Appendix B:

THE ASIAN FINANCIAL CRISIS:

EXPLANATIONS, CONTROVERSIES, RESPONSES

 Click Here for an abridged copy of this article on MS Word '97, revised for publication.

 

 

 

GLOBAL CAPITALISM AND THE ASIAN CRISIS IN RETROSPECT

 

DIFFERING INTERPRETATIONS OF THE CRISIS

	The origins
	The causes
	Exchange rate misalignment and currency runs
	Should the IMF change its stripes?
	The proposal for an Asian Monetary Fund

 

THE EVENTS UNFOLD: A REVIEW OF COUNTRY EXPERIENCES

	De-pegging the Thai Baht
	Collapse in Indonesia
	The Hong Kong currency board
	South Korea succumbs
	Outrage in Malaysia

 

"ASIAN CAPITALISM" IN THE AFTERMATH OF THE CRISIS

	Radical prescriptions
	Asian capitalism revisited
	The road to recovery
	Conclusion

 

 

 

 

GLOBAL CAPITALISM AND THE ASIAN CRISIS IN RETROSPECT

In the wake of the Asian Financial Crisis of 1997-99, Asians may be excused for some ambivalence about the phenomenon of "globalization" of markets, finance, production, and information. On one hand, most educated Asians aspire to play leading roles in the modern (liberal) world order on an equal footing with Westerners, and of course they want to enjoy the opportunities of the global economy. They know they can excel because they had done so for at least three decades before the crisis hit.

On the other hand, Asians may understandably feel somewhat abused by the forces unleashed with globalization and liberalization. Until the crisis hit in July 1997, the many admirers of the Asian "miracle" economies praised their high savings and investment, stable and effective governments, and market-friendly, farsighted policies. Today, Asian "crony" capitalism is derided for reckless investment, corrupt and nepotistic governments, and policies that disregard market discipline. Obviously there is truth in both assessments of Asian capitalism –so Asians are in some doubt how to proceed from here.

Asia’s acquiescence to the popular trend of globalization will be tempered by at least three restraining tendencies. First, in response to any reform, a conservative reaction sets in, a feeling that the old ways should not (and indeed cannot) be entirely discarded. Can the same formula that led to the "Asian miracle" be completely abandoned now? For example, the interfirm networks that interlace the economies of Taiwan and China, Japan and Thailand, and similarly are effective throughout East Asia, were part of the reason these economies did so well in the past. Effective international networking is seen by theorists as a key source of competitive advantage in international business, and a majority of the best-known interfirm network organizations are found in Asia, such as Japanese keiretsu, Korean chaebol, and overseas Chinese family business networks.

The second restraining tendency that slows Asia’s adjustment to globalization is that firms and financial institutions in Asian countries cannot race ahead of their own societies’ ability to change. The case of Matsushita illustrates the halting pace of progress in Asia’s biggest economy, Japan. Once one of Japan’s most old-fashioned firms, since March 1998 Matsushita has been attempting to phase out the traditional employment practices of seniority-based promotion, lifetime employment, and pervasive company welfare. New recruits are now offered the option to get more money but with fewer of the traditional perks and less security; alternatively, they can accept less pay now but more company welfare –including company dormitories and various other subsidized company services. Although increasingly new-hires are taking the money –and the challenge of being retained and promoted based on merit— more than half still opt for the traditional employment package. And Matsushita is also bound by its promises of lifetime employment to existing staff. Furthermore, the Japanese school system still produces graduates who tend to conform more easily to obedient, collectivist organizational behavior.

A third moderating influence on change in Asia has to do with political processes. The crisis of Asian capitalism has been dealt with as a problem of political economy, but political change is always uncertain. As the crisis engulfed Asia in 1997 and 1998, the dominant liberal doctrines of the day ruled out any interpretation or resolution of the crisis that might detract from the ideological fervor to achieve free, globalized markets. To doubt this liberal ideology was dangerously radical and not politically acceptable at the IMF, in America, global banking circles, and also in countries adversely impacted by the crisis that want to look attractive to global capitalists.

To understand the downside of globalization and why Asians might be slightly reluctant to subject themselves to it so readily in the future as they did in the halcyon days of the pre-crisis 1990s, we will present some explanations of the crisis and some of the controversies that arose. Then we look at the aftermath of the crisis and attempt to discern how Asian countries will respond.

 

DIFFERING INTERPRETATIONS OF THE CRISIS

The origins

The Southeast Asian currency crisis broke out in Thailand, apparently precipitated by persistent, large current account deficits¹ and a currency pegged to the appreciating US$. The current account measures the net of all short-term international transactions including trade in products and services, and interest. "Thailand’s current account deficit --the sum of its trade deficit and the intterest on its foreign obligations-- had exceeded 4% of its GDP since 1990, implying that Thailand had to attract that much foreign capital each year."²   It appears from the Mexican debt crisis of 1994 that current account deficits in excess of 4% of GDP are a sign of trouble ahead.³  Many countries in Asia evoked speculative interest on that criterion (see Table 1).

Foreign capital began a mass exodus in the summer of 1997. The Thai currency crisis spread to Indonesia, Malaysia, and the Philippines which also linked their currencies to the US$ and had large current account deficits (see Table 1).  All of these countries, later followed by South Korea, had to allow their currencies to depreciate precipitously.

Thailand, Indonesia, and South Korea had high ratios of foreign debt to local GDP and lacked sufficient reserves to meet short-term foreign exchange obligations. All required assistance from the International Monetary Fund. The Philippines was already under an IMF program; Malaysia strenuously avoided appealing to the IMF. All countries were ultimately compelled to follow the standard IMF remedy: tight fiscal and monetary policies. In exchange for a US$17 billion bailout agreed for Thailand in August 1997, US$ 43 billion for Indonesia in October, and then $57 billion for South Korea in December, the IMF required a long list of reforms.  However, the IMF remedy had very doubtful, even negative results, and the Asian financial crisis remained unresolved well into 1999.

 

TABLE 1: PRE-CRISIS CURRENT ACCOUNT BALANCES (as a % of GDP) ⁴

 

The causes

Marcus Noland⁵ identified "four principal causes" of the Asian financial crisis: "exchange rate misalignment", "export slowdown", "weak financial institutions", and "moral hazard". We develop our initial analysis around these points.

While the US dollar was generally depreciating from 1985-95, pegging currencies to the dollar improved export competitiveness vis-a-vis other countries --notably with Japan and Europe-- while also assuring stability in trade and investment relationships with the USA. However, after reaching a low point of 80 yen in the spring of 1995, the tide turned as the US$ commenced a long-term upswing. Asian currencies tied to the dollar appreciated along with it, which dampened their export competitiveness.

Several regional developments also affected Asian exports. In 1994 China unified its official and swap markets for currency conversion, effectively devaluing the renmindi by one-third and leading to a boom in Chinese exports largely at the expense of exporters in Southeast Asia. Then during 1995-96 world demand slumped for a key Asian product, semi-conductors, which significantly dampened Asian export growth. Finally, continuing economic stagnation in Japan affected trade and investment well beyond the Asian region.⁶

Concerning Asia's "weak financial institutions", poor supervisory arrangements had allowed banks to finance long-term domestic lending with short-term foreign borrowing. In many countries, equity markets were relatively less developed and debt financing relied upon too much, often involving lending directed by governments.   Or worse, as was commonly alleged: "financial decisions were strongly influenced by non-economic considerations, including outright corruption."⁷

Moral hazard refers to expectations of bailouts for investors or recipients of capital. It prevails in countries that favor particular investors or classes.   Domestic banks (and depositors) and corporations hoped their governments would come to the rescue of national institutions (and savers). Foreign banks were expecting the IMF to force debtor countries to pay up.  All parties seemed to be right.

The economic causes have been well developed in the literature by Noland and many others. Causes of a political and social nature are less easily established, but certainly the perception of political risk in the region was crucial. One part of the problem is Asian political processes, which we now denigrate with such expressions as "cronyism". Another aspect is the political economy of the IMF rescue attempt and the long-standing inability of the United States –and American bankers—to countenance any policies that might give some credence to undemocratic or socialist political cultures or solutions to the crisis that were otherwise contrary to the "American way". There seems a need for all concerned (the Clinton administration, Asian leaders, even financiers and other market players) to be "politically correct".

Singapore’s Senior Minister Lee Kuan Yew⁸ attributed the crisis to a loss in investor confidence caused by over-spending, made possible because of poor supervision of banking systems and arguably exacerbated by corruption and cronyism. But the key source of the problem, according to LKY, was political.  Governments were too preoccupied with political difficulties to take action on warning signals from the market. Thailand had six governments in five years. Malaysia’s prime minister became embroiled in his own verbal condemnations of foreign speculators and refused to respect the verdict of market forces. Indonesia was dominated by a ruling family that refused to allow political options to itself.  South Korea started with a ‘lame duck’ president and ended with a coalition government.

LKY was too diplomatic to criticize regional leaders; nor would he question prevailing liberal ideology at such a sensitive time for his country. But a tacit point LKY could well have in mind is that not only can governments misjudge markets, markets also misjudge governments. LKY has always believed, in the fashion of Asian paternalists, that markets function better with appropriate government guidance. Globally integrated markets are beyond this kind of oversight however. Global market players only vaguely understood Asian political developments and are quite uncertain about the merits of "Asian capitalism". The International Monetary Fund, lamenting the failure of its policies in Asia, noted that once the crisis started the success of any policy hinged on how markets reacted, and there were perhaps deficiencies in the way the substance of the programs was communicated to the markets. (IMF,1999) It is possible that short-term market reaction to, say, reform in Indonesia reflected misapprehension about the incumbent administration. This put the country ‘between a rock and a hard place’: the country seemed destined to total collapse with Suharto or without Suharto.

Psychology, the most important factor in the great economic crises in history, is the least assessable of all market forces. Perceptions of risk had altered, and market players viewed economic policy through an ideology-tainted lens that gave a dim picture of Asian ways of doing things.

It was indeed a crisis of confidence.  Those administrations that earned the proper liberal credentials or made the 'right' kind of public utterances got a better press.  This may help to reassure the global financial community --which adheres to the liberal market perspective of the US government and bankers.  Of course, respecting the prescriptions of the International Monetary Fund was also prerequisite to being 'politically correct', and many would argue that only disciplined compliance with IMF 'conditionality' would enable countries to gradually rise above their vicissitudes. 

