CHAPTER THREE
IN THE 1980S AND 1990S, surpluses produced by exporters like Germany and Japan were looking for markets.1 Poorer developing countries, with low levels of per capita consumption and investment, were ideal candidates for boosting their spending, provided they could get financing. In fact, even though they too focused on producing for export markets, a number of developing countries, like Korea, invested a lot as they grew, importing substantial quantities of raw material, capital goods, and machinery. In doing so, they ran large trade deficits and helped absorb the surpluses.
Developing countries had to borrow from abroad to finance the difference between what they spent (their consumption plus their investment) and what they produced, as well as to pay interest and principal on prior borrowings. In the 1950s and 1960s, much of this borrowing came from other countries or from multilateral institutions like the World Bank.2 However, in the 1970s and 1980s, Western banks, recycling the mounting petrodollar surpluses of Middle Eastern countries, assumed more of the lending to developing countries. In the 1990s, foreign arm's-length investors such as mutual funds and pension funds increased their share of lending to developing countries by buying their government and corporate bonds. Thus foreign financing of developing countries became increasingly private and arm's-length.
Unfortunately, few countries have the discipline to borrow and spend carefully while running large trade deficits. Indeed, large amounts of foreign financing tend to encourage wasteful spending decisions. Many developing countries learned from terrible crises in the 1980s and 1990s that it was very risky to expand domestic spending rapidly through a foreign-debt-financed binge, whether the expansion was through consumption or investment.
The boom in busts in the 1990s had varied effects on the behavior of developing countries.3 For those like Brazil and India, which were consuming too much, the financial difficulties made them liberalize their economies and cut back on excessive and populist government spending, leading to more stable and faster growth. The busts led exporters, like the East Asian economies that had been borrowing to fund investment, to curtail investment so as to reduce their dependence on foreign borrowing. They started intervening in their exchange rates, building up exchange reserves, and in the process pumping their savings out into the global economy, ready to finance anyone who wanted to spend more. With the East Asian economies absorbing fewer imports, the surpluses searching for markets elsewhere increased, making the global economy yet more imbalanced. The fault line described in the previous chapter deepened.
In the perfect world envisioned by economists, a country's investments should not depend on its savings. After all, countries should be able to borrow as much as they need from international financial markets if their investment opportunities are good, and their own domestic savings should be irrelevant. So there should be a low correlation between a country's investment and its savings. In a seminal paper in 1980, Martin Feldstein from Harvard University and Charles Horioka from Osaka University showed that this assumption was incorrect: there was a much higher positive correlation between a country's investment and its savings than one might expect if capital flowed freely across countries.4
The interpretation of these findings was that countries, especially poor ones like Burundi and Ecuador, could not get as much foreign financing as they needed, so they had to cut their coats to fit the cloth. However, there is another explanation, not necessarily incompatible with the first. Countries might also have chosen to limit their foreign borrowing, thus inducing a strong correspondence between their investment and their savings. But why would they do so if their investment opportunities, once they overcame the organizational deficiencies noted in the previous chapter, were high?
To try to understand this question, some years ago I undertook a study with Arvind Subramanian, now at the Peterson Institute, and Eswar Prasad, now at Cornell University, in which we looked at the correlation between the average current-account surpluses of developing countries and their growth over recent decades. The current account is just the difference between a country's savings and its investment. A surplus indicates that the country contributes savings to the global pool, while a deficit indicates that it borrows from the rest of the world to finance its investment. A current-account surplus typically also means a trade surplus: the country exports more than it imports.
We found a positive correlation for developing countries: the more a country finances its investment through its own domestic savings, the faster it grows. Conversely, the more foreign financing it uses, the more slowly it grows. Of course, a country might need foreign financing either because it saves very little relative to the norm or because it invests a lot. We found that the more a country invests, the more it grows, which is natural: by investing, it increases its roads and machines, all of which go to make its workers more productive. However, the more its investment was financed from foreign sources as opposed to domestic savings, the slower its growth. Interestingly, these relationships did not hold for developed countries. Developing countries, at least the ones that grew fast on a sustained basis, seemed to avoid significant foreign financing.
