International Financial Policy John Coleman up to This

International Financial Policy

John Coleman

Up to this point in the course we developed the concept of a “real” (or “supply”) shock as well as a framework to understand the effects of real shocks on the global economy. Variables we considered consisted of the real values of the wage rate, employment, GDP, the interest rate, savings, consumption, investment, the current account, and the exchange rate. We also built on this material by examining the long-run determinants of the price level and its rate of change (inflation). Once we understood what determined the price level and its rate of change we were in a position to discuss key determinants of nominal variables such as nominal GDP, nominal interest rates, and nominal exchange rates. This lecture develops the concept of a “monetary” shock as well as a framework to understand the effects of monetary shocks on the global economy. Once we have a solid understanding of the effects of monetary shocks, we will be in a position to understand how any country uses its international financial policy to manipulate its economy, and the goals it attempts to achieve be setting its international financial policy. In this sense, this lecture is perhaps the key lecture in this course. I wish to start this lecture on monetary policy and the economy with a cautionary note. In attributing real effects to shocks stemming from monetary policy, in this course we will take the perspective of the loanable-funds theory. This view of the effects of monetary policy shocks seems to closely reflect the views of both central banks and the financial press. Since one objective of this course is to teach you how to interpret articles from a variety of news sources, this perspective seems best suited to our purpose. This theory, however, draws a sharp distinction between the short-run and long-run responses of the economy to actions by central banks. This theory is thus fundamentally dynamic, which requires somewhat more effort to capture with the supply and demand diagrams that we have relied on so far. Also, in discussing the short-run response of the economy, both central banks and the financial press make some rather strong assumptions concerning the timing of various reactions to monetary policy shocks. They base these assumptions on their sense of how markets realistically react to these shocks. Once we have a clear understanding of the effects of monetary shocks, we will ask what goals the Federal Reserve and other central banks around the world attempt to attain by shocking the economy. We will think of a central bank as having two goals. The first goal is to promote steady growth in real GDP and the second is to promote a steady low rate of 1 inflation. Unfortunately, these goals often seem to conflict with each other in the sense that one goal can only be attained at the expense of the other. For example, a central bank often tries to raise the short-term interest rate to control inflation, but high interest rates tend to lower the growth rate of output. Conversely, the central bank sometimes lowers interest rates to bring the economy out of a recession, but this may lead to an acceleration of inflation. The central bank continually attempts to strike a balance between its two objectives. We will end this series of lectures by examining the international financial policy of various countries around the world, such as Mexico, Argentina, Russia, Thailand, Indonesia, Germany, and Japan. Remarkably, despite the different reputations of many of these central banks, they seem to perform in roughly the same way as the Fed. This similarity in monetary policy has important implications for things like exchange rates and international capital movements.

Dow Jones Interactive file:///C:/classnotes/macro/lectures/WSJ1-9-91.htm

THE WALL STREET JOURNAL

Wednesday, January 9, 1991

Fed Reduces Rates Again In Bid to Bolster Economy --- Action Is Expected to Trim Charge on Federal Funds To About 6 3/4% From 7% By Alan Murray Staff Reporter of The Wall Street Journal

WASHINGTON -- The Federal Reserve cut short-term interest rates another notch yesterday, continuing its efforts to bolster a recessionary economy.

The action is expected to bring the key federal funds interest rate down to about 6 3/4% from 7% in recent weeks. Other short-term interest rates are likely to decline accordingly.

The reduction comes barely three weeks after the Fed's last easing move and illustrates the central bank's growing concern about the economy. In addition, the action follows the government's takeover Sunday of the Bank of New England, which has heightened fears that a weak economy could lead to financial crisis.

"We're in a recession, and as long as we're in a recession, the Federal Reserve will be in an easing mode," says Robert Dederick, chief economist of Northern Trust Co.

Many economists believe the Fed will have to cut interest rates further to get the economy growing again.

...

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THE WALL STREET JOURNAL

Wednesday, August 17, 1994

Fed Lifts Short-Term Rates By Half a Percentage Point --- Latest Move in Bid to Curb Inflation Likely to Boost Most Costs of Borrowing By Paulette Thomas Staff Reporter of The Wall Street Journal

WASHINGTON -- The Federal Reserve pushed up short-term interest rates by a half percentage point, sending Wall Street and the Clinton administration a clear inflation-fighting message.

The interest-rate boost, intended to keep the economy from overheating and inflation at bay, is likely to raise borrowing costs for consumers and businesses; indeed, many big banks immediately raised their prime lending rates yesterday. The half-point jump triggered rallies in the stock and bond markets, which have been unnerved for much of the year by the incremental increases in short-term rates favored by Fed Chairman Alan Greenspan, usually a quarter-point. It's also likely to bolster the flagging dollar against foreign currencies. ...

In the bond markets, where inflation is feared because it reduces the value of fixed-rate instruments, the Fed's fifth interest-rate increase this year was hailed as aggressive and decisive. The 30-year bond jumped almost 1.75 points to 101 17/32, or nearly $17.50 for a bond with a $1,000 face value.

"Previously it was the water-torture approach to monetary policy," said Bruce Steinberg, manager of macroeconomic analysis at Merrill Lynch & Co. "Now they're introducing a period of monetary policy stability."

Although the Clinton administration publicly went along with the move, some Democrats worried that the rate increase would choke off job growth before the administration has even taken credit for the economic recovery. ...