We address the IMF role later. Also, the issue of political correctness will be a recurring theme. First, we return to a problem of pegged exchange rates.

Exchange rate misalignment and currency runs

Exchange rate misalignment led to market imbalances, inviting speculation that wreaked havoc.  Market manipulations by speculators in Hong Kong and elsewhere are frequently cited in the popular press.  For example, a New York Times article [reprinted in Straits Times 10/1/98 p60] identified a "lending syndrome" that can occur when exchange rates are fixed: "The Asian crisis stems in part from a lending syndrome that appears periodically, when interest rates vary markedly from country to country. The opportunity arises for a Japanese or European or US bank to borrow yen or dollars at low interest rates, and re-lend the money at significantly higher rates for short periods to banks in, say, Korea or Thailand, which then re-lend the money for long periods at still higher rates to local companies. The foreign banks roll over the yen or dollar loans as they expire, until the borrower’s currency, such as the Korean won or the Thai baht, loses value. The foreign loans suddenly become more expensive to repay. The lenders, alarmed, refuse to roll over the short-term debt. The borrowers cannot repay fast enough, and a crisis erupts... Pegged currencies encouraged the risk-taking." The lending opportunity should disappear if exchange rates and interest rates are both market determined because the two rates move in relationship to each other (according to the "interest rate parity" theorem).

Peter Drucker⁹, referring to the foreign exchange market, dubbed its liquidity "virtual money" --it "has no existence" outside global money markets; it "has no economic function"; and it "fits none of the traditional definitions of money, whether standard of measurement, storage of value, or medium of exchange."(p4) But its gross volume far surpasses the money involved in conventional economic activities such as investment and trade that such "world money" was created to support. "And because it serves no economic function and finances nothing, this money also does not follow economic logic or rationality. It is volatile and easily panicked..." (p4) And it brings economic collapse in its wake. "But so far there is no other control on fiscal irresponsibility. The only thing that can work is fiscal and monetary policies that free a country from depending on borrowing short-term, volatile world money..." (p5)

Do speculators deliberately promote currency runs and cheer as currencies and stock markets plummet --and economies collapse? The multi-billion dollar hedge funds certainly thrive on market activity, and it matters not which way the market is moving, only that they can get on the bandwagon. If they bet wrong they can still win, according to a commentator in Singapore¹⁰: "The strategy is simple: Well before they mount an assault on a currency, the hedge funds borrow huge amounts of the very currency they want to bring down. Often they borrow as much as ten times the amount they intend to sell. When they start selling the currency, they know for sure that interest rates will spike up as a result --often from below 10 per cent to well past 100 per cent. Lending at, say, 150% what you borrowed at 7-8% is a nice business; it yields huge profits when you’re lending in the billions. Often these funds ...corner all available liquidity in the money market, so they become the only major lenders of the currency they have attacked. The art of this strategy is this: Even if the central bank succeeds in defending its currency and inflicts forex losses on speculators, the hedge funds would have made many times more in the lending market. What if the central bank buckles and allows the currency to fall? Then the funds hit a double jackpot, and win in the currency market too. When the baht was attacked in this way in June-end --again said to be led by Mr Soros-- the major funds walked away with profits of up to US$1 billion... Four months later, it was the turn of the Hongkong dollar... Sources say the big funds entered the money market a month ago to borrow Hongkong dollars at around 7%; they are now on-lending these dollars at sky-high rates... When the speculative attack was at its fiercest, overnight HK$ cost as much as 250% to borrow....When interest rates explode with the force witnessed in the Asian markets, the first to plunge are the stock markets. The next to come under pressure are the real estate markets. And if interest rates stay high, the whole economy slows down... And before they launch their currency attack, they short-sell the stock market too, knowing that other, less agile, market players will have to sell their stocks to get their hands on local funds. This stock sell-off frightens genuine foreign investors into selling out too; when foreigners sell off, preferably in a frenzy, they have to convert their proceeds into foreign currency for repatriation... That’s how it all snowballs."

Currency runs thus lead to market panic.  The International Monetary Fund provides the major bulwark against adverse market pressures, but there is a perception that the IMF has not been effective in the Asian Crisis so far.

Should the IMF change its stripes?

The IMF was founded in 1944 to oversee fixed currency rates (the Bretton Woods agreement) and provide a pool of funds from which member nations could borrow short to medium term to settle international payments and maintain their exchange rate. The demise of the Bretton Woods system in the early 1970s and the advent of floating rates left the IMF with a diminished role in the international monetary system.  Since exchange rates would now presumably adjust downward in response to a balance of payments deficit, IMF credits would be less appropriate.

Nevertheless, the vast majority of countries today, especially in the developing world, still try to manage their exchange rates, and this "managed float" is condoned by the IMF for purposes of stability.  The IMF still functions today in much the same way it did in 1944 --as a sort of credit union, with nations depositing money that is lent to members in need. The United States has the biggest say in IMF affairs, with an 18% voting share on the board, and its top policymakers are consulted closely by the IMF.

During the so-called Third World Debt Crisis of the 1980s, the IMF assumed its current role as lead lender to nations facing severe difficulties making their international payments.  In return for temporary financing to Third World governments (most notoriously Latin American and East European) to prevent default on massive sovereign debts owed to international commercial banks, the IMF imposed conditions on its loans: strict monetary and fiscal policies to control deficits and inflation of debtor nations --which caused sharp contractions in economic growth rates. Critics "see an institution stuck in a mind-set that it developed during the Latin American debt crisis of the 1980s, when the chief problems were runaway budget deficits and inflation. The IMF is prone to fall back on familiar budget-cutting and other austerity measures, these critics complain. And it has not yet honed its expertise for dealing with problems that have cropped up in the 1990s, notably the weaknesses in many countries’ banking systems and their vulnerability to sudden withdrawals of ‘hot’ foreign money."¹¹

Some analysts (such as Joseph Stiglitz, former chief economist at the World Bank) say Asia’s problems lay in the private sector, and thus IMF prescriptions calling for austerity among countries with low sovereign debt levels and high savings rates were not just inappropriate, but damaging. Tight monetary and fiscal policy quickly strangled all remaining strength in the healthy part of Asian economies, worsening matters rather than resolving them. Conspiracy theorists¹² argue that macro-economic restraint is precisely the IMF’s intent, choking off escape routes until recalcitrant Asian governments gave way to free market reforms. There is an ideological contest going on here, "a massive battle ... between the free market system and another type of capitalism, and there is no doubt the IMF represents the free market system. You can say it’s American imperialism, but there are two systems competing here and the IMF is handmaiden to one of them. It’s always been that way. There is no conspiracy." (anonymous analyst, Straits Times 12/1/98 p43) Asian governments have long been pressured by liberal opinion to accept the ideologies of the West on faith --again, the necessity to be ‘politically correct’.

Since the IMF has assumed a role of ‘crisis manager’ and arbiter of economic policy for national economies facing default, seldom has the Fund’s performance gone without strong criticism. So with the Asian financial crisis, the IMF was vilified for fiscal conditions attached to its bailout for Thailand, and these had to later be relaxed. Similarly the initial closure of 16 banks in Indonesia only added to the panic, and the IMF and the US condemned the Suharto regime for what they saw as a crooked brand of capitalism, undermining the government’s legitimacy and inspiring internal protests. For Korea, monetary and fiscal restraints may have been inappropriate, according to a prominent IMF critic¹³: "The IMF threw together a draconian program for Korea in just a few days, without deep knowledge of the country’s financial system and without any subtlety as to how to approach the problems."

A writer¹⁴ sympathetic to the views of developing countries identified six major criticisms of the IMF:

1 forcing countries to abandon policies of nurturing domestic enterprises and instead fully open their economies to foreign ownership --and takeovers of local institutions at firesale prices;

2 forcing liberalization American-style that countries had been unwilling to allow in multilateral negotiations (e.g. WTO), to gain access to their markets;

3 favoring international banks at the expense of domestic institutions by not allowing governments to aid domestic institutions while asking governments to pay back all external debt, thus bailing out foreigners while insisting locals "play by strict market rules";

4 requiring inappropriate fiscal and monetary restraints, which "kill off key local private-sector institutions" that were otherwise healthy;

5 dictating radical policies made by IMF staff based in Washington "who do not understand the countries they are presiding over";

6 not practicing what they preach about "transparency".

Jeffrey Sachs¹⁵ remarked: "While it pays lip service to ‘transparency’, the IMF offers virtually no substantive public documentation of its decisions... The world waits to see what the Fund will demand of country X, assuming that the IMF has chosen the best course of action. The world accepts as normal the idea that crucial details of IMF programs should remain confidential, even though these ‘details’ affect the well-being of millions. Staff of the Fund, meanwhile, are unaccountable for their actions... it defies logic to believe that the small group of 1,000 economists on 19th Street in Washington should dictate the economic conditions of life to 75 developing countries with around 1.4bn people."

Martin Feldstein¹⁶ argued that the IMF should change its approach, to revert to its traditional role of providing balance of payments support to stabilize exchange rates. Institutional and structural change in the crisis-hit Asian economies was unnecessary, in Feldstein’s view, and sweeping and painful reforms were counter-productive. "Although such changes may be desirable in many ways, past experience suggests that they are not needed to maintain a flow of foreign funds." The IMF could have brought about some tightening of fiscal and monetary policy simply through "technical" advice rather than the controversial so-called "conditionality" that accompanies its aid package. "The IMF would be more effective in its actions and more legitimate in the eyes of emerging-market countries if it pursued the less ambitious goal of maintaining countries’ access to global capital markets and international bank lending." The IMF could have simply provided a temporary bridge loan to enable private corporate borrowers to meet their obligations to foreign banks¹⁷, and then helped in organizing the banks into a negotiating group to arrange needed restructuring of loan portfolios. Instead, by organizing a huge pool of funds from official sources, foreign lenders received an implicit guarantee on their loans and arguably are thus encouraged to take excessive risks in the future. The banks did not share with borrowers the burden of bad lending decisions.

In its zeal to provide official financing to prevent economies going bust, the IMF is regularly accused of running roughshod over issues of national sovereignty, imposing hardship on local populations, and even sowing the seeds of future crises. Critics say foreign lenders will again throw money around the world recklessly if the IMF provides official bailouts to ensure countries do not default on their debts. The Indonesian government was especially concerned that the Fund was imposing austere policies on already hardpressed citizens; the IMF recanted, but too late for Suharto.