In creating a bias in favor of producers, developing countries have stunted the development of their financial systems. This makes it hard for them to use foreign financing to expand domestic demand for goods and services effectively. Indeed, with the exception of foreign direct investment—for instance, Toyota's setting up its own factory in China—foreign financing ultimately relies, either directly or indirectly, on the willingness of the developing-country government to support domestic expansion, rather than on the ability of its private sector to do so. Because foreign lenders focus on the creditworthiness of the country and its government rather than on the specific attributes of the project being financed, and because they effectively obtain seniority over domestic lenders, foreign lending tends to be more permissive than it ought to be, given the benefits of the project. Furthermore, because political compulsions invariably force governments to press hard on the accelerator, countries tend to overuse foreign finance until they are yanked back by a sudden stop in foreign inflows. The ensuing bust tends to set back growth tremendously.
A government-directed, producer-biased strategy of growth tends to stunt the development of that country's financial sector. Because banks are told whom to lend to, and because domestic competition among producers is limited anyway, banks tend not to seek out information or develop their credit-evaluation skills. The legal infrastructure to close down weak borrowers, or to enforce repayment from recalcitrant ones, is virtually nonexistent.
As we saw earlier, the government does try to help producers by setting deposit rates low in order to lower the cost of credit. However, because interbank competition is limited, banks tend to become very inefficient, with bloated staffs and excessively bureaucratic procedures. Anyone who wishes to cash a check at a public-sector bank in a developing country would do well to develop an attitude of resignation while watching the check crawl from desk to desk, adding signature upon signature, before it finally appears at the cashier's window. These inefficiencies as well as limited competition result in an enormous interest spread (the difference between the bank's lending rate and its cost of funds): in Brazil, the spread routinely has been more than 10 percentage points even for short-term loans to corporations in good standing, whereas it is a fraction of a percent in industrial countries. Thus much of the cost of capital advantage obtained by setting deposit rates for households very low is lost through inefficiencies in the banking sector.
Not only do households get little for their savings, but they also find it very difficult to borrow. Lending to households is very risky even in a modern financial system like that of the United States, and doubly so in an under-developed financial system. Mechanisms to track credit histories simply do not exist. Because few people have jobs in the formal documented sector, and a significant portion of incomes—such as remittances sent by workers to their parents—are not based on formal contracts, banks have little information on which to base lending decisions. And because the judicial system does not allow easy enforcement of claims against assets, banks cannot lend easily against houses or washing machines.
Households do borrow from moneylenders, with kneecaps sometimes serving as collateral against default, but such borrowing takes place at astronomical rates of interest. The formal banking system could charge high interest rates to compensate for the risk of default (but lower rates than the informal system), but such practices are typically blocked by politicians, who “fight” for citizens by capping formal-sector interest rates at low levels, thus making lending unprofitable and driving households to the informal and unregulated moneylenders. Everything changes as the financial system develops, but this is a reasonable description of many developing countries’ financial systems in the 1990s.
I said earlier that there were broadly two reasons a developing country could need foreign financing: if it saved little relative to the norm or invested significantly more than the norm. Let us now consider circumstances in which a country saved too little.
Given that developing-country households find it hard to obtain retail credit, they typically cannot overrun their budgets. Instead, they save for a rainy day, anticipating the difficulties they will experience when times get tough. Unlike its counterpart in the United States, therefore, the underdeveloped financial sector in a developing country makes it difficult for the government to use easy credit as an instrument to carry out populist policies. Instead, the developing country's government performs the role of the financial sector, borrowing and offering transfers and subsidies to favored constituencies so as to allow households to spend more. So the primary reason a developing country saves little is that the government runs large deficits and borrows to finance them. Usually, these deficits are caused by overspending on transfers and subsidies to politically favored segments of the population—by political logic rather than economic rationale.
For example, Kenya, a country that survives on international aid and had an annual per capita income of US$463 in 2006, paid its legislators a base compensation of about $81,000 a year, tax free, plus a variety of allowances and perks that effectively doubled their take-home pay.5 In a year of widespread drought, a favored car for legislators was the Mercedes-Benz E class, supported by a “basic” monthly car allowance of $4,719. The legislators had the gall to hold up a drought-relief bill as they demanded a higher car allowance, citing the shoddy condition of the roads in their constituencies as justification. Unsurprisingly, the public's demand that the legislators fix the roads had little effect, but the raise went through. These “public servants” earned significantly more than most Kenyan corporate executives and more than their counterparts in the developed world.