Several of the nation's largest banks -- including Citicorp, BankAmerica Corp., Chemical Banking Corp., Chase Manhattan Corp., Norwest Corp. -- raised their basic lending rates soon after the Fed's action, to 7.75% from 7.25%. ...

For consumers, the results of the Fed's move will be mixed. Interest rates for adjustable-rate mortgages and home equity loans, which are tied to short-term rates, will rise. Credit-card rates may also rise, although increases will be tempered by competitive pressures in the card industry. But interest rates that consumers receive for savings accounts and bank certificates of deposit will also increase. In addition, if long-term interest rates decline as a result of the Fed's action, rates for long-term fixed mortgages will decrease. ...

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Monetary policy, made to measure The Economist; London; Aug 10, 1996

How closely does central banks' behaviour follow simple monetary-policy rules? And how closely should it?

Although plenty of the world's central banks have targets for inflation, none is sure precisely how, or how rapidly, changes in monetary policy affect the economy. Therefore they cannot be certain that a sensible-looking interest-rate cut will not revive inflation - or that a cautious-looking rise will not tip the economy into recession.

IT MIGHT seem that central bankers can rest easy these days. The great beast, inflation, seems tamed, having fallen to only 2.8% in America, 1.4% in Germany and nil in Japan. Have monetary policymakers got it licked?

Central bankers will tell you that they have not, and not just out of modesty. Although plenty of them have targets for inflation, none is sure precisely how, or how rapidly, changes in monetary policy affect the economy. So they cannot be certain that a sensible-looking interest-rate cut will not revive inflation-or that a cautious-looking rise will not tip the economy into recession.

Hence the search for the holy grail: a simple rule for choosing an optimal monetary policy that keeps inflation down without hitting the economy too hard. Several have been tried. One was the gold standard, under which national currencies could be exchanged for the metal at a fixed price. Another, in vogue in the early 1980s, was a target for the growth rate of the money supply. However, sooner or later-in severe recessions, say-it has proved necessary to ditch such rules and act pragmatically. So is there a possible rule for all seasons, which will tell central banks how to adapt their policies to circumstances without compromising their anti-inflationary zeal?

One such rule was developed in 1993 by John Taylor, an economist at Stanford University who now advises Bob Dole, the Republican Party's presidential candidate. Mr Taylor's argument is that central banks ought to "lean against the wind" when setting interest rates. Therefore, he suggested, short-term nominal interest rates should be equal to the sum of four things.

The first is the real short-term rate that is consistent with "neutral" monetary policy-ie, one that is neither expansionary nor contractionary. The second is the expected inflation rate. Then, in the simplest and commonest version of the Taylor rule, 0.5 percentage points should be added to, or lopped from, short-term rates for every percentage point by which the current inflation rate is above or below its target. And fourth, the same adjustment should be made for the "output gap"-ie, for every percentage point by which GDP is above or below its long-term trend level. The idea is that output above trend is a signal of inflation on the way; below trend, the reverse.

Several studies have found that central banks have, in effect, been following the Taylor rule for some time. Mr Taylor himself found that America's Federal Reserve tracked it between 1987 and 1992. Most striking, in a recent paper* Richard Clarida of Columbia University and Mark Gertler of New York University argue that despite its professed adherence to monetary targets, Germany's Bundesbank actually acts as if it is following a sophisticated version of the Taylor rule. It adjusts rates on the basis of expected, not current, inflation; and it raises rates sharply when inflation threatens to rise, but cuts them less readily when the pressure is off.

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[Graph] Caption: Well Taylored

According to Gavyn Davies, Martin Brookes and Stuart Culverhouse of Goldman Sachs, an American investment bank, American, German and Japanese three-month rates have tracked the simple Taylor rule fairly closely in the past ten years. In America policy has deviated greatly only twice (see chart): in 1986, after the oil-price collapse, rates were kept too high; and in 1992-93, the Fed held rates down to bolster the fragile balance sheets of American banks.

The Goldman Sachs team goes on to assess whether, according to the Taylor rule, the G7 economies' central banks are on track now. They say that in Britain, France, Germany and Japan, rates are about right. But in Canada and Italy, the Taylor rule implies that rates should be more than 1.5 percentage points below their current levels. And in America, there is a case for a rate rise of a percentage point or so within a year.

Looser than it looks

But how exact can such calculations be? As the Goldman Sachs team acknowledges, estimating the Taylor-rule rate is tricky. In a new paper^ Alison Stuart, an economist at the Bank of England, describes some of the difficulties.

Take the neutral short rate.A common procedure is to use an average of inflation-adjusted past rates, which on the Goldman Sachs estimates yields about 2% for America and 3.5% for Britain, France and Germany. But Ms Stuart points out that in theory the rate should be quite close to the long-run trend rate of economic growth; so while 2% is fine for America, 3.5% looks on the high side for Britain. A percentage-point change in the estimated real rate leads to the same change in the nominal rate prescribed by the Taylor rule.

Similarly, estimates of the output gap can vary a great deal, because no one knows for certain how fast an economy can grow. A rise of half a percentage point in the trend growth rate adds up, over five years, to an increase in the estimated output gap of 2.5 percentage points; in the Taylor rule, this would imply a reduction in the optimal short-term interest rate of .25 percentage points.

