Ten
Monetary Stabilization in LDCs

Ronald I. McKinnon

Economic liberalization and monetary stabilization are complementary concepts. When inflation is high and uncertain, the full deregulation (liberalization) of markets in goods, financial capital, or labor services cannot work well.

Part 1 of this chapter analyzes the difficult problem of bringing domestic inflation under control in a liberalizing economy, with emphasis on interest-rate and foreign-exchange management. How can certain key prices interest rates, exchange rates, and wage rates be kept properly aligned during the process of disinflation?

Part 2 then examines the proper role of international capital flows in promoting this stabilization, with particular focus on the syndrome of LDC overborrowing when a liberalization program appears to be successful. However, overborrowing in Latin America and elsewhere in the Third World over the past two decades indicates something more than domestic financial mismanagement within LDCs. Institutional arrangements in the international capital market have proved detective: large commercial banks from the industrial countries have been implicitly subsidized to undertake unduly risky international lending. The possibilities for increasing the efficiency of the international capital market by restructuring the regulatory arrangements governing international banks and the Eurocurrency system are then discussed.

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1
The Domestic Interest Rate and Foreign Exchange Management:
Lessons from Chile and Korea

Why should price-level stabilization be the first order of business in promoting sustainable economic development?

In financial markets within inflationary economies, savers and investors must contract at real rates of interest, which are only known ex post. Thus, to minimize the price-level risk to both parties, free capital markets typically operate at very short term. But this short-term indebtedness, which could take the form of the intermediate-term loans with floating interest rates, leaves nonbank firms highly vulnerable to future fluctuations in their own effective real rate of interest. The financial positions of banks, which dominate "organized" lending in LDCs, become correspondingly precarious.

In other words, high and variable general price inflation is inevitably associated with high variability in relative prices. Individual firms find it more difficult to project the future course of their own real profits. Because borrowing and lending are short-term, the risk of default on fixed-interest loan contracts is correspondingly high. The economy's ability to allocate capital efficiently is severely impaired.

In foreign trade, the real exchange rate in inflationary economies is difficult to predict. As domestic price inflation fluctuates relative to the nominal exchange rate, the future profitability of exporting or importing becomes highly uncertain. Exporters, and businessmen whose products must compete with imports, find it more difficult to make sensible investment decisions. Exchange-rate uncertainty also makes import liberalization particularly the elimination of nontariff barriers such as quotas and exchange controls more difficult politically and also less desirable economically.

Because the government's own fiscal deficits and general lack of control over central-bank credit are usually responsible for this price-level uncertainty, a second-best case can be made for officially indexing a few key prices whose relative values are potentially sensitive to monetary disturbances: the exchange rate, some standard bank interest rates (including perhaps that on government bonds), and a basic standard wage. Without such indexing, exporters and importers, depositors and borrowers, workers and managers would face too much uncertainty for liberalized (unregulated) open markets to work well. Such indexing is commonplace in inflation-prone Latin America.

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Difficulties in controlling government fiscal deficits are, of course, not peculiar to less developed countries. Lacking open markets in government bonds or other primary securities, however, LDCs are more likely to lose control over domestic money growth when fiscal deficits appear, because the government must sell the bulk of its own debt to the banking system within which the central bank is often the principal buyer. Therefore, inflation in LDCs is best considered a form of taxation to cover uncontrollable gaps between government expenditures and traditional taxes. Indeed, when inflation accelerates in LDCs, traditional tax revenues may lag even further behind expenditures leaving the price level highly unstable (see Aghevli and Khan 1978; Tanzi 1977).

From this starting point of a (typical) inflationary and partially indexed less developed economy with uncontrolled government deficits, suppose that a major fiscal reform suddenly makes full monetary (price-level) stabilization feasible. Government expenditures, including credit subsidies financed by the central bank, are reduced and/or traditional tax revenues are increased. The otherwise quite different experiences with inflation and disinflation of Chile and Korea in the late 1970s and early 1980s are useful benchmarks. Both achieved sufficient internal fiscal control to eliminate the need for the inflation tax as a means of public finance. Thus both could embark on credible programs for stabilizing their domestic price levels.

Even as improved fiscal policy permits growth in domestic central bank credit to be reduced in the transition from very high to low inflation, there remain difficult problems of how to manipulate previously indexed wages, interest rates, and the exchange rate. As the economy evolves toward price-level stability, the government must consistently manage these key nominal prices in order to prevent serious real price misalignments. What are the basic issues?

Should access to foreign capital be limited so as to secure control over the real exchange rate?

Can "orthodox" tight money based on high real interest rates be effective in disinflating?

Should monetary policy rely on fixing the nominal exchange rate and international commodity arbitrage to stabilize domestic prices?

Is traditional backward-looking indexing of wages or exchange rates consistent with price-level stabilization in the future?

A historical case-study approach is used to analyze these fundamental problems of keeping exchange rates, interest rates, and wages

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"correctly" aligned during the transitional period of disinflation that is a precondition for full-scale economic liberalization. The failed Chilean stabilization attempt from 1978 to 1982 is treated first. Then some key differences with the more successful, but less demanding, Korean stabilization of 1979 to 1983 are pointed out.

Economic Repression and Liberalization in Chile

By the end of 1973, virtually every measure showed that the Chilean economy had become massively repressed. In foreign trade, extremely high tariffs on the order of 100 percent (table 10. 1) significantly understated the actual degree of protection. Exchange controls, quotas, and outright prohibitions proliferated over the whole range of both imports and exports.