When the government's borrowing exceeds available domestic resources, and it does not have access to official government-to-government aid, it turns to foreign private lenders. Because governments command some credibility, and have some access to borrowing from multilateral institutions like the IMF, lenders are willing to finance them for a while. Knowing, however, the temptations that face an opportunistic government—to inflate away debt if denominated in the domestic currency or to pile on more and more debt on existing debt, thus eroding its value—foreign lenders take precautions. They demand repayment in foreign currency (which is not affected by the country's ability to inflate or devalue its currency), and they shorten the terms of their loans in proportion to the country's indebtedness, so that they can pull their loans at short notice.
Instead of controlling its spending, therefore, the populist government that has exhausted its ability to borrow domestically turns to foreign lenders to finance it. Thus the circumstances in which foreign loans are made are not propitious. Knowing this, foreign lenders demand protection, which the government can typically give only by eroding the rights of existing domestic creditors—for instance, the more the overindebted government borrows in foreign currency, the higher the inflation it will eventually have to generate to erode domestic-debt claims on it. Moreover, because foreign investors make short-term loans, any adverse political development may scare them into refusing to refinance the government. Even more problematic, a substantial improvement in opportunities in their home countries—such as a rise in interest rates—can cause foreign investors to pull their money out en masse.6
All these factors were at play in the Mexican crisis of 1994. The sexenio, or six-year administration, of President Carlos Salinas de Gortari was coming to an end. In the traditional fashion of the dominant party, the Partido Revolucionario Institucional (PRI), he launched a spending splurge to keep voters happy. Domestic savings dropped by 3.3 percent of GDP between 1991 and 1994, with much of it accounted for by an increase in government spending, leading to a current-account deficit that touched 7 percent of GDP in 2004. Even while the need for foreign financing mounted, political developments took a turn for the worse. In Chiapas, aggrieved peasants rose up in an armed rebellion against the government, and later in the year, the PRI's presidential candidate, Donaldo Colosio, was assassinated. Moreover, the Federal Reserve of the United States raised interest rates throughout 1994, from 3 percent to 5.5 percent, giving investors the incentive to bring their money back to the United States.
As foreign investors became more worried about financing the Mexican current-account deficit, the government started converting its short-term pesodenominated debt into tesobonos—short-term bonds that were indexed to the dollar-peso exchange rate and would protect investors from a devaluation. But as political uncertainty increased, even this was not protection enough. Investors started selling out, converting their pesos into dollars, and departing the country. The central bank's exchange reserves became depleted, and the new president, Ernesto Zedillo, had a full-blown crisis on his hands when he entered office. Eventually, an enormous loan was put together by the U.S. Treasury and the IMF to prevent Mexico from defaulting on its debts. Investors in the tesobonos were paid back, but the country went through a wrenching crisis, and those who held on to peso-denominated debt suffered heavy losses.
The 1994 Mexican crisis was a classic populist emerging-market crisis, driven by excessive government spending. The 1998 East Asian crisis was different, first because the crisis stemmed from excessive investment by countries that did save considerable amounts, and second because in many countries, the domestic private sector was centrally at fault. To understand what happened, we need to examine corporate investment in a producer-biased economy.
I argue above that bank funds are costly in a producer-biased economy, despite the subsidies offered to favored borrowers. In these economies, new corporate investment is most easily financed by resources that are produced by the corporations themselves—funds generated by growth in sales and profitability. For existing corporations that are well connected to the banks, this practice saves on costly borrowing. For corporations that are young and do not have strong bank relationships—such as the fast-growing but underfunded private sector in China—it may be the only option. Therefore corporations typically invest substantially more only when they grow faster, with their saved profits financing investment. The producer-biased strategy facilitates this kind of growth because the surplus value generated by the economy is allocated directly to producers, enhancing their profits and their ability to invest, instead of winding its way circuitously through households and a financial system that is incapable of lending effectively.