Thus a central bank could pitch rates anywhere in a fairly broad range and still comply with the rule. No wonder, then, that most central bankers seem to be observing it. But even if precision were possible, would the Taylor rule be the answer to monetary authorities' worries?

No, because it includes only part of the information available to central bankers. And at times, it may make more sense to act on other information-about the exchange rate, say-than to stick to the rule. Indeed, as the Goldman Sachs team notes, exchange-rate movements explain much of French and Italian monetary policy, making the Taylor rule a poorer guide for those countries. So although the rule is a useful check on monetary policy, it is not reliably safe. Central bankers will probably never be able to take it easy.

[Footnote] * "How the Bundesbank Conducts Monetary Policy." NBER Working Paper No. 5581, May 1996. ^ "Simple Monetary Policy Rules." Bank of England Quarterly Bulletin, August 1996.

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DOW JONES NEWSWIRES

April 22, 2002

FED WATCH: Lehman Tailors Taylor Rule For A Better Fit

By Michael S. Derby

NEW YORK -(Dow Jones)- Whether the Fed lifts interest rates in coming months depends solely on U.S. economic performance, rather than from any desire to "normalize" what most agree are very low rate levels, argue Lehman Brothers economists in a new research note.

They've reached that conclusion after some tweaking of the so-called Taylor rule, a formula authored by current U.S. Treasury Under Secretary for International Affairs John Taylor. The rule seeks to describe the correct level for the overnight federal funds rate - the Fed's benchmark - based on the relationship of inflation and growth levels.

The Taylor Rule states that interest rates should fall by half a percentage point for every percentage point decline in economic growth, below the level of growth the Fed deems non-inflationary.

Lehman economists Ethan Harris and Tom Heenan wrote that the rule, as described by Taylor, hasn't done that great of a job correlating the actual movement of the fund target since at least the late 1980s. But with a few technical modifications the Taylor rule suddenly moves into a tight relationship with the actual movement of the target.

The results of the their modification, now crowned the Harris-Heenan Rule, suggest strongly that the Fed will let the economy's movements dictate the direction of the funds rate. When there's an unambiguous recovery in the economy and inflation stays low, the funds target will rise, they argued.

In that case, what the Fed will not do, Harris and Heenan conclude, is seek to take back what were widely seen as emergency interest rate cuts that followed the Sept. 11's terrorist attack, simply in an attempt to normalize interest rates, the economists said.

In the months following Sept. 11, the Fed sliced the funds rate from 3.5% to 1.75%, in what many analysts said was a course of action aimed primarily at bolstering confidence in markets and the broader economy.

The rule "contradicts concerns that the funds rate has a strong tendency to 'mean revert' to a more 'neutral level,"' the Lehman Brothers economists wrote. "Aggressive Fed tightening is possible, but only under boom-like conditions." Yellow Light

The two economists said their modifications, while having "a tendency to over-predict the funds rate" has "predicted exactly the 4.7% percentage point drop in the funds rate" from the last quarter of 2000 through the first quarter of the first quarter.

The majority of Fed watchers now expect that the central bank will wait until the Aug. 13 Federal Open Market Committee gathering to put in place its first rate hike since May 2000. It's then, they believe, that the FOMC will lift the funds rate to 2% from 1.75%. The Fed began the cycle at a funds rate of 6.5%.

The sentiment that the Fed will move later rather than sooner gained ground last week after testimony by Fed chairman Alan Greenspan.

In an address before Congress Greenspan said that the road to recovery was still riddled with uncertainties, suggesting that the central bank would not be raising interest rates any time soon. It wants to ensure the economic rebound is for real, economists said, a disposition that suggests significant caution on the monetary

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policy front. -Michael S. Derby, Dow Jones Newswires; 201-938-4192; [email protected]

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Real Exchange Rates and Real Interest Rates

When rates of inflation differ across countries, it is the real exchange rate rather than the nominal (that is, actual) exchange rate that matters most to the balance of payments. The real exchange rate takes into account changes in price levels. For example, if Japanese prices doubled while US prices remained unchanged, then for a given nominal yen/dollar exchange rate, the real exchange rate -which measures the purchasing power of the dollar in terms of Japanese goods- would drop by half. A real exchange-rate appreciation signifies that a country’s goods and services are becoming more expensive compared with foreign products; a real exchange-rate depreciation indicates that a country’s products are becoming cheaper compared with foreign products. When a country’s inflation rate differs from inflation rates abroad, its competitive position generally will be stable if its nominal exchange rate adjusts by enough to keep its real exchange rate stable. Exchange-rate movements are often determined primarily by capital movements, especially in the short run. Capital tends to flow from countries with low real interest rates to those with high real interest rates. The real interest rate is (approximately) the nominal interest rate less the expected rate of inflation. When differences in nominal interest rates merely reflect differences in expected inflation rates -that is, when real interest rates are the same across countries- capital flows are unlikely to occur in response, since exchange rates are likely to change in the future to compensate for different rates of inflation. An inflow of capital into a country with a high real interest rate will create demand for the domestic currency, causing it to appreciate. Conversely, the currency of a country with a low real interest rate will depreciate as capital migrates out of that country. As a result, monetary and fiscal policies that affect real interest rate differentials will cause movements in the exchange rate.

Box 7-3.