Table 10.2 shows the basic macroeconomic and financial statistics for the Chilean economy from 1970 to 1982. The government budget deficit was out of control and had become fully monetized, reaching almost

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25 percent of GNP in 1973. Moreover, this understated the extent to which the central bank either directly or indirectly was forced to provide subsidized credit lines to a wide variety of enterprises and government agencies throughout the country.

Chile had a long history of using the central bank and a large stateowned commercial bank (the Bank of Chile) to provide credit subsidies for "development" purposes to enterprises throughout the country. But under Salvadore Allende's socialist government in 1970-73, worker collectives seized operational control of most industrial enterprises and some large farms. Because wages rose sharply, relative to (nominally frozen) output prices, these enterprises began to run with large negative cash flows which were then covered by new and extended credit lines from the banking system.

The result was massive inflation in the mid 1970s, partially repressed in 1973 by price controls, but subsequently becoming open with their removal. Because of the inflation, interest-rate restrictions, and heavy reserve requirements (more than 80 percent) on deposit-collecting banks, the Chilean financial system operated with negative real rates of interest from 1973 into 1975. The domestic flow of loanable funds in any open, organized capital market was virtually nonexistent. In view of this economic chaos, as well as for political reasons, foreign capital (other than short-term trade credit) was completely unavailable to the Chilean economy.

In 1974, however, there began a remarkable series of liberalizing reforms and moves toward monetary and fiscal stabilization the results from which are immediately evident by glancing at tables 10.X1 and 10. 2. Government expenditures were cut, income taxes were rationalized, and commodity taxes were consolidated through the imposition of a uniform 20 percent value-added tax. By 1978 the fiscal deficit was negligible, and surpluses developed over the next three years.

Equally importantly, the government undertook additional draconian measures to liberalize the domestic financial system. It phased out automatic official credit lines to prop up failing industrial and agricultural enterprises. Reserve requirements on deposit-taking banks were greatly reduced, and by 1976 formal interest ceilings on deposits and loans were eliminated. Commercial banks, the principal financial intermediaries, were sold back to the private sector, thus creating a vigorous competitive market for deposits and loans. Interest rates rose sharply from negative to very high positive levels, thus encouraging high real financial growth (table 10.2).

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However, with the benefit of hindsight, we now know that interest rates became unduly high in real terms. This created severe adverse risk selection among nonbank borrowers and substantial moral hazard among the banks themselves. The failure to exercise proper supervisory control over the banking system was not, at the time, recognized as such, but became an important contributing factor to the ultimate breakdown of Chile's otherwise well-designed program of economic liberalization, as we shall see.

Reforms were equally remarkable in the foreign-trade sector. Nontariff barriers had been pretty well eliminated by 1977; table 10.1 shows how tariffs averaging over 90 percent in 1973 were scaled down to a flat 10 percent across all imported commodities by mid 1979, a reform that lasted through 1982.

Given the severe distortions that had developed in the Chilean economy by 1973, these new policies for freeing international trade and eliminating domestic financial repression seemed to be remarkably well ordered in a "textbook" sense. They were widely applauded by almost all economists who were then first-hand observers. Thus the numerous banking failures and severe downturn of the economy from late 1981 to 1984, leaving the economy with a huge dept-overhang relative to the size of its shrunken GNP, was distressing not only to Chileans but to the economics profession.

Granted, much of Chile's economic decline was owing to adverse world economic conditions in the early 1980s: the unexpected deterioration in the terms of trade of nonoil primary products, the sharp increase in international real interest rates, and unexpected appreciation of the dollar, which further contributed to the real cost of servicing Chile's external debt.

Nevertheless, a careful assessment of the monetary stabilization program, where price inflation was successfully reduced from several hundred percent per year in the mid 1970s to almost zero by late 1981 is in order. Did the authorities make any substantial technical errors in the administration of their foreign exchange and domestic financial policies? With the benefit of hindsight, what should they have done differently to support their general goal of liberalization?

Vittorio Corbo (1985, 1986) has developed the now generally accepted view of where Chilean financial policy went astray. In order to curb domestic price inflation, beginning in early 1978 the rate of depreciation in the nominal exchange rate was deliberately reduced below the differential between inflation in Chilean prices and that prevailing in the

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international economy. The apparent real interest costs of foreign borrowing in dollars fell below those prevailing in domestic financial markets in pesos. The resulting huge inflow of foreign capital forced an undue appreciation in the real exchange rate. This caused a profit squeeze in Chilean industry and agriculture, and defaults on domestic bank loans. The subsequent banking collapses in 1982 83 were worsened by previous regulatory lapses that had permitted the commercial banks to accumulate too many bad loans.

However, what the Chilean financial authorities should have done with respect to foreign-exchange and interest-rate policies in the late 1970s remains to be spelled out. Let us review their policy options.

The Monetary Stabilization Problem of February 1978.

What was the economic dilemma facing the Chilean authorities at the beginning of 1978, prior to their fateful adoption of an "active" (my terminology: see McKinnon 1981) downward crawl for the exchange rate?

While the government had virtually eliminated any need for the inflation tax as a means of public finance, in 1977 the rate of price inflation was still over 60 percent. Although it was substantially less than in 1975 and 1976, the authorities rightly thought this inflationary momentum to be unwarranted.

Prior to February 1978 the exchange rate had been "passively" (but only partially) adjusted to compensate for internal price inflation and to roughly balance international payments with significant restrictions on inflows and outflows of private capital. Even so, a very sharp real appreciation of the currency took place from 1975 to 1977 (see table 10. 3). And this increase in the real value of the peso was probably important in reducing price inflation from more than 300 percent in 1975 to less than 70 percent in 1977.

