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Thursday, January 18, 2007

Devil May Care: Can Heterodox Policies Co-exist With or Become a Limited Part of Free Market Systems?

by Artim : New York

What do Thailand and Ecuador have in common? Though this may seem like an obtuse question, the answer clearly is a “Devil May Care” attitude to their, respective, structural policies. Clubbing Thailand in the same league as Ecuador may seem a bit harsh for any seasoned emerging market watcher; although, arguably, they do now share the dubious distinction of -either actively considering or- directly putting at risk policy keystones of their [post-crisis] economic recoveries to the detriment of foreign investors and conventional perceptions of sustainable policies. We think the unanticipated policy heterodoxy of the two referenced countries is important to watch and assess carefully as they could represent potential precedents for nasty --anti-foreign-- political, policy and legal surprises in several emerging markets down the road. Our fear is premised on the notion that further such event risks cannot be ruled out given country specific idiosyncrasies amidst: 1) global liquidity growth and risk seeking behavior that continues to outpace structural & institutional improvements(or lack thereof) in several countries; and, 2) An increasingly apparent failure of multilateral frameworks for ensuring free trade and optimal investment flows.

Turning briefly to individual country experiences…

In Ecuador’s case, considerable investor uncertainty has arisen after the new President, Mr. Rafael Correa, has persisted with his inclination to restructure (if not outright default on) Ecuadorean $-bonds. Moreover, there is also considerable uncertainty regarding President Correa’s plans for ‘de-dollarizing’ the Ecuadorean economy. Much has been written in the press and in EM analysts’ notes about the foolishness, and long-term costs, of a needless external debt default. I, however, focus here on the reasons for the “Devil May Care” attitude that underpins the Ecuadorian President’s push for de-dollarization.

First, and foremost, it must be remembered that adoption of the US$ as legal tender, in 2000, was the cornerstone of controlling inflation and restoring depositor faith in the banking system in the aftermath of the country’s financial crisis of 1999-2000. After dollarization, the Ecuadorean economy has grown at a respectable (average annual) clip of 4.7%, inflation declined from 91% in 2000 to 3% in 2006, and –in the same time period- the fiscal deficits have been restrained to within 1% of GDP. Decent growth, low inflation (& low real interest rates) and the absence of serious fiscal imbalances enabled a substantial reduction of Ecuador’s public debt burden, from a peak of 84% of GDP at the beginning of 2000 to an estimated 32% in 2006.

However, such notable fiscal and monetary improvements have not been accompanied by significant improvements in the underlying productive and employment generating capacities of the economy. The ratio of agriculture:services:industry sectors, in the overall economy, have largely remained unchanged roughly in the order of 6:34:60; though, with a slight sectoral tilt in favor of industry – due mostly to the development of the oil sector amidst globally high crude prices. However, the concentration of employment in low-value add sectors (yes, Ecuador remains a large producer of bananas, plantain, shrimp & fisheries.) amidst a capital-intensive oil-industry driven economic expansion has actually led to a creeping rise in recorded unemployment to nearly 11% of the labor force in 2006, up from under 9% in 2001. When such structural economic deficiencies are combined with Ecuador’s unique set of political tensions, and congressional schisms, it comes as no surprise that the broad swell of economic frustration has been cycnically channeled into anti-foreign creditor sentiment and resentment toward the country’s corrupt business class and querulous legislature by the likes of Mr. Correa. Setting aside domestic political considerations and shenanigans for the moment, the crux of President Correa’s economic argument is that Ecuador needs a wider range of public investment, since the private sector remains either too small or too inefficient or too corrupt to assist with the country’s pressing human and infrastructure development needs. However, substantially larger outlays of public monies without concomitant plans to increase the revenue base –within a dollarized regime- imply a populist fiscal stance that is inconsistent with price stability, external competitiveness and the country’s growth prospects.

Clearly, the only way to sidestep such constraints is to de-dollarize the monetary system. But even then, the new President appears unafraid or unconcerned about inflationary impacts from the (ostensible) monetization of a sharp escalation of fiscal imbalances. I think this lack of fear is based on two important global trends. First, is the preponderance of global liquidity backed by the Latin American financier of last resort – Hugo Chavez. The referenced benign global liquidity backdrop, bolstered by regional leftist-political and financial support clearly solidifies the expectation that any fiscal and monetary costs and risks can be stanched, in the short-term, by inflows from Chavez and eventually be passed on to foreign investors, in the long-term. After all, Chavez purchased Argentine global bonds –since Argentina was cut off from global primary debt markets- and then, subsequently, the Venezuelans went on to sell the Argentine debt to global investors in secondary markets at a handsome profit! De-dollarization could ultimately also set the stage for a harsh restructuring of Ecuadorean sovereign debt owed to foreign investors (I find it hard to foresee a unilateral restructuring or forced default while Ecuador’s monetary system remains dollarized; as all of its trade & capital account payments ultimately have to clear in the U.S. payments systems). The second factor underpinning the President’s bravado has to do with the gradual increase in Ecuador’s trade integration that has brought few economy wide benefits. Ecuador’s trade/GDP ratios have crept up from 56%, in 2001, to roughly 62% in 2006; not exactly a ringing indicator of trade integration, but it appears worse when most of the increase is accounted for by the exports and imports of the capital-intensive oil industry. In this regard, the President has –unsurprisingly- been dismissive of Washington’s offer of renewing its unilateral Free Trade Agreement (FTA). The Ecuadorean’s clearly expect a steady stream of hard currency from fairly inelastic global demand for its oil, with or without a spaghetti noodle network of bi-lateral trade deals that have been of little use to it in fostering more labor-intensive specialization in other higher value-add industries.