2 200 Real Exchange Rate 1 fference i 0 180 te D a Real Interest Rate Difference -1 160

Interest R -2 eal 140 -3 Index 1995=100 Real Exchange Rate

-4 120 -Germany R S U -5 100 1980 1984 1988 1992 1996 2000 year Exchange Rate and Interest Rate Differences: US and Germany Economic Report of the President 1993

Recent Pitfalls in Progress Toward Monetary Uniﬁcation

A development that potentially could slow progress toward the EMU is the partial collapse of the EMS in September 1992. ... German reunification was a welcome development that helped to mark the end of the Cold War. However, the costs of raising productivity and providing a social “safety net” in the former East Germany sharply increased German government spending. ... In response to increased government expenditures and higher inflation, Germany tightened monetary policy ... In consequence, ... the rise in interest rates that had begun in 1988 continued through 1992. In order to maintain their exchange rates within their prescribed bands, the other EMS countries were forced to increase their interest rates as well. Countries such as the United Kingdom, where interest rates and inflation had been declining, were prevented from further reducing interest rates. This tightening of monetary policy exacerbated the already existing slowdown in growth. In the United Kingdom, where output had declined to a level more than 4 percent below its previous peak and the unemployment rate had climbed above 10 percent by mid-1992, increasing pressure developed to ... drop out of the EMS so that interest rates could be lowered. ...

10 te a 8 th R 6 P Grow 4 GD eal 2 R

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-4 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 years Argentina, 1990-2000 Exchange Rates

Pesos per Dollar Rupiah per Dollar 13200 15400 11000 2200 4400 6600 8800 24 30 36 42 48 54

Sep95 Sep95 Philippines Indonesia Sep97 Sep97

Sep99 Sep99 The Asian Crisis Sep01 Sep01

Baht per Dollar Ringgit per Dollar 4.8 2.4 3.6 4.2 25 30 35 40 45 50 55 3

Sep95 Sep95 Malaysia Thailand Sep97 Sep97

Sep99 Sep99 Sep01 Sep01 Dow Jones Interactive file:///C:/classnotes/macro/lectures/SEAsiaCrises1_full.html

The Wall Street Journal

Caveat Lender: Southeast Asian Banks Contribute to a Bust In the Economic Boom --- Financial-Sector Weaknesses Are Roiling Currencies; Regulation Has Been Lax --- The Bungee-Jumper Report

By Darren McDermott and David Wessel Staff Reporters of The Wall Street Journal

A new wave of anxiety is washing over financial markets in Southeast Asia. This one is driven not by worries over trade deficits or politicians' rhetoric, but by fears about the health of the Asian banking systems.

The fears are well-founded.

Consider the all-too-typical case of Nikon Industries Corp., a Philippine maker of electric appliances. It borrowed $150 million during the past two years to buy parts, gambled the money on local real estate and lost it this summer when the effects of the financial crisis that began in Thailand hit the Philippines.

The question isn't why Nikon executives did something that seems so foolish; businesses make bad bets all the time. It's why did 23 Philippine banks lend Nikon the money, and why didn't government supervisors stop them?

The Nikon debt, a droplet in Asia's ocean of bad loans, helps explain why the Asian economic-growth miracle was so abruptly interrupted -- and why it is so difficult to get growth going again.

As the World Bank asked in a recent report: "Are financial sector weaknesses undermining the East Asian miracle?" Its answer: Yes.

In Indonesia, intensifying rumors about an impending bank failure drove the rupiah down 8.5% against the dollar on Friday alone. The currency has plunged 34% since July 1; each decline makes defaults on Indonesia companies' $56 billion in foreign bank debt more likely.

In Malaysia, the largest savings bank weathered a two-day run late last month on unfounded rumors that its founder had died and the bank would fold. In Thailand, where the government has closed 58 of 91 finance companies, Moody's Investors Service Inc. predicts that as many as five of the country's 15 commercial banks could fail by the end of 1998.

Devaluing a currency doesn't always trigger economic disaster. Britain's 1992 devaluation fueled an export boom that propelled its economy faster than almost any other in Europe. But in Southeast Asia, the potential export gains are, for now, overwhelmed by the devastating effects of devaluation on fragile banks that relied heavily on overseas money.

As growth boomed throughout Asia, overeager banks made loans to companies and consumers that didn't know how to handle the money and frequently lost it in the overbuilt real-estate sector. Connections between borrowers and lenders, as the World Bank put it, were sometimes "perverse."

Government supervision failed to keep up with the extraordinary growth in bank lending. Even worse, a tradition of lending to friends -- either of bank owners or of powerful politicians -- means many loans will never be repaid. In some instances, the politically well-connected routinely move money from banks they control to industrial combines they own.

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"We get these family-owned banks run by people who are also in other businesses. They just aren't trained to be bankers; they are entrepreneurs. There's a matter of a conflict of interest in a region where there has been so much opportunity for the taking," says Washington Sycip, founder of Manila's SGV Group and dean of the Philippine financial industry.

Elsewhere, banks lend to politicians' pet projects, regardless of risk. In Indonesia, even privately owned commercial banks have been approached to join a $690 million loan to a "national car" project teaming President Suharto's youngest son, Tommy, with debt-ridden Kia Motors Corp. of South Korea. And monetary authorities told state-owned Bank Negara Indonesia to "assist" Bank Yama, which is controlled by the president's eldest daughter and widely believed to be illiquid.

