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Charging ahead: America's biggest new export--credit cards--could bring down the world economy.

FOR MOST OF THE LAST TWO GENERATIONS, the global economic system operated under a paradoxical division of labor. Americans consumed, while Asians--and much of the rest of the world--saved. The vast American consumer market helped drive the whole world economy. But since Americans were spending at such a prodigious clip, they weren't able to save much. That created two problems: There wasn't a lot of capital for business investment and even less to make up for the country's huge current account deficit--a function of our buying more from foreigners than we sell them. That's where the saving of the rest of the world came in. Foreigners saved so much that they had plenty of capital to invest--and where better to invest it than in the galloping, consumer-driven American economy?

Foreign investors, banks, and other companies purchased American equities, treasuries, and greenbacks, and invested in the United States (According to a recent Merrill Lynch report, the United States absorbed nearly three-quarters of the savings of the world's major industrial countries in 2002.) This inflow of foreign capital has kept America's current account deficit stable and U.S. inflation low, making it easier for American consumers to keep on buying. Asians, meanwhile, needed our consumption-driven economy because their export-driven economies thrived on Americans who spent every dollar they earned, and then some. This division of labor may have been morally dysfunctional. But as a global economic order, it worked like a charm.

Of course, economists long warned that the system was inherently unstable. If foreigners suddenly lost faith in the U.S. economy and pulled out their billions, the market would bid the value of the dollar down dramatically. Indeed, since the stock market bubble burst in 2000 that's already begun to happen. In the last two years, foreign investment in the U.S. economy has plummeted to levels last seen in the early 1990s. With America at war against terrorism, anxious economists now worry that rising anti-Americanism or just the war-induced strains on the American economy could prolong the foreign investment drought or dry it up even more, leading to a sharp devaluation of the dollar, and perhaps even a cycle of worldwide recession.

There's no way to predict if any of this will come to pass. But the crux of the problem is that these possibilities remain outside America's control. The only way to truly solve the problem is for Americans to save more at home or sell more goods and services overseas. Ironically, though, what may bring the whole system crashing down once and for all is one of America's own most rapidly growing exports: credit cards.

Sticky Rice, Stickier Debt

Until the mid-1990s, consumers outside North America and Western Europe rarely ran up large amounts of personal debt. With the credit card market in the developed world still growing, big credit card companies did not focus on the developing world (which includes most of Asia). Countries like Thailand still hadn't developed large populations of middle class consumers. But traditional mores also played a role. In Asia, where people historically considered saving an important virtue and conducted nearly all transactions in cash, personal debt was less a fact of life than a source of shame. As recently as the mid-1990s, South Koreans saved more than 30 percent of their GDP, while Americans struggled to save a measly 1 percent (though U.S. home values and ownership rates, a form of savings, did rise).

For a variety of reasons, however, the situation has recently begun to change. As some developing countries boomed during the 1990s, they germinated millions of new middle- and upper-class consumers who had more capital and more desire to purchase consumer goods and their own homes. Many of these new consumers were under 40--men and women less tied to traditional mores of saving. Many had traveled in North America and seen how Americans easily obtain loans, sign mortgages, and whip out credit cards. After the Asian financial crisis of 1997, which depleted much of the savings of this new middle class, credit was often the only way to keep buying.

At the same time, the late-1990s financial crises prompted Asian, Latin American, and Eastern European governments to try to stimulate domestic consumption to boost national growth rates. Two key ways to do that were to lower rates of interest and ease the regulation of credit. Over the last three years in Thailand, Prime Minister Thaksin Shinawatra has toured the country to encourage Thais to spend more. In South Korea, the government has called on Koreans to borrow as much as possible. In China, the state has gone so far as to create whole new national holidays to give citizens more time to shop.

Meanwhile, intensive lobbying by banks, finance companies, and credit card firms has prompted governments to lower the minimum-income bar for credit cards and other consumer loans. For the lenders, the motivation was obvious. Credit-card operations can generate returns of more than 50 percent, since card issuers often charge interest rates of more than 20 percent. As Noam Neusner noted in U.S. News and World Report, "for banks, personal, unsecured loans--[i.e. issuing credit cards or personal loans to people who are a high risk not to pay their balance] represent one of the most profitable niches." And as markets in the developed world became saturated, debt issuers turned to the developing world to keep their profits rolling in.