The more ‘politically correct’ view at the IMF, however, is that the way banks, corporations, and governments have operated in many Asian economies is basically flawed. US Federal Reserve Chairman Alan Greenspan remarked: "With governments in the background and cross-holdings of stocks among conglomerates, lending was an issue of connections with presumptions of government support, not of sound banking practices." Weak corporate governance, poor standards of disclosure, and lack of transparency allow excessive lending for poorly conceived investment, with neither governments nor stock markets really knowing the extent of bad loans.

But the well-deserved criticism of Asian capitalism is not the end of the story.   Henry Kissinger remarked that in Southeast Asia: "Crony capitalism, corruption and inadequate supervision of banks were serious shortcomings.  But they did not cause the immediate crisis; they were a cost of doing business, not a barrier to it."¹⁸

"Much depends on what caused East Asia’s crash. Explanations abound, but --with some simplification-- they divide into two broad categories. One emphasizes that the crisis was homegrown, the product of crony ‘Asian capitalism’. The other emphasizes panic. It points out that no one foresaw the crisis; that by conventional indicators of economic health (budget deficits and so forth) the Asian economies were in good shape; and that no economic change occurred in 1997 to justify such a massive loss of confidence. There is probably some truth to both interpretations, and most observers believe the crisis was a combination of the two... Crucially, these two interpretations imply different conclusions about how best to prevent and deal with future crises. If you regard Asia’s crash essentially as a crisis of Asian capitalism --especially its opacity, poor regulation and cronyism-- then systemic reforms should be geared towards reinforcing transparency, improving supervision and limiting moral hazard. But if the crisis was primarily one of panic, then the goal should be to control unstable markets while providing more public money or creating new, reassuring rules."¹⁹ Some Asian governments ascribed to this latter view, and one attempt to overcome the panic was an Asian Monetary Fund (see next section), ardently advocated by Japan, Malaysia, among others. Another reaction is a feeling of resentment and regret for having liberalized financial markets in the first place. Some of the most open economies suffered most, while China, Taiwan, India and other countries that restrain capital flows were spared the worst of the crisis.

"Under IMF leadership, current account convertibility is nearly universal -- anyone can take their domestic currency, exchange it for foreign currency, and purchase foreign goods and services."²⁰ Allowing free markets for currency exchange on the capital account (debt and equity transactions, effectively including those cash transactions not related to trade in goods and services) is seen by many policy-makers as the key source of difficulties. Taiwan’s central bank, the Central Bank of China, has tightened up its monitoring of currency trading, and Taiwan has delayed the abolition of all cross-border capital controls planned for 2000. Until the crisis hit, China had been promising to allow free capital movement (its currency was internationally convertible on current account only); now the Chinese government is reluctant to take this step.

The proposal for an Asian Monetary Fund

Originally proposed by the Japanese finance minister at the IMF/World Bank annual meeting in Hong Kong in September 1997, the idea of a separate fund outside the control of the IMF was not favorably received by the US and the IMF. The proposed facility was to amount to US$100 billion contributed largely by Asian and Oceania countries, to deal with regional financial crises. The US reportedly disagreed with the idea of a Japan-led fund at the outset, believing it should be within the scope of Asia-Pacific Economic Cooperation (APEC) or an extension of IMF emergency financing facilities. The IMF was concerned that funds might be lent out on terms softer than dictated by IMF "conditionality".

Asian finance officials met in Manila in November with the IMF, World Bank, and Asian Development Bank (ADB), and together with the US, Japan, Australia and Canada they agreed any new bailout mechanism must complement the supervisory role of the IMF. The meeting stopped short of endorsing an Asian rescue fund but called for a new "framework for regional cooperation". At the annual APEC forum in November 1997, Japan abandoned its original proposal for an emergency fund and instead backed the new concept and financial arrangements by the IMF. On December 1st Association of Southeast Asian Nations (ASEAN) financial officials met in Kuala Lumpur and endorsed the idea of a standby fund to supplement IMF loan packages. They also agreed to set up a surveillance system and meet more often to monitor each other’s economies. For this purpose, a permanent secretariat for finance ministers would be set up with the help of the ADB. An apparent compromise between the positions of the US versus several ASEAN countries was the dual stipulation that the new facility would be outside the jurisdiction and mechanism of the IMF, and it can be given only to a country which has received help from the IMF. Actual donations to the fund were deferred.

Today, under the auspices of ASEAN+3 (Japan, China, South Korea and the 10 members of the Association of South-East Asian Nations), the AMF has evolved into a working arrangement, including for example region-wide currency swaps to help them deal with a future Asian crisis. This time, the previous detractors including the US have not objected. It is an idea whose time has come. The AMF should be better able to address emerging problems and financial needs in the region than the IMF has proven to be. Asian countries may thus be more in charge of their own destinies, and able to obtain regional financing rather than relying on western financiers. This in turn can prompt western bankers and investors to supply new finance.

 

THE EVENTS UNFOLD

De-pegging the Thai Baht

On July 2nd 1997, after weeks of selling pressure from speculators exchanging the baht for US dollars, Thailand announced a change in the exchange regime to a managed float system, abandoning a 13-year old peg to a basket of currencies dominated by the US$. A poorly regulated financial sector, and the fact that the baht had been fixed to an appreciating dollar, caused a magnitude of financial instability which threatened to undo the gains made by Southeast Asia over the past three decades.

The US dollar had long been cheap, but it began to strengthen in spring 1995 and accelerated its appreciation in 1997 (38% against the yen and 27% against the deutschemark in the period April 1995 - June 1997), bringing the baht up with itt. Thailand’s export industries became less competitive, while favoring imports. Its earlier export success was based on low cost labor, but emerging low-wage competitors in Asia eroded that advantage --not only China, but India, Vietnam, even countries like Bangladesh were taking away their business. Total exports declined by 0.2% in 1996 compared with gains of over 20% per annum earlier in the decade.

Thailand’s export industry required a structural shift as it could no longer compete in low-end product markets, but the country was not effectively moving up the technology chain. The greater management and technical skills required were not being provided by the country’s antiquated educational facilities. The Labor and Social Welfare Ministry’s Skills Development Department estimated in March 1996 that 27 million Thai workers, nearly 80% of the adult workforce, had only primary school education.

Thailand’s current account deficit was persistently high during the 1990s and hit new peaks in 1995 and 1996. The declining competitiveness was exacerbated by other factors, not least of which was political instability and rampant corruption. The perception was that Thailand’s leadership lacked the political support, and the competence, to deal with the country’s problems. With the resignation of Prime Minister Chavalit Yongchaiyudh in early November 1997, Thailand had been through four governments in three years and six finance ministers in two years.

Recent governments had favored expansionary policies to win popularity, in contrast to the unelected government of General Prem Tinsulanonda (1980-88). Prem had instituted austerity measures and structural adjustments that led to Thailand being the world’s most rapidly growing economy from 1985-94. Subsequent democratically-elected governments allowed the effects of an overheated economy to accumulate. The economy was growing rapidly and popular sentiment strongly favored continuing expansion. As Thais got richer, demand increased for imported luxury goods and investment in property and the stock market. But their success was illusory --based on an overvalued currency and sharrp increases in asset values. Growth rates were unsustainable due to an over-dependence on US$-denominated debt which was plowed into non-productive investments such as property development, consumer goods, and the stock market.

Under a "financial system master plan" of the early 1990s, Thailand undertook to reform the financial sector to turn Bangkok into a regional financial centre. The Bangkok International Banking Facility was launched in 1993 to enable Thai companies and banks to borrow money from abroad. This dramatically increased offshore funding to finance development and also to fund Thailand’s foreign investment into Indochina, Myanmar, and other regional economies. The hope was that due to increased competition, Thai banks would become alert to new technology and improve services.

Net capital inflows increased from 8% of GDP in 1990 to 14% in 1995. The large inflows led to a rapid growth in the country’s external debt. Since most of this debt was private, there was little overall supervision of debt management. An inordinate amount of this debt was short-term (over 50% in 1995). Many problems emerged: short-term borrowing to finance long-term projects, borrowings that exceeded capital of firms, lack of consideration for exchange rate risks, and over-investment in property and stock market assets.

Finance companies had been able to borrow indiscriminately at low US dollar interest rates and, it seemed, convert to baht without foreign exchange risk. In the absence of sufficient industries in which to invest, much of this easy credit was invested in property development. A construction spree was accelerating since the early 1990s. The result was oversupply of commercial and residential buildings.

Thailand’s foreign reserves increased rapidly, from about $16.5 billion in 1990 to 46.5 in 1995, which was often highlighted by the authorities as a strength in the economy. However, the ratio of short-term external debt to reserves in 1995 was 1.0 --so much of the country’s reserves could quickly disappear as a result of debt recall.

Speculative attacks on the baht began as early as August 1996. The pressure stepped up in May and June 1997, as hedge funds took up large positions against the baht. In order to maintain the peg to the dollar, the government bought baht on the open market.²¹ As a further defense of the baht, during the summer of 1997 interest rates were increased. Developers and manufacturers faced difficulty meeting their debt payments. Thai private sector businesses had $74.4 billion in foreign-currency debt at the end of July. To repay debt obligations, they bought US dollars, causing further declines in the baht and rises in the Thai interest rate. The banks and finance companies that made these loans were going bankrupt --16 were suspended in June.

The Bank of Thailand was forced to let the baht float on July 2nd, and the currency fell precipitously. Bad debts mounted. The government went on to further suspend 58 (of a total 91) finance companies and asked them to merge with stronger institutions. It also promised concessionary loans to prevent shut downs and unemployment.

Defense of the currency and failing finance houses have cost the economy dearly. Thailand had a previous experience in this: In 1996, the Bank of Thailand bailed out Bangkok Bank of Commerce which had more than half of its assets in bad loans. This cost the Bank of Thailand $2 billion. Now the government had to spend $16 billion to pay back depositors of the 58 failed finance houses.

On August 11th a group of donors led by the IMF agreed to lend Thailand US$17.2 billion (10 billion direct from the IMF and the rest mainly from Japanese banks). In return Thailand had to commit to

~ current account deficits of 5% in 1997 and 3% in 1998

~ allow financial sector bankruptcies

~ an increase in value added tax

~ more privatizations of state assets

~ allowing foreigners to own a majority stake in financial institutions (from the prior limit of 25%).