Despite its promises, Indonesia's central bank has been unable to clean up banking problems. It still hasn't liquidated Bank Summa, which was closed in 1992 leaving a $180 million debt to the central bank. Neither has Indonesia moved against Bank Pacific, which is partly owned by the central bank. Bankers say Bank Pacific's former president, the daughter of a Suharto ally, had her bank guarantee loans -- now in arrears -- taken by a finance company she also controlled.

Banks in China, Korea and Japan are sitting on hundreds of billions of dollars of bad debts, too. But the Southeast Asian formula was especially risky: The economies were hooked on a steady inflow of foreign money and pegged their exchange rates to the dollar in order to keep the money coming. Local banks borrowed foreign currencies, leaving themselves or, in other cases, their customers vulnerable to a fall in the value of the local currency.

For a time, rapid economic growth and exceptionally high domestic savings rates hid the flaws in this strategy. But the credit boom wasn't sustainable. When the time came to raise interest rates, whether to cool off overheating economies or defend currencies, Southeast Asian central banks hesitated: Their banks were too fragile. The central banks were forced to let their currencies decline, inflating the cost of paying back foreign debt. That made it harder for businesses that had borrowed in foreign currencies to repay loans, further weakening the banks.

Joseph Stiglitz, chief economist at the World Bank, calls this "a vicious circle in which [an] initial [economic] shock triggers banking problems which in turn exacerbates the shock."

The experience of the Philippines, Thailand and others are proof of what the U.S. Treasury, stern central bankers from around the globe and international financial institutions have preached with conviction: The prosperity of Asian and other emerging-market economies hinges on strengthening their banks and finance companies and the regulatory oversight of them. With underdeveloped stock markets and embryonic bond markets, developing nations rely much more heavily on banks to move money from savers to business investment. When banks pull back, the economy suffers severely.

The Thai crisis, prompted and exacerbated by the fragility of its banks and finance companies, finally has goaded Asian governments and bankers into action. Malaysia and the Philippines have limited lending for residential and commercial property by financial institutions to 20% of their loan portfolio. The Philippines has plans to cap dollar-denominated lending. Indonesia's central bank again is vowing to liquidate insolvent banks if they don't heal themselves or merge.

Hungry for bank capital and, just as important, management expertise, Asian governments are following Mexico's lead and permitting foreign banks to buy into local banking systems. Thailand is allowing foreigners to buy majority ownership in Thai banks; the Philippines permitted two Singapore banks to buy controlling stakes in two troubled, midsize banks.

Ask China's finance minister, Liu Zhongli, what he has learned from Southeast Asia's travails, and he says: "A country should strengthen banking supervision and regulation. This is extremely important for developing countries."

The Philippine banking system, in better shape than Thailand's, is the first in southeast Asia to go through what governments elsewhere are still hiding: a string of bankruptcy-protection filings. So far this year, Nikon and 13 other firms have asked Manila's Securities and Exchange Commission for protection against creditors. As economic growth took off earlier this decade, the Philippines welcomed foreign banks and allowed small new

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private banks to proliferate and compete with big state-owned behemoths. As banks fought for market share, competition set off a burst of lending. Loans grew a remarkable 52% in 1996. But credit standards fell in the rush to hand out money. Smaller, aggressive banks lent to unworthy borrowers simply because they were customers of big, well-established banks.

On top of it, the central bank held the peso steady against the dollar so banks and borrowers alike saw little risk in taking advantage of the cheaper interest rates on dollar borrowings. Foreigners eagerly played along, pumping billions of dollars into the fragile Philippine financial system and pushing up prices of property and other assets -- further increasing the temptation for companies in other industries to gamble on the boom. Dollar-denominated loans between 1992 and 1997 jumped to 25% from 16% of banks' total loan portfolio.

"Southeast Asia became a victim of complacency," says Rafael Buenaventura, chief executive of PCI Bank, one of the country's more-conservative large banks. "There was so much money coming in."

Overenthusiastic about Manila's booming real-estate market, where prime office rents doubled between 1994 and 1996, Nikon's corporate parent, EYCO Group, decided to borrow its way to prosperity. It used all available funds from all the companies it controlled to buy property. Into the kitty went Nikon's dollar-denominated loans, most of which were earmarked for buying overseas parts for the fans, coffee makers and other appliances it makes. (Nikon isn't related to the Japanese camera maker.)

"At the time that those investments and expansions were made, there was no cause for alarm because the market situation was very bright and very promising," EYCO Group said in its petition for debt relief and restructuring, the Philippine equivalent of filing for bankruptcy protection. The investments "would result in a bigger real-estate base, which would be a very credible collateral for further expansions," the company said.

In fact, as Thailand's economic problems mounted early this year, investors took a second look at Southeast Asia's property boom and decided it was more like a bubble. Suddenly Nikon's investments looked a little shaky. Worse, pesos were suddenly worth less against the dollar, and the company owed dollars. The Philippine peso has plunged 26% since early July, increasing the value of Nikon's loans. When the Philippine central bank boosted interest rates to stem the peso's fall (prime lending rates hit 34% at one point), Nikon could no longer borrow enough to pay its debt.

Nikon's bankers say they didn't know their loans were being commingled. "Our exposure is to their manufacturing operations," says O.V. Espiritu, chief executive of Far East Banking Corp. At least it was supposed to be. But regulators say bankers should have known how their clients were using loans. Analysts add that regulators should have made sure the banks knew. But Bangko Sentral ng Pilipinas, the central bank, says it is short of staff and needs new computer equipment -- now on order -- to see patterns buried deep in the data it collects from banks.