True, the peso was greatly undervalued in 1975, because capital flight forced a rapid depreciation of the currency. Yet if the same ad hoc exchange-rate adjustments had continued after 1977, the real value of the peso could well have continued to increase. Few people now realize that the exchange-rate policy the Chilean authorities were following prior to February 1978 was not sustainable indefinitely.

What was needed was a "forward-looking" monetary policy that would stabilize the domestic price level and price expectations while at the same lime preventing further appreciation in the real exchange rate. At the beginning of 1978, some substantial change in monetary and exchange-rate policies was warranted to break the economy's inflation-

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ary momentum. The highly desirable fiscal reforms by themselves were not sufficient to establish monetary control.

The Domestic Monetarist Solution.

One school of thought actively advocated in Chile in 1977-78 was the standard Friedman-Meltzer approach of "domestic monetarism": secure control over the domestic monetary base, get rid of capital account restrictions, and float the exchange rate. Then, target some domestic monetary aggregate such as M₁ or M₂ to grow at a smooth rate consistent with future price-level stability and/or some deliberate pace of disinflation. A credible announcement effect would then directly reduce private inflationary expectations.

In my view, this strategy could well have proved more devastating to the Chilean economy than what actually happened. Because of the fast pace of financial transformation (the demand for real cash balances was rapidly increasing as inflation diminished), the authorities could not accurately estimate what the "correct" rate of growth in domestic nominal M₁ and M₂ should be. (And table 10. 2 shows that the ratio of M₂ to GNP was indeed unstable.) This unpredictable growth in monetary aggregates is characteristic of any economy moving from a state of repression to a more liberalized financial system. Suppose they had directly tightened control over the monetary base and successfully reduced inflationary expectations. With an open capital account in the balance of payments, a massive shift in international portfolio preferences in favor of the Chilean peso would have occurred anyway  perhaps even earlier. The problem of excessive capital inflows would still remain.

Because asset markets adjust much faster than do goods markets, in 1978 a floating Chilean peso would have appreciated sharply even in nominal terms. Although price inflation might then have come down more rapidly (despite the presence of backward-looking wage indexing), the gross overvaluation of the peso would have occurred much sooner, crushing the profitability of the Chilean export and import-competing sectors even before the tariff reductions were completed in mid 1979.

In summary, adopting a floating exchange rate in the 1970s would not have solved the fundamental problem of avoiding excessive capital inflows and real currency appreciation in the course of moving the increasingly open Chilean economy from very high inflation to a stable price level. Even the much milder U.S. price disinflation of 1980-82 led to a sharp appreciation of the floating dollar, along with a depression in American tradable goods industries.

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The Exchange Rate as the Forward Signal.

In February 1978 a successful monetary stabilization clearly required some unambiguous signal(s) around which private expectations could easily coalesce   indicating that price inflation would be reduced to the international level in the near future. Quite plausibly, the authorities decided to use the dollar exchange rate as the intermediate target for Chilean monetary policy: both as a signal for what they intended the rate of disinflation to be and, partly, as a forcing variable through international commodity arbitrage for achieving it.

The sweeping trade liberalization gave the authorities confidence (false, as it turned out) that domestic price inflation would quickly con-

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verge to the international level if the exchange rate were fixed. Because fiscal policy was such that the central bank could subordinate monetary policy to achieve any reasonable target for the nominal exchange rate, such a policy was credible and seemed potentially effective in stabilizing the price level.

This was the rationale for announcing and widely publicizing an active forward downward crawl, or tablita , for adjusting the exchange rate on a daily or weekly basis by very small amounts. The numbers going into the preannounced tablita were inevitably somewhat arbitrary: 24 percent depreciation in 1978 and 14 percent in 1979, after which the

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nominal exchange rate would be fixed indefinitely. The announcement effect was designed to allow private contracts denominated in pesos to anticipate the cessation of inflation.

Table 10.3 shows these decelerating movements in the nominal exchange rate converging in mid 1979 to a fixed exchange rate, which was sustained through June 1982. This tablita system broke down with the exchange devaluations of 1982 amid general economic decline.

The Indexing Problem.

This movement to an active downward crawl  or "forward" stabilization in the nominal exchange rate by the Chilean government was not itself a policy mistake, as is often suggested. Rather the absence of suitably supporting capital-market and labor-market policies as well as external stress eventually caused the stabilization policy to fail.

Consider the labor market first. Corbo (1985) correctly emphasizes the inconsistency between the forward-looking indexing of the nominal exchange rate and the backward-looking indexing of money wages, which is often found in high-inflation economies. Chilean wages were linked to the past rate of inflation, which was very high relative to that anticipated in the future. Thus, as international competition from newly liberalized foreign trade and the ever-slower downward crawl in the nominal exchange rate slowed price inflation in the tradables industries, growth in money wages continued at a much faster pace. Indeed, from early 1978 to early 1982, Corbo's data in table 10.3 show that the ratio of tradables prices to wages fell more than 50 percent.

In retrospect, it seems as if money wages in February 1978 should have been put on the same forward-looking tablita as the exchange rate. Similarly, all other prices indexed to ongoing inflation, such as charges for the use of public utilities, should have been put on the same tablita .

Putting wages under the same forward-looking indexing procedure would have fixed them in terms of the prices of tradable goods. The price of nontradables could, however, still have continued to edge upwards. However, because wages are a dominant factor in determining the cost of nontradable services, the sharp fall in the ratio of p_t /p _n between 1978-81, shown in column (3) of table 10. 3 would not have occurred.