This kind of resource allocation is beneficial in some respects. Profitable corporations, which presumably have better investment opportunities, have more resources to invest in their existing businesses: profitability therefore drives investment, improving on the politicized investment decisions the state or the banking system would otherwise make. The danger, of course, is that profitable firms continue doing more of the same until they build overcapacity and extinguish the profits. For small countries focused on exports, the world market is typically large enough to make this possibility remote. For a large country like China, overcapacity is a clear and present danger.
Corporations mitigate such problems by diversifying. South Korea's chaebols —conglomerates with businesses in areas as diverse as construction and electronics—or India's family-owned conglomerates, like the Tatas or the Birlas, essentially try to replicate the role of the financial system by creating an internal capital market within the conglomerate. Although the loss of corporate focus in conglomerates has often been found to be a problem in developed countries, resulting in storied corporations like ITT or Litton Industries being broken up, conglomerates have proved very valuable in developing countries because the alternative—relying on the financial system for funds—is so inferior.7
Of course, if corporations want to grow really fast, internal funds may not be enough. Also, new entrants into emerging industries need financing. Fast-growing young industries may therefore move to borrowing from domestic banks. And if domestic savings are not enough, they have to borrow from foreign investors. This is what corporations in East Asian countries did in the early 1990s.
We are already familiar with the export-led growth path followed by the East Asian economies. Having enjoyed a period of rapid growth, these economies started increasing their investment, financed with sizeable capital inflows from abroad in the early 1990s. Investment as a fraction of GDP, averaged across Korea, Malaysia, and Thailand, increased from an already high level of 29 percent in 1988 to an extraordinarily high 42 percent in 1996.
Yet these economies simply did not have the capacity to undertake this level of investment effectively. Ambitious corporations dreamed of silicon-wafer fabrication facilities, petrochemical complexes, and integrated steel plants. A $1.2 billion semiconductor plant started in Thailand in December 1995 as a joint venture between Texas Instruments and the Alphatec group was typical.8 The fabrication facility was state-of-the-art, intended to produce 16- and 64-megabit dynamic random-access memory chips, with the output to be purchased by Texas Instruments. The eventual aim was to build a 4,000-acre high-tech park, called Alpha Technopolis, to rival Taiwan's famous Hsinchu Science-Based Industrial Park. The vision was grand, perhaps overly so.
After their initial role in directing credit and creating strong national champions, East Asian governments withdrew from the business of allocating credit, a task that had become much more difficult as businesses moved up the ladder of development into more complicated technologies. The task of credit allocation then devolved to domestic banks.
Domestic banks historically had overcome the impediments to lending—such as the difficulties of enforcing repayment—by developing near-incestuous, long-term relationships with firms. Regular visits and meetings with clients gave them access to information that was not public, as did cross-shareholdings and membership on the companies’ boards. Furthermore, given the difficulty that outsiders had in accessing such information, the banks had a hold over their borrowers. Borrowers repaid for fear that their bank would cut them off from further funds and no one else would step up to lend.
Such relationships carried costs. Banks could not lend easily outside their existing circle of relationships, and they risked supporting client firms long after they should have been closed down. Outsiders had little idea of what was really going on in firms. Corporate practices were not transparent; nor were cash flows within or between the extensive corporate pyramids and cross-holdings. It was difficult to assess the extent to which a corporation was close to banks or the government and the extent of implicit or explicit support it could count on. Furthermore, the relative priority of other investors in claims to corporate assets in case of liquidation was uncertain, and the absence of a clear, effectively implemented bankruptcy code further reduced investor confidence.
As corporations invested at a faster rate than could be financed by domestic savings, they had to turn to foreign capital. But foreign investors, many of whom were banks, did not know much about domestic corporations and had little confidence that they would be able to enforce their rights in court. Unlike domestic banks, which enjoyed close relationships with firms, foreigners were not willing to lend long term and leave themselves exposed to potential malfeasance by corporations.