"There was so much pressure to book the business that the standards dropped," says Leonilo Coronel, executive director of the Bankers Association of the Philippines. Even if banks had tried to check whether Nikon was part of a group taking on big debts for a property-market gamble, the association's informal credit bureau wouldn't have had that data, he says.

In a sense, Nikon was simply a replay of a case that many bankers had dismissed earlier as a fluke. In March, sugar refiner Victorias Milling Corp. collapsed under $220 million of debt that was lent against assets expected to bring only about $100 million when sold later this month.

Victorias, an 80-year-old blue-chip borrower, had turned to property when deregulation of the sugar industry caused profits to sag. Busy trying to check out their new customers, banks continued lending to Victorias until it declared in April that it was out of money.

Convinced that Victorias was a harbinger of things to come, Deutsche Morgan Grenfell banking analyst Michaelangelo Oyson began a book-length research report on Philippine banks. Issued in August, it had a free-falling bungee-jumper on the cover. It predicted nonperforming loans would rise sharply as weak and overextended borrowers were pushed into default. Philippine central-bank Governor Gabriel Singson blasted Deutsche Morgan Grenfell for being "unduly negative."

Just a week later, Nikon sought protection from creditors. "We are aware that there will be some more loan

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defaults," central-bank Deputy Governor Alberto Reyes now says. "The banks should tighten up on their credit. We have told them that."

Bankers say they have learned their lesson, and they remain upbeat. "There's no question there will be some problems along the way. We may need to restructure some of our companies, but that's banking," Mr. Buenaventura of PCI Bank says. "I see tough times ahead. But I don't see a meltdown."

If the Philippines avoids a banking meltdown, it may be only because the system has had less time to overheat; the Philippines was still mired in recession while Asia's tigers were growing rapidly through the late 1980s. "We haven't had 10 years of 8% to 9% economic growth" as in Thailand, says Patrick Dewilde, treasurer for the Philippines at Citibank, a unit of Citicorp. "Our little asset bubble is only three years old."

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The Wall Street Journal

Real Politics: After Long Pursuing Growth, Brazil Shifts To Preferring Stability --- To Defend Its Currency, It Is Retrenching Sharply; The Pain Is Felt Already --- Privatization Still Sambas On

By Matt Moffett Staff Reporter of The Wall Street Journal

November 12, 1997

SAO PAULO, Brazil -- Economic growth had always been a religion in this vast nation, even if it came at the expense of rampant inflation and inequality. But now, facing a withering speculative assault on its currency, Brazil is throwing its economy into deep freeze in the name of a new creed: stability.

This week, the government imposed a tough austerity package that will raise taxes and the prices of everything from fuel to international air travel to beer. It also will lead to the dismissal of 33,000 government workers and ban new hires.

The retrenchment plan, designed to control the trade and budget deficits that have spooked investors, comes on the heels of the Central Bank of Brazil's move to double short-term interest rates to a towering 46%; that action is already emptying out shopping centers and factory floors. The government also is striving to accelerate a fire sale of $60 billion in state assets, ranging from the national telephone company to prime real estate, in the world's largest privatization program.

The objective: At all costs, save the real, the currency that has been central to reducing the annual inflation rate to 5% this year from 2,500% in 1993. Even many ardent Brazil bulls concede that the real, which now is equivalent to slightly less than a dollar, is overvalued.

A stable currency is the linchpin of President Fernando Henrique Cardoso's program to deliver Brazil from a quarter-century of economic chaos. Devaluation, Central Bank Governor Gustavo Franco says, is "unthinkable."

The outcome of the effort to defend the currency will go a long way toward determining whether this nation of 160 million takes its place as a major player in the world economy or remains perpetually "the land of the future." Says Paulo Ferraz, president of Banco Bozano, Simonsen SA, a Rio de Janeiro investment bank: "There's no country that goes without having its system and will tested . . . that's what's happened here."

For Brazil, which historically managed to generate economic growth even when it was enduring frantic inflation, the stabilization plan is a bitter pill. The package of tax increases and investment cutbacks unveiled this week will take about $18.6 billion out of the economy -- a huge hit amounting to nearly 3% of the country's annual output. And it is already having ripple effects. Cia. Cervejaria Brahma, Brazil's largest brewing company, almost immediately said it was shelving for now a $300 million investment plan.

"The government's actions will lead to what, by Brazilian standards, is a very painful economic slowdown," says Lawrence Pih, president of Moinho Pacifico Ltd., a Sao Paulo milling company, who adds that suppliers and banks are already getting stingy on credit. "But this could be the last chance for the real."

If the government can actually see the plan through -- not a sure bet, given the country's unpredictable political system -- Brazil still has enough resources to muddle through the crisis that spread here from panicked Asian markets. Although Brazil's government lost about $10 billion in hard-currency reserves since late October, it has about $52 billion left with which to defend the real. Brazil got a vote of confidence from the investment community last week, when a Brazilian consortium snapped up an electric utility for $2.8 billion, a premium of about 70% over the bidding floor in the privatization.

But still hanging over the economy are plenty of clouds that seem unlikely to dissipate until after the October 1998 national elections. Meanwhile, foreign investors are apprehensive. "It's absolutely vital" that Brazil stabilize its currency, says Thomas R. Smith, senior vice president for Community Energy Alternatives Inc. "They've got

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to stick to their guns." The electric utility, a subsidiary of Public Service Enterprise Group Inc. of Newark, N.J., is part of a consortium that paid $1.49 billion for a privatized Brazilian utility just days before the October market turmoil.