However, if the economy tended to absorb large amounts of foreign financial capital while the exchange rate was pegged by the tablita (as happened), the domestic money supply would expand unduly and this

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inflationary pressure would effect the prices of nontradables more than tradables. Therefore, in the presence of massive capital inflows, even "correct" wage indexation could not have fully resolved the problem of avoiding exchange overvaluation.

In summary, it is now commonly accepted that better synchronization of those indexation procedures under government control in February 1978 would surely have prevented much of the gross overvaluation of the peso that was later observed. But why the downward-crawling tablita rather than moving directly to a fixed exchange rate?

In the extreme case, where the government controls all nominal prices in the economy, inflation could be halted immediately by decree. The authorities could simply promulgate a fixed exchange rate as well as fix all other nominal prices under their control. No forward-looking tablita would be necessary other than the announcement that the nominal exchange rate would remain fixed indefinitely. In effect, the tablita could be completely truncated with no continued inflationary momentum in domestic prices.^[1]

In the newly liberalized Chilean economy of early 1978, however, the move to free trade was designed to restructure relative prices. Thus a general freeze of nominal prices of all goods and services would have been out of keeping with the very nature of the reforms (unlike one on wages, which were controlled by the government anyway). Without such a general freeze, therefore, one could expect some price inflation to continue even if wages were put on the same tablita as the exchange rate.

In general, the greater the forward contracting in pesos in private transactions, the stronger the case for stretching out the tablita for some months. Assuming the Chilean government was unwilling to undertake a general price freeze, the active forward crawl toward a fixed exchange rate within two years does not seem wrong even with the benefit of

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hindsight provided that other controlled prices in the economy were also on the same tablita .

Monetary Stabilization before Full Financial Liberalization.

How should domestic financial policy be implemented during the transaction from high to low inflation?

In Asian countries like Korea and Taiwan, regulatory authorities have been more consistently cautious than their Latin American counterparts about decontrolling (fully liberalizing) the activities of commercial banks for which the state is necessarily the lender of last resort. Bank loan portfolios have been more carefully monitored (not always benevolently), and competition in the money markets has typically been limited by state-set standard deposit and loan rates. Indeed, until the early 1980s, Korean and Taiwanese commercial banks were state-owned. In both countries, open money-market competition has been pretty well confined to a fringe of nonbank trust and finance companies, as well as a vigorous informal credit market.

At the same time, however, these Asian economies have generally avoided substantial financial repression by having official bank deposit and loan rates set at levels that are moderately positive say, 5 to 10 percent in real terms. The Taiwanese government has consistently maintained positive real interest rates by keeping domestic prices stable, rather than allowing inflation to develop and having to use high nominal rates of interest to offset it (Cheng 1986), and real financial growth has been correspondingly higher in Taiwan, with virtually no dependence on foreign borrowing. Korea has been less consistent in following a nonrepressive financial strategy, but has managed to avoid inflationary extremes, such as those found in Latin America.

Only in the mid 1980s, when domestic prices in both Korea and Taiwan had been stable for some time, such that flows of funds through nonbank intermediaries as well as primary securities markets at long term became more fully developed, were both governments willing to contemplate more complete decontrol and privatization of their commercial banks. In other words, both Asian governments first sought monetary (price-level)stabilization together with some financial deepening, before fully liberalizing the capital-market activities of commercial banks.

In contrast, the failed liberalizations during 1977-82 in the Southern Cone of Latin America not only in Chile, but also in Uruguay and in Argentina were all characterized by rather complete deregulation and privatization of the commercial banks while inflation remained high and

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unstable. Banks could pretty much charge what they wanted on loans, and bid freely for foreign funds in dollars as well as domestic funds in pesos, despite the fact that their deposit bases were either implicitly or explicitly insured by their home governments and the nonbank parts of their domestic capital markets remained undeveloped.

With the benefit of hindsight, we are beginning to understand that full liberalization of the banks in such inflationary circumstances was premature. Unduly high real interest rates will likely prevail in such circumstances, leading to adverse risk selection both in the quality of the nonbank borrowers who come forward and in the banks' own behavior. And these problems with exercising prudent control over bank loan portfolios become magnified in stressful periods when the central bank is trying one way or another to impose "tight" money in order to disinflate successfully.

High Real Interest Rates and Adverse Risk Selection.

Again the Chilean experience with bank supervision and control is very useful for understanding how adverse risk selection works itself out in inflationary circumstances. Table 10.4 summarizes some extensive financial data provided by Rolf Luders (1985) on the extraordinary pattern of deposit and loan rates both nominal and real after most commercial banks had been returned to the private sector by 1976. Two characteristics stand out.

The first is the very high real interest rates, calculated ex post on the basis of experienced inflation rather than on ex ante expectations of it. For example, in 1978 the "real" lending rates on peso loans was 42.2 percent on an annualized basis although lending was typically much less than a year in duration. The net annualized spread between peso deposits and loans was about 10.7 percentage points, after taking out the effects of reserve requirements. To achieve these real yields, the nominal peso loan rate was 85.3 percent, less than a third of what it had been in the more inflationary year 1976.

The second striking characteristic of table 10.4 is the large spread between the apparent interest costs of borrowing in pesos compared with borrowing from domestic banks in dollars, which, after the deregulations of the mid 1970s, accounted for almost half of total bank loans (Luders 1985). Adjusted downward for the experienced rate of peso devaluation, this spread was as high as 48.9 percentage points in 1976 and then fell to 8.6 percentage points (still high) in 1980 before increasing again to 24.3 percentage points in 1981. It then fell sharply with the

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"surprise" devaluations of 1982. Indeed, often the "real" cost (adjusted for the domestic rate of price inflation less the rate of exchange devaluation) of borrowing in dollars was negative even though real borrowing costs in pesos remained very high.

