The Dog That Didn't Bark: Moody's, Et.Al. Fail Investors In Asian Markets, Miss Warning Signs In China And Russia

(Washington, D.C.): Yesterday, Moody’s and other rating agencies announced what every
knowledgeable investor on the planet had long since figured out: South Korea, Thailand and
Indonesia’s sovereign debt instruments (not to mention that of a number of their major banks and
financial services companies) are now “below investor grade” — read, junk bond status. Malaysia
was downgraded as well, to a less serious degree.

As the New York Times put it today: “Moody’s Investor Services began to catch up with the
market by downgrading four nations, three of them to ratings below investor grade.…This is
the first time Moody’s jointly downgraded a handful of countries in the [Asia-Pacific] region.”
(Emphasis added.) It appears to have occurred to Moody’s only recently that Japan’s banking
crisis and market downturn — which the Financial Times today described as a “death spiral” —
would preclude Japanese consumers from purchasing large volumes of exports from its neighbors
in Asia and prevent troubled Japanese banks from providing large scale new lending throughout
this troubled region.

Missing the Boat on China…

The Western rating agencies are apparently trying to top this dismal performance by following the
lead of the U.S. and its allies — who are determined to prevent China and Russia from
undergoing financial meltdowns of their own. For example, today’s New York Times reports that,
while Moody’s was downgrading South Korean, Thai, Indonesian and Malaysian sovereign debt,
it “affirm[ed its previous] ratings for Hong Kong and China.” As it happens, these ratings are
extraordinarily high. In the case of China for instance, its long-term foreign currency bonds are
rated by Moody’s to be “A3” — the agency’s seventh highest rating. China’s long-term foreign
bank deposits are somewhat lower, at “BAA2.” Neither of these have changed in at least the
past year.

This comes in contrast to analyses cited by the highly regarded DRI/McGraw-Hill Global Risk
Service during the second quarter of 1997. DRI/McGraw-Hill warned that as much as “20-40%
of China’s outstanding stock of loans, valued at $600 billion can be classified as non-performing.
So far, the problem has been contained. However, should things go wrong in China’s banking
sector, the ramifications in developing Asia could be huge.”

The scale of the decline of so-called “Red Chip” stocks (i.e., China-based, government-controlled
or -affiliated entities) on the Hong Kong market have, in many cases, fallen faster and further than
have counterparts among pre-takeover Hong Kong Blue Chips. It is also the view of some
respected analysts in Asia that China’s much-touted hard currency reserves are, in fact, seriously
encumbered by virtue of the need to prop up large — and, in many cases, doomed — Chinese
state-owned industries and enterprises.

…And Russia, Too

Today’s Washington Times features a front-page report by Martin Sieff entitled “Russia Next in
Line for Economic Collapse: Experts Warn of Political Consequences.” According to the Times,
Moscow’s plan partially to float the ruble next week could compound a financial crisis already
gripping Russia, as well.⁽¹⁾ The International Monetary Fund has, nonetheless, just released yet
another $700 million of the Kremlin’s $10 billion credit line on what has become an increasingly
politicized basis. In the absence of vastly increased collection of unpaid taxes, however, this
payment may amount to little more than a “Chinese clean-up” — permitting the Yeltsin
government to meet its immediate obligations to pay off politically-important domestic
constituencies and foreign creditors and investors who can, in turn, help to perpetuate the myth of
Russian solvency and fiscal responsibility. As Mr. Sieff puts it: “The country has been able to
avoid a collapse in part because of fresh infusions of money from the International Monetary
Fund, which lends to Moscow at highly favorable interest rates.”

The larger problem remains, though:

That is more than double Russia’s
$28 billion debt when Mr. Yeltsin was re-elected 18 months ago.

The Washington Times reports that “The proposed changes couldn’t come at a worse time,
said Marshall Goldman, director of the Davis Center for Russian Studies at Harvard University.
‘There is concern over the uncertain state of President Yeltsin’s health, at the continuing
extremely high level of criminal penetration of the financial system and over the impact on Russia
of the Asian financial crisis,’ Mr. Goldman said.

Mr. Sieff also quotes Keith Bush, Director of Eurasian Studies at the Center for Strategic and
International Studies as saying, “the new flexibility, combined with declining confidence in the
Russian currency, could lead investors to switch into dollars ‘in a massive way. We might then
see a massive dollarization in Moscow and a huge run on the ruble,’ he said.”