The hope was to prop up the financial system and avert the crisis of confidence and thus stem capital flight as early as possible. However, political stalemate hampered progress in restructuring the financial sector.

The baht had fallen by 32% against the dollar by early September. Devaluation should give exports with low import content a stimulus, but since the import content of Thai exports was about 42% of the total value, most Thai exporters could not seize the opportunity. Furthermore, companies holding large amounts of unhedged foreign debt would suffer the increased cost of servicing their loans. The downgrading of Thailand’s local and foreign currency debt ratings by international agencies such as Moody’s and Standard & Poor’s compounded the problem, as Thai firms could not obtain financing. Thai companies owed creditors abroad an estimated US$91.6 billion at the end of October, about $20 billion of which was up for renewal by the end of the year. Corporations defaulting on their loans would in turn increase the non-performing loans held by Thai banks and finance companies.

By November, despite the IMF bailout, the currency had fallen 50% from its level on July 1st. Evidently, the government was not getting a grip on the economy. Thailand had four finance ministers and two permanent secretaries of finance in the previous 12 months. With such political uncertainty, creditors seemed unable to decide on any rescheduling of debt, and the government was unable to get quick passage of finance-sector reforms.

Prime Minister Chavalit, who headed the shaky coalition government, announced his resignation effective November 6th. His replacement was Chuan Leekpai, already well-known for heading Thailand’s longest tenured government in a decade (less than three years during 1992-95).

Chuan outlined his policies in Parliament [Straits Times November 21st], setting six months to one year as a target to restore economic stability. His highest priority was to decide the fate of the 58 suspended finance companies which had about 1 trillion baht (about US$25 billion) in bad loans mainly in the property sector. Other tasks were to relax foreign restrictions, facilitate inflows, accelerate exports, ease unemployment, rehabilitate industry, and reform politics.

On December 8th all but two of the 58 suspended finance companies were shut down permanently, with 6000 employees immediately losing their jobs to add to the 14000 unemployed when the companies were suspended. Good assets would be consolidated into one or two new commercial banks, and bad assets would be liquidated. Public deposits and debt would be repaid by the government. The two firms that survived the review had met four conditions: capital adequacy, debt repayment capability, liquidity, and able management. The firms were given 90 days to put into action their rehabilitation plans. The stock market and Thai baht shot up on the news --the baht recovering from an all-time low the previous week. Nevertheless, Thailand suffered from the general malaise in the region well into 1999.

Collapse in Indonesia

After squandering foreign exchange reserves in a vain effort to keep the rupiah within its band, the Indonesian central bank let the rupiah float on August 14th.

Although Indonesia was considered reasonably sound in terms of its economic fundamentals, it ultimately suffered the worst damage from the currency crisis. A plausible explanation for this was political inertia. The initial reluctance of the Suharto regime to dismantle national monopolies, liquidate defunct financial institutions, and achieve greater budget discipline was symptomatic of an inability, or an unwillingness, to satisfy market expectations of reform. In the early days of the crisis the government postponed or cancelled 70 major infrastructure projects, but still maintained some of the most controversial, such as the national car and the domestic manufacture of aircraft by a state enterprise.²²

In September a government decree declared US$17 billion worth of projects "postponed" and another $3 billion "under review". However, the government never defined what these terms actually meant, which left the door open for lobbying by companies to keep their projects on track. In November Suharto reversed the decision on $2 billion of the "postponed" projects, plus gave the go-ahead on those projects "under review". Projects brought back to life included four power projects (two being developed by American multinationals), an airport project led by Suharto’s eldest daughter, and the eight projects "under review".

On November 1st 1997 Jakarta unveiled a 3-year IMF stabilization scheme in exchange for US$30 billion in standby credits and soft loans.  (Total credits were later stated at 43 billion, with additional funds contributed by neighboring countries and other sources.   But even this appeared insufficient by mid-1998.) Contributors included not only the IMF but Japan, Singapore, Asian Development Bank, World Bank, USA, Australia, Malaysia (in order of size of commitment), and others. Highlights of the reform program included:

~ liquidation of some 19 ailing banks

~ removal of government monopoly over specified products

~ national car project to be subject to WTO ruling

~ reduction of import and export taxes

~ a budget surplus of 1% of GDP for 1998/99 fiscal year.

In what analysts described as "intra-elite bargaining", Jakarta seemed ready to abolish some sacred cows. Consider the case of government monopolies over imports of key commodities. Starting in 1999, commodities including wheat, flour, soya beans and garlic would be imported freely.²³ Previously, only the National Logistic Board (Bulog) was allowed to import these commodities. This raised concerns within the powerful Indonesian armed forces (Abri) of potential food riots resulting from the inevitable rise in prices of basic food items. The state’s monopoly over the import of key commodities was, after all, meant to stabilize their prices. However, Bulog had long been criticized for creating barriers which benefitted a few large conglomerates that control the food industry. For example, the import of wheat was dominated by the Salim Group of Liem Sioe Liong (a crony of Suharto), which bought wheat from Bulog at heavily subsidized rates and sold it back at a profit after milling. Consumers and downstream industries paid a higher price for it.

Over the weekend of November 1st, the monetary authorities liquidated 16 banks, including banks owned by some of President Suharto’s sons and one of his daughters. Suharto’s half-brother (Probosutedjo) and his son (Bambang Trihatmodjo) both hit out at the government for closing their banks, saying the closure was unjust and inflicted inappropriate losses. Bambang said his bank "only violated the Legal Lending Limit... If we want to be fair, about 90% of Indonesian banks must have violated that requirement." Probosutedjo defied the closure rule by keeping his bank open to allow small depositors to claim their funds. Suharto asserted the government would not reverse its decision, but by the end of the week the central bank assured the banking community that there would be no more shutdowns.

A confidential report prepared by the IMF in early January 1998 acknowledged that this element of the Fund’s strategy backfired, helping trigger a bank panic that was still rippling across Asia. When Indonesia was forced by the IMF to close particular banks, the move was expected to restore confidence in the remainder of the country’s banking system by eliminating bad apples. The report said: "These closures, far from improving public confidence in the banking system, have instead set off a renewed ‘flight to safety’." By the end of November, two-thirds of all the banks in the country had experienced runs on their deposits.

The Indonesian currency continued its slide through the rest of 1997, and fresh waves of selling in the new year sent the rupiah below 10000 per dollar on January 10th. Indonesians began panic buying of food items as concern mounted of shortages and skyrocketing prices.

Rumors had been causing more uncertainty --that Suharto was sick, that he would not seek re-election, that the government would declare a debt moratorium. When a country declares a moratorium (which cuts off loan payments to creditors), this halts a fall in the value of its currency temporarily, but the country is likely to be blacklisted by creditor nations and banks for years afterwards. A debt moratorium in Indonesia would likely send severe ripple effects throughout the region. For example, most Japanese banks that had lent money to Indonesia were also heavily exposed to South Korea and Thailand; banks which had agreed to roll over their debt in the other Asian economies under intensive care by the IMF would get hit on all fronts.

On January 16th Suharto announced a new agreement with the IMF. Although praise streamed in from leaders worldwide, markets did not respond positively to the agreement. Lack of rescheduling of debt payments was perhaps one reason. The IMF and the government said that the corporate debt issue should be resolved when the rupiah recovered. Total external debt (public and private) had grown to US$140 billion at the end of 1997, half belonging to the private sector.

On January 22nd the rupiah plunged to 16500 per dollar, representing a 66% fall in two weeks and an 85% loss in value since the start of the Asian currency crisis in July 1997. At such levels the economy was close to paralysis with no functioning financial system and companies virtually certain to default on foreign currency debts. Investors were reported unnerved by the specter of foreign debt and doubts over political succession. The markets reacted negatively to prospects of BJ Habibie, who they associated with Indonesia’s high-cost projects, being the vice-president.

During February 1998, as the currency crisis failed to respond to the remedies so far, Suharto was pushing for a radical alternative: the creation of a currency board that would lock in an exchange rate for the rupiah. The IMF opposed the idea and threatened to cancel its rescue effort if a currency board was adopted. Currency boards had successfully stabilized currencies in Hong Kong and a few other countries, but Suharto had to drop the idea. (See next section on The Hongkong currency board.)

After failing to satisfy markets with the IMF packages agreed in October 1997 and renegotiated in December, a third deal was announced on April 10, 1998. A key point of the 117-point reform package concerned offshore debts. It stipulated a Mexico-style solution whereby the government would not bail out firms but once a deal was reached with international banks the government would provide the necessary foreign exchange that was needed to repay the debt.

At a crucial meeting in New York between the Jakarta government and a Bank Steering Committee representing thirteen foreign lenders, debt reductions were called for of up to 50%. According to official figures, Indonesia’s private sector debt stood at US$73.9 billion at the end of 1997. The massive debt was blamed as one of the key catalysts for the economic turmoil. Finally at a meeting in Frankfurt on June 4th, agreement was announced to allow Indonesia’s corporate sector to reschedule its external debt over eight years with a three-year breathing space in which only interest would be paid. Still, the rupiah languished --Reuters quoted a source: "The debt talks used to be very significant but now political concerns and how to make basic foods available at affordable prices are more significant." (Straits Times 5 June 1998 p1)

On May 5th, ahead of the schedule required by the IMF, Indonesia announced a rise in prices of petrol by 71%, kerosene by 40%, and other reforms. Unrest quickly spread. (The price hikes were reversed after Suharto’s resignation later in the month.) Coincidentally on the same day, IMF managing director Camdessus announced his recommendation to release the first US$1 billion of financing to Indonesia, delayed since March. (However, amid mass rioting, the funds were soon put on hold again.)

A  news report at the beginning of 1998 estimated that the financial crisis had forced 2.4 million people, mostly temporary workers, out of work. By mid-1998 the figure was estimated at 15 million.

Under mounting pressure from domestic unrest, President Suharto resigned on May 21, 1998, which event may be considered to demarcate the Asian Crisis into two phases: until then it was a Financial Crisis; now it was a Political Crisis. "The rioting against Indonesia’s President Suharto has inaugurated Round Two of the Asian economic crisis, a phase where politics will count even more than money..."²⁴ It marked a break-off point, where the logic of market speculation against misaligned currencies, failures of financial institutions, and weak economic performance was secondary, and the real variable (in Indonesia anyway) was politics. Political and social stability, essential for investor confidence, remained elusive leading up to the election scheduled for June 1999.