At the time, virtually everyone thought this difference was owing to imperfections in financial arbitrage because of the remaining restrictions on foreign capital inflows. Indeed, this belief prompted the authorities to loosen capital restrictions even further in 1980 thus worsening

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the overborrowing syndrome shown by the very rapid 1978-81 buildup of external debt (table 10.2).

Sadder but wiser, we now understand that these incredibly high interest rates on peso loans represented, in large part, the breakdown of proper financial supervision over the Chilean banking system. Neither officials in the commercial banks themselves nor government regulatory authorities adequately monitored the creditworthiness of a broad spectrum of industrial borrowers: "The internal source of difficulty in Chile was a proliferation of bad loans within the banking system. I he rolling over of these loans, capitalizing interest along the way, created what I call a 'false' demand for credit, which, when added to the demand that would normally be viable, allowed real interest rates to reach unprecedented (and, 10 many, incredible) levels" (Harberger 1985, 237).

This form of Ponzi game, however, had a peculiarly international flavor. Chilean financial intermediaries not only banks incurred exchange risk as they extended loans. James Tybout (1986) and others have shown that the large economic groups, or grupos , used their control over domestic banks together with their overseas contacts to get dollar credits at relatively low interest rates in order to relend at the extremely high, but, as it turned out, false, interest rates denominated in pesos. (Because banks were officially restricted from directly assuming foreignexchange exposure, they simply made dollar loans to the grupos ' industrial companies, which then did most of the ongoing lending in pesos.) Thus these grupos continued to show increases in their nonoperating earning in 1980 and 1981, well after their operating earning had soured. Some were recording unrealized capital gains, from some very dubious assets, as earnings on their books.

Of course, it is a little unfair to imply, with the benefit of hindsight, that all these Chilean firms actually knew at the time that they were engaged in a Ponzi game. Many probably suffered from excessive optimism regarding future asset values and rates of return hopes that were ultimately dashed by the real exchange-rate overvaluation and the downturn in the international economy, neither of which were easy to predict at the microeconomic level. Nevertheless, the extraordinary level of "real" interest rates from 1977 to 1981 should have alerted the authorities to the adverse risk selection.

Scaling Down Nominal Interest Rates in Line with the Tablita.

Should more comprehensive financial measures in the capital markets have been taken in February 1978 to assist with the macroeconomic

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stabilization of Chilean price levels? Except to advocate more stringent (unspecified) controls on foreign capital inflows, authors writing on the experiences of the Southern Cone do not seem to have fully come to grips with this financial issue.

Clearly, everyone now agrees that money wages along with other significant prices that the government controlled should have been put on the same forward-looking tablita as the exchange rate. But did it then make sense to have left extremely high nominal interest rates (over 80 percent in 1978) on peso loans in place when the government was planning such a fast convergence to price stability? Politically, Chilean workers would be less likely to accept a scaledown of their nominal claims when nominal interest rates remained so high. Perhaps a standard nominal interest rate on peso loans, whose term structure was indexed to the tablita , should have been promulgated simultaneously with the new exchange-rate policy in February 1978. The authorities could have aimed at keeping the standard loan rate between 8 to 12 percent in real terms, with real deposit rates 2 to 3 percentage points below this level.

The Korean Experience, 1979-83

Are there precedents of other governments scaling down domestic nominal interest rates in the course of a major disinflation? The Korean government's successful price-level stabilization of 1979-83 provides one such example. The relevant interest-rate data are provided in table 10. 5.

Although much less than Chile, Korea suffered from inflation averaging over 20 percent during 1979-81. In real terms, its standard nominal loan rate of 20 percent (made somewhat greater by the use of compensating won balances) was slightly negative.

Then, with a big fiscal improvement and monetary stringency, Korea's internal inflation rate was driven down to about 7 percent in 1982 and only 3 percent in 1983. The Korean authorities anticipated declining inflation by quickly reducing the standard loan rate in stages, to 10 percent by mid 1982. Nevertheless, the loan rate became positive in real terms (see the far-right-hand column of table 10.5). Over the same interval, the standard short-term interest rate on won deposits was reduced from 14.4 to 6 percent.

It should be noted, however, that the Bank of Korea did not attempt to use the exchange rate as the forcing variable for domestic price-level stabilization. Indeed, as table 10.6 shows, from 1980 to 1983 the won depreciated a bit faster than the reduction in the domestic inflation rate. In part because the Korean foreign-trade sector was not as fully liberalized as the Chilean, the Korean government did not believe that inter-

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national commodity arbitrage could be used to stabilize the domestic price level. Instead, the nominal exchange rate was managed by an informal downward crawl to adjust passively to declining domestic inflation. Thus, as price-level stability was secured, the syndrome of exchange overvaluation was avoided.

This scaling down of domestic interest rates as inflation slowed, while maintaining the rate of downward crawl in the won against the dollar to reflect the inflation differential between Korea and the United States, prevented undue incentives for moving foreign capital into the Korean economy. Even so, the Korean government maintained substantial controls on the capital account to prevent a further untoward buildup of international indebtedness.

A Rationale for Interest-Rate Management.

Why should interest rates on bank assets and liabilities be reduced in the course of a major disinflation by deliberate public policy? Shouldn't nominal interest rates be bid down by the market, be allowed to fall naturally, as inflation recedes?