The stability of the real will largely depend on how much economic pain Brazilians are willing to tolerate. The economic chill is especially bitter because three years of stability have, almost overnight, created a flourishing consumer culture. Before the 1994 launch of the real, Fabio Barbato owned one electronic appliance: a black-and-white TV set purchased on the black market in Paraguay. Now, the Rio de Janeiro machinist has two color TVs, a videocassette recorder, a stereo and a camcorder. Unfortunately for Mr. Barbato, the interest-rate boost instantly raised the installment payments on all his new toys. "I'd ask my boss for a raise -- but I'm sure I'd get fired," he says. Instead, he plans a sidewalk sale.

Business, too, is feeling the bite. No sooner had Lojas Arno, a furniture retailer in southern Brazil, put out an advertising supplement offering merchandise in 10 interest-free installments, than the rate rise kicked in. Unable to kill the ads, the retailer is eating the loss. Developers in the normally vibrant Sao Paulo real-estate market say property sales are down 50%. And in the first of what might be many such announcements, Multibras SA, a big kitchen-appliance maker, laid off 500 workers at a plant here last week.

Of course, the uncertainty is having its greatest effect on financial markets, which have lately been volatile even by Brazilian standards. The Sao Paulo stock market had plummeted about 32% in less than three weeks prior to announcement of the austerity package on Monday. The market was up 2% on Monday on news of the package, but yesterday it slipped about 3% in light trading as investors began to grasp the plan's full recessive force.

Luis Paulo Rosenberg, a director of Linear Investimentos DTVM SA, says Brazil's markets are proof of the correlation between "consumption of Prozac and potential rate of return." Only last August, Mr. Rosenberg and other partners in the asset-management firm were featured in the country's largest business magazine. With the stock market up almost 90% in July from the prior 12 months, Linear's "Risk Team" of executives was touted as a symbol of the new Brazil.

Now, Linear remains symbolic, though in a different way. The $800 million of assets it managed before the sell-off has shriveled about 30%, the result of both customer withdrawals and plummeting asset values.

The Brazilian with the most riding on the real is President Cardoso, who has staked his credibility on currency stability. A devaluation would probably torpedo his presidential campaign and spark a populist backlash. But the recent austerity measures are also unpopular, and his approval ratings have taken a hit.

The emerging squeeze will thus test the commitment to economic stability of a nation that not long ago was unusual in combining fast growth with steep inflation and repeated devaluations of its money.

"By putting a brake on the economy to preserve stability, Brazil is finally accepting the economic rules of the real world, not some fantasy economy," says Augusto Franco, an economist at Federation of Industries for the State of Rio de Janeiro.

Before the real replaced a quick succession of other currencies, a system of indexation had kept the prices of everything from taxi fares to hotel minibars moving in lock step with the sliding currency. The symmetry wasn't perfect: Affluent people could protect their savings in interest-bearing accounts, but the poor, who kept their money under a mattress, suffered from eroding purchasing power.

Mr. Cardoso and his rock-solid real, which was introduced in July 1994, broke the indexation chain and sparked the consumption boom. But some analysts contend that he carried the strong-currency policy too far. Originally, the overvalued real had been designed as a transitional device; after Congress passed budget-balancing measures, the economy would have a new anchor in fiscal policy, and monetary policy could be eased. However, Congress has dithered three years over the budget measures, including proposals to revamp the tax system, the civil service and a social-security program that begins paying benefits to some workers in their 40s.

Mr. Cardoso deserves part of the blame. He rammed through a constitutional amendment allowing him to seek re-election rather than expending political capital on the long-delayed budget reforms. Budget cutting, the key to enabling Brazil to reduce the value of the real in an orderly fashion, could wait until his second term, starting in

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1999, he decided. But while reform was deferred, the pumped-up real was helping to turn a $10 billion trade surplus in 1994 into a trade deficit estimated at $10 billion this year.

So, the real was vulnerable in July, when Brazil felt the first aftershock of the currency crises roiling the Southeast Asian tigers. At first, Mr. Cardoso, with characteristic Brazilian bravado, dismissed talk of a contagion. "We're not a tiger," he said. "We're a whale."

Ignoring the second aftershock became impossible in October, when Brazilian stocks plunged. The quick-thinking director of the Sao Paulo Stock Exchange probably saved the day by hurriedly installing "circuit breakers," which halted the free fall. Then, the Central Bank's Mr. Franco reached into what he called his "bag of mischief" and emerged with his draconian rate increase. Not even President Cardoso ventures a guess on when rates will drop again. "God only knows," he says.

How vulnerable is Brazil's economy to the kind of currency meltdown that has afflicted the Asian tigers or, previously, Mexico? Less perhaps than it may appear at first glance, but more than Brazilians or its ardent backers admit.

Unlike the case in many Asian nations, the Central Bank of Brazil maintains controls on capital inflows and thus can limit speculation. "This isn't an open market," says Fernao Bracher, president of Banco BBA Creditanstalt SA, of Sao Paulo. "Foreign-exchange regulations make speculation complicated, risky and expensive."