This crucial deregulation has allowed banks and card companies to pursue a wider range of clients, many of whom have minimal savings and no credit history. In South Korea, for example, it has become so easy for lenders to issue credit cards that the local media reported last year that banks had mistakenly given household pets--which could hardly have a credit rating--their own credit cards. In golf-mad Thailand, card issuers have offered free links lessons. And credit-card issuers have pursued similar tactics across Latin America and Eastern Europe.

Foreign governments and global lenders have both tried to encourage developing world consumers to open their wallets and global consumers have happily obliged. Until recently, credit cards were unheard of in China. Today, however, Chinese use plastic for more than $200 billion worth of transactions annually. India and Indonesia reported major increases in mortgage applications, consumer loans, and credit card purchases in 2002. Across Asia, Visa International increased the number of cards issued by 25 percent last year alone, and cash withdrawals using Visas rose by 44 percent. According to The Economist, households now account for nearly 40 percent of East Asian banks' total lending, up from 27 percent in 1997.

Thailand and South Korea have become even more obvious examples of American-style spending. Visa says that total spending on its cards in Thailand is rising by more than 40 percent annually. In South Korea the story is the same. As one South Korean told The New York Times in December, the average Korean worker now carries four credit cards (more than 10 million South Koreans carry four or more, while the average bank worker carries between 10 and 15). Meanwhile, consumers in Eastern Europe, Latin America, and even Africa have actively followed suit. Schroder Salomon Smith Barney, an investment bank, estimates that between 1997 and 2001, household lending in Hungary, Poland, and the Czech Republic rose by more than 25 percent. As The New York Times recently reported, Russians also are beginning to utilize debt to pay for mortgages and large appliances. Household spending in South Africa, the biggest economy in Africa, has soared since 2000. And while Latin America has been hit by a series of financial crises from which, unlike Asia, it has not completely recovered, consumer spending--especially spending on credit--is rising there as well, in the region's more developed economies.

Extra Credit

As in the United States, the expansion of household spending in the developing world has had many positive impacts. It has not only helped buoy domestic economies hit hard by the economic shocks of the late 1990s but also provided new markets for foreign companies. Chinese acceptance of credit and auto financing, for instance, has helped Volkswagen make China its largest market; other automakers plan to follow suit. "The Chinese are becoming more used to financing. Once we establish the type of comprehensive GM financing systems we have in the US, we expect to see a huge jump in purchases," General Motors China head Philip Murtaugh told me last fall in Shanghai. Leading automakers are also developing plans to expand their product lines in Mexico, Brazil, South Africa, and Chile, in part because of the explosion of borrowing on credit--a development which mirrors the pattern in America during the early 20th century. Rising consumer spending has also filled many countries' tax coffers, since in most developing countries sales taxes are much easier to collect than income taxes--income-tax avoidance is very high.

Yet the hard truth is that no one really knows what the impact of this consumer spending will be. These benefits could be outweighed by the potentially destructive impact of unleashing easy credit and American-style personal spending in developing nations with nascent systems of credit checks, unsustainable trade imbalances, and weak and opaque banking systems. In the United States, though financial companies have more leeway to lend to lower-income consumers than they used to, they are still subject to a range of state and federal regulations. Banks, credit card issuers, and other consumer lenders can also utilize America's well-developed system of credit checks to discover which potential customers are bad credit risks. Consequently, US. lenders generally are able to avoid lending or offering credit cards to high-risk clients.

Most developing countries lack the regulations and credit-checking services to deal with their rising numbers of consumer loans, credit cards, and mortgages. In Mexico, for instance, few banks require card recipients to show any credit history; minimum income, or even knowledge of how to use a card. As one Mexico City taxi driver told The Financial Times, "There's always someone offering me free credit." In Hong Kong, the lack of regulations has allowed credit card companies to aggressively target university students, helping the students obtain a credit card in minutes with nothing more than a photo identification. (Last May, Hong Kong's Consumer Council, a research and advocacy organization, chastised the government for allowing banks and other card issuers to use misleading tactics in their campaigns for students.)