First, the question of correct macroeconomic signaling. If an individual sees very high nominal interest rates above recorded inflation, he could interpret this as a signal that most other people in the economy expect inflation to continue and the stabilization program to fail even though the high nominal rates could be explained ex post on other grounds. Indeed, if enough firms borrow heavily at very high nominal rates of interest, it becomes more probable that the government will keep the inflation rate high in the future in order to bail them out. This reinforces private fears that inflation will not wind down.

Second, when inflationary expectations are still high and uncertain, the problem of adverse risk selection at the microeconomic level in the Stiglitz-Weiss sense is particularly acute (see Stiglitz and Weiss 1983, 913-27). In contracting at any nominal interest rate substantially above the "normal" 10 to 20 percent range approximating average real rates of return, the borrower must bet on what the future inflation rate will be and also determine the riskiness of his own project. He will then accept a riskier project in the hopes of a favorable high yield in case inflation doesn't bail him out and he has to default anyway.

But the Stiglitz-Weiss model has a natural check on adverse risk selection. The financial institution will charge a less-than-market clearing rate of interest and simply ration equivalent borrowers observationally. Or, if more information becomes available, risk-averse lenders will gravitate toward those borrowers who appear to be safer, with more collateral or equity participation.

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However, this natural tendency to prudence among nonbank lenders may be seriously undermined in the case of banks, custodians of the money supply, who receive (de facto) deposit insurance from the government. This insurance leads to serious problems of moral hazard where, unless closely supervised, private banks may well undertake very risky and seemingly high-yield lending on the presumption that adverse out-comes leading to major losses will have to be covered by the monetary

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authority while net profits from favorable outcomes will still accrue to the owners (bank shareholders). Insured financial intermediaries will exhibit more risky behavior than the uninsured.^[2] And, in the event, mass insolvencies in the Chilean banking system in 1982-83 led to a renationalization of the banks in order to protect domestic depositors as well as foreign creditors.

Even in the highly developed capital market of the United States, federal deposit insurance is creating severe problems for bank supervisors in curbing undue risktaking by commercial banks as well as savings and loan institutions (see Kane 1985). In a developing country without an equities market or well-developed accounting standards, and where private (but insured) banks are the principal lenders, the probability of a capital-market equilibrium with very high "real" (but phoney) interest rates and undue adverse risk selection is much greater (Cho, 1986).

Although government supervisory control over private banks can prevent undue risktaking at falsely high real rates of interest, this supervision does not guarantee that the government itself will not exert pressure to make bad loans! The Korean price-level stabilization of 1980-84 was very successful, but the government's pressure on the banks in the 1970s was less benign. Because of its determination to support the development of domestic heavy industry and Korean contractors undertaking major construction projects in the Middle East and elsewhere, the Korean government coerced the banks into making risky long-term loans, many of which became nonperforming. In the 1980s the Bank of Korea still provided subsidized credit lines (official discounting at below-market interest rates) to various commercial banks to enable them to avoid bankruptcy by keeping these old (1970s) loans on their books. This bad loan syndrome continues to hinder the full liberalization of the Korean financial system despite the successful monetary stabilization.

Implementing Tight Money in the Transition from High to Low Inflation.

In retrospect, it seems clear that Chile should have tightened up more on the domestic flow of bank credit (inclusive of that financed by foreign borrowing) and relied less on the exchange rate as a lever for securing

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the price level. However, because of acute potential problems with adverse risk selection, orthodox tight money relying on very high nominal (and real) interest rates could not work.

The Koreans implicitly recognized this in bringing about their successful price-level stabilization. Nominal interest rates were scaled down consistent with keeping real rates positive, albeit below market clearing levels. And although the Bank of Korea also reduced reserve requirements as fiscal policy improved, central bank credit was rationed to the commercial banks and foreign capital inflows were limited in order to secure the desired deflation without significant overvaluation of the exchange rate. That is, tight money was imposed while real rates of interest were kept positive and fairly constant by decree.^[3] This meant that, in order to disinflate, the Korean banking system as a whole rationed credit to the private sector. However, because the Korean government's fiscal deficits were simultaneously reduced (as was also the case in Chile), the real flow of loanable funds to the private sector actually increased, thus relieving the supply constraint on domestic output. No net credit squeeze on the private sector was necessary once the Korean government and its various special agencies stopped directing the flow of bank credit to itself.

Given the equally good, and perhaps even more favorable, fiscal conditions existing in Chile, it seems with the benefit of hindsight, of course that in February 1978 the Chileans should have followed an internal interest-rate and bank-credit policy more like Korea's of 1981-83. Then some of the burden of bringing about disinflation could have been taken off nominal exchange-rate policy, which, as I have suggested, was not itself misguided.

2
Controlling International Capital Flows

Overborrowing in the course of an economic liberalization program is a problem of which our profession has become acutely aware owing to the recent experience of the Southern Cone countries.

In the particular case of Chile, analyzed above, a huge inflow of foreign capital from 1978 through early 1982 appreciated the real ex-

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change rate and undermined the Chilean central bank's control over the money supply and domestic credit expansion. As suggested in part 1, this financial deluge from abroad could have been slowed if (1) the term structure of nominal interest rates had been scaled down in line with the slowing of the "active" downward crawl in the exchange rate, and (2) internal inflation itself had been moderated by putting wages and other key internal prices on the same forward-looking tablita .

That said, I very much doubt that, without a system of exchange controls in place for preventing borrowing from abroad, inflows of foreign capital would not still have been "excessive." If the Chilean monetary stabilization cum trade liberalization had continued to appear successful, or at least was not obviously on the brink of collapse, some unavoidable pressure to overborrow would still have been there.

