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Dangerous Markets reviews
the dynamics of financial crises that have wracked countries around the world.
The authors looked into what caused each crisis, how the country reacted, and
the successes or failures of efforts by businesses and governments to respond.
At the same time, the authors looked at what financially healthy countries do
right.
Below are a few of the many case studies that influenced the book and the recommendations it makes.
 | | Mexico: The Dynamics of a Crisis Answer |
| | | | Japan: The Rising Cost of Delayed Reforms Answer |
| | | | China: Plugging into the Global Economy Answer |
| | | | India: Seeking a Second Generation of Reform Answer |
| | | | Singapore: Development as an International Financial Center Answer |
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| | | Mexico: The Dynamics of a Crisis | | In 1989, Mexico began an economic reform program that culminated in the signing of the North American Free Trade Agreement (NAFTA) in late 1993. As part of that program, the financial sector was liberalized and opened to foreign competition, and eighteen state-owned banks were privatized.
The new bank owners, many of them inexperienced, paid a high price, and sought to recoup their investment through rapid expansion. At the same time, the banks found themselves awash in funds – thanks to the elimination of reserve requirements, an increase in deposits (in part prompted by the confidence the reforms inspired), loose monetary policy, and foreign borrowing, which trebled.
Not surprisingly, a lending boom ensued. As credit expanded, the balance of the banks' loan portfolios shifted away from traditionally safe borrowers, such as the government and large corporations. Banks filled the void by lending to lower-rated corporations, small businesses, and consumers but didn't have the credit analysis skills required to screen them. Bank regulators failed to monitor the risks arising from these new types of lending. Fundamental shifts in the economy caused a further deterioration of loan portfolios.
The crisis erupted in 1994, when political instability and rising U.S. interest rates ended investor confidence in Mexico, breaking the pegged exchange rate. Mexico also held an election in 1994, and it was not a good year. During the campaign, one of the leading candidates was assassinated, and in an unrelated incident a rebellion broke out in the country's Chiapas region, thus undermining investors' confidence. Interest rates and foreign debt repayments soared while credit dried up and many companies went bankrupt. | | | | | | Japan: The Rising Cost of Delayed Reforms | | The Japanese economy continues to stumble. Since the stock market crash in 1990, Japan has failed to develop a recipe for revitalization. Instead of tackling necessary reforms, the government has allowed a gradual decline, one that may now be reaching crisis proportions. The potential for crisis is evident in the real economy, the financial sector, and macroeconomic policy.
In the real sector, companies face slumping demand and overcapacity. This is particularly true in the construction and retail sectors, and has led to an increased number of bankruptcies over the last several years. Yet the banking sector continues to prop up companies that are not profitable, by providing debt at exceedingly low interest rates.
Japan's financial sector is also struggling. Banks have been left holding the bag as companies have gone bankrupt instead of paying their debts. Recent regulatory changes have made improvements in the near term unlikely. To make matters worse, Japan's productivity is also lagging. The Japanese economy is 31 percent less productive than the U.S. in terms of labor and 39 percent less productive in terms of capital.
From a macroeconomic perspective, Japan is plagued by deflation and depressed spending. A continuous decline in consumer prices and retail sales over the past two years has contributed to a fall in GDP both in nominal and real terms. To date, Japan's government has avoided a fiscal crisis because of unusually low interest rates.
However, should interest rates on government debt rise to normal levels – about 6 percent – the true state of Japan's fiscal health would be revealed. At that interest rate, Japan's debt would consume 28 percent of total government spending. Japan's poor fiscal position has already prompted domestic credit rating downgrades by several ratings agencies, including Moody's and S&P.
Japan has muddled through its financial and economic problems for over ten years. Whether a crisis looms on the horizon is unclear, but many of the warning signs are flashing. Only time will tell whether the private sector and the government are able to finally take the steps necessary to jumpstart the economy – their track record to date, however, is not reassuring. | | | | | | China: Plugging into the Global Economy | | Despite impressive economic growth and progress toward integration into the global economy, China might yet experience a future financial storm. Whether and when the storm materializes depends on several key factors, predominantly in the real sector and the financial sector, but some are macroeconomic factors.
Based on information available on publicly traded companies, there has been value creation in the real economy over the past five years, with the exception of 1999. These figures, however, probably mask problems in other parts of the economy. State-operated enterprises (SOEs) and other nontraded corporations are thought to have systematically destroyed value throughout this period, in large measure neutralizing the contributions of the healthier publicly traded companies.
The performance of the real economy is further hindered by a lack of available capital (despite high domestic deposit rates) for commercially driven firms that have the potential to create economic value. These companies are crowded out by lending to the less sustainable, but politically important SOEs and by other "policy" lending targeted at developing or ailing sectors of the economy.
The potential for problems is also evident in China's financial sector. According to Standard and Poor's, the Chinese banking sector is "technically insolvent." Market estimates of nonperforming loans (NPLs) are as high as 44 percent of GDP in 2001, largely due to the preponderance of lending to financially unsustainable SOEs.
