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CIAO DATE: 12/03
Back to Bailouts
On The Issues
August 2002
Approval of loans to Uruguay and Brazil signals that the Bush administration's position of refusing to bail out mismanaged economies has given way to the mistaken policies of the past.
The International Monetary Fund and the U.S. Treasury have abandoned their short-lived policy of benign neglect and have come racing back to Latin America. Treasury Secretary Paul O'Neill is no longer talking tough love. With the recent bailouts of Uruguay and Brazil, he's no longer practicing it either. Will they never learn?
After offering more than $250 billion dollars of assistance to debtor countries in the swinging 1990s, new management at the International Monetary Fund (IMF) and the U.S. Treasury took a new tack. No more bailouts of badly run economies! No more money to defend exchange rates! From now on, risk and return would be related. Losses would teach the virtues of due diligence and careful risk evaluation.
This was not a punitive, small-minded assessment. The judgment was that IMF rescue operations, assisted or even developed by the U.S. Treasury, had increased country risk by encouraging too much borrowing. Instead of taking in risk capital by offering equity, companies in emerging markets could hold onto their equity and leverage earnings by borrowing dollars from local banks. The local banks borrowed dollars from foreign lenders but lent in local currency. This added a currency risk to the banks' default risk. When foreign lenders became nervous about the size of the borrowing country's or banks' repayment obligations, they did not renew their loans. A run soon started against local banks, currency and government debt.
This policy reached a peak in the Clinton years, when Mexico, Russia, Korea, Thailand, Indonesia, the Philippines, Brazil, Argentina, and others received massive IMF, Treasury, and multilateral loans to bailout banks and pay off foreign lenders. Often, the foreign banks renewed their loans, on more profitable terms, after the IMF put in new money.
U.S. Policy Shift
Wall Street worshipped at the Robert Rubin-Larry Summers shrine. The bankers collected fees for renegotiating the debt. They declared these policies successful because they were repaid, even though countries like Mexico, Korea, Thailand and Indonesia suffered deep recessions and ended with larger debts.
The new Bush policymakers in 2001 said that the bankers were at the wrong shrine. It would do no good to pray for the past to return. The new officials understood moral hazard and decided it was time for the lenders and borrowers to understand it too. If lenders know that they will be bailed out, they do not properly assess risks. Lenders could no longer collect the 10, 15 percent, or greater premium on loans to risky borrowers without bearing the risk that those premiums reflected. From now on, lenders would have to take losses.
The new, hard-nosed policy did not apply everywhere. U.S. allies and clients of the United States continued to get aid the old way. Turkey was a special case, a long-time IMF client that occupied a strategic position of great importance. Then came Pakistan, an off-again, on-again client that suddenly found itself in a strategic position.
These were supposed to be exceptions. Argentina became the showcase of the new policy. Lenders took large losses when the Argentine government defaulted on its debt. Under the new rules, Argentina had to make, not just promise, fiscal, monetary, and other economic reforms. With a government that was incapable of enacting reforms, the Argentine economy collapsed at a rate reminiscent of the Great Depression. The Duhalde government has not even been able to organize a coherent set of promises in its seven months in office. Too inept to reopen its banks, the government allowed its people to sink into poverty. Many moved abroad, a sure sign of despair.
The IMF and the Treasury stayed with the new policy despite pressure from Argentina, international lenders, and the well-intentioned, but mistaken, development organizations that think moral hazard is fictitious and see more taxpayer money as the solution to any problem.
The Argentine crisis did not spread to other countries. Mexico, Brazil, and Chile did not lose foreign loans or suffer big withdrawals. Despite its weak and fractured government, Peru sold ten-year debt for the first time in decades. Brazil's currency appreciated, and the central bank reduced interest rates.
Uruguay was the exception. Its banks were full of deposits owned by prudent Argentines who had put their money abroad. Argentine tourists dominate the considerable tourist expenditure at the beautiful Uruguayan beaches. Tourism is more than 15 percent of Uruguay's GDP, and many of the tourists come from Argentina. Argentina's decision to limit withdrawals from its banks limited spending, including spending on vacations in Uruguay. Many Argentines who had funds abroad withdrew them. Large withdrawals began to look like a run on Uruguay's banks, so that some were soon illiquid. A floating currency made peso withdrawals more costly but could not prevent the loss of dollar deposits. Slower growth in Brazil, Uruguay's large neighbor, added to Uruguay's economic problem.
Bad Policies Return
Uruguay turned to the IMF for help. They have now arranged $3.8 billion in credit lines, more than $1100 per capita. Whatever benefit the credits may bring must be balanced by the fact that Uruguay has mortgaged its future to the international institutions.
Next came Brazil. Nationalism and populism have always been a strong force in Brazilian politics. When early polls showed that the two populist candidates were far ahead, with the government candidate a distant third, prudent local and foreign investors began to withdraw their money. Why wait for a possible disaster? If the government candidate won, an investor could come back without a loss.
Enter the central bank, the IMF, and the Treasury. They are going to "defend the real," one of the worst policies imaginable in these circumstances and one that is certain to make things worse, not better. By supporting the exchange rate, Brazil gives the people who want dollars a better price at which to buy them; they have to pay fewer reals per dollar. Give people more opportunity to leave and on better terms, and more will leave. The country has a bigger debt, no matter who wins the election.
The bailout ignores two crucial lessons. First, economics teaches that money can solve monetary problems, not real problems. The IMF is in the "money" business. Populist and nationalist policies are real shocks. The IMF should stay away because money cannot solve Brazil's political problem. Second, Brazil's total debt service prior to its October election is a fraction of its available reserves. There is no risk of default before the election. If the government candidate wins and maintains responsible policies, the money will return after the election.
The Bush administration policy is now in shambles. Any hope of rescuing the IMF from the IMF bureaucracy is disappearing.
Postscript
The markets first reaction was strongly positive. The real rose against the dollar and interest rates fell. That lasted one day, a false euphoria reflecting the actions of speculators covering their short positions. The next day the decline resumed. The real has now settled somewhere in between, partly held up by the central bank and by news from the political campaign that one of the leading candidates appointed a market oriented economist as adviser. Major foreign banks announced that they would not lend to Brazil, even for short-term export financing. After writing off billions of dollars of losses in Argentina, international bankers are cautious.
Some take comfort from the mild statements of support for the IMF program by the two populist candidates. Such statements are worth little. Once in office, the new president will choose from the many commitments and promises. Usually the IMF has been more anxious to send the money than governments to honor the promises. If Argentina had kept its promises and the program had worked, it would not now be suffering from the worst depression in its tortured history.
Allan H. Meltzer is a visiting scholar at AEI.
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