-term maturities (e.g., medium-term notes, commercial paper, repurchase agreements, and the rapidly growing listings of securities on various foreign stock exchanges, as for instance, American Depository Receipts on the New York Stock Exchange) and the advent of debt and equity securities trading through computer network-based dealers, instead of the floor of financial stock exchanges (Scholte 1997).
The globalisation of the world economy is undeniable. Recent economic turmoil in Asia proves this. Real estate lending in Thailand precipitated a stock market crash in Hong Kong, where 75 percent of the market capitalisation is real estate-based, which sent the Dow Jones industrial average into a tailspin. However, the effect of globalisation on ‘economic sovereignty’ and the modern nation-state has been the subject of heated debate cutting across various disciplines. In the liberal tradition of international political economy, some observers have argued that globalisation has robbed governments of even a minimal degree of influence with regard to the management of macroeconomic policy. They claim that global integration is emasculating the modern state. The tasks that have traditionally been regarded as the realm of public governance have moved beyond the reach of government, and thus beyond the reach of voters. Global markets are in charge. Governments often have little else to do other than to stabilise prices and government spending in order to avoid pressures on their currency and to attract foreign direct investment (FDI). According to adherents of this view, globalisation of the international economy fuelled by the liberalisation of capital movements, the deregulation of major financial markets and the adoption of floating exchange rates, has undermined the ability of the modern nation-state as an effective unitary economic actor (Schmidt 1995; Hirst 1997). As Evans (1997:65) has observed,
No one questions that the traditional Waltzian logic that competing ‘national interests’ continue to drive the ‘interstate system,’ but the muted great power struggles of the post-bipolar world leave international relations increasingly contaminated and often overshadowed by the private logic of the global economy.
Global economic integration thus explains, at least in part, the political malaise affecting many of the world’s major democracies. These developments have largely enfeebled the modern territorial nation-state.
Support for the view that global integration has enfeebled the state is widespread. It comes from conservatives and socialists alike, in large countries, and in small countries, which have suffered the loss of economic sovereignty even prior to the advent of contemporary globalisation. Noteworthy radical writers who see globalisation as a threat to national economic sovereignty are Dos Santos (1971) and Richard Sklar (1975). A notable example in the conservative tradition is the study by Thygesen, Kosai, and Lawrence (1996). These authors have recognised constraints globalisation imposes on national economic policy. The works of Eric Hobsbawm (1994) and Stephen Gill (1995) are noteworthy examples of socialist and radical approaches. Kenneth Clark, a former British Chancellor of the Exchequer put it best when he said in The Economist that “the plain fact is that the nation state as it has existed for nearly two centuries is being undermined … The ability of national governments to decide their exchange rate, interest rate, trade flows, investment and output has been savagely crippled by market forces.” In that same issue, Stanley Fisher, another notable authority, has observed that “[t]he state’s powers over the price of money … tax rates, industrial policy, the rate of unemployment, have been blown away” (The Myth of the Powerless State 1997).
In support of this perspective, it can be said that the scale of economic activity no longer corresponds to the territory of the nation-state. In this global environment, governments that adopt protectionist trade policies, advocate restrictions on FDI and adhere to national monetary policies that try to buck transnational financial markets, will render their economies unattractive to international investors and trade, and consequently become non-competitive and unsuccessful.
At the other extreme, adherents of the realist tradition of international political economy continue to stress the primacy of the nation-state as the central actor (Tarzi 1991). Similarly, Gilpin (1975) has argued that since the initial movement of American capital and corporations abroad, the State Department and the White House have sought to channel American foreign investment in a direction that would enhance the foreign policy objectives of the United States. According to Gilpin, it was the concerted efforts of nation-states, the United States in particular, that created the post-World War II economic institutions such as the International Monetary Fund (IMF), the World Bank, and the General Agreement on Tariffs and Trade (GATT). These institutions in turn created the foundation for a global economy based on open and expanding international trade, monetary relations, and foreign investment (Gilpin 1975).
The realists have correctly argued that underlying contemporary international economic relations is the reality of the persistence of nation-states and interstate relations as the bedrock of international economic governance. As public institutions continue to formulate responses to exchange rate and financial instability, they mediate the impact and shape the consequences of globalisation. As some adherents of the realist school, Strange (1990) and Gilpin (1975) in particular, have argued, evidence suggests the close interdependence between the effectiveness of economic governance by nation-states and collective governance through multilateral institutions. 2 However, realist writers fail to appreciate that global economic relations have created a new context for state actions in national and international economic policies. Increasingly, private transnational transactions have been the source of wealth and power, creating doubt that states are the pre-eminent actors they once were.
This article takes the position that the interplay between the transnational economic forces and the territorially bound nation-state lies somewhere between the extremes of globalism that sees a state’s international economic function as essentially obsolete and the realism of Krasner (1978; 1987), who sees national governments as the real actors in the formation and implementation of international economic policy. Global integration has dramatically changed the rules of macroeconomic policy. Specifically, this author argues that in circumstances where ‘policy misalignments’ exist, defined as a basic incompatibility between economic fundamentals and macroeconomic policy fundamentals, markets act as a disciplinary mechanism, punishing national governments for unsustainable economic policies out of synch with the reality of economic fundamentals. These policy misalignments may be imbedded in an overvalued exchange rate, bulging current account deficits, excess economic capacity, expansionary monetary policies, etc. that tend to undermine the soundness of an economy and its financial systems. National policies that are out of synch with deteriorating underlying economic fundamentals, in turn, create disturbances in markets, as market participants, both domestic and international, lose confidence.
