Devaluations Don’t Bring Prosperity

Southeast Asia’s financial turmoil, entailing a near meltdown in Thailand followed by massive devaluations throughout the region, requires a far more thoughtful and durable policy response than the familiar International Monetary Fund quick fix of higher tax rates and lower exchange rates.

It is best to start at the source, Thailand, before examining the regional currency contagion and what to do about it. Thailand’s problem has internal, not external, origins. Thais have been pulling money out of a few lesser banks and numerous finance companies and putting it in big Thai and foreign banks. Meanwhile, since devaluing in early July, the government has shut down another 42 of the country’s 91 finance companies, in addition to 16 it had already closed in June.

The failed financial institutions will be put into liquidation, just as many American savings and loan associations were not too long ago. Their liabilities—deposits—can be assumed by surviving banks, which will receive liquid claims against the central bank and long-term government bonds. Surviving banks and finance houses can, in effect, swap government bonds for the seized assets of failed institutions on the open market.

The curative measures involved will lead to a well-capitalized, world-class Thai financial system. If handled properly, the case could set an example for much of the world.

It is vitally important not to sap the capital strength of surviving banks. First of all, reserve requirements should be increased for all short-term claims against financial institutions, such as checking accounts. Banks and finance houses will acquire government debt by selling equity and long-term subordinated debt. The capitalization of surviving Thai financial institutions can become as sound as anywhere.

If the IMF has its way, however, that may never happen. Although financial turmoil in Thailand had internal origins, the IMF now proposes external solutions. Its package includes raising the value-added tax by three percentage points and adopting contractionary monetary and fiscal policy with the intent of reducing the current account deficit.

Current account deficits have long been common among most of the Southeast Asian “tigers,” and are often essential for the economic progress of such countries. The creation of jobs requiring high skills and offering high wages may depend on continuing foreign investment, which enhances the demand for skills. Net capital inflows are complementary to current-account deficits. Yet the IMF seeks to impose fiscal stringency in order to deal with a totally unrelated financial aneurysm—namely, a “speculative” assault on the baht that was exacerbated by structural flaws in Thailand’s currency regime and by faulty tactics for “supporting” the exchange rate.

Like the fiscal austerity schemes, a strategy of deliberate, proactive devaluation is too often a condition for IMF lending. Such devaluation involves an attempt to manipulate the real terms of trade in order to discourage imports and promote exports.

The illusion that currency depreciation is stimulative is based on the fallacy that exports will become cheaper, and thus the outside world will want to buy more of them. It pivots on the idea that wages will become cheaper relative to, say, baht prices of exports. Exports sold for a given number of dollars yield more baht; so it then becomes more profitable to export. The imported portion of workers’ consumption, meanwhile, becomes more expensive, so real wages are slashed. Workers’ reduced purchasing power, and relatively higher prices of imports, are supposed to crimp imports. By making the terms of trade worse, and slashing real wages, trade deficits shrink.

This Keynesian cult of self-mutilation is flawed. For instance, currency depreciation cannot address the pressing problem of the acute shortage of skilled labor in Thailand. Experts say that more than 35,000 new technicians must be trained each year in order for Thailand to sustain brisk economic growth. Cutting real wage rates will not stimulate the supply of skilled labor, and existing shortages block the expansion of finished-goods exports that devaluation hopes to promote.

Meanwhile, capital flows to devaluing countries are apt to be curtailed, as foreign lenders reduce their exposure and nurse their wounds. Many regional entrepreneurs will find it more difficult to borrow hard currencies in a floating exchange rate regime. The cost of hedging, even if currency is available, becomes prohibitively expensive. In sum, with less foreign lending and skilled labor already scarce, the devaluing country’s capacity to export does not increase. Two unpleasant realities must follow:

First, to the extent that competition within the region forces down the dollar prices of the region’s exports, most of the loss of real income for the region’s workers translates into gains for foreign consumers and importers. Second, even if the physical quantity of exports were to increase by 10% when dollar prices of exports fall by 5%, the dollar income from export sales would rise by less than 5%. Along the way, the production of additional exports (if feasible) burns up valuable resources, while useful imports of both capital and consumption goods are cut off. At best, the result is only a slight reduction in what has been for the most part a healthy trade deficit, all achieved by impoverishing the region’s labor force.

The IMF should understand this. It understands correctly that the baht and other regional currencies ought to be linked to baskets of hard currencies. Too many politicians and central bankers would otherwise find the siren call of inflationary finance irresistible. Yet the IMF has not been prepared to support measures that would make Asian currencies immune to assault.

It can be done, however. The attack begins when currency is massively sold short by “speculators” who need to put up very little capital. The spot exchange rate then plunges, just as U.S. stocks did on October 19, 1987 on news that stock futures had collapsed. One way to provide protection is to widen the bounds within which fixed exchange rates are allowed to fluctuate, for much the same reason that Keynes proposed widening the “gold points” in 1923 to defend a fixed parity with gold. Keeping the upper and lower bounds for exchange rates too close offers speculators a free ride.

Countries like Thailand can prepare for this. With the aid of guarantees from the IMF, Group of Seven countries or others, large amounts of the “hard” currencies backing Asian money can be acquired by Thailand and others in exchange for sales of long-term debt denominated in, say, U.S. dollars. Such “paper spins” do not involve any real resource cost for the apparent donors. The point is not to deploy such a maneuver prematurely. The Thai baht, Malaysian ringgit and so on should not be supported until assaults against them have spent their force. At that point, vastly augmented reserves can be put into play, relative to exchange rate bands that are perhaps 20% above and below the central rate. Speculators will not get another free ride.

But what needs to be understood is that, in the long run, currency depreciation will not alter demand and supply curves, in terms of real wages. Unless economic fundamentals are changed, the cost of labor will soon rise again as nominal wages catch up to prices, then rise faster for a while, during the inflationary interval that inevitably follows devaluation. If labor costs really were uncompetitively high at the time of devaluation, then they will increase less than prices. But the workers’ distress, and continuing distrust, will impede productivity, disrupt production and destabilize politics—undermining investment prospects in the process. This is another heavy price to pay for the misunderstanding, by Western experts, of a technical malfunction in some financial markets.