Widespread corrupt practices, meanwhile, have led merchants in other countries to shun plastic altogether. When I traveled to Argentina in the winter of 2001-2002, I often found k difficult to convince retailers to take my American Express, the supposed gold standard of credit cards. Retailers had become so used to seeing fraudulent cards and other forms of questionable scrip issued by Buenos Aires banks and even provincial officials that they no longer trusted anything but cash. Meanwhile, the national government was taking virtually no steps to investigate any of the cards. Most merchants simply adopted a policy summed up by a sign in one cafe: "Se Acepta Dolares."

As a result of so much fraud and so much easy credit, many lenders in the developing world have found themselves overwhelmed with bad consumer loans and huge numbers of personal bankruptcies. To take just one example, 2.5 million South Koreans have fallen into arrears on their credit-card payments, in a nation of only 48 million people. In February, South Korean banks estimated that nearly 8 percent of credit card bills in the country were outstanding for a month or more, roughly double the percentage in the United States, and last year South Korea suffered its largest number of personal bankruptcies ever. According to banking industry statistics, personal bankruptcies are also rising in China, Mexico, Argentina, Chile, Brazil, and Thailand. In Hong Kong, personal bankruptcies are soaring by more than 100 percent per year. Even small, isolated countries like Bolivia have been affected by the rolling wave of easy credit and bankruptcy.

The rising tide of personal bankruptcies not only bears a social cost of broken families, domestic violence, and suicides, it also cuts into global lenders' ability to finance business loans. This isn't the case in the United States, because our capital base is vastly larger and deepen But in Asian countries with smaller capital bases the problem is immediate and acute. In South Korea, several large banks, including Kookmin, the country's largest lender, have seen their net losses rise over the past four quarters--Kookmin lost $173 million in the fourth quarter of 2002 alone--because of what analysts told The Financial Times was a pattern of "reckless lending to consumers [without] properly assessing the creditworthiness of consumers" As a result, Kookmin and several other large South Korean banks have had to increase their cash reserves to cover non-performing consumer loans; in so doing, they have sharply reduced their loans to businesses. In fact, this spring South Korea's credit card companies and banks have had to issue more than $1 billion in new shares in an effort to address a looming cash crunch, a move which has rattled South Korea's stock markets. A similar pattern has been observed in other countries in Asia, Latin America, and even Russia. Even major financial players can be affected. Last year, HSBC had to drastically increase its provisions for potential defaults, in part because of personal bankruptcies in Hong Kong, which thereby reduced the amount of capital HSBC had to lend.

Drawing funds away from business investment can be a serious drag on economic growth. Banks reduce their capital bases, interest rates are forced up, capital becomes harder for businesses to raise, and companies slip into bankruptcy. Indeed, corporate bankruptcies in South Korea, Hong Kong, Thailand, and elsewhere in Asia have risen over the past two years, as many businesses have been unable to find new sources of financing from banks weighed down by portfolios heavy with non-performing loans. The decline in investment is often compounded by the binge-and-purge effects of high consumer debt, in which consumers run up huge credit card bills and then spend virtually nothing for months. This cycle can make it hard for retailers to make long-term business plans.

Prominent economists have begun to realize the potential dangers excessive consumer lending poses to the developing world. Last fall, the International Monetary Fund's chief representative in Seoul, Paul Gruenwald, expressed serious concern that South Korea's economy could be undermined by the "booming" number of bad loans to households and high credit card delinquency rates. Gruenwald has advised the South Korean government to take measures to reduce Koreans' consumer spending binge, and the IMF has since issued several other warnings about excessive, unregulated consumer lending in the developing world. Taking the advice, the South Korean government recently has announced government measures designed to bail out cash-short Korean credit card companies and restore banks' liquidity. Kim Gwang-Lim, South Korea's vice minister of finance, warned that if such a bailout does not succeed, "the potential impact from credit card companies' problems on the financial markets will be significant. Such problems could trigger chaos ... and a possible collapse of the entire financial system."

Unsustainable Development

As 1997's Asian financial crisis demonstrated, crises in one developing nation's economy can rapidly spread to others, sparking a wave of destabilization throughout the world economy. Indeed, many of the countries experiencing rapid run-ups of consumer credit are those which went through snaps of boom and bust in the middle 1990s. Beside the growth of easy personal credit in Asia, economic weakness in Mexico--another country where minimal regulations on consumer loans have led banks to lend recklessly--could ripple throughout Latin America, of which Mexico's is the second-largest economy.