Using the financial markets as a point of departure, the author will argue that the plunge in the exchange value of the Mexican peso at the end of 1994 and early 1995, the turmoil in the ERM in 1992 and the recent sharp exchange rate adjustments in a number of Asian economies, are examples of how global finance acts as a punishing level on policy misalignments, actual or perceived with shocking alacrity. One striking feature of the market’s disciplinary action, one that is entirely a new development in the global economy, is that it has changed the timing and the severity of the consequences, if economic constraints and fundamentals are ignored. The effect of globalisation, it will be shown, is not so much that governments are forced to sacrifice ‘national economic sovereignty’. Rather, it is that is in a world of increasing capital mobility there is a premium on adopting and implementing a sound budget and interest rate policy, creating a robust financial system, and allowing exchange rates to provide appropriate signals for the broader pricing structure of the economy. Below we will amplify these points.
It has been noted earlier that countries with a weak and overvalued real exchange rate, bulging current account deficits, and large budget deficit, embedded in heavy public sector borrowing and expansionary monetary policies, are most vulnerable to a reversal of capital inflows. Two other factors are low national reserves relative to their liquid liabilities and a weak banking system (Corbo 1994:153; Folkers-Landau 1995; Frankel and Rose 1996). Accordingly, we characterise those fiscal and monetary policies as ‘appropriate’, ‘sound’ or fundamentally stabilising when macroeconomic policies purport to pre-empt, guard against or otherwise lessen the severity and impact of the above factors which tend to undermine the soundness of an economy and its financial systems. Here, a few examples will serve to elucidate this issue. For the period 1989-1994, as a group those countries that did not experience any currency crises showed an average surplus of almost one percent of gross domestic product (GDP), as opposed to deficits ranging from 2 percent to 8 percent of GDP for Mexico, Argentina, the Philippines and several other Asian economies that did experience crises (Goldstein 1998:3-22). Thus, a fiscal policy may be said to be ‘misaligned’ if a country’s budget deficit exceeds two percent of its GDP. Conversely, a fiscal policy may be said to be ‘sound’, if budgetary targets remain below this threshold, and thereby enable the government to maintain fiscal discipline. An irresponsible fiscal policy behaviour can be regarded as one of several factors that increases the likelihood of a currency crisis.
The government’s handling of the banking sector is another example to illuminate appropriate and stabilising macroeconomic policies. During the 1980s and into the early 1990s, banks in Indonesia, Argentina, and Colombia engaged in a lending frenzy. In order to raise deposits, banks increased interest rates. In the case of Colombia, the average interest on short-term loans maturing in six months increased by an average of 2 percentage points, from 5 to 7 percent. In Indonesia, money market interest rate increased by 3 percent, from 5 to 8 percentage points (Garcia 1997). Moreover, banks in these countries engaged in funding risky projects such as financing of skyscrapers and commercial buildings in the face of 60 to 70 percent prevailing commercial occupancy rates (Tanzi and Davoodi 1998). These countries experienced a progression from bank privatisation and deregulation to lending boom to eventual bust. In contrast, several countries, notably Chile, implemented a public policy mix that combined banking privatisation and deregulation with close governmental supervision. While reducing barriers to entry, and rationalising reserve requirements, the Chilean government also forced banks to comply with the capitalisation standard of the Basel Accord. As a result, banks remained solvent (Garcia 1997).
As already stated, this study will look at global markets as a ‘disciplinarian’ of national governments in circumstances where governments engage in policies incompatible with economic fundamentals. It will be shown that a basic incompatibility between the expansionary monetary and fiscal policies of the several governments and the fixed exchange rate regime, an incompatibility that could not be sustained with a finite stock of international reserves, has been central to understanding the financial problems in Mexico and Hong Kong. For example, the static response of the national governments in Mexico during the peso crisis and, most recently, the failure of Hong Kong’s financial authorities to stave off global financial pressure, including speculative attacks, both spring from an incompatibility between government policy and a fixed exchange rate. In these instances, a combination of rising nominal interest rates, rising wages and prices, overvaluation of the real exchange rate, and in the case of Mexico, a widening of current account deficits, made it difficult for these governments to sustain their commitment to peg the nominal exchange rate. Therefore, the issue is not, as adherents of globalisation would argue, a loss of economic sovereignty. Rather it is the adoption of inappropriate and unsustainable economic policies. Likewise, as various examples below will show, the view of those who argue that national governments are the dominant unitary economic actors is not adequate. Domestic and international financial forces do severely limit the ability of national governments to engage in and maintain unsound macroeconomic policies. This is especially the case when the country in question is a recipient of large sums of highly liquid portfolio investments.
