[asia-apec 1260] y2k analysis

[Roberto Verzola]

Y2K: The Homestretch
by Roberto Verzola

     As Y2K preparations reach their homestretch, fund movements
caused by the Y2K problem's differential effect on the perception of
financial risk associated with various countries, markets and firms
will become a major concern.

     This concern should be especially intense in Asia. It is here
where fund movements in 1997 caused a currency crisis that triggered
bankruptcies, recessions and devaluations in vulnerable countries that
eventually included Russia and Brazil.


State of Y2K readiness

     Last July 22, Inspector General Jacquelyn Williams-Bridgers of
the U.S. Department of State testified before a U.S. Senate Special
Committee on the Y2K Problem, where she reviewed Y2K-readiness
worldwide:

     * "Approximately half of the 161 countries assessed are reported
to be at medium-to-high risk of having Y2K-related failures in their
telecommunications, energy, and/or transportation sectors. The
situation is noticeably better in the finance and water/wastewater
sectors, where around two-thirds of the world's countries are reported
to have a low probability of experiencing Y2K-related failures";

     * "Industrialized countries were generally found to be at low
risk of having Y2K-related infrastructure failures, particularly in
the finance sector. Still, nearly a third of these countries (11 out
of 39) were reported to be at medium risk of failure in the
transportation sector, and almost one-fourth (9 out of 39) were
reported to be at a medium or high risk of failure in the
telecommunications, energy or water sectors";

     * "Anywhere from 52 to 68 developing countries out of 98 were
assessed as having a medium or high risk of Y2K-related failure in the
telecommunications, transportation, and/or energy sectors. Still, the
relatively low level of computerization in key sectors of the
developing world may reduce the risk of prolonged infrastructure
failures"; and

     * Key sectors in Eastern Europe and the former USSR are "a
concern because of the relatively high probability of Y2K-related
failures".


Failures in every sector, region and level

     Bridgers did not report how much of her assessment was based on
self-reported progress, and how much was based on
independently-audited reports. Since many Y2K progress reports are not
audited and therefore tend to be too optimistic, the situation could
actually be more serious than reported. One also wonders how the
financial sector can be at a low risk while sectors it totally depends
on like energy and telecommunications are at high-to-medium risk.

     Bridgers concludes: "the global community is likely to experience
varying degrees of Y2K-related failures in every sector, in every
region, and at every economic level. As such, the risk of disruption
will likely extend to the international trade arena, where a breakdown
in any part of the global supply chain would have a serious impact on
the U.S. and world economies."

     As actual reports/rumors of Y2K failures come in, the perceived
risks per firm, sector, and country will change. And as these
perceived risks change, fund managers and depositors will keep moving
their funds away from high-risk areas towards low-risk areas.

     This is simply rational economic behavior, part of the cold logic
of finance and investment. This is exactly how fund managers behaved,
when they withdrew their funds from Asia in 1997 to move them into
areas of lower risk.

     These sudden fund flows bear watching.

     Most well-informed fund managers would have access to similar
information and will therefore tend to move in similar directions.
Those who lack information will tend to follow the placement decisions
of the better-informed. This leads to "herd behavior," a
follow-the-leader or follow-the-crowd strategy which tends to magnify
small changes and cause huge impacts.


Beware of herd behavior and positive feedback

     With feedback, the situation is worse. If the resulting effects
in turn intensify the causes, this leads to even greater effects,
which then further feed back into the causes. This positive feedback
loop is a formula for rapid change, explosive growth, and extreme
instability. By removing barriers to capital flows, financial
liberalization increased the possibility of such positive feedback
loops. When foreign speculators in 1997, for instance, rushed to sell
their Thai baht for US dollars in fear of a baht depreciation, the
sudden demand for dollars caused the baht to depreciate. This further
fuelled the baht-to-dollar panic and eventually triggered the global
financial crisis whose repercussions we still feel, two years later.