The Hong Kong currency board

The currency board concept

A currency board operates to fix the exchange rate, with all other monetary-policy goals such as interest rates, employment, and the stability of the banking system subordinated to that one purpose. Thus, if it did not work the currency board would generate economic and political chaos.

The Gold Standard --the international monetary system that led to unprecedented stability and growth in world trade in the late 19th century-- had a similar self-equilibrating mechanism. When a trade deficit occurred, the country’s currency ended up in foreign hands as payment for net imports. Central banks were required to redeem their own currencies with gold at a fixed rate, which took their currency out of circulation. This reduced the money supply and hence had a deflationary effect. The resulting price reduction persisted until the original deficit was eliminated. Many people look upon the old Gold Standard with great nostalgia.

A system based on a currency board resembles the Gold Standard and goes one step further than a system of fixed exchange rates such as Bretton Woods. Under the Bretton Woods regime central banks promised to exchange their local currency for foreign currencies at a set rate. With a currency board, the central bank must also guarantee this exchange by keeping reserves essentially equivalent to the domestic money supply. In this sense the foreign exchange regime is quite immutable. That means the central bank cannot print money beyond its own level of reserves. It is reduced to a clerical role. It cannot finance budget deficits or prevent a credit crunch if investors want to convert their domestic assets to, say, dollars or yen.  The attraction is exchange rate stability --an enforced discipline that keeps inflation and deficits in check.  However, Hong Kong has endured sudden jumps in interest rates, along with resulting unemployment and steep declines in stock market and property values.

The Hong Kong experience

The Hong Kong dollar’s peg to the US$ was put in place under the currency board system on October 17, 1983. (A wave of speculative attacks had been triggered by political jitters over initial diplomatic negotiations concerning the then colony’s prospective handover to China in 1997.) Three note-issuing banks are required to purchase certificates of indebtedness from the Hong Kong Monetary Authority with foreign currency pegged at the rate of HK$7.80 to one US$. The certificates give the banks rights to issue Hong Kong currency. The banks are in turn guaranteed foreign exchange at the same exchange rate when they withdraw the local dollar from the money supply and surrender it, along with the certificates, to the Authority. The currency peg is self-regulating, in that if the HK$ weakens demand for US$ will induce the banks to sell HK$ at the ‘bargain’ official rate back to the government. This will dry up the local money supply and drive up interest rates to support the HK$. Higher interest rates would deter speculators who sold HK$ forward or short and had to borrow the currency at high rates to square off their positions. High rates would also attract a balancing inflow of capital into HK$ deposits.

In recent years, Argentina, Estonia, Bosnia and Bulgaria established currency board-like systems inspired by the Hong Kong example, and Indonesia was considering the system in early 1998. One of the strongest arguments for a currency board is the demonstrated ability to withstand political shocks and uncertainties. Thus Hong Kong’s currency board, apart from withstanding the threat of total collapse in 1983-84, passed two more tests: the transfer of sovereignty to China in June 1997, and the Asian currency contagion when it spread to Hong Kong shortly after the handover.

However, the surge in interest rates --overnight rates rocketed to as high as 3300% in mid-October 1997-- wreaked havoc on stock and property markets.

Hong Kong’s foreign exchange reserves actually increased in October. Although a considerable amount of its immense stock of reserves of US$88.1 billion were spent buying HK$ when the currency came under attack by speculators, borrowing rates surged (as high as 300%), denying access to the HK$ speculators needed to resell, hoping to buy back cheap later. As speculators settled their accounts, they had to sell US$ through the currency board.

The 1997-98 attacks on the HK$ were a reflection of uncertainty over whether the US$ peg would be abandoned. The initial impact of the Southeast Asian currency crisis was moderate because regional countries represented a relatively small share of Hong Kong’s trade, and the product composition of Hong Kong’s exports meant there was limited direct competition in third markets. Nevertheless, by mid-1998 Hong Kong was suffering from recession along with most of East Asia.

During the last two weeks of August 1998 the Hong Kong Monetary Authority spent an estimated $15 billion to support its stock market.  In the thin trading of that time speculators had made easy money selling HK$ and simultaneously shorting the stock market.   The HKMA took its gambit in the teeth of the spreading meltdown in emerging markets, but claimed victory as the stock market index gained 19%.  (Critics complained that Hong Kong was only lucky --the Russian government's debt default in August hit hedge funds' liquidity, forcing liquidation of short positions in Hong Kong.)

A currency board for Indonesia?

The American advisor who advocated the currency board to President Suharto contended the system was "foolproof".

In Indonesia’s case, the decline in the domestic money supply --required to cover the rupiah with central bank reserves-- would lead to higher interest rates and further damage the weak banking system. Cynics charged that Suharto’s support for the currency board concept was self-serving, as his family businesses probably would be in a position to obtain the US$ they needed to pay off foreign debts and thus stay solvent, even though such demands by too many corporations would cause the system to fail. But if the system did work, investors would hang on to their rupiah, foreign banks would extend their loans, and the crisis would end.

Prerequisites for a successful currency board were all quite uncertain for Indonesia. First, Indonesia did not have adequate reserves to defend its currency at any reasonable fixed rate. Second, the banking system probably could not survive with excessively high interest rates. Third, wages and prices --needing to decline in lieu of devaluation-- were not flexible enough to adapt to competitive pressures. Fourth, there was real uncertainty that the government was strong enough to abrogate its own control over the unpopular policies associated with such a system. Indeed, the riots resulting from higher prices, unemployment, and ethnic resentments did not inspire much confidence in the political stability of the Suharto regime.  Suharto was forced to abandon the currency board idea (his last gasp before resigning), under pressure from the IMF and almost all considered opinion.

In the aftermath of the Crisis, during October 1998 the rupiah benefited from a general market recovery in the region, moving from the range of 11-12,000 per dollar to the 7-8,000 range.  Pundits attributed the sudden appreciation partly to expectations that a new peg to the dollar was being contemplated, perhaps including a currency board.   Malaysia's daring gambit with currency controls was seen as encouragement.   Many of the reasons for being unable to install a currency board before were no longer applicable.  Indeed, the downside --bank failures, deflation, mass unemployment-- had already been realized.  Most importantly, foreign exchange reserves had been replenished from recent surpluses in the current account.  Although finance officials faithfully deny any intervention mechanism is being considered, the currency board idea may yet resurface.

Korea

The crisis in Korea was relatively more important on a global basis because the Korean economy was the 11th largest in the world. The Korean won had been gradually adjusted in value to maintain competitiveness, from a rate of 700 per dollar in 1990 to 884 at the end of 1996. A current account deficit had been caused largely by a collapse in the world market in 1996 for a major Korean export, semiconductors, but by mid-1997 the current account deficit was only 2.5% and declining. However, Korea faced illiquidity in meeting its short-term foreign debt obligations.

As the financial contagion reached Korea in November 1997, the country’s foreign debt was estimated at around US$110 billion, of which 20-30 billion needed payment by year-end and about 70 billion would mature within a year. Banks were already saddled with mounting bad debts, perhaps too conservatively estimated by the central bank at 16% of all loans. Interest rates were rising fast as the central bank mounted a costly campaign to stem the currency’s decline, repeatedly buying won with US$. Foreign exchange reserves were depleted from commitments to buy won in the forward market, to as little as half their officially stated level of US$30 billion. Currency and stock market values were daily hitting all-time lows. International credit rating agencies such as Moody’s Investors Service cut ratings for key banks to just above junk-bond status. The focus of bank lending on a handful of customers (the chaebols) made matters worse, with as much as 40% of loans to the huge industrial groups, many of which were beginning to have trouble with their debts.

The average debt-equity ratio among the conglomerates, which had invested heavily in extra capacity, was more than 350%. Such tactics succeeded as long as the country was growing at close to double-digit rates and could export, but slower growth and a higher-cost economy had dulled the country’s export competitiveness. Corporate failures led to credit downgrades for domestic banks. Foreign banks refused to roll over short-term loans for Korean financial institutions, which in turn stopped issuing letters of credit to Korean companies. The companies in turn had trouble paying for goods and services in international transactions.

Leading South Korean steelmaker Hanbo Steel defaulted on its loans on 23 January 1997, marking the first of 8 major companies among the country’s 50 largest chaebols to declare insolvency in 1997. The currency, starting at 888 won per dollar on July 1st, fell to 901 by August 19th, 913.50 on October 2nd, 953 on October 28th, to 984.70 on October 30th. On November 17th the central bank announced it would no longer defend the prevailing level then at 986, and the won immediately fell to 1008.50. On November 19th the government widened the daily trading band from 2.25% to 10% and the authorities said they would cease to intervene. By November 20th the won had plunged to its new limit-down level of 1139.

The next day, 21 November 1997, South Korea bowed to recommendations from the IMF and "other allies" and announced it would ask the IMF for a massive bailout package. One of the first steps was to suspend operations of 9 of the country’s 30 merchant banks. This threatened further corporate failures as the merchant banks refused to roll over debts and called in their loans.

New external financing dried up and reserves declined sharply, with a large amount used to settle the short-term debt of Korean banks’ offshore branches. Added to the problems in the financial and corporate sectors, political stalemates undermined market confidence as the National Assembly failed to pass key reform bills.

Concern mounted of a risk of payment default on short-term debt. South Korea was due to receive $9 billion of its rescue package but the debt due was $20 billion in the same period. Financial creditors continued to pull back, and the won hit lows of nearly 1900. In mid-December Korea abolished the 10% span within which the won was allowed to move against the US$ daily. By Christmas the won had reached 2000, as the government revealed that its total foreign debt was twice previous estimates, at over US$200 billion.

Martin Feldstein²⁵ argued that there was no fundamental insolvency in Korea because its total foreign debt was only about 30% of GDP, "among the lowest of all developing nations". Whereas the country needed coordination of US, Japanese, and European creditor banks to restructure short-term debts, what was provided in early December 1997 to pay the foreign currency debts was a US$57 billion pooling of official funds (sources: IMF $21b, ADB $4b, World Bank $10b, plus contributions from US, Japan, Canada, Australia, Germany, France, Britain and others). In return for this cash infusion, Korea was to accomplish fundamental structural reform, by:

~ adopting tighter monetary and fiscal policies and accept slower growth --to keep inflation below 5%, and the current account deficit below 1% of GDP

~ improving corporate and state disclosure to strengthen the transparency of its financial system

~ increasing the foreign ownership ceiling of Korean firms from the current 26% to 50% and then 55% in stages

~ allowing more open access to domestic markets by foreign banks and insurance companies

~ allowing imports of certain industrial products, particularly Japanese cars

~ improving credit evaluation by banks

~ allowing autonomy for the Bank of Korea

~ reforming the chaebols, for example to improve the system in which chaebol units cross-guarantee loans

~ reducing debt-equity ratios for Korean corporations

~ reforming labor laws to make it less difficult to lay off workers and provide more labor market flexibility.