One major implication of the analysis of those who argue that globalisation has caused a serious loss of ‘economic sovereignty’ is that somehow this is a highly negative or disruptive development. In contrast, the central implications of this study will be that market response, while sometimes disruptive and negative, overall, is a highly positive self-correcting mechanism. Put differently, the maintenance of financial stability in an environment of global capital markets calls for greater attention by governments to the soundness of public policy. The study recognises that financial crises cannot be attributed only to the macroeconomic policies of governments, to weaknesses in the local economy and local financial institutions. The extent to which excessive capital flows, short-term portfolio capital flows in particular, and investor speculation, make financial crises more likely also need to be addressed. 3
In the literature, five major clusters can be identified regarding the globalisation of financial markets and the interplay between the state and global finance: (1) many accounts seek to explain it with reference to technological and market forces (Hamilton 1987; O’Brien 1992); (2) several studies emphasise the behaviour and interests of states as important determinant of the globalisation of financial markets (Ruggie 1982; Pauly 1988; Helleiner 1992; 1995; Kapstein 1992); (3) literature dealing with the loss of national economic sovereignty due to globalisation (Gill and Law 1989; Strange 1990; Gill 1995); (4) the financial and economic causes of capital flows and currency crises (Feldstein and Horioka 1980; Calvo and Leiderman 1993; Sachs 1995); and (5) approaches to preventing financial crises, or reducing the incidence of such crises (Tobin 1978; Hawley 1987; Underhill 1991; Vipond 1991; Porter 1993). In contrast to the existing body of work, this study fills a gap in the literature by paying greater attention to the ways in which ‘public policy misalignments’ or incompatible and unsustainable government policies trigger reactions in the global markets, and how global market forces and national economic fundamentals interact. As a result, this study takes preliminary steps towards identify and explaining various types of constraints on the economic policies of national governments. However, before we proceed further, and on the basis of this introductory discussion, it is necessary to clarify the conception of financial globalisation guiding this research. Financial globalisation is thus defined as the process which leads to the emergence of a single, increasingly integrated and universal world financial market operating ‘transnationally’, and therefore largely transcending state frontiers. 4
Global Finance Versus the Macroeconomic Policy of Fixed Exchange Rates
In the mid-1970s, the major industrialised countries abandoned the Bretton Woods fixed exchange rate system agreed upon in 1944 in favour of the free market system of floating exchange rates. The free market system offered a mechanism for correcting trade imbalances and stabilising economic activity. This system allowed exchange rates to better reflect macroeconomic fundamentals such as incomes, money supplies, and interest rates. Fixed exchange rates, by contrast, tended to be economically and politically not feasible, as demonstrated by the collapse of the Bretton Woods agreement in 1973. Specifically, the fixed rate system leads to unpredictable exchange rates in part because rates are arbitrarily set by governments. Rates thus become subject to the vagaries of political and bureaucratic developments and do not accurately reflect economic fundamentals. Fixed rates thus make it possible for fiscally irresponsible governments to export their inflationary policies abroad.
The mismatch between the macroeconomic policy of fixed rates and the underlying fundamentals of a country’s economy creates opportunities for financial speculation, as investors correctly anticipate adjustments in otherwise unsustainable fixed rate pegs.
Since exchange rates are the relative prices of currencies and since the relative price of currencies, like any other goods, cannot be fixed in the long run, a fixed exchange rate system is, in the long run, not a viable option. Yet many governments, for reasons beyond the scope of this article, have opted for fixed rates. 5 In such circumstances, global financial markets have acted to discipline national governments for policy misalignments. Consequently, governments have been forced to alter economically unsustainable policies or preserve a policy posture at a huge price.
One aspect of the fixed rate regime especially warrants attention: whenever there is a discrepancy or policy misalignment between the monetary and fiscal fundamentals required to preserve the exchange rate peg and the actual behaviour of these macroeconomic fundamentals, a balance of payments crisis is likely to occur. This imbalance will in turn give rise to a currency crisis and speculative financial attacks of a global nature. In a country playing host to large global portfolio investments, such events are followed by severe international financial market reactions in the form of quick withdrawal of portfolio investments. Governments are often unable to stave off both the initial reactions of global financial market participants and the consequences of market actions.
As we shall see later, such was the case regarding the 1994 Mexican currency crisis. Here, the Mexican government pursued expansionary monetary and fiscal policies inconsistent with the peg. The latest currency crisis in Hong Kong, South Korea and the British experience with the ERM in 1992 also demonstrate the vulnerability of national governments to the challenge of global financial markets in circumstances where governments pursue incompatible and unsustainable macroeconomic policies. Investors might ‘short’ the exchange rate or buy put options, bidding that the rates will be adjusted downward. Alternately, they might ‘go long’ or buy ‘call options’ in anticipation of upward rate adjustments. 6 The sheer size of the financial flows through such derivative instruments could, in turn, precipitate an exchange rate adjustment crisis. Below we will comment on these crises to illuminate the broader thesis set out in the introduction.
The Mexican Crisis of 1994
Mexico introduced several market-driven economic reforms in the 1980s, including trade and investment liberalisation, privatisation, deregulation, tightening fiscal policy, and entry into the NAFTA (North America Free Trade Area) regime. The Mexican economy responded. The country recorded growth of 3.9 percent in both 1990 and 1991, and inflation fell below 20 percent in 1992. Further, exports grew swiftly, wage levels stabilised and the debt crisis seemed to have been brought under control. One major remaining economic problem was the huge current account deficit financed in part by global portfolio investments. Wall Street in particular was searching for high returns in Latin American stock markets or buying dollar-denominated Mexican tesobonos. These were debt issues which enabled the Mexican government to exchange large quantities of pesos for dollars, building up substantial reserves which the government planned to use to support the high exchange rate peg. Capital inflows which began in the late 1980s accelerated swiftly in the early 1990s, and reached a record high of US$ 29.4 billion in 1993. The changing pattern of capital markets in Mexico was increasingly obvious as the Mexican equity prices (in dollars) were ten times higher at the start of 1994 than their level at the start of 1989. Yet, in spite of these successes, the 1994 crisis unfolded quickly and forced the Mexican government to change what in retrospect turned out to be a set of unsustainable policies.
