This month, as a result of the crisis in Asia, President Clinton will push Congress to spend an extra $18 billion on International Monetary Fund loans. The administration has promised the American taxpayer that these bailouts wont cost anything because, in the past, our troubled trade partners have repaid. A case in point is Mexico, which paid back its $40 billion loan from early 1995 ahead of schedule. So whats the problem?
There are several, actually.
First, the fact that Mexico repaid its debt does not imply that anyone else will. In fact, the IMF already has a number of deadbeat debtors on its dole, such as Russia and Kenya.
Its elementary that a loan is either repaid or defaulted on. But that binary choice certainty tells us nothing about the relative likelihood of these possibilities. Implying that a repaid loan had a payback probability of 100% is like implying that a defaulted loan had a payback probability of 0%. If that were true, nobody would make bad loans.Prospective Risk
Capital markets evaluate credit risks based on the likelihood of repayment, before a loan is made. The higher the prospective risk of default, the higher the interest rate. To wit, Brazilian bonds are riskier than Swiss bonds, and therefore Brazilian borrowers must compensate investors with higher yields.
In assessing a loans prudence, the critical question is whether the interest rate is commensurate with the risk. To the extent the IMF sets below-market rates, the recipient governments effectively receive handouts from the U.S. and Western Europe.
And this is what is taking place. Recent IMF packages to South Korea, Thailand, and Indonesia involve interest rates ranging from 4.6% to 4.8% on dollar-denominated debt with a maturity of three years. Even the U.S. government has to pay substantially more (about 5.5%) for debt of that term. What this means is that, even if there were no risk of default at all, American taxpayers would still be losing money, because the rates at which they are lending dollars are lower than the rates at which they are borrowing dollars.
The worlds bond traders have priced East Asian credit risk rather differently from the IMF. In December 1997, while negotiations were taking place with bank creditors in New York, the state-guaranteed Korean Development Bank attempted to issue $2 billion worth of bonds at a 500-basis-point premium over U.S. Treasuries (offering annual yields of 10.5% in dollars). This premium was too low and the paucity of buyers forced lead underwriter J.P. Morgan to cancel the offering. At the time, secondary South Korean sovereign debt was trading at a spread of 900 basis points over U.S. Treasuries (about 14.5%). On the dates of their respective IMF bailouts, the credit ratings for Thai and Indonesian debt were even lower.
These so-called IMF loans, then, actually offered extraordinarily generous rebates of about 10% below market rates. On the $117 billion lent to East Asia under IMF auspices thus far, the region is saving about $12 billion a year in interest payments. Over three years, South Korea, Thailand, and Indonesia will have received a direct wealth transfer of at least $35 billion, mostly from U.S. and Western European taxpayers.
But this $35 billion figure actually understates the true scale of the transfer. Investors priced South Koreas debt at a yield of 14.5% only because there was a good chance the IMF would come in sooner or later and rescue them. Absent the market-distorting activities of the IMF, the risk premium on this sovereign debt would have been even greater.
More specifically, much of this $35 billion will amount to a wealth transfer from middle-class Westerners to East Asian governments, banks, and their rich equity owners, and from there to wealthy Western and Japanese investors who risked capital in foolish ways (or perhaps not so foolish, since there was a good chance they would be bailed out in the end). The whole series of transactions amount to a remarkably regressive tax.
Curiously, the U.S. government lends money through the IMF at far lower rates of interest than it charges to most domestic loans to Americans. In the case of loans guaranteed by the Small Business Administration, for example, the prevailing interest rate hovers around 10.75%; university students must pay about 9% on college loans; and veterans must pay about 7% on federally guaranteed mortgage loans. All of these borrowers are safer credit risks than East Asian governments.
These numbers explain why the prevailing pro-IMF rationalizations start with the premise that circumstances are highly abnormal. In one of the more common apocalyptic scenarios being peddled by proponents of the IMF bailout, the crisis in Asia triggers a domino effect, leading to a bank collapse in Japan, a recession in Western Europe, and economic catastrophe in the U.S.Asian Flu?
The problems with this doomsday scenario is that it depends on the Clinton administrations characterization of the market meltdown as an Asian flue -- a bug that strikes without cause and could strike the U.S. It doesnt, and it wont. The debacle in Asia was caused by crony capitalism, an oxymoron describing the ways in which politicians infect markets by distorting prices and artificially creating winners and losers. Investors were encouraged to take enormous gambles in real estate, finance, and other industries -- and when these gambles produced big losses, the current crisis ensued. We dont face this problem in the U.S., so we shouldnt fear being infected by Asias ills.
Most peculiarly, the IMFs remedies seem designed to avoid a theoretical economic disaster by replicating the policies that led to an actual economic disaster. After all, the difference between the crony capitalism of East Asia and the crony capitalism of the IMF is primarily quantitative: Whereas the governments in East Asia subsidized companies and industry sectors, the IMF operates on a much grander scale by subsidizing entire countries. The IMF, despite its efforts to push economic reforms, rewards bad regulatory regimes in the same way East Asias crony capitalism rewarded bad investments. There is good reason to be wary of a cure whose side effects include generating more of the same disease.