Solvency issues of the banking system notwithstanding, the liquidity of the financial system is very high. Annually, the Chinese national savings rate is equal to roughly 39 percent of GDP, continually replenishing the losses of the banking system. The crisis might be contained by the unflagging willingness of the Chinese to save, especially if domestic depositors decide to maintain their savings in the banking system rather than moving their resources elsewhere.
Macroeconomic factors are also a cause for worry. As in Japan as of 2002, China has experienced deflation for four years. Meanwhile, estimates of government debt are as high as 75 percent of GDP, fueled by state bank loan bailouts, "policy" lending, and pension liabilities. Moreover, China, like many emerging economies, continues to lack transparent, market-driven rules of conduct, which are vital for future economic stability.
China has been slow historically to address these critical issues, although World Trade Organization membership may force its hand to accelerate reforms and prevent a future crisis. | | | | | | India: Seeking a Second Generation of Reform | | Ten years ago the Indian government embarked upon reform, liberalizing the economy to open it to global markets. Today, this liberalization effort is showing mixed results.
Despite strong GDP growth (averaging 5 to 6 percent annually), a reasonably low current account deficit (less than 2 percent of GDP), and ample foreign reserves (over $30 billion), an analysis of India's economy shows indications of distortions in three areas: the real economy, the financial sector, and macroeconomic policy. India is considering a "second generation" of reforms to further liberalize the economy and correct these market distortions, but if distortions remain unchecked, a financial crisis could emerge.
In the real economy, steady value destruction has been evident over the past eight years. This value destruction has been sustained since 80 percent of available capital is directed at nonprofitable sectors, a trend that is unlikely to change in the near future due to government-directed lending regulations, high transaction costs, and depressed market conditions. The financial sector also appears weak – as of 1998, 46 percent of financial institutions had returns on assets (ROA) of less than 1 percent, and the banking average ROA was 0.55 percent in 2001.
Both the real and the financial sectors are impeded by poor macroeconomic policies. The Indian government exercises significant ownership and control over the economy, directly owning 60 percent of assets in the real sector and 75 percent of assets in the financial sector. In addition to a strong presence in the economy, the Indian government has been intervening in the economy through fiscal policy and monetary measures to maintain liquidity and the exchange rate, and to support weak institutions.
Despite weakness in these three areas, the outlook for India is not all gloom. The economy has low foreign debt exposure and has been able to avoid a credit boom in the real sector. But government and macroeconomic reforms are needed – more privatization and liberalization in the real sector, a reduced presence of the government in the real and financial sectors, fewer requirements on government-directed lending, and a greater reliance on market decisions to allocate savings. Whether these reforms will occur in time to prevent a crisis remains to be seen. | | | | | | Singapore: Development as an International Financial Center | | In late 1997, while the Asian financial crisis was raging all around Singapore, the central bank, known as the Monetary Authority of Singapore (MAS), saw an opportunity to make Singapore an attractive financial center. Singapore was literally an island of stability in large part due to the tough, highly principled regulation of its financial institutions. Within two years, Singapore was well on its way to becoming a major financial center, rivaling Hong Kong as the leading financial hub in Asia.
Much of the success that Singapore experienced was due to the unique vision and leadership of senior government and business leaders, the embracing of global standards; the willingness to jettison sacred cows, a rigorous, multi-year approach, and the effort to enlist executives from the private sector to drive many of the recommendations.
Deputy Prime Minister Lee Hsieng Long personally led the initiative and put his own reputation as head of the MAS on the line. He established a Financial Service Sector Review Group (FSRG) that led the change. Within a year, Singapore had a well-functioning debt market with some international players, such as the World Bank, raising tranches of debt in Singapore dollars. For years, many countries in Asia have studied, debated, and analyzed the benefits of establishing a debt market, but only Singapore has made real progress from a very small base.
Similarly, the MAS recognized the crucial importance of asset managers in driving activity in financial centers and attracting service providers such as investment banks. The MAS aggressively pursued the top asset managers in the world, and asked them to locate their Asian headquarters in Singapore. By 2000, Singapore ranked third behind Japan and Hong Kong in terms of percent of assets managed in Asia, with a compound annual growth rate from 1997 to 2000 of 29 percent.
Singapore prodded its banks to get ready for greater competition with foreign players, eventually opening up the market completely and encouraging in-market consolidation. It opened up the legal profession to foreign firms to help upgrade skills in financial services, and merged cash and derivatives exchanges into a single equity exchange under the leadership of a CEO brought in from the United States.
Singapore effectively leveraged the private sector by creating multiple private sector committees to make recommendations on the best way to promote Singapore as a financial center. With the help of external consultants, the MAS also interviewed more than a hundred intermediaries and investors both within and outside Asia to assess their competitive position and to develop their recommendations. Relying on market input and private sector advice throughout the process was the only guarantee that intermediaries would embrace them. | | | | |
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| | In This Feature | |
 | Five Case Studies | |
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