The Mexican crisis appears to be a classic case of downward pressure exerted by global financial markets on a pegged (or targeted) exchange rate in circumstances where national authorities pursue macroeconomic policies incompatible with the exchange rate. The Mexican government allowed its current account deficit to rise to about 8 percent of GDP, and financed this deficit by highly volatile, short-term portfolio-based capital inflows. Consequently, this equilibrium became vulnerable to domestic or international shocks that could, in turn, change the sentiments of foreign portfolio investors, Wall Street institutional investors, and particularly bond and equity fund managers. The economy was vulnerable because capital inflows large enough to finance such a huge current account deficit were unsustainable. Yet the Mexican government had made an implicit commitment to avoid any substantial movement in the nominal exchange rate. This created an urgency to maintain the unsustainable capital inflows and consequently increased their relative importance to the country’s economic health. In addition to this ‘flow side’ of the crisis, the rapidity with which domestic monetary aggregates grew in conjunction with the conversion of cetes into dollar-denominated tesobonos, referred to earlier, combined with erosion of official foreign exchange reserves, made the public sector generally, and the banking sector in particular, increasingly vulnerable. To these may be added growing doubts about the government’s fiscal and monetary discipline, along with inadequate policy responses to burgeoning current account deficits. These factors precipitated a self-fulfilling attack on the peso and helped trigger the September 1995 confidence shock. The ultimate result was a drastic withdrawal of liquid portfolio investments.
It is instructive to note that the Mexican government was forced to widen the exchange rate band on 20 December 1994 and to abandon the exchange rate peg altogether in favour of a floating rate on 23 December 1994. As a result, financial markets quickly adjusted the peso value, depreciating the peso against the dollar by 50 percent in less than two weeks. Abandoning the exchange rate peg meant that the Mexican government was unable to sustain the exchange rate policy, a commitment that created the condition for the initial capital inflows. This led to a crisis of confidence on the part of global financial market participants and to capital outflows. It was only after the Clinton administration’s US$ 50 billion rescue package enabled Mexico to pare down the current account deficit that the currency crisis stabilised (Leiderman and Thorne 1996).
The Asian Contagion of 1997
The currency crisis in Asia lends additional proof to the general proposition set out in this article that globalisation of the financial system has made national governments’ exchange rate policies subject to correction in the marketplace. Governments whose national economic policies were misaligned, including the British government, Hong Kong, Mexico, and most recently many Asian governments, have all blamed marauding currency speculators as the cause of capital crises. However, speculators cannot succeed in dislodging an exchange rate system compatible with and firmly aligned to appropriate economic fundamentals, cost structure and policies.
A combination of low levels of inflation and high rates of savings and investment, including investment in human capital through education, led to rapid economic growth in Asia throughout 1970s and 1980s. However, it was in the 1990s that a dramatic rise in foreign net capital inflows took place. The total net inflows of FDI, equity and long-term debt instrument purchases was US$ 25 billion in 1990, and exploded to over US$ 110 billion by 1996. The portfolio portion, the largest segment, was based on expectations of market participants and investors in the United States, Western Europe and Japan, of a high rate of return in the form of higher yields, rising stock prices and capital gain in these emerging markets, as compared to the developed world. Apparently, the flow of such huge sums of investment money in such a short time was greater than could be profitably deployed with a reasonable risk. In such circumstances of rapid growth and ample liquidity and limited short-term profitable alternatives, the real estate sector absorbed the lion’s share of these investments, as shown by lavish construction projects based on marginal economic rationale. A significant proportion of the assets of the domestic financial system were thus based on real estate portfolios. As mentioned earlier, the largest percentage of capitalisation of Asian stock market exchanges was based on real estate. In Hong Kong, for instance, this was as high as 75 percent. In order to maintain high rates of return on equity, businesses were borrowing heavily, increasing debt leverage which, in turn, added to financial fragility. Direct and implicit government guarantees of debt compounded the problem as lenders slackened vigilance on loans. In these circumstances of sky-high debt and huge real estate portfolios as a basis of financial assets, the margin of error for rising interest rates or economic slowdowns, as recent events in Asia has demonstrated, was razor thin.
Once again, the pegged foreign exchange rate served as the culprit that triggered global financial markets to react. Specifically, the rapidly growing foreign currency denominated debt put pressure on companies to earn foreign exchange to pay interest on corporate debt, thus sapping their economic strength and weakening their export position. Since exports of goods and services figure heavily in the economic growth of these economies, a slowdown in export earnings growth and the resulting excess domestic capacity placed many highly leveraged businesses in an economic tailspin. 7
As a result, the fixed exchange rate regime came under great pressure as institutional investors reduced the pace of new capital inflows. As the fear grew among investors that governments in the region would be forced to devalue their currencies, vast numbers of Asian businesses attempted to convert domestic currencies into foreign currencies and tried to delay the conversion of export earnings into domestic currencies. In response to pressures on the exchange rate, governments in Asia tried to raise interest rates. This potent combination of higher interest rates and slow economic growth made stock markets vulnerable and the position of domestic financial borrowers untenable. The 1997 currency crisis of Hong Kong helps illuminate this problem. In particular, it highlights the cost of maintaining a fixed exchange rate regime in the face of deteriorating economic fundamentals. Below we provide a brief exposition of the crisis in Hong Kong.