Martin Sieff concludes that, “If that happens, Russia will be ill-equipped to stem the flood.
Russian banks would need capital of at least $67 billion to cover a concerted run on the
GKOs, experts say.” What is more, Russia has nowhere near the hard currency reserves it needs
to protect against this eventuality. Specifically, Moscow acknowledges having just $18 billion in
foreign currency reserves — a claim that is almost certainly exaggerated. Even if true, this sum is
clearly inadequate given that, according to Interfax news agency, Russia’s central bank spent
almost $3 billion to prop up GKOs and other federal government bonds in November alone.

Despite all this, Moody’s has yet to change its ratings over the past twelve months on
Russia’s long-term foreign currency bonds and long-term foreign bank deposits, “BA2”
and “BA3,” respectively. It is ironic, not to say irresponsible and absurd, that Western
governments and commercial banks agreed just a few weeks ago to the debilitating debt write-down implied by a twenty-five-year “rescheduling” of some $100 billion of Soviet debt owed
these Western public and private sector institutions.

The Bottom Line

In the wake of the burgeoning international financial meltdown, the conventional wisdom has it
that the appropriate response is to throw American taxpayer funds — either directly or indirectly
through multilateral institutions like the IMF and World Bank — at those whose non-disclosure,
misconduct, corruption and failed industrial, banking and other misguided policies brought about
this avoidable global debacle. The William J. Casey Institute of the Center for Security Policy
believes, however, that three precepts should govern any assistance that might be forthcoming
from the U.S. treasury:

First, the Treasury Department’s Exchange Stabilization Fund (ESF) was designed for
largely overnight currency stabilization needs and foreign exchange swaps — not to be an
Executive Branch slush-fund for medium-term loans to foreign governments. The use of the
ESF should be restricted by legislation and all U.S. financial commitments and
disbursements to these, in effect, defaulted sovereign borrowers should require advance
approval by the Congress.

Second, the American taxpayer should no longer be subjected to the sort of “moral
hazard” involved in the recent Mexican bail-out — where private sector investors and
bankers were repaid in full, with profit, by the American people. The Washington Post
yesterday quoted Lawrence Lindsey, a former Federal Reserve governor who is now a Fellow
at the American Enterprise Institute, as saying: “In fact, one of the reasons we have Asia is
that we bailed out Mexico. We signaled to creditors around the world that you could
feel free to lend in Asia, and the U.S. Treasury and the IMF would bail you out if you
got in trouble. Now if we bail this one out, we’ll have established a second precedent, and the
next time, it will be bigger and arguably something we can contain less easily.”

These private investors and bankers understood the risks involved in these higher-risk
emerging market economies and should absorb the totality of their losses.

Third, the U.S. should not engage in even a limited bail-out — including the IMF/World
Bank variety — for foreign governments engaged in activities harmful to vital U.S.
national security interests (e.g., Russia and China). Foes of freedom need to know they
cannot — and will not — have it both ways.

The Casey Institute believes that an important ingredient in such a principled approach to
international financial crises — one made all the more necessary by the appalling inadequacies of
Moody’s and other rating services to provide early warning of looming downturns — are the
enhanced reporting requirements and taxpayer protection mechanisms contemplated in S. 1315,
the U.S. Markets Security Act of 1997. This legislation — which would establish an Office of
National Security at the Securities and Exchange Commission — was introduced recently in the
Senate by Sen. Lauch Faircloth, Chairman of the Financial Institutions and Regulatory Relief
Subcommittee of the Senate Banking Committee, and Rep. Gerald Solomon, Chairman of the
House Rules Committee.

Finally, the Casey Institute considers the attached op.ed. article by syndicated columnist A.M.
Rosenthal from today’s New York Times to be required reading for those who wish to have
American international investment actually serve U.S. national interests — as well as those of the
individuals and entities involved. The secret to doing so, as Mr. Rosenthal brilliantly observes, is
by insisting that such investment actually advance democratic capitalism — a prescription that we
would be wise to follow assiduously in East Asia, China and Russia.

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1. This crisis was forecast by the Casey Institute in its Perspective entitled Russian Bonds
Rocked By Second Senate Hearing in a Week Focusing on Undesirable Foreign Penetration
of U.S. Markets (No. 97-C 169, 10 November 1997).