A key measure to end the liquidity crisis was announced on January 29th by the government after weeks of negotiations with 13 leading international banks. The government and global creditors reached a debt swap agreement to exchange about US$24 billion of the nation’s short-term debt for government-guaranteed loans. A call option provision allowed Korea to repay early --that way, if its credit ratings improved it could go to the market for fresh credit on more favorable terms. Markets responded enthusiastically to the announcement, the won moving up nearly 10% to 1525 per dollar.

This was despite a parallel announcement of the closure of 10 ailing merchant banks, among 14 whose operations had been suspended in December. Korea’s 30 merchant banks had become rising stars in global finance with their aggressive investment drive in emerging markets. Some 24 of them had sprung up in the last two years alone as they generated easy profits by raising cheap funds abroad and investing them in high-return but high-risk markets such as Indonesia, Russia, and Brazil.

Korea’s militant labor unions had paralyzed the government in 1997 with nationwide wildcat strikes in protest against labor reform legislation. On 6 February 1998 the government reached a landmark agreement making it easier for companies to shed workers as they restructure. However, as unemployment rose from 2-3% then to 8.7% a year later (February 1999), the unions were threatening to abandon the truce.

In addition to bemoaning the pain of economic austerity, many in South Korea felt some anger that the nation had surrendered control of the profits and management of its economy to foreigners. The Federation of Korean Industries raised a question just as the IMF and the government were coming to terms: "In ...other countries receiving IMF funds, has the IMF ever demanded the dissolution of conglomerates?" A Hyundai director asked: "Without the chaebol, how can the country survive? The IMF is intervening in the sovereignty of our country." Another chaebol executive was quoted: "The United States may have played some role behind the IMF call with the aim of holding Korean firms in check in the world market." "Opening of our financial markets won’t help solve the problem. Rather, it will bring us into slavery", said the Korean Confederation of Trade Unions. (all quotes in "Pressure on Chaebol", International Herald Tribune, 4/12/97, pp 1,8)

Malaysia

Currency and stock markets became the target of speculative attack in July 1997, due to fears that Malaysia was next in line to the financial crisis then beginning in Thailand. The current account deficit improved in 1996, but FDI inflows could not fully offset the 1996 deficit, resulting in a basic balance deficit of RM1 billion. FDI outflows of RM6.6 billion further exacerbated the strain in the BOP. Despite this, the central bank increased its foreign exchange reserves by RM6.2 billion due to massive net inflows of short-term capital at RM11.2 billion. However, the danger of relying on such a volatile source to finance the current account deficit was made evident when this capital was withdrawn and the ringgit dropped dramatically. The Malaysian central bank, Bank Negara, attempting initially to defend the value of the ringgit, depleted reserves by 12.5% in a mere span of two weeks.  On July 14th the government abandoned defense of the ringgit.

Overall money supply (M3) had been growing at 20%, and growth in bank loans surpassed 30% with high nominal interest rates and low inflation, hence high real interest rates. Loans to the "unproductive" property and security sectors increased sharply, with more sluggish loan growth to manufacturing.

The large-scale banking failures suffered by Thailand and Indonesia were not expected in Malaysia due to better central bank supervision and regulatory control.    Banks were better capitalized, with capital adequacy ratios at 11% (permanent capital 9.5%) at end-September 1997, compared to international guidelines of 8% (permanent capital 4%). Although lending for properties and share-financing was a problem, most borrowings were local which reduced the currency risk of loans. The ratio of non-performing loans to total loans was only 3.3% in June 1997 --half the level leading into Malaysia’s last major economic crisis in 1986. It reached 9.7% by April 1998.

Government spending plans had long been disparaged as grandiose. Indeed, the clustering of several mega projects in the government’s "Vision 2020" concept gave rise to questions of financial feasibility. Some national projects included:

~ the Multimedia Super Corridor (MSC), a 15-by-50 km zone extending south from Kuala Lumpur, wired with advanced telecommunications infrastructure

~ Putrajaya, a new administrative capital to be located in the MSC

~ Cyberjaya, the centerpiece of MSC, to house information technology firms

~ Bakun hydroelectric dam

~ Linear City, the world’s longest building

~ a new international airport

~ a "mountain highway" to open the country’s west-central interior to tourism.

These projects were expected to have high import content and also divert resources from the traded sector.

Malaysia’s Prime Minister Dr Mahathir bin Mohamad has been criticized as contributing to the lack of confidence by his verbal assaults on those disinvesting from Malaysian currency or shares, calling them manipulators, saboteurs, and even racists out to wreck the country’s economy. Dr Mahathir warned that for developing countries "the fight for independence will have to begin all over again for the present market rules will surely result in a new imperialism more noxious and debilitating that the old". "A liberal policy on currency and share trading has resulted in abuses which undermine years of painstaking efforts to develop the countries of Southeast Asia." "Many other poorer countries have worse data than we do. Why are their currencies remaining stable?" He called currency speculation "unnecessary, unproductive and immoral" and declared that "it should be made illegal". "I want to limit trading times and amounts" for the foreign exchange market. There were even threats to "punish those who helped the foreigners". His comments were associated with government impositions of curbs on foreign exchange and stock trading. On August 28th the government placed a ban on short-selling of 100 designated blue-chip stocks. Short sales were prevented by imposing a share delivery period of 5 days. There were also limits on the amount of local bank loans and a US$2 million limit on foreign bank currency swaps for non-commercial purposes. Furthermore, big state-owned funds were ordered to mop up shares to bolster prices. Banks were barred from making margin calls on shares pledged as collateral. The crowning measure was announced on September 3rd, a RM60 billion fund (equal to roughly 43% of Malaysia’s GDP) to prop up the depressed stock market. This effectively would create a two-tier market, opening the opportunity for foreign investors to sell shares to domestic players who could then pass them on to the government fund at a premium. In response to such designs, investors dumped both their shares and the ringgit. The policies were soon rescinded when they failed to prop up the markets.

On 17th October 1997 the government presented a belt-tightening budget (which was followed with tight monetary policy by the central bank).  A target of 7% GDP growth was pronounced unrealistic by commentators, and the markets responded negatively to the government's package.  Finally on 5th December, Deputy Prime Minister Anwar Ibrahim introduced a "self-imposed IMF program" which was better received in the markets.

Several events, towards the end of 1997, seemed like more meddling by the government and resulted in the currency and stock markets taking another beating. Two government-linked companies shuffled their assets in what appeared to be a bailout for influential investors: the country’s largest construction firm UEM transferred cash to its debt-laden parent Renong in exchange for approximately one-third of its parent’s shares. The deal provoked challenges of "cronyism" and for lacking transparency. Before being privatized several years earlier, Renong was the main business vehicle of the United Malays National Organization, the main party in the ruling National Front coalition.

Later that same week a government takeover of the deferred Bakun dam project precipitated renewed selling on the markets. The government explained that the main contractor withdrew from the project since it had been deferred. Markets nevertheless suspected bailout conspiracies, and the stock market declined 11% , hitting a 7-year low which meant the Kuala Lumpur Stock Exchange, Southeast Asia’s largest, emerged as the world’s worst performing market for 1997.

In hindsight (at the APEC meeting in late November), Mahathir remarked: "What appears to be clear is that if you do criticize the currency trader, immediately they hit back at you by lowering your currency. In the history of mankind, anybody who goes against established authority will be regarded as heretics and will be punished... As long as these people with US$3.6 trillion can play around in the market, anything can happen."

Deputy Prime Minister and Finance Minister Anwar Ibrahim, generally regarded as Mahathir’s eventual successor, was perceived as more balanced in his views, but he did support his boss, for example the Straits Times on 2/11/97 quoted him: "In whatever activity, be it cooperatives, banking or insurance, we have rules, but not in currency trading. This is what Prime Minister Datuk Seri Dr Mahathir Mohamad is talking about and now people accept this." Even Mahathir’s nemesis, the international financier George Soros²⁶, would seem to agree: "The markets need to be kept under some better control. You also need a market, so let’s say outlawing me would do more damage than it would do good. But to change some of the rules by which we play --that’s perfectly legitimate, and I am pushing that this should be considered."

Malaysia’s rhetorical response to the crisis was characteristically paternalistic, even quaint. Deputy PM Anwar called on Malaysians to grow vegetables in their gardens to avoid imports. Dr Mahathir mooted his pet plan for a regional trading arrangement using regional currencies instead of the US dollar. Although he received diplomatic support from some Southeast Asian countries, details of the mechanism were never resolved --such as the possible use of the Singapore dollar as common currency (Singapore was less than sanguine), and creation of a "clearing house" to settle payments. [ST 7/2/98 p48]

Malaysia’s long-term plans to combat the crisis were to cut the current account deficit by a two-pronged approach to delay some major infrastructure projects and also enhance export competitiveness and import substitution. Government departments at one stage were directed to cut expenditures by 30%.  The banking sector was pressured to engage in mergers.

All Southeast Asian currencies and stock markets continued to decline through the rest of 1997 and into 1998, the declines even accelerating from about November 1997. As the first full week of trading in the new year started, regional currencies hit new milestones. The Malaysian ringgit fell below 4 per dollar, the Thai baht below 50 per dollar, and the Indonesian rupiah touched another all-time low.

During 1998 the tight macroeconomic policies contributed to a worsening recession.   Second-quarter GDP declined 6.8% (1st quarter: -1.8%).  As a new wave of speculative pressures hit currency and stock markets from Asia to Russia to Latin America, the Malaysian government imposed capital controls and fixed the ringgit at 3.80 to the dollar (about 10% above the currency's prevailing levels).

Given that Malaysia's economy was so dependent on trade and FDI (moreso than any other Southeast Asian country except Singapore), leakage would be hard to avoid.  Exports could be under-invoiced, and imports over-invoiced, to park foreign exchange offshore.   Long-term investment might be put off by higher costs, potential corruption, or simply annoyance at new bureaucratic red tape.  There was even talk of capital flight.  However, low external debt and miniscule foreign liabilities in the banking system reduced the potential for leakage.