In October 1997 currency speculators world-wide attacked the Hong Kong dollar, the last Asian currency still pegged to the US$. The Hong Kong government found itself between a rock and a hard place. It had the option to ignore this event and see its currency, pegged at 7.80 Hong Kong dollars to one US$, depreciate in value. This depreciation would have meant that Hong Kong would have foresaken its top financial priority which the government considered the key to the island’s future economic health. Alternately, it could defend its dollar against foreign currency but at a very high cost to the economy. The government chose the latter option. The financial board of Hong Kong nearly depleted its US$ 88 billion foreign exchange reserves to ward off a run on the currency and protect the exchange rate. In the process, overnight interest rates in Hong Kong reached as high as 280 percent, and left the stock market’s Hang Seng Index with its biggest-ever point loss (Business and the Economy 1997). In percentage terms, the index plunged 10.4 percent, from 11,000 to 10,460 (One World, One Market 1997). Since about 70 percent of the market capitalisation of the Hang Seng is real-estate based, the rising interest rate is likely to put additional downward pressure on Hong Kong’s financial market (Where Asia Goes From Here? 1997). For this and other reasons, the contagion effect of the global financial markets quickly materialised as the crisis spilled over to markets in other Asian countries, Latin America, Europe and North America. The Dow Jones industrial average lost 2.3 percent, Japan’s Nikkei 3 percent, London’s FTSE 3 percent and Germany’s DAX index 4.75 percent (Business and the Economy 1997:16-7).
For Hong Kong, one of the strongest monetary authorities in the world, the economic cost of defending its currency in the face of a global speculative attack far exceeded the benefits of guarding the currency. Rising interest rates are expected to curtail Hong Kong’s economic growth (Where Asia Goes From Here? 1997:96-7). The currency crisis in Hong Kong, Thailand, Malaysia, Indonesia and the Philippines is likely to make a bad economic situation worse in Japan and, according to Wall Street Analyst Joe Battapaglia, could shave one quarter to one half percentage point from US economic growth in 1998 (ibid.). However, it is worth noting that Battapaglia’s prediction did not materialise. In 1998 the American economy grew at a robust rate of 3.9 percent, compared to 3.8 percent in 1997 (InterBusiness Issues 1999:46-7).
The vulnerability of the Hong Kong currency peg to global financial pressure is embedded in the policy misalignments associated with fixed exchange rate pegs described earlier. In this case, the exchange rate peg was largely out of synch with excess economic capacity and a slowing economy. Global financial markets correctly anticipated that Hong Kong, Taiwan, Thailand, South Korea, Malaysia and Indonesia would soon feel the pressure to devalue their currencies to make their exports more competitive. This sense of anticipation was evidenced by the type of financial strategies that global financial market participants employed. Specifically, investors engaged in using ‘short’ position and ‘put’ options. 8 These instruments are used when investors anticipate and bid that a currency will be devalued or the exchange rate will be adjusted downward.
Further, to correct the incompatibility between a macroeconomic policy reflected in an overvalued exchange rate peg and the fundamentals of the economy, the markets moved ‘long’ on the American dollar, appreciating its value vis-à-vis these currencies.
Those who argue that national governments have lost the ability to manage the economy in the face of globalisation, notably Scmidt (1995) and Art (1997), would regard the recent Hong Kong currency crisis as evidence in support of their arguments. Realist writers, notably Krasner (1987), and those who adhere to state-centric approaches, for example Gilpin (1975), will no doubt point to the ability of Hong Kong’s Financial Board to stave off the attack by global currency speculators — the Hong Kong dollar closed at $ 7.71 down from the $ 7.80 official peg — as an example of the ability of determined national monetary authorities to fend off powerful forces if the economic stakes are high enough.
However, what happened in Hong Kong reveals, contradicting the Realists, that globalisation does constrain the ability of national governments to carry out or sustain micro-economic policy. (Sachs et al. 1996) This is not due, however, to the ‘loss of economic sovereignty’, rather it is caused by ‘policy misalignments’ or incompatible and unsustainable government policies. To the extent that national governments are forced to adopt policies in accordance with improving economic fundamentals, the ramifications are, contrary to the alarm over the image of a powerless state embedded in the neoliberal position, an aid to better serve national economic interests. Overall, economic fundamentals in conjunction with the forces of global markets act as constraints on the policy of national governments. More importantly, unlike the past, the reaction of markets to serious national macroeconomic policy mistakes tends to be sharp, quick and severe — a phenomenon of financial globalisation.
The currency and economic crisis in Asia highlights several important issues. First, huge current account deficits financed by foreign portfolio investments are vulnerable to sudden withdrawal. Further, large net foreign currency exposures and constraints on exchange rate fluctuations are incompatible with long-term financial stability. Governments that pursue macroeconomic policies encouraging such a state of affairs are likely to trigger global financial market reactions. Second, the dilemma of monetary policy for national authorities which seek to fix exchange rates is clear: governments that choose to fix foreign exchange rates are not likely to retain control of interest rates; if they choose to control interest rates, they may not be able to fix the currency. The United Kingdom, for example, failed to resolve this dilemma, and the ERM collapsed.
Third, there is a quick contagion effect of weakness or a crisis in one economy spreading to others as investors perceive similar vulnerabilities. The 24 November 1997 issue of Fortune reported that from October 1997 through mid-November 1997 Thailand’s currency lost 58 percent of its value, Malaysia 32 percent, Taiwan 12.1 percent, South Korea 14.3 percent, the Philippines 33.4 percent, Indonesia 53 percent and Singapore 12.3 percent. Declines in the market capitalisation of stock exchanges have mirrored currency declines. During the final quarter of the 1997 fiscal year, Hong Kong’s stock exchange was off by 20 percent, Thailand 45 percent, Malaysia 46 percent, South Korea 28.3 percent, the Philippines 42.5 percent, Singapore 28.7 percent, and Indonesia 21.6 percent (Where Asia Goes From Here? 1997).