Turning to Thailand…

Investors are by and large used to the sort of political and policy volatility that is a direct consequence of institutional weaknesses and political bickering in such countries as Ecuador. But clearly, there was a much stronger consensus that Thai policy-makers have matured or were at least widely expected to act accountably. The forcible removal of Prime Minister Thaksin in a [peaceful] coup-de-tat was welcomed by the country’s political class and foreign investors as good riddance of divisive and corrupt influences. Moreover, the promises of constitutional reforms and early elections by the provisional administration, and the lack of any serious political disturbances offset any lingering fears of lack of legitimacy that in turn could lead to prolonged policy gridlocks. However, subsequently, the “Devil May Care” attitude of the Bank of Thailand in its efforts to stem the “excessive” inflow of foreign capital led it to impose strict controls on foreign investment inflows, on Dec. 19, 2006. Although, certain restrictions were eased within days of its imposition, as local equity markets tanked; most of the draconian controls remain in place, and were ratified --in the “Foreign Business Law”-- by the government, in mid-January ’07. While the BoT may profess that its hand was were forced by the dearth of policy options in the face of excessive inflows of speculative capital and too much appreciation of the Thai Baht, I remain unconvinced. In fact, not only does the unorthodox imposition of such capital controls mark a drastic departure from Thailand’s post [1997] currency crisis policy of maintaining a clearly defined and transparent free float of the Thai Baht with no capital controls but it: 1) is reminiscent of precisely the kind of policy arbitrariness that is often associated with the un-thoughtful acts of unelected or unaccountable public officials, and predicated on the belief that it does not really matter since ample global liquidity is still out there; and 2) also goes to show that multilateral frameworks for reducing regional currency pressures either do not work or are vastly underutilized.

Setting aside, for the moment, more deeper political considerations that have been channeled into anti-foreign sentiment [against the Singaporeans, and other foreign investors] and used as a rationale for the government’s anti-foreign investor policies; recent interviews by the BoT governor Ms. Tarisa Watanagase- have proved extremely revealing of the mindset of the country’s new policy makers. Mrs. Watanagase says -- “I’ve been criticized for taking the market by surprise by taking unconventional methods, especially capital controls…” She then goes on to say “…conventional wisdom works only when you are in a conventional environment.” The question that, then, arises is – are the FX appreciation pressures at other emerging markets any less exceptional? Does Brazil’s FX appreciation of 40-50% in the past year also not warrant an “unconventional” policy response? Or what about appreciation pressures on the KrW, S$, or even IDR, and so on? The financial press has reacted by alternating between condemning the investor uncertainty that the BoT’s actions have generated to being sympathetic about how Thailand had few other good policy options other than to change the rules of the FX game itself; although there has been near universal chastisement of the clumsy manner in which Thailand went about actually implementing its unorthodox controls. The broader points that are often missed here are that: First, Thailand could have done much more in terms of market based measures such as raising its cash reserve ratios and cutting interest rates more sharply to dissuade speculative money flows (as it appears to be doing in recent days); and, second, as a sitting member of the ASEAN, Thailand could have done more to galvanize ASEAN to take up a collaborative stance on currency policy coordination amongst its membership and/or take a common position vis-à-vis China’s RMB policy. Lack of action on the latter (policy coordination) may reflect disbelief that coordinated multilateral FX policies have any chance of success; or perhaps the interim Thai administration simply didn’t have the wherewithal to solidify its domestic legitimacy before taking on broader issues of regional, and global, concern. But what is clear is that an arbitrary policy stance that depends on elements of shock or surprise or is inherently punitive in nature tends to view the utilization of highly unorthodox methods as if it were among a range of acceptable policy options (while invoking “exceptional” circumstances). And as such, these heterodox policy measures are also predicated on the firm belief that global liquidity is here to stay and that there will be no long term adverse impacts. If such assumptions and predications did not exist, then, in my opinion, the draconian policy measures would not be implemented to begin with.

So the key question to take away from all this is -- can drastic regime changes become mere instruments of policy choice in countries that otherwise retain a nominal commitment to free trade and liberal economic systems? My answer would be, No! However, the instances of Thailand and the evolving situation in Ecuador seem to suggest otherwise. Thereby showing once again that conventional notions of what might be possible and acceptable --from a monetary policy standpoint-- may be undergoing considerable transformations, thanks in large part to the lack of adequate risk differentiation in a highly liquid world that acts as an opiate against the institutional and/or structural shortcomings of specific countries.