Instead, foreign creditors lent short term, in foreign currency, and often not to the corporation directly but to the domestic bank, which then lent to the corporations. Lending to the domestic bank effectively placed the government on the hook. Unless it was willing to see its banks fail, the betting was that the government, which was in fine health, would bail out a distressed bank, and hence its foreign lenders. Other foreign investors came in through the equity markets as portfolio investors, confident that they could sell and depart at the first sign of trouble.
The loans that domestic corporations took from their relationship banks were also typically denominated in foreign currency. Banks wanted to offload currency risk onto firms. The firms were willing to bear this risk because loans denominated in foreign currencies had lower interest rates, and the domestic currency had been relatively stable against foreign currencies.
The problem, therefore, was that managed capitalism was not equipped to deal with a plentiful supply of arm's-length money from outside. When money was scarce and the government directed lending, large projects were scrutinized carefully by the government before it directed certain banks to finance them. Although those close to the government benefited excessively from this privileged access to finance, there was at least a layer of oversight. Moreover, corporations had been careful because defaults against their traditional lenders could mean a permanent cutoff of funding. But now, with money plentifully supplied by foreign investors who themselves exercised little scrutiny because they thought they were well protected, competition to make loans heated up, and domestic corporations’ fear of being cut off by domestic banks became remote. Corporations became less careful, and domestic banks, flooded with money that had to be lent, did not compensate by increasing their own diligence.
The East Asian crisis was thus largely a result of corporate overinvestment, in commercial real estate as well as manufacturing. And although the well-connected elite and investors stood to benefit if things went well, ultimately the risks of an economic collapse were borne by the government and hence by current and future generations of domestic taxpayers. Foreign borrowing was essentially a way for the country's private sector to socialize the risk of systemwide default.
A few governments contributed to the problem. For instance, the Vision 2020 plan set out by Malaysia's prime minister Mahathir Mohamad included the Bakun Dam (then Asia's largest hydropower dam), the Petronas Towers (one of the world's tallest buildings), a supermodern airport, and a new national administrative capital near Kuala Lumpur, appropriately called Putrajaya (City of Kings).9 Mahathir's vision was certainly of pharaonic proportions: when I passed through Kuala Lumpur recently, the huge airport still looked impressive, well-maintained, and state-of-the-art—though it was largely bereft of planes and passengers. But generally, government excess was not the central problem (as it had been in previous developing-country crises, like that of Mexico in 1994). The fault lay with private excess funded by easy and hence dangerous foreign money.
The classic ingredients for a bust were in place: excessive investment financed with short-term debt, with the additional risk of a foreign-currency mismatch. All that was needed was the final trigger. This came from two related sources.
First, the overambitious investments themselves went sour. By early 1997, Alphatec had collapsed under its debts while its memory-chip plant was still under construction. Alphatec itself was only a small family-owned business with very limited experience in the semiconductor industry, and this lack of experience showed. Construction was plagued with delays: the plant was being built on land so marshy that concrete pilings had to be driven down to stabilize the buildings, at great cost. There was no clean water or power, both critical for chip manufacture, so Alphatec had to build the necessary facilities, adding further to costs. And even before high-tech plants like Alphatec's were completed, investors became concerned about their viability and started pulling out.
The second trigger was the depreciation of the Japanese yen against the dollar, starting in 1995. This made Japanese exports far more competitive than exports from East Asia, where currencies were linked more closely to the dollar. Rather than sourcing from Thailand, with its uncertain quality and small pool of scientists and engineers, importers around the world now preferred to return to tried and tested Japan. East Asian exports started faltering, corporate profitability plummeted, and investment projects started closing down.
Foreign investors started pulling out their money. Speculators joined the frenzy as they saw countries trying to defend exchange rates that were now distinctly overvalued. And as the countries used up their foreign exchange reserves in this defense, the likelihood of a devaluation became a certainty. The devaluation bankrupted first the many firms who had borrowed in foreign currencies and then the domestic banks that had lent to them. For even as these banks found that their borrowers could not repay, they had to repay their own foreign lenders. The East Asian miracle turned into a bust of gigantic proportions.
