Analysis: Asian Crisis May Take a Painful Step

by David E. Sanger

WASHINGTON -- When the history of Asia's deepest crisis in decades is written, the past six months of market panics, escalating international bailouts and the direct use of U.S. taxpayer funds to save South Korea's financial system may look like just the first phase of a long and far more painful trauma.

So far the crisis has hovered in what most Asian experts and U.S. officials call the "market phase," as investors fled first from the currencies and stock markets of Thailand and Malaysia, then from Indonesia, and then from South Korea.

Their currencies have plummeted 50 percent or 60 percent, and every day there have been increasingly urgent meetings -- some run out of the White House situation room -- as U.S. officials, their counterparts in foreign capitals and officers of the International Monetary Fund have plotted ways to restore the confidence of investors.

So far, they have failed more often than they have succeeded.

Just ahead, many suspect, is a far more painful phase, one that will move the Asian crisis from the trading floor and the boardroom to the factory floor and the street.

The bitter medicine ladled out by Washington and the IMF in return for their rescue packages prescribes the closing of failing banks and businesses, and layoffs on a scale that the Asian economies, accustomed to spectacular growth, have not seen in modern times.

Last week's second effort to save South Korea, for example, came only after the president-elect, Kim Dae-jung, agreed to abandon the social contract that guaranteed the government would let no major national enterprise fail.

"We're one or two months away from what could be real trouble -- when the factories close, when the unemployment rates shoot up," said one senior U.S. official involved in the desperate scramble to keep the crisis from seeping out of Southeast Asia. "The hope is that we're doing the right things to make sure this passes as quickly as possible, as it did in Mexico. But there are no guarantees."

The very real possibility of what Treasury Secretary Robert Rubin delicately called "the risk of political and social instability" if South Korea's markets descend into further chaos is what gradually led Clinton's top advisers to conclude that they had to reverse course in their strategy for dealing with the Asian crisis.

In doing so, they have edged in a direction that Rubin has repeatedly insisted in the past makes him immensely uncomfortable: bailing out private banks and investors, as well as governments.

Until the day before Christmas, Rubin's official approach to the Asian crisis was to provide policy advice to the stricken countries, but stop short of directly providing loans to South Korea the way Washington did in Mexico, following the collapse of the peso three years ago this week.

As the IMF assembled rescue packages for Indonesia in September, and Korea in November, Rubin limited Washington's financial stake in the rescue efforts to participation in a "second line of defense," which he declared would be tapped only if all other aid was exhausted. That conveyed the symbolism of U.S. commitment to Asia's stability, but allowed the administration the political cover of arguing that no U.S. cash was at risk.

Now it appears that Rubin and his deputy, Lawrence Summers, who together engineered the successful Mexican bailout, underestimated the extent to which the severity of the Asian crisis would require Washington to get involved more deeply. While publicly insisting in recent weeks that the $57 billion program led by the monetary fund should be sufficient, they gradually came to the conclusion that the United States would have to do far more.

"We had reached a moment when it was clear that the markets were not responding to the first program" to stabilize Korea's plummeting currency, a participant in one crucial meeting 10 days ago recalled, "and if we didn't get something together that was better, Kim was going to get buried in the wreckage."

Officials in the Defense and State departments constantly raised the political risks of economic chaos in South Korea, a country where 37,000 U.S. troops are stationed to deter North Korea from pouring across the border in a last, desperate attempt to save the starving North from slow disintegration.

But that discussion, the participant noted, was less intended to "sway the debate than to establish how we could explain to the country why our national security interests are bound up in the economic problem."

The result was a two-pronged strategy whose chances of success may be decided over the next few weeks.

Rubin has now authorized a loan of $1.7 billion to South Korea in early January, part of a $10 billion package of emergency relief, with the additional contributions coming from other large industrialized nations and the IMF.

Treasury officials are calling this just an acceleration of their initial program, but it represents a fundamental shift -- an acknowledgment that the United States must put taxpayer dollars at risk. The money comes from the same source that was used in the Mexico bailout, the Exchange Stabilization Fund, whose transactions require no congressional approval.

At the same time, the Treasury pressured U.S. banks to speed up their fledgling efforts to renegotiate their loans to South Korea's drowning financial institutions. The hope was that the $10 billion loan would give Korea time, but that the rescheduling of debt by private banks in the United States, Japan and Europe would actually ease the crisis by giving Korean banks more time to pay back short-term loans that are denominated in dollars.

The banks were threatening to default on those debts because Korean companies were going bankrupt -- and because the fall of the South Korean won means that it now takes twice as much local currency to pay back a loan made in dollars as it did at the beginning of the year.

The strategy may ease the immediate crisis. But it has many hidden costs, and it undercuts Rubin's past efforts to make sure that private investors pay dearly for unwise investments in ill-managed economies.

In an age when governments talk endlessly about deregulation and letting market forces rule, the direct loans from Washington and its allies cut in the other direction.

In the Mexican case, Washington's argument was that the Mexican government could not be allowed to default on money it borrowed directly from financial institutions around the world. But unlike Mexico, the Korean government borrowed relatively little. In the Korean case, it is private banks that did the borrowing -- often at the prodding of Korean government officials -- and so the bailout in this case involves preventing private banks from defaulting.

The distinction is important, because it is politically much more difficult to defend saving private Korean banks than it is to defend saving the democratically elected government of South Korea.

"This is a tough argument to make," said Jeffrey Garten, the dean of the Yale School of Management and formerly the undersecretary of commerce. "To Rubin and Summers, the real issue is not whether you are saving governments or companies, but assuring financial stability for the country. And that means shoring up whatever part of the system is weak.

"But it is a hard case to make to the public," Garten said, "because you are essentially bailing out private entities" -- in this case, non-American private entities.

Rubin seemed to acknowledge that when he said last week he "wouldn't spend a nickel to help private investors and private creditors."

"On the other hand, we have an enormous stake in re-establishing financial stability in South Korea," he said. "An inevitable byproduct of that is that investors are going to do better than they would otherwise have done."