For decades America has relied upon the rest of the world to finance its consumption. But rising amounts of personal debt in foreign countries, combined with a dimming view of the American economy, could put a damper on this trend. As foreign banks and other lending institutions--which do not enjoy the American luxury of being able to sustain their problems by tapping into pools of foreign investments--slash their capital base due to consumer debt, they may reduce their holdings in the United States. Of course, foreign institutions are not going to just stop investing in America, but even marginal reductions in their investments could have a serious impact on the American economy. Indeed, the pullout has already begun. Foreign direct investment into the United States fell from $301 billion in 2000 to $124 billion in 2001, the most recent year for which comprehensive data are available. And foreign investors have slashed their net purchases of U.S. treasuries, greenbacks, and corporate bonds over the past year--corporate bond purchases fell by a whopping 60 percent in September 2002 from a year before.

If foreign money continues pulling out of the United States, leading economists warn, America's debt and current-account deficits might no longer be sustainable, leading to a dollar crash and deep damage to the American economy. "At some point, probably relatively soon, as foreigners pull out their capital, the current-account deficit just won't be able to be maintained anymore," says Robert E. Scott, head of research at the Economic Policy Institute, a leading liberal D.C. think-tank. In a comprehensive research report, Scott's EPI colleagues conclude that the current-account deficit will soon become unsustainable, the dollar will begin to weaken, and the United States will be forced to address this imbalance in trade by moving away from the strong dollar policy which has been a hallmark of both the Clinton and Bush administrations and allowing the dollar to weaken, thereby accepting a deflation in Americans' real incomes. The EPI economists conclude that bringing the current account deficit into balance would require a 10-percent drop in America's GDP. And EPI is hardly the only organization making these claims. Last fall, Stephen Roach, chief economist at Morgan Stanley and one of the most thoughtful, long-term predictors of the world economy, warned clients in a research note that "America's ever-widening current account deficit is on an inherently unstable path."

A long-term slowdown of economic growth in the United States could have pervasive effects around the globe. First, American consumer consumption would almost certainly slacken, as Americans began to save more to pay off higher domestic financing. That drop in consumer spending might then further depress global economic growth. Without the uber-consumer nation running at full speed, years might go by before the world economy escaped the cycle of weak consumption and slow growth. Despite increased consumer spending throughout the developing world, Asian countries like Thailand, Malaysia, and South Korea still depend on exports for as much as 50 percent of their gross domestic product. For these states, as well as for most developing countries in Latin America, the United States is by far the largest market. Similarly, China has built up the largest trade deficit with the United States of any country in the world. A falling dollar, which would make exporting to the United States less profitable, would only compound foreign companies' problems.

Cutting Cards

The consumer-credit problem has not yet developed into a full-blown crisis. Most Asian, Latin American, and European nations have not yet reached American levels of consumer indebtedness and low savings rates. Foreign banks and other lending institutions still possess pools of liquid capital to invest in the United States, keeping America's current account deficit afloat.

There is still time for governments, international financial institutions, credit card companies, banks, and other lenders to work together to prevent a global consumer debt crisis. But, in order to give the developing world the benefits of the consumer credit revolution America has enjoyed and protect developing nations from the potentially destructive impact of unleashing easy credit, countries, banks, and credit card issuers around the globe need to be subjected to stricter rules on lending. In short, they need the type of laws we have here in the United States. Nations could impose age limits and minimum income standards for applying for credit cards--a policy Singapore, among some other countries, has already adopted. They could also force credit card companies to charge reasonable interest rates and to use transparent advertising. The United States and other developed countries could work with developing countries to implement internationally recognized credit-evaluation procedures and crack down on banks that continue offering easy credit while defaults and delinquencies soar.

Unfortunately, such changes don't appear likely. Neither the United States nor the European Union has shown much willingness to police credit card companies and other lending institutions, let alone teach developing nations to police consumer-lending markets in their own countries. The world's financial media have largely ignored the consumer debt problem as they have focused primarily on the admittedly sexier topic of corporate fraud and bankruptcy. Meanwhile, consumers in the developing world just keep charging and charging and charging ...

JOSHUA KURLANTZICK is the foreign editor of The New Republic.
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Author:Kurlantzick, Joshua
Publication:Washington Monthly
Date:May 1, 2003
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