Originally published in The Boston Globe
Tuesday, November 7, 2000

Economic risks from abroad
By Martin and Kathleen Feldstein

The sharp rise in the price of gasoline and home heating oil is a painful reminder of how vulnerable we are to economic events on the other side of the globe. These higher energy costs are raising inflation both in the United States and Europe. Economists rightly worry that these higher costs also will slow the economy, possibly pushing us into an actual downturn.

Oil prices are not the only way in which foreign economic events can damage the economies of the US and Europe. Three years ago the financial crisis in Asia and Latin America caused currency values to collapse in several emerging market countries, leading in turn to widespread bank failures and sharp economic downturns that turned 8 percent growth rates in one year into 8 percent declines the next. These currency and economic crises threatened to weaken our banks and securities markets and to cut exports from the United States and Europe to emerging market countries. While the fear of such a crisis has receded, the problem has not gone away.

We recently spent a weekend at a meeting of economic experts and financial officials from the United States, Europe, and key emerging market countries of Asia and Latin America that was organized by the National Bureau of Economic Research. The group reviewed the current economic conditions in the countries that were hit by the financial and currency crises of 1997 and 1998 and discussed how the risks of crises could be reduced. We were encouraged that the emerging market countries are taking steps to reduce the risk of another round of crises. The actions of these countries are a direct response to what are now seen as the three major reasons for the crises that hit Thailand, Korea, Indonesia, Mexico, and other countries: fixed exchange rates, excess short-term dollar debts, and weak domestic banking systems.

The primary cause of the crises was overvalued currency exchange rates that led to large trade deficits. Currencies became overvalued because governments had fixed their values to the dollar at levels that became unsustainable when economic conditions changed. Thailand, for example, had set an exchange rate of 25 bhat per dollar.

During the 1990s this caused the bhat to be much too expensive, encouraging imports and reducing the demand for Thai exports. By 1997, Thailand had a current account deficit with the rest of the world of more than 7 percent of its GDP. Financing that deficit required a capital inflow to Thailand of an equal amount. When investors worldwide concluded that lending that much money to Thai banks and companies was too risky, the flow of funds dried up and the value of the bhat collapsed, falling from a value of 4 US cents per bhat to a value of only 2 US cents. Companies that owed dollars but earned their profits in bhat found themselves bankrupt, bringing down Thai banks with them. That led to widespread layoffs and triggered a spiral of declining income and employment.

This same painful experience was repeated in many countries around the globe. The good news is that those countries and others in the developing world have learned that trying to operate a fixed exchange rate is a mistake. They now let the market determine the value of their currency.

The second major cause of the crises was the excessive short-term borrowing of dollars by corporations and financial institutions in the emerging market countries. This provided a low cost source of funds as long as the foreign lenders were prepared to renew these loans each year as they came due. But when the lenders realized that many of the countries did not have enough foreign currency to repay their loans if others didnt continue lending to them, they decided that it was safer not to renew their own loans. This also caused a sharp fall in the value of the debtors currencies, plunging many of their companies and banks into bankruptcy.

On this too the countries have learned the key lesson that it is a mistake to have more short-term debts in dollars and other foreign currencies than the country has dollar reserves that can be used to repay those loans if creditors do not want to roll them over. The countries are now borrowing less and paying the extra price to keep those debts long-term so that they have time to adjust if creditors become reluctant to continue lending.

The combination of floating exchange rates, reduced borrowing, and increased foreign exchange reserves substantially reduces the risk of major currency and economic crises in most emerging market countries. But the problem of weak banking systems in those countries remains.

While the emerging market countries have learned how to reduce their risks, neither they nor the International Monetary Fund and World Bank have learned how to manage crises that may occur in a way that causes less pain and less potential damage to the global economy. Thats why we came away from the weekend with a combination of optimism that progress is possible and has been achieved but with a continuing sense that more must be done to protect the economic future.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.