The devaluation of the Brazilian real has kept emerging markets at the top of bankers’ and regulators’ priority lists. As the crisis struck, the Malaysian second finance minister was on a tour of Europe designed to gather support for the country’s controversial approach – an approach the minister insisted was working and would be continued indefinitely. More than a year on from the start of the crisis, there is still no consensus on what policies are appropriate for these troubled countries.
However, as Brian Caplen’s story reveals, many of the assumptions on which policy ideas have been based are wrong. But revealing – with the benefit of hindsight – what actually went wrong, means apportioning blame. And that has caused an unseemly row between bankers, academics and politicians.
This much seems clear: emerging-market corporates, but particularly Asian corporates, undertook heavy borrowing in foreign currencies without any consideration of the risks. No account was taken of the likely impact of devaluation nor did companies know or care that their rapid investment growth was producing returns below the cost of capital. Domestically this credit growth was driven by crony capitalism and poor banking supervision. Internationally, it was driven by overcapitalization and a relaxation of credit criteria.
If all that seems obvious, read the enraged comments of those who believe that criticism of emerging-markets corporate governance is part of a US-inspired plot to impose US-style capitalism on the world. Even some western financiers wonder whether these studies – many sponsored by the World Bank – are an attempt by the bank to stake out territory at a time when the Bretton Woods institutions are struggling to define their role.
Politicians from the emerging markets have tried to blame the destabilizing effects of unfettered capital flows, hedge funds and speculators. The Malaysians punished foreign equity investors by locking them in until September this year and are now worried about outflows when the lock-in period expires. The minister even spoke about new measures to prevent capital flight.
The numbers do not bear out these claims. Foreign equity flows did not precipitate the crisis nor did equity funds act in a volatile manner during it. Bank lending was far more volatile and important a source of instability and much of that was driven domestically.
Again reaction to these claims is extreme. Again the World Bank is attacked for its apparently institutionalized inability to accept that international capital flows are large enough to destabilize an economy or that they are inherently volatile.
This debate has to be resolved and resolved fast. If national currencies are a luxury few countries can now afford, emerging markets need to start organizing themselves in currency blocs. If corporate governance is the issue then the multilaterals have to persuade emerging-market governments of the wisdom of good corporate governance, banking supervision and transparent capital markets. If irresponsible foreign lending is a problem then new BIS regulations should be considered.
One thing though does seem clear. In Asia, and to a lesser extent in the other emerging markets, the development of transparent and efficient local bond markets was not seen as a priority. Had these existed, they would have acted as a buffer, absorbing inflows of foreign capital that instead fed straight through into the banking system causing a surge of bank credit. As Euromoney has long argued, the development of liquid domestic bond markets should be a policy priority for ministers and central bankers wherever they are.