To be sure, there are differences in the kind of economic challenges each country in the region faces. In South Korea, for example, the challenge is to restructure the troubled chaebol (large conglomerates such as Samsung and Daewoo), open financial markets to foreign investors and recapitalise banks battered by corporate bankruptcies. Further, South Korea needs to rationalise its corporations by freely allowing mergers and acquisition. The Philippines, on the other hand, needs to keep a lid on inflation. Indonesia and Malaysia are among the shakiest of the Southeast Asian economies. The economies in these two countries suffer from endemic system-wide economic problems: high debt and overcapacity. Indonesia, similarly to South Korea, needs to swallow the IMF’s medicine to cut the national budget. Until recently, Thailand faced similar challenges (Sarel 1996) Thailand needed to reduce the trade deficit, put brakes on consumption, move toward more value-added capital-intensive businesses and adopt constitutional reform to stabilise the government. In 1999, Thailand took several steps to alleviate these problems. As of the time of writing, the current account deficit of 1996 and 1997 has become a large surplus. At the cost of a severe recession, Thailand succeeded in putting the brakes on consumption. Thailand also enacted a new and much more democratic constitution. Malaysia has to reduce both public and private debt. All countries in the region, perhaps with the exception of Singapore, need to deregulate their economy and tighten monetary policy so as to squeeze out excesses in the real estate sector in order to cool this overheated segment (InterBusiness Issues 1999:47-50).
Perhaps the most important lesson of the current crisis is that globalisation of finance, by triggering such crises, will accelerate in Asian countries the dismantling of a system that emphasised a disproportionately large role for government-directed investment. Whenever serious mistakes arise from government-directed or influenced investments, private global capital flows will become adverse, exposing misguided policies, and domestic structural and institutional flaws of the system. In the case of South Korea, for example, the government sometimes provided support for ailing companies that should have gone bankrupt, and it extended loans and guarantees to private firms driven, not by market forces, but by a national ‘industrial policy’ (Tanzi and Davoodi 1998). In many of the Southeast Asian countries facing the current economic and financial crises, such government loans led to a misuse of resources, unprofitable expansions, losses, and eventually loan defaults. When a government guarantees those foreign currency-denominated loans, as had been the case in some of the Asian economies, it makes the national government vulnerable to the backlash of financial markets.
This account clearly illuminates the proposition that the major issue national governments face in an age of global finance is not ‘the loss of economic sovereignty’. Rather, it is the misguided macroeconomic policies of national governments that are the culprits. Seen from this vantage point, the globalisation of finance is a positive force that exposes macroeconomic policy mistakes (Greenspan 1997a).
The United Kingdom and the ERM in 1992
In 1992, an uncontrollable wave of selling defeated the British government’s effort to defend its currency and forced it to leave the ERM. This is often cited as solid evidence of the powerlessness of national governments in the face of economic and financial globalisation. The actual picture is far more complicated when one asks why did waves of ‘short selling’ hit the currency market in the first place and whether the British government’s macroeconomic policy was unsustainable and thus vulnerable to such attacks.
In the case of ‘Black Wednesday’, the global financial markets correctly anticipated a crisis. This crisis would be caused by inflationary pressures, rising budget deficits and excess domestic credit creation. At the same time, the British government sought to preserve a nominal exchange rate peg within a tight ERM regime. The United Kingdom had entered the ERM in 1990 at an unsustainable target rate of one pound to DEM 2.95, when the rate of British inflation was almost three times that of Germany (Hirst 1997). Therefore, it was no surprise that markets responded rapidly to these damagingly overvalued exchange rates.
The financier George Soros, several major Wall Street hedge fund managers and many other currency speculators world-wide correctly concluded that the German Mark (DEM) would continue to muster strength. The reason being that the German government kept interest rates relatively high in order to sustain capital inflows needed to contribute to the restructuring of the economy of former East Germany. In contrast, the British overvalued exchange rate was unsustainable. The British government had deliberately allowed the pound to appreciate against the mark. Consequently, financial market participants used derivative financial instruments to attack the peg, and created a massive downward selling pressure as a result. The British government launched a buying spree of its national currency on the open market in order to stave off the downward pressure on its currency, but to no avail.
In short, financial and economic fundamentals were incompatible with the ERM required exchange rate. As in the case of Mexico, this incompatibility could not be sustained with the finite stock of British financial reserves. An overvalued exchange rate, undisciplined monetary policy and inflationary spikes conspired to create the preconditions for market reactions. To be sure, prior to the crisis the British government did have the option of devaluation within the ERM, which would have created a more realistic and sustainable exchange rate. However, such action would have raised doubts about the British commitment to a unified European currency regime, and was therefore politically not palatable (Scholte 1997).
Once the market concluded that devaluation was unavoidable, reaction was swift, sharp, and powerful. This crisis could have been avoided altogether, however, had the United Kingdom entered the ERM at a realistic and sustainable rate. Put differently, effective public policy options to stabilise the exchange rate were available and could have pre-empted a crisis. As the above account suggests, a misguided public policy, not the powerlessness of national governments, was the cause of the crisis.
An important lesson of the Black Wednesday episode is that financial globalisation will trigger severe reactions to national government policies that seek to change prices in financial markets. Financial markets punish national policies that are incompatible with or insupportable by real economic fundamentals.