Capital controls allowed the government to loosen fiscal and monetary policy without sending the ringgit through the floor.  On 23rd October 1998, Dr Mahathir seemed to flout his power to manipulate the market by announcing a high budget deficit for 1999.   Given the success so far of Malaysia's daring gambit, there might be implications for the eventual reform of the global financial system. 

 

 

"ASIAN CAPITALISM" IN THE AFTERMATH OF THE CRISIS

Is it Time to Get Radical?

The causes of the Asian Financial Crisis might be interpreted in two ways: 1) a failure of Asian capitalism, or 2) a failure of market capitalism that led to a loss of confidence in Asian capitalism. Both these categories of causes have considerable basis. The first obviously was fundamental --weak financial institutions, moral hazard, etc (refer back to The Causes). But our faith in the international financial system and even financial liberalism has also taken a blow.²⁷

Pinpointing and effecting some control over the actual forces at work, including politics and other non-market factors that contributed substantially to the loss of confidence, has not been easy. The two categories of causes operate in tandem, i.e. even if you ascribe to the second category of arguments, there must probably be real economic frailties before markets suffer a blowout.

According to The Economist²⁸, the most obvious and remediable need is better information and sound financial practices –reform seems appropriate for Asian governments, companies and banks, and also the IMF. But the Asian financial community was experiencing considerable progress and development even before the Crisis (see later The Road to Recovery). The World Bank credited Asian "policies to increase the integrity of the banking system" and "creating effective and secure financial systems" as prime causes of the East Asian "miracle".²⁹

By the autumn of 1998 acceptance of capital controls was spreading.³⁰ This represents a sea change in economic thinking. Among economic theorists, the belief that free capital movement increases efficiency has been as much an article of faith as the traditional belief in the gains from free trade. However, a revisionist view has emerged as a result of the Asian Financial Crisis. Revisionists³¹ argue that the case for capital mobility is much weaker than the case for free trade. Markets for goods and services are reasonably stable; yet in financial markets, bubbles and crashes are endemic. Revisionists also question the assumption that capital mobility has been a source of economic benefit³² –least of all for Asia. For example, China, Taiwan and others (Japan in the early days) enjoyed economic success without allowing capital mobility.

George Soros espouses his "reflexivity" phenomenon to explain what motivates market players like himself.   Reflexivity means supply and demand are not independent but are structured through perceptions of market possibilities, which perceptions in turn influence the possibilities. Essentially, the valuation of financial assets depends less on economic fundamentals than on investor expectations of the behavior of other investors. Soros therefore questions the viability of free capital markets: "As I said, there is a question whether we can live with this knowledge of reflexivity, because when you have that knowledge, and everybody else in the market has that knowledge, markets become inherently unstable... I’m afraid that the prevailing view, which is one of extending the market mechanism to all domains, has the potential of destroying society...."³³   However, taking in the notion that market forces may be less than economically beneficial and rational is hard for the 'politically correct' to swallow.

Western laissez faire market theory is a conceptual heritage of the 18^th century Enlightenment. According to Ayres(1998)³⁴, the liberal quest of creating free "globalized markets" for everything represents a "victory of academic theory over common sense." This represented to Ayres the latest and probably the final utopian project inspired by the Enlightenment, driven "by the world’s last great Enlightenment regime," the United States. Of course, free market ideology is always questioned when market forces seem beyond control, but the global capital meltdown of 1997-9 exacted too high a price in social dislocation and economic and political instability for our faith in the liberal vision of utopian society to endure. Complaints are mounting as, for example, debt to international banks is prioritized over public provision of education, health and other services.

 

‘Asian capitalism’ revisited: results rather than free-market principles

The currency crisis has been a watershed event in East Asia’s development. In 1993 the World Bank³⁵ praised Asian governments for their market-friendly public policy, and particularly for an effective government role in achieving what the Bank called "stable and secure financial systems" and "macroeconomic stability". This macroeconomic stability was largely based on stable exchange rates linked to the US$. Now the formula for the East Asian Miracle has become a recipe for collapse.

Asian economic growth and the associated expansion of intra-Asian direct investment was largely predicated on a rather fortuitous circumstance that prevailed among exchange rates in the region, which promoted the "flying-geese"³⁶ pattern of trade and investment. The strength of the Japanese yen relative to the dollar since 1985 facilitated Japanese foreign direct investment into Asian countries (whose currencies followed the US$). Yen investments in turn created greater economic growth in the region, which spurred more trade and investment. This virtuous cycle was interrupted when the US$ instead appreciated. The US$ began to slowly turn around after hitting a low of 80 yen in the spring of 1995, and by the summer of 1997 the US$ was appreciating rapidly against virtually every major currency in the world.

Is macroeconomic stability, which was credited so much for Asia-Pacific success since the mid-1980s, gone forever? Stable exchange rates linked to the US$ contributed to the East Asian economic "miracle", as yen appreciation since 1985 led to a surge of Japanese investment in the region, an export boom, and considerable technology transfer and industrial upgrading. Foreign investment came to Southeast Asia both for purposes of "outsourcing", or offshore production to export to the world market, and for purposes of market access to the growing purchasing power of regional consumers. Now the boom in regional markets has come to an abrupt end. Exporters to America and Europe expected to benefit from currency devaluation; but high import content keeps some export prices up, or low commodity prices keep returns down. One analyst argues that the historical experience in economic crises indicates that despite devaluation exports are almost never the source of recovery.³⁷ Throughout the first year of the Asian Crisis, currency volatility, high interest rates, and high inflation discouraged potential investment in export industries.

The recessionary trap of tight money hand-in-hand with a weak currency may have finally been thwarted by the policy reversals of August-September 1998 in Hong Kong and Malaysia. These dramatic new strategies reflect the growing sentiment and conviction that stability must be reinstated, at the expense of some freedom in the flow of money.

Developing Asian countries may wish to return once again to the old "managed float" regime or some other formula³⁸ for regulating their currencies to control volatility and maintain an appropriate purchasing power. However, government intervention in foreign exchange markets was largely discredited by the Crisis. The defenses the region put in place in response to the attack on the Mexican peso ("repurchase agreements" between central banks to provide mutual support of regional currencies) were not successfully employed to stem speculation. In the early days of the Southeast Asian currency debacle, there was fruitless talk of creating an Asian Monetary Fund, an IMF-type institution to be funded and operated by Asian countries.

Now Malaysia’s and Hong Kong’s new interventionism signals another test of governments versus markets. Dr Mahathir, an ardent advocate of the AMF, was probably justified in avoiding IMF help for his country, if he still believes in the Malaysian government's developmentalist capacity. Mahathir's reasoning in calling for an AMF represented a wish (probably futile) to have Asians solve their own problems, since Asians may be more likely to retain some features of their "Asian capitalism". The IMF is, after all, a bureaucracy domiciled in Washington DC --effectively a state-owned enterprise ('oowned' by member countries of the IMF) subject to all the failures of government interventions in markets. The IMF's claim to represent the values of market liberalism is only indicative of the ideological bent of its administrators.

In a self-assessment published in 1999,³⁹ the IMF asserted that their policies should have restored investor confidence. But for only vaguely understood reasons –including perhaps the increasingly negative perceptions of global market players about Asian political developments and Asian capitalism generally-- capital continued to exit. It seems market reaction, apart from the policies themselves, was a crucial variable.

Do the new interventions indicate a recasting of public policy in Asia away from laissez faire? The current generation of politicians has been taught to keep their hands off the marketplace. However, the original character of Asian capitalism was never entirely lost. Asian capitalism still manifests a pervasive government role, with paternalistic leaders often taking on the responsibility to manipulate market forces in favor of the government’s social, political or economic objectives.

Nor are much maligned institutions of the old Asian capitalism departing the scene –80% of new financing goes to the top five chaebols, as smaller firms go bankrupt and banks concentrate resources on the safest bets. Thus, there is room for doubt about how much will really change in Asia. Few Asians wholly embrace a reform process (largely based on the mold of modern American capitalism and the broadest extension of free markets) with the inherent message that Asian capitalism was wrong. The South Korean president does seem more enthusiastic about the benefits of change, but despite his efforts the chaebols have increased their dominance of the economy.

Much of East Asia’s financial market liberalization only occurred in the last decade, especially in Indonesia and Thailand. Liberalization at first brought dramatic economic success, but today governments realize they must focus on rescuing the real economy of production and consumption from the ravages of their failed experiment of the early 1990s in free financial markets and banking systems. Despite the clamor for political change in so many Asian countries, there is ample evidence of a return to the old reliance on government to solve a nation’s ills. A few examples follow:

~ Bank restructuring in Japan, as well as South Korea, Malaysia and Indonesia is extending government ownership and control in the financial sector. Japan’s $500 billion rescue package for its banks will result in subscribing banks agreeing to stringent government monitoring and even nationalization.

~ Hong Kong’s Chief Executive Tung Chee Hwa seems to be reversing the island’s colonial legacy of laissez faire, for example with measures to support the property market. This resulted in a subsequent surge in property sales that fueled the October 1998 stock market rally. Hong Kong’s market ploy to buy off hedge funds dumping local currency and stocks was (perhaps only luckily) successful in the near term, lifting the Hang Seng stock index by the end of October 1998 nearly 50% from its pre-intervention lows in mid-summer.

~ Malaysia’s first desperate attempt at currency controls in 1997 failed badly, but their September 1998 policy was more carefully conceived. Besides this device, billion-dollar rescues of banks and well-connected companies (e.g. Renong) are being mooted. Government-run trusts have reportedly been buying stocks heavily. The government has been undeterred by its many detractors.

~ With IMF blessing, the Indonesian government has nationalized nearly all formerly private banks, including the largest, Bank Central Asia. The state food monopoly Bulog is still in business (again with IMF approval) despite the IMF’s initial insistence that food distribution be privatized.

~ The Thai government now runs 6 of the nation’s 15 banks and nearly all of its 60-odd finance companies.

~ In South Korea, state-guaranteed bonds are being used to raise cash for the government’s Korea Asset Management Corporation to buy dud loans. The government injected 41 trillion won ($29 billion) into the financial system in 1998 and plans to spend another 21 trillion in 1999.