     If Y2K problems change risk perceptions, which then trigger fund
movements that lead to herd behavior, the resulting rush can break the
weakest links in the system. Failures in the weakest links can then
lead to a bigger rush, which can overstress other links and cause even
worse failures, if not panic and collapse.

     Globalization has made economies tightly interconnected. So,
failures in vulnerable countries and firms can propagate to others,
including countries and firms that are fully Y2K-compliant and those
that are not even automated.


Avoiding collapse: options

     Governments will presumably do everything to control the
situation and ensure a "business as usual" post-Y2K scenario. They can
either: 1) dampen changes in the risk perceptions, so that
risk-avoidance becomes unnecessary, 2) dampen fund movements, to
minimize herd behavior, or 3) improve the system's capacity to absorb
the stresses of herd behavior.

     Unfortunately, it is too late for the first option to be
effective.

     Because of late conversion efforts, Y2K failures will surely
occur. The Bridgers report makes this clear. As failures occur, are
confirmed or even simply rumored, risk perceptions per firm will
fluctuate, triggering all kinds of risk-avoiding fund flows.
Ironically, even Y2K conversion successes and failure-free claims can
encourage their own fund flows, as investors seek low-risk shelters
for their funds.


Dampening fund movements

     Critics of financial liberalization had long advocated the second
option. The proposed Tobin tax, China's highly regulated stock and
currency markets, and Malaysia's fixed exchange rate are variations of
this theme.

     However, neo-liberal economists and the IMF have invariably
resisted these proposals to restrain gain-maximizing capital. They can
hardly be expected to restrict capital that is minimizing its risk and
even trying to preserve itself. To impose such restrictions as bank
holidays and withdrawal ceilings today would also simply erode the
public confidence and trust upon which the whole system stands.
Surely, the banking system cannot survive the loss of confidence by
the owners of even just 10% of its deposits.


Raising reserve requirements

     The third option is to improve the financial system's capacity to
absorb the stresses of huge fund movements and herd behavior, if that
is at all still possible.

     Central banks can do this by raising bank reserve requirements
one or more percentage points every month until they peak in the most
critical months before and after the Y2K rollover. This way, banks
would be flush with cash for responding to all but the worst kind of
mass withdrawals by depositors worried about the safety of their
funds. Some governments had actually done this in the past, under the
guise of "mopping up excess liquidity". This reduced the money in
circulation and, as banks scrambled to retain their profitability and
borrowers competed over less money, increased interest rates. In
reality, governments did this to 1) finance their deficits by
borrowing from the public, which would be attracted by the higher
interest rates, or 2) make their local currency appreciate vis-a-vis
the dollar, which would be attracted into the country by the higher
interest rates. Because these policies increased debt stock and
encouraged speculation, they contributed to what later became the
Asian financial crisis. In a critical situation such as the Y2K
transition, however, such emergency measure can prepare banks against
panicky depositors.

     In the past months, however, countries like the Philippines have
actually been reducing, instead of increasing, their mandatory bank
reserve requirements. While this move reduces interest rates and leads
to an appearance of recovery from the crisis, it makes the banking
system even more vulnerable to excessively large withdrawals. There is
still time for the system to correct this perverse policy and
gradually raise bank reserves -- but the banks must do it right away.

     As depositors and fund managers get their funds out of high-risk
areas, where will they put them? Presumably in real, tangible assets
which do not lose their value so easily -- land, production facilities
and tools, goods, precious metals, and so on. As most who are familiar
with financial statistics know, however, some $20 to $50 of money or
its equivalent is circulating today for every dollar of real goods and
services. If these floating money now simultaneously try to convert
themselves into real goods and services, we'd have the equivalent of
some 20 cars racing for the parking space for one.

     Given these narrow options, perhaps the final option should now
also be seriously considered: that of preparing for the highly
probable and working out the least painful way of transforming what is
turning out to be a fundamentally flawed system.