The East Asian banks turned to their governments, and the governments appealed to the IMF to give them the foreign currency that they needed to pay back foreign lenders and preserve their banks. Fund money came with conditions attached: actions that countries had to take—some before getting a loan, others after—to qualify as borrowers in good standing. Some conditions were relatively standard: after all, any lender, especially a lender who lends when no one else is willing, needs to put in place covenants to ensure that the borrower will repay. But others were onerous.
The East Asian governments believed the Fund overreached in two ways. First, it stipulated conditions that suggested it simply did not understand that it was dealing with a different client from its usual ones. By and large these were not governments, like Mexico's, that had overspent themselves into trouble. Rather, the domestic private sector had run amok with investment, with foreign lenders lacking discipline because of the implicit guarantees that they correctly surmised governments would honor. The immediate need was to restore financial stability, perhaps infuse some government stimulus to compensate for the sharp decline in economic activity, and then, with confidence restored, sort out the mess over time.
This was indeed what Western governments did in their own economies in 2008–2010, and what the IMF eventually turned to doing. But proud East Asian government officials were initially treated as derelicts who did not understand how to run clean governments. Overnight, managed capitalism was labeled crony capitalism, and there were certainly enough examples of cronyism to allow the Western financial press to go to town. Some of the initial policy advice from the Fund, the World Bank, and Western governments seemed to be focused on punishing the cronies, instead of recognizing that the system was so interconnected that many innocent people would suffer in the process. Empathy was missing, perhaps because managed capitalism seemed so alien to the outsiders who were now calling the shots.
The second way the Fund overreached was in setting conditions, often dictated by its major shareholders such as the United States, that attempted to reform the East Asian countries according to Western notions of governance. For instance, Indonesia was asked to undertake 140 or so actions in 1998, including disbanding the clove monopoly, strengthening reforestation programs, and introducing a microcredit scheme. To the cynic—and cynics were sometimes correct—these moves were really intended to open up large protected segments of the country to Western firms and advocacy groups. Although some of these measures may have benefited the country in the long run, these were decisions for the people themselves to take, not for foreign officials to require when the country was flat on its back. The unfortunate photo of the IMF managing director, Michel Camdessus, with his arms crossed and towering over a seemingly cowed President Suharto of Indonesia as he signed the IMF agreement suggested an image of the conqueror accepting the unconditional surrender of the defeated.10 Although the true circumstances were more benign, the photo compounded the sense that this was a new form of financial colonialism.
In sum then, in a developed country, especially one with well-functioning capital markets and financial institutions, foreign investors typically have information and rights similar to those of domestic investors. They do not demand special rights and privileges; nor do they try to get implicit government backing (by lending via domestic banks) or explicit backing by lending to the government. Firms and households borrow directly, forcing foreign investors to make careful decisions. If they don't, they have only themselves to blame and have no recourse to the government.
In a developing country, by contrast, foreign borrowing is typically a last resort. Because foreign investors worry that they know far less than the well-connected domestic banks and are less able to enforce payment, they try to improve the security of their claims by requiring payment in foreign currency and by shortening the maturity of their loans. Paradoxically, the underdevelopment of the domestic financial system allows the late-arriving foreign investors to demand and receive privileges that typically eat into the value of the existing domestic investors’ claims or, via the implicit guarantees offered by the government, into the taxpayers’ wealth. Moreover, the protection they receive makes them less careful about what they finance. In turn, because borrowers, whether the current government or banks, do not face the full cost of foreign borrowing, they have a tendency to overborrow.
Parenthetically, readers will note that the U.S. subprime market, with its substantial quasi-government presence, was a departure from the developed-country norm and in many ways reflected the deficiencies present in developing countries. This is precisely the analogy that needs to be drawn. I return to these issues later in the book.
The crises of the 1990s had a differential impact on economies. Countries that were saving too little were forced into much-needed reforms. For countries like India, which experienced a crisis in 1991 as a result of large government and current-account deficits, and Latin American economies like Brazil, whose vulnerability stemmed from too little saving, the crises were a signal that the old model of managed but inward-looking capitalism was broken. Both India and Brazil liberalized their economies, reducing government control and ownership, removing price and interest-rate controls, bringing greater competition into the financial system, opening up to imports and foreign investment, and letting the exchange rate float. They also adopted more sensible macroeconomic policies, cutting government deficits (for a while at least) and improving monetary management.