In addition, Brazil has lengthened maturities on its public debt. There's no large-scale equivalent to Mexico's infamous tesobonos, the short-term dollar debt that imploded following the devaluation. And Brazil hasn't gone through the kind of real-estate speculation that helped sink some Asian tigers. Brazilian banks seem healthier, though appearances can deceive; one bank, which failed in 1995 with a negative net worth of $8 billion, had been insolvent for several years before going belly up, auditors found.

The Brazilian penchant for playing fast and loose with the economic rules is one reason many analysts still worry. Even strict capital controls can be circumvented via offshore affiliates, and limiting speculative flows of capital in favor of fixed investment doesn't guarantee monetary stability. Brazil covers roughly half its current-account deficit, the broadest measure of trade, with incoming foreign investment in plant and equipment, a very high total in Latin America. But fixed investment covered even a larger share of the deficits of some of Asia's fallen economies.

Whether Brazil's multiparty political system is disciplined enough to go along with the government's bold austerity plan remains to be seen. A proposal to keep Brazil's Congress in session on weekends to press emergency budget-cutting legislation was greeted with ridicule last week. "If we can't get the votes on Wednesday, how are we going to get them Saturday or Sunday?" asked Jose Anibal, a legislator in Mr. Cardoso's own party.

Despite opposition, the government needs to pass enough of the austerity package so that jittery investors will allow the government to reduce interest rates from the current sky-high levels. Meanwhile, government economists are counting on the slowdown in the economy to reduce next year's current-account deficit to about $25 billion from a previous forecast of as much as $40 billion. A lower deficit could be financed almost completely with proceeds from privatization rather than with speculative capital flowing into the stock and money markets.

But counting so heavily on privatization during a financial crisis is a high-risk strategy, akin to holding a yard sale during a hurricane. Moreover, Brazil's courts have a penchant for tripping up deals. The sale of cellular-phone concessions, which began amid much optimism in July when BellSouth Corp. bid $2.5 billion for the license in the city of Sao Paulo, ground to a halt a month later because of a legal snarl that shows no sign of quick resolution.

Nevertheless, deals are getting done -- about $23 billion in privatizations so far this year. Typical was last week's sale, at a rich premium, of Sao Paulo's electric utility despite turbulent markets and legal challenges. Says Mr. Rosenberg of Linear Investimentos: "Brazilians muddle through. A straight line is against our culture. We like to samba."

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3.5

2.5 exchange rate Pesos per Dollar 2

1.5

1 Dec00 Jul01 Dec01 Jul02 Dec02 date Collapse of the Argentine Peso Argentina - ISI datasheet Demographics and Employment 1998 1999 2000 2001 2002 Employment Rate 36.90% 36.80% 36.50% 34.50% 32.80% Unemployment Rate 12.40% 13.80% 14.70% 18.30% 21.50% Structure of the Economy 1998 1999 2000 GDP (Billion US$, Current Prices) 288.12 278.32 276.87 268.60 105.80 GDP Growth (% Annual Change) 3.90 -3.00 -0.50 -4.50 -13.60 Industrial Production Index (IPI) 106.59 118.22 110.41 91.10 98.00 Aggregate Demand (Million US$) 327,027.10 312,889.61 310,638.88 293,526.64 84,527.86 Prices and Inflation 1998 1999 2000 Consumer Price Inflation (IPC) (apr) 0.90% -1.10% -0.90% -0.73% 39.40% Wholesale Price Inflation (IPIM) (apr) -3.50% -3.60% 4.00% 2.40% 120.00% Producer Price Inflation (apr) -3.40% -4.00% 3.70% 2.30% 123.50% Fiscal Information 1998 1999 2000 Government Balance (% of GDP) -1.39% -2.60% -2.40% -3.05% -2.50% Monetary Data 1998 1999 2000 Monetary Base (Million US$) 16,370.17 16,492.77 15,077.00 11,982.00 6,874.08 Foreign Exchange Rate 1.00 1.00 1.00 1.00 3.49 Call Rate (1 Day) or Overnight Rate 7.00 7.10 8.90 5.85 5.75 1 Year Interest Rate 15.40 17.20 - - 1.73 Financial System 1998 1999 2000 Total Deposits (Million US$) 76,427.00 78,661.00 83,847.00 63,059.00 18,293.91 Deposits - Local Currency (Million $) 34,831.06 32,607.45 32,003.71 16,458.40 66,221.00 Deposits - US$ (Million US$) 41,962.96 46,054.54 51,908.82 46,600.60 841.00 Liquidity Ratio - 36,70 37,76 25.47 - Balance of Payments 1998 1999 2000 2001 Exports (FOB) (Million US$) 26,441.00 23,332.90 26,409.50 26,655 12,421.90 Imports (CIF) (Million US$) 31,404.40 25,508.10 25,242.90 20,313 4,232.00 Current Account (Million US$) -14,553.95 -11,945.21 -8,909.14 -4,429 2,705.20 Capital Account Balance (Million US$) 18,570.00 13,409.00 8,792.00 -3,789.00 -5,106.86 International Reserves (Million US$) 24,906.00 26,407.00 26,491.00 19,349 9,993.00 Debt and Resource Flows 1998 1999 2000 External Debt (% of GDP) 30.30 50.30 45.10 56.00 152.00 Country Risk (Basis Points) 700.00 531.00 766.00 4,404.00 6,169.00

Ratings S&P: SD - SD Fitch: DDD

Sources : Ministry of Economy, Indec, Banco Central de la Republica Argentina, JP Morgan Notes and Methodology