The Korean Experience of the Mid 1960s

A neater capsule experience we could study, without being distracted by the widespread overborrowing by LDCs in the 1970s, whether or not they were liberalizing, is the Korean liberalization of the mid 1960s. Korea prior to that time had an export/GNP ratio of less than 3 percent  almost all foreign exchange earnings were U.S. military Counterpart or funds from USAID (the U.S. Agency for International Development). Inflows of private foreign capital were negligible because foreign bankers considered the repressed Korean economy to be risky and unprofitable. Joan Robinson and the Cambridge group used to compare North Korea very favorably to South Korea as a successful model for economic development!

Under pressure from USAID in 1964, there were major trade reforms in Korea, a unification of the currency associated with a large exchangerate devaluation, and some liberalization of imports. But then in 1965, under the influence of Edward Shaw, John Gurley, and Hugh Patrick, there was a major financial reform. The domestic capital market, which had been totally moribund, was suddenly brought back to life when interest rates were removed from very low pegs at negative real levels to high pegs at positive real levels. This was accompanied by a major fiscal reform: there was no change in the tax law, but a different director was put in charge of the tax-collection mechanism. Tax revenues doubled in the course of a year. These reforms laid the basis for the Korean economic success in subsequent years.

By the end of 1965, when these reforms had taken hold and exports had begun to grow rapidly, the domestic price level was actually stable.

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Both the financial and foreign-trade reforms were very successful. By the end of 1965, however, international lenders had sharply changed their assessments of Korea's prospects. At the time of the major liberalization in foreign trade and finance, the profitability of the economy increased in the eyes of foreign lenders and domestic borrowers. Such sharp shifts in portfolio preferences are not smooth apparently because of the great herd instinct among international bankers.

So beginning in mid 1966, a large inflow of short-term capital suddenly hit the astonished Koreans. An acute dilemma resulted for macro-economic policy. If the Korean government simply let the exchange rate appreciate, that would, of course, hit Korea's nascent export industries very hard, something they found unacceptable. If the government just hung on with the fixed exchange rate while being inundated with finance capital, it would lose control over the money base and inflation would come back (which it did). In fact, the real exchange rate would still turn against exporters as the prices of nontradables were bid up; the change would just not be so precipitate (for a more complete analysis, see McKinnon 1973).

Moreover, scaling down the newly increased domestic interest rates conflicted with the pressing need to encourage real growth in domestic financial intermediation. Relative to GNP, the Korean banking system and the flow of loanable funds was much smaller in the early 1960s than in the early 1980s.

Once lost, price stability in Korea was not regained until the Kim Jae-Ik stabilization of 1981-83, discussed in part 1. After 1966 inflation and eventually devaluation proceeded, along with some degree of regression in financial liberalization. The burden of foreign indebtedness was troublesome in the 1970s, although manageable in the Korean case.

Market Failure in the Adjustment of International Asset Portfolios

The question is, what should the Koreans have done in 1965-66 and the Chileans have done in 1978-81 when confronted with large capital inflows? Why, in a sense, did the international capital market fail in each period?

Once a successful stabilization cum liberalization program, where the profitability of the economy suddenly rises, is undertaken, there is a once-and-for-all attempt by foreign lenders to get a piece of the action and increase their claims on the newly liberalized economy. This inundation with foreign capital is possible even in the case of a pure trade liberalization when there is not a major financial stabilization occurring at

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the same time. But if there is a major financial stabilization, with interest rates moved from low pegs to high pegs as in the Korean case, or interest ceilings removed altogether in the Chilean mode, then the inflow of capital is greatly exaggerated.

So what is the nature of the market failure here? Initial expectations of future profitability turn out to be wrong. People look at the real exchange rate and interest rates immediately after the reform and project them into the indefinite future. They look at profitability myopically as individuals and borrowers, not taking into account what will happen if they all transfer foreign capital simultaneously. What seems profitable for any one of them will become less profitable within a few years.

You might think this irrational. People should be able to grasp this system and see that the real exchange rate will turn against exporters once capital inflows increase at the macroeconomic level. But these were once-in-a-lifetime experiences for the Koreans in the 1960s and the Chileans in the 1970s, and for most of the international lenders in each episode. Individuals cannot easily anticipate what will happen to the general equilibrium of the economy in the future.

This problem is made more acute insofar as the financial flow into LDCs, even though it may be financing longer-term projects, is usually very short-term. And short-term finance might have to be repaid just at the juncture when the real exchange rate starts to turn adversely against exporters. So, if this myopia exists in the international capital market, there is a very good case for doing what the Chilean government tried to do: keep short-term funds out while allowing longer-term borrowing. By 1979, however, the Chilean government was not stringent enough in preventing the accumulation of short-run indebtedness by Chile's private sector.

In addition, we know that in any purely private capital market each individual borrower faces an upward-sloping supply curve for finance. That is not really a distortion. The more that is borrowed, the riskier the loan gets at the margin. The upward-sloping supply curve imposed by private lenders accurately reflects the increasing riskiness to the private borrower as he increases his exposure.

Consider instead the real world of the 1970s and 1980s, where governments guarantee all credit flows. The host government in the borrowing country guarantees private foreign credits, either officially or unofficially. In the lending countries, there are official export-import banks and deposit insurance for commercial banks. Consequently, the normally upward-sloping supply curve for finance did not face individual

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private borrowers in the Third World in the 1970s. Because of the government guarantees that were involved, they could borrow at a virtually flat rate of interest.