The Market as a Possible Determinant of Financial Crises
The reversal of capital flows cannot wholly be attributed to misguided and misaligned macroeconomic policies of national political authorities and to weak economic fundamentals of the local economy. It stands to reason that large capital inflows today may set the stage for large outflows in the future. One authoritative study suggests that a sudden flight might be triggered by circumstances beyond policy-makers’ control (Calvo 1996). In addition to the size of capital inflows, its composition is an important factor. Specifically, one need to distinguish between portfolio capital (short-term flows in the form of equities, short-maturity bonds, and deposits in local banks), and FDI. The latter is motivated by the desire to access markets and resources, and it has a long-term investment horizon. In contrast, portfolio investment is motivated by participation in the earnings of local enterprises through local capital gains and dividends. It tends to have a short horizon and is more volatile than FDI flows (World Investment Report 1997) In a world of fickle private capital movements, a sudden and sharp reversal in large flows of these short-term portfolio investments can occur in response to the latest investment style, or mood of Wall Street institutional investors, portfolio managers and traders. This combination of excessive capital flows and their short-term composition help explain why, for example, did the ‘Asian contagion’ not spread to Bangladesh, Pakistan and other poor developing countries, and why these nations did not experience currency crises. In spite of the fact that current account deficits, bulging budget deficits, overvalued exchange rate, fragile banking and financial systems and other economic fundamentals were worse in these countries than Asian countries such as Thailand, Indonesia and Korea. The amounts of short-term portfolio capital in these countries were small compare to the large emerging markets economies of Asia. Foreign portfolio equity investments are nearly non-existent in Bangladesh. Pakistan accounts for less than 1 percent of total capital inflows to emerging markets, and about 3 percent of the total size of such flows to Asia (Kuczynski 1994).
Preliminary evidence on the size and composition of short-term capital flows lends support to this argument. The distribution of portfolio equity and bonds investment is skewed towards upper-middle income countries. That is because these countries have established stock markets offering a broad base for investing in the securities of publicly traded companies. Further, the stock markets of these countries are sufficiently liquid to allow investors and financial speculators to purchase or sell securities in a timely fashion. In 1996, the volume of new equity raised on international capital markets by some of the leading emerging markets (South Korea, Malaysia, Singapore, Taiwan, Hong Kong, Mexico, Brazil, Argentina) increased from US$ 10.5 billion in 1995 to US$ 15 billion, a staggering increase of almost 34 percent over 1995 levels, thereby illustrating the resilience of the newly industrialising countries as an attractive destination for portfolio investments. Between 1986 and 1995, stock market capitalisation of these countries rose more than tenfold, from US$ 171 billion to US$ 1.9 trillion. By the end of 1995, 17,000 companies were listed and traded on the stock markets of these leading emerging markets countries (World Investment Report 1997:48-51).
We should also take note of the inherent instability of financial markets. In this regard, it has been observed that financial markets involve maturity transformation, and thereby rely on the law of large number-independent, imperfectly correlated transactions. Thus, “when something signals all individual transactors to move in the same direction in the same short interval, the basic fragility of any financial system is revealed” (Calvo 1996:207).
We should, however, leaven our observations regarding the role of imperfect markets and market failures with caution. A study by Sachs and others (1996) reveals that the impact of the level and composition of short-term capital inflows on the likelihood of financial crises occur indirectly, by affecting the real exchange rate. In 1993, for example, countries that came under attack, Argentina, Mexico, and the Philippines had, on average, short-term portfolio capital flows of 1.4 percent of their respective GDP. By contrast, Chile absorbed more of this so-called ‘hot money’, or about 3.5 percent of GDP, yet avoided any currency crisis or sharp reversal in currency and remained unscathed (Sachs 1996:10-4).
Conclusion
According to the neoliberal school of thought, globalisation has enfeebled the modern nation-state and rendered it unable to effectively manage the economy. Global markets are now in charge. Adherents of the state-centric interpretation of international political economy, a contending school of thought, continue to stress the primacy of the nation-state as the unitary economic actor and dominant force in international economic relations. This article transcends both positions, by narrowing and recasting the general thrust of the relationship between the state and global economic relations to focus instead on macroeconomic policy. Further, after examining the interplay between global finance and national currency, budget and monetary policies, and using several recent case studies, this study shows that in circumstances where policy misalignments exist, when governments adopt monetary policies that have the unintended effect of undermining the soundness of the economy and the financial system, markets act as a disciplinary mechanism, sanctioning policy mistakes. National policies that are not in synch with deteriorating underlying economic fundamentals, in turn, create disturbances in the financial markets, as investors and economic actors, both domestic and international, lose confidence.
Using several case studies, this article has illuminated the ways in which global financial markets act as a punishing level on policy misalignments, actual or perceived, with shocking alacrity. One entirely new and significant attribute of the global market’s discipline is that it has changed the timing and severity of the consequences, if governments ignore the constraints of economic and financial fundamentals. The effect of globalisation therefore is not, as critics referenced in this article assert, that it forces governments to sacrifice ‘national economic sovereignty’, rather it is that in a world of increasing capital mobility there is a premium on having a sound financial system, a sound budget and interest rate policy, an exchange rate environment that provides appropriate signals for the broader pricing structure of the economy, and the pursuit of macroeconomic policies that strive to achieve a degree of economic stability. Markets react quickly and negatively to significant macroeconomic policy mistakes made by national political authorities. The key issue, therefore, is not that nation-states no longer matter. Nation-states do matter, and national economic policies are still an important determinant of national economic success. The key issue is that global financial integration has had a dramatic influence on the rules of macroeconomic policy, the fundamentals of a national economy. Thus, for instance, while Mexico’s 1994-95 economic crisis was signalled by cross-border capital flows, it was imbedded in the circumstances of the Mexican economy and was domestic in origin.