During the long period of protected managed growth, they had built strong corporate organizations that were fully capable of prospering as competition increased. And enhanced competition brought out the best in these companies. Tata Steel (before it acquired the European steel giant Corus) had one of the lowest costs of steel production in the world, while Embraer, a privatized Brazilian aircraft manufacturer, developed a strong market in midsized planes around the world.
These late liberalizers had large enough domestic markets that they did not have to favor the export sector. Both Brazil and India “managed” their exchange rate, but they did not try to gain a serious competitive advantage by trying to hold it down. Moreover, with firms already strong, they did not have to repress the household sector—not that their now-vibrant democracies would have allowed them to! They liberalized deposit interest rates, cut taxes on households, and allowed the financial sector to expand household credit. As a result, both Brazil and India have healthy levels of private consumption and domestic-oriented production sectors that are almost as efficient as their export-oriented sectors. Although a boom in commodities has led to a rapid expansion in Brazil's exports, its economy is diversified and resilient enough to weather a temporary drop in commodities prices if it comes. For both these countries, the silver lining in the cloud of having missed the right moment to switch to exports is that they have not had to switch back. They now enjoy more balanced economies, less dependent on exports for growth.
The East Asian economies, with the exception of Indonesia, recovered quickly: their devalued currencies made them very competitive, and they expanded exports even while replacing imports with cheaper domestic production. They also slashed investment—on average, across Korea, Malaysia, and Thailand, investment came down from 41 percent of GDP in 1996 to 24 percent of GDP in 1998, and it stayed low. Domestic savings picked up a little initially, from 38 percent of GDP to 41 percent of GDP, but drifted down over time to below 1996 levels. This is important, for the reason for their rising trade surpluses is not that East Asian households cut back dramatically on consumption and increased their savings. Instead, governments and corporations cut back on investment. The net effect on the world's supply of savings was the same—from being net borrowers from the world economy, the East Asian economies started pumping their savings into it. But demand for investment goods—for hard assets such as plant and equipment—plummeted. These were typically goods that had been imported, so the reverberations were felt around the globe. The global supply glut again went looking for countries that would overspend.
Countries that had focused on export-led growth learned an important lesson. It is a fool's game to succumb to the temptation of cheap goods and easy money: rapid debt-fueled spending invariably ends in tears. More specifically, because managed capitalism was hard for foreign investors to understand or navigate, they responded by retaining the right to exit at short notice, holding equity or short-term debt claims. And exit they did, sometimes without full regard to the country's fundamentals, so that financing with flighty foreign capital was akin to running a small bank without deposit insurance—a recipe for fragility. Although the exporters did understand the need for financial-sector reform, they did not believe that the crises indicated any problems in the broader strategy of export-led growth. Instead, the crises reinforced their beliefs that generating trade surpluses was even better than simply being export oriented, for it allowed the country to build foreign exchange reserves. The route to such surpluses was to cut back on investment, which also helped these countries avoid the boom-bust cycle in investments to which they had been prone.
The attempt by these exporters to achieve safety, though, has increased the rest of the world's vulnerability. The supercharged export-led growth strategy they have subsequently followed not only increases the burden on the rest of the world to create demand for their goods, but it also accentuates the domestic distortions the strategy previously created, which were highlighted in the previous chapter.
The new strategy also led to an enormous buildup of the exporters’ foreign-exchange reserves. These reserves went looking for a home around the world. To attract them, a country had to be willing to spend much more than its own producers could supply, and it needed a strong financial system capable of attracting the inflows and reassuring the exporters that their savings would be safe, safer than the developing countries had been. The obvious candidate was the United States (along with, to a lesser extent, Spain and the United Kingdom).
The United States, with growing inequality making the political environment favorable to more debt-financed consumption (as I argue in Chapter 1), was a prime candidate to be the new demander of last resort. However, the policies in the early years of this century that pushed it firmly into the role of the world's new designated spender were driven by a new phenomenon: recoveries in the United States were increasingly “jobless,” and the U.S. safety net was wholly inadequate to cope with them.