Combining this microeconomic distortion with macroeconomic myopia, capital inflows by private borrowers are further magnified at the time the liberalization occurs. Overborrowing in the Southern Cone in the 1970s was of an order of magnitude greater than what had occurred in Korea in the mid 1960s: an (impossible) attempt to absorb large amounts of foreign capital very quickly.

In the more recent Kim Jae-Ik stabilization of 1981-83, the Korean authorities fearful of the existing high level of international indebtedness more deliberately limited new inflows, in addition to scaling down domestic interest rates as described above. Also, perhaps fortunately, by the early 1980s international banks were so overcommitted in their LDC lending that they did not swamp the Korean economy a second time.

Encouraging Liberalization without Absorbing Foreign Capital

Where do we come out on this for policy? At the very minimum, official agencies such as the World Bank and the International Monetary Fund should not try to buy a trade or financial liberalization by giving aid. It is wrong to try to bribe someone into liberalizing, because by injecting capital at the time the liberalization occurs, the liberalization is made much harder to sustain. The abortive efforts to liberalize trade in Pakistan and India in the 1950s and 1960s, where aid was sometimes used as a lever to induce governments in the subcontinent to expand the flow of imports into their economies, may indeed have failed for this reason. If foreign capital is allowed to come in, the real exchange rate turns against exporters and firms competing with imports and makes it unduly hard for them to adjust to the removal of protection.

The temptation to bribe a country into opening its trade accounts often occurs because it has an uncovered fiscal deficit, which the international agency agrees to cover if it agrees to liberalize. This is a bad combination if any liberalization is to be sustained for more than a few months or a year. Fiscal policy should be brought under control before, or along with, the move to liberalize foreign trade and the domestic capital market. Liberalization of the capital account of the balance of payments then comes last (for more complete analysis, see McKinnon 1982, 159-86, and Edwards 1984).

I realize the Chilean experiment ultimately broke down (as all Latin American economies got themselves into trouble in the early 1980s),

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even though Chilean fiscal policy was sound. Nonetheless, there is still a strong case for not requiring a big fiscal prop from some outside lender. As far as possible, trade liberalization and financial stabilization should be a "bootstrap" operation that a country performs for itself  possibly with technical assistance from agencies such as the World Bank. Exports and imports should remain in normal balance. If a big injection of official capital finances an unusual bulge in imports during liberalization, the wrong price signals are thrown out in private markets. Then, too, private lenders often magnify any such official injection by following the lead of the World Bank or IMF. Clearly, free inflows of foreign financial capital should only be allowed at the tail end of an otherwise successful program of liberalization. During liberalization, stringent controls on suddenly increased inflows of short-term capital are warranted.^[4]

Reforming the International Capital Market

Apart from these macroeconomic control problems within individual LDCs, there is the failure of the institutions in the international capital market per se. Government guarantees both in the industrial economies that do the lending, and in the borrowing countries have created massive incentives to misallocate capital. How can one succinctly characterize the distortions involved?

(1) Neither private lenders in industrial countries nor private borrowers in LDCs see normal commercial risks. Good and bad projects get the same government credit guarantees.

(2) Commercial banks in the industrial economies have been less regulated in their risktaking in international lending than in their domestic lending. This inadvertent regulatory loophole was, in part, associated with the development of the Eurocurrency market in the late 1960s. Moreover, public agencies in the industrial countries, such as the U.S. Federal Deposit Insurance Corporation, give commercial banks undue incentive to take risks in the unregulated part of their loan portfolios without worrying about a run on their deposits. Consequently, commercial banks have completely preempted the inherently risky lending to LDCs. The dominance of commercial banks in the international capital market is an artifact of unbalanced regulatory policies in the industrial countries.

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(3) Mainly as a consequence of (1) and (2), there has been virtually no development of a "normal" long-term primary securities market where borrowers in LDCs sell bonds or equities to individual lenders in the wealthier economies.

Clearly, the private international capital market today looks very different from how it did prior to World War I. At that time, the building of American or Argentinian railways was financed largely by the issue of long-term sterling bonds in London. Tea or rubber plantations were financed by the flotation of equities. A major bankruptcy in, say, a railway project would put the bond holders out of pocket without jeopardizing the solvency of any major bank or the monetary system. Commercial banks were confined to discounting short-term trade bills associated with identifiable inventories or goods in transit. Merchant banks did the (risky) underwriting of bonds or equity flotations and on occasion provided risk capital directly to overseas investment projects.

Although it sounds anachronistic, I think that the international market in private financial capital in the 1980s should be encouraged to evolve back to something closer to its late-nineteenth-century format. This would happen naturally, of course, if official guarantees of private credits were phased out, deposit insurance were circumscribed, and the regulation of the commercial banks' international and domestic activities were brought into better balance with respect to loan-loss provisions, capital restraints on lending heavily to one borrower (or guarantor), and so on. Commercial banks, the custodians of the national money supply and the international payments mechanism, should not be in the business of highly risky long-term lending.

Unlike in the nineteenth century, however, official agencies such as the World Bank or IMF would still play an important role for those countries that remained poor credit risks if and when the private flows of international finance were so liberalized. The World Bank's technical assistance and long-term project support for poor countries would remain invaluable, as would IMF's role as an international crisis manager on a shorter-term basis. Both would nicely complement the evolution of an active long-term international market in bonds and equities from which deposit-taking commercial banks were largely absent, although they might play a limited "facilitating" role:

Even in an international bond or equity market, there is room, indeed an essential role, for banks even perhaps for deposit-taking commercial banks. We saw that in all the major pre-1914 capital markets, financial in-