The peculiar impact of financial globalisation in circumstances where national economies are highly exposed to or integrated into the global economy is that whenever public policy-makers ignore these constraints, globalisation manifests itself in the form of ‘market discipline’ applied to inconsistent, incompatible or flawed policies. Both Mexico’s 1994 crisis and the British ERM episode indicate that misguided public policies that seek to change prices in the financial markets by fiat, not the powerlessness of national governments, were the major impetuses behind these crises. Put differently, financial markets sanction national policies that are incompatible with or insupportable by real economic fundamentals or performance. Further, the sheer size, sophistication and dynamism of financial markets have compressed both the timing and severity of reactions to public policy mistakes, as evidenced by the peso crisis of 1994, the British ERM episode, and global financial markets’ reaction to Hong Kong and Southeast Asian currency crises.
Regarding monetary policies, market reactions are sharp, quick and severe; regarding fiscal policies, it appears that a time lag is involved: global financial markets enable national governments to borrow more and more cheaply than would otherwise be the case. However, if governments do not manage their budget deficits, the eventual punishment may be severe. This is especially true if governments finance current account deficits through dollar-denominated portfolio investments that could be quickly withdrawn. Indeed, this is one of the lessons to be drawn from the Mexico’s tesobonos crisis of 1994.
The Asian contagion shows that large current account deficits financed by foreign portfolio investments that can be instantly withdrawn, and large net currency exposures coupled with constraints on exchange rate fluctuations, are incompatible with long-term financial stability. Further, a fixed foreign exchange regime poses a dilemma for national authorities: governments cannot have both a fixed exchange rate and also maintain control over interest rates. A government that implements a fixed exchange rate regime should recognise that it is not likely to retain a substantial measure of control over interest rate policy. Conversely, to have control over interest rates, national authorities may have to forsake a fixed exchange rate currency regime. This is the dilemma that the United Kingdom faced in 1992, and was unable to resolve.
The ramifications for central banks and monetary policy are especially critical. Whereas expansionary monetary policy runs the risk of fuelling inflation, and increasing nominal and real long-term interest rates, a tight monetary policy reduces the ability of market participants to acquire the necessary credit needed to lubricate transactions in the economy. The challenge for national monetary authorities is to strike a proper balance between the two. However, as the ongoing Asian economic crisis has shown, other governments do not have this luxury. Governments that issue debts, and guarantee the liabilities of depository institutions in the face of a large budget deficit, risk the downgrading of their sovereign credit rating. In this sense, financial markets do exact a price for erroneous fiscal and monetary policies.
Based on this study, this author suggests that it is more fruitful for scholarly research to pay greater attention to the ways in which incompatible and unsustainable government policies trigger reactions in the global markets, the variety of interactions between global market forces and national economic fundamentals and, as a result, identify and explain the various types of constraints on the economic policies of national governments.
April 1999
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Notes:
*: Shah M. Tarzi, Ph.D., is Lee L. Morgan Professor of International Economic Affairs, Bradley University, Peoria, Illinois, United States. Back.
Note 1: Cf. the definition at the end of this chapter. Back.
Note 2: Examples include the World Trade Organisation (WTO), the World Bank, the IMF, and regional bodies such as the European Union (EU) and the North American Free Trade Association (NAFTA), the Organisation for Economic Co-operation and Development (OECD), the Bank for International Settlements (BIS), specialized agencies of the United Nations, and the Group of Seven (G7). There are also examples of joint efforts to regulate international banking (Scholte 1997:450). Back.
Note 3: A separate chapter below will address this important issue. Back.
Note 4: This conception embodies references in the text to ‘globalisation’, ‘global’, ‘transnational’, and ‘international’. For other meanings of globalisation and financial globalisation see, Scholte (1997:430-7), Gill (1995:399-423), and Hobsbawm (1994:287-343). Back.
Note 5: The discussion on the role of fixed versus floating exchange rate is informed by the insightful work of Rolnick and Weber (1989). This report may be accessed at: http://woodrow.mpls.frb.fed.us/pubs/ar/ar1989.html. Back.
Note 6: A ‘short sale’ is the term used to describe the selling of a borrowed financial instrument at the market price. This strategy is used by those who anticipate a decline in the value of equities or financial instruments. A ‘put option’ is a contract which gives the right to the owner to sell an equity or a financial instrument at a specified price, called the ‘strike price’, within a specified period. ‘Put option’ investors profit from the decline in the value of the underlying equity or financial instrument which they expect will occur. A ‘call option’ is a contract which gives the right to the owner to buy an equity or a financial instrument at a specified price, called the ‘strike price’, within a specified time frame. ‘Call option’ investors profit from the appreciation in the value of the underlying equity or financial instrument which they expect will occur A ‘long position’ is the term used to describe someone who owns (holds) a security or an option. A ‘short position’ is the term used to describe someone who has written (sold) a security, a financial instrument or an option. For details, see Scott (1988). Back.
Note 7: This section of the present study has benefited and draws upon the insights of several speeches by the Federal Reserve Chairman, Alan Greenspan (1997a, 1997b) and other Fed governors (http://www.obg, frb.fed.us/boarddocs/speeches/1997). Back.
Note 8: These financial strategies (see note 6 above) are used in both the foreign exchange markets, in anticipation of devaluation of a currency, and in the equity markets. Back.