Throughout Asia, the need to enforce restructuring --and higher standards of corporate behavior-- is bringing the governments in. As nationalized banks swap bad debts for equity in firms, governments will own more corporate assets as well. Their involvement in most cases will be long-term.

Nevertheless, in the longer term the East-Asian "miracle economies" are not likely to wrest control of their destinies from global markets and financial institutions -- whether or not Malaysia’s daring gambit with capital controls succeeds in the near term. It will be necessary, as Dr Mahathir must learn to his chagrin, to respect the values of the global economy --to be ‘politically correct’. The secret to a renewed Asian "miracle" will be to once again be perceived as an attractive place to put money.

 

The road to recovery

To better understand the potential for recovery, in this section we explore the main markets for debt and equity financing: commercial banks, bond and stockmarkets.

Asian finance boomed in the 1990s, until the Financial Crisis. Three forces propelled financial development in Asia (excluding Japan):⁴⁰

1        The demand for capital was immense for emerging economies in Asia, most notably for infrastructural development. Power blackouts in the Philippines, traffic jams in Bangkok, impassible roads in China, long waiting lists for telephones in India, all attest the poor infrastructure in developing Asia that needs urgent attention. The Asian Development Bank estimated that developing Asian countries would need $1 trillion in new investment in infrastructure for the 1990s --35% for China alone. That forecast was coming to fruition until the crisis hit. Latent demand remains to be satisfied.

2        Capital flowed in as private equity rather than simply government budget allocations, commercial loans and foreign aid. An advantage of private investors is that they often manage their own financing –thus they promoted development of domestic capital markets. But private firms need confidence that domestic markets will provide liquidity and good prices for their flotations. Portfolio flows will have to grow once again. Indeed, this reveals the folly of capital controls once recovery starts.

3        National governments were well aware even before the Crisis of a need to revamp banking services and capital markets. New stock exchanges were being opened and banks deregulated. Expanded financial markets meet the demand for capital by attracting more sustainable flows of domestic savings and foreign investment.

Robust investment in Asia's emerging financial markets was a driving force behind the region's accumulation of large foreign exchange reserves. Combined reserves held by central banks in Asia were reported⁴¹ at $609 billion (the European Union had only $343 billion), with the Bank of Japan having far the largest share at over $200 billion. The Economist⁴² reported the top ten holdings, which included six Asian countries: Japan (1st, with as much reserves as the 2nd and 3rd places combined); Taiwan (2nd); China (4th); Singapore (5th); Hong Kong (6th); Thailand (10th). (Thailand depleted its reserves drastically during the summer of 1997 --see endnote⁴³.)

Reserves are finally being replenished again, due to current account surpluses. In the malfunctioning markets of the Crisis era, governments can have a substantial role to ‘recycle’ the surpluses now being generated in virtually every crisis-hit country. A noble (yet controversial) purpose might be to rejuvenate capital markets: tap liquidity in the economy through bond issues for example (see later), and put money back into national markets as Malaysia is attempting to do.⁴⁴

Debt financing –banks and bond markets

Asian banks had been growing very successfully and making profits through the mid-1990s, largely due to the immense pool of funds made available by high domestic savings rates. Relative dominance by banks facilitated government-directed financing in the early years. Furthermore, governments intervened in support of their domestic banking industry by owning banks or by guaranteeing loans made in compliance with industrial policy. Today, governments from Japan to Indonesia have to nationalize banks in the name of reform. However, local banks, whether state-owned or private, face new competitive pressures from many quarters: foreign competition, other domestic markets, and the growing variety of ways to raise capital.

Concerning the variety of ways to raise capital, disintermediation has been a growing phenomenon in Asia. Instead of employing banks as intermediaries to obtain their loans, borrowers go straight to capital markets to issue their own debt instruments. Now there is a need to securitize bad debts at substantial discounts. To raise money in the current credit crunch, enterprises can repackage into marketable securities anything on their balance sheet that provides a regular income stream.

Similarly, investors are putting their money in other domestic markets instead of only investing in bank accounts. For example, in India mutual funds are gaining on the banks as a receptacle of funds. In this way the raising of capital revolves less and less around traditional bank lending and increasingly around the capital markets --particularly bond securities.

In the fledgling bond markets of Asia, governments may have relatively more room for bond issues due to very low sovereign debt.⁴⁵ Fiscal stimulus requires financing which might be raised in bond markets. A Malaysian banker remarked: "I believe that we will increasingly see restructuring schemes involving the swapping of future cash flows [for current bad debts]. Here the government can have a substantial role to play. In the domestic market, the government can enhance the creditworthiness of any bond issue arising from such swaps." In Singapore, large state-owned firms and statutory boards, which used to rely on borrowing from the postal and savings banks, are now actively encouraged to raise money through bond markets.

Financial liberalization and the restructuring of domestic banks is allowing foreign banks to enter the competition. Thus, the Asian banking community is under pressure; but most banks were doing well until the Crisis. Their success was due to the entrance of new savers and new borrowers still demanding their services. Peasants from the countryside were becoming newly rich, and they tend to save in the traditional way, in local banks. Small and medium-sized enterprises were emerging in great numbers to meet the opportunities in Asia's dynamic economies, and these firms are not sophisticated or reputable enough to float new securities themselves.

Liberalization has allowed local banks to diversify and compete freely in new businesses. The theoretical benefits of liberalization come into play, i.e. the bracing winds of competition force local banks to modernize and compete with the best banks in the global industry and with the capital markets. The big commercial banks in Malaysia and Singapore were developing investment-banking and stock-broking expertise before the Crisis. Thus banks have growing interests in capital markets.

Equity markets

Stockmarket capitalization in Asia (excluding Japan) increased from $195 billion in 1987 to $1000 billion in 1994, just before the Mexico crisis. Asia's share of the global equity market was rising to match its big share of the world economy. The largest markets as of September 1994 were in Hong Kong, Malaysia, Taiwan, South Korea, Thailand, Singapore, India, China, and Indonesia in that order. (In terms of number of companies listed, India is far the biggest --India under British rule established its first stockmarket in the 19th century.) Ironically, the largest two markets are now basing recovery upon interventionist policies --a rejection of economic orthodoxy!

The year 1993 was a watershed --it was the year international investment funds flocked to Asia (besides being a bull-market year). American outflows to foreign stockmarkets increased by four times. But 1997 marked a changing of the tide; and in autumn 1998 capital was withdrawn from emerging markets worldwide.

Investment in capital markets in Asia may continue to recover strongly, as the crisis in confidence subsides. With large privatization flotations, stock markets can continue to expand and mature. The privatization of Singapore Telecoms in 1993 increased market capitalization by 20%. Issues for major infrastructure are planned for the future. Indeed, privatization will be demanded once again by the IMF. Now governments are enlarging their portfolios to salvage impaired national assets, but much of this will eventually be re-privatized. Thus, there will be no shortage of investment opportunities. And as Asia's rumor-driven equity markets broaden and mature, they will lose some of their notorious volatility.

Risk of market volatility should be reduced by portfolio diversification into Asia where market movements have not correlated with New York. But did portfolio diversification actually reduce risk, as it is supposed to? High-flying global markets tended to be risky even before the Asian Financial Crisis of 1997-8. The Taiwan market fell by 80% in the early 1990s. Shenzhen's B share market (for foreign investors) lost 50% in the first half of 1994, and Shanghai's A market (for local investors) crashed 40% in two days in October 1994. The Mexico blow-out at the end of 1994 had much wider international repercussions that certainly burned a few fingers. Indeed, emerging markets are more volatile, for legitimate reasons:

1        Investors are still groping for fair values. Market prices anywhere, after all, have no binding rules of value; and emerging markets have an insufficient track record to legitimize given price levels.

2        Small investors and syndicates are relatively dominant, rather than professional investment houses that should be more rational and more stable in their investment behavior.

3        Regulation is generally weak, and manipulation more possible. In thinly traded markets, major players can control the market to an alarming degree.

In the early 1990s Thailand, Malaysia, India, and China established 'securities and exchange commissions' in the model of the American SEC. Singapore is attempting to develop institutional investor organizations, which helps stability. Now the urgency of reform is top priority, to reinforce supervision and improve transparency in markets.

From our examination of the main sources of financing --commercial banks, bond and stockmarkets-- it is evident that the financial institutions are not standing still and are potential means for mobilizing debt and equity, as capital inflows return. In the long term, East Asia’s markets will once again attract private investment.

 

Conclusion

East Asian governments seek a rebirth for their countries, but in their own image –upon their own social, economic, and political foundations. Asians are in the process of reappraisal of, for example, the relationship between government and business and proper standards of conduct and disclosure. Western-style responses will not always be appropriate. The challenge is to resurrect Asian capitalism, renewing the values and institutions that led to the Asian "miracle" and jettisoning the elements that led to the Asian "crisis".

Today’s dominant political-economic doctrines rule out an interpretation of the crisis, or solutions to it, that impute blame on the effects of the ideology of free global markets. No East Asian country, not even Malaysia, wants to withdraw from the global economy, but their faith in the international financial system and even global capitalism has surely diminished.

At this late stage in the Crisis, we are still left with more questions than answers. The key perhaps is to ask the right question. It may be appropriate to ask: How can the international financial regime accommodate the different, legitimate forms of national capitalism and allow them to coexist globally?

There appears a need for a two-pronged approach: to reform national financial systems but also create smoother transitions in global systems. As if to demonstrate self-confidence that their "Asian capitalism" does not deserve its bad press, Asian governments are now stepping in to solve their own problems in their own ways.  Even so, selective government interventions should be expected to be market-friendly.  This will be essential to make Asian financial markets attractive to investors as the region finally recovers. 

 

(Click Here for an abridged version of this article on MS Word '97,focusing on responses.)

 

endnotes:

¹ James Dean synthesizes recent arguments by himself, Paul Krugman and others that large current account deficits were sustainable as long as capital account surpluses were well invested.  But unrestricted, cheap foreign capital led to excessive monetary growth and asset inflation.  Because banks dominated financial intermediation in the economies worst-hit by the Crisis, banks in effect controlled the countries' money supply.  By this account, the Asian Crisis was precipitated  not by current account deficits but by asset deflation and the first failures of financial intermediaries in Thailand.  (See James W Dean, "East Asia Through a Glass Darkly: Disparate Lenses on the Road to Damascus," for Geoffrey Harcourt, ed, Essays in Honour of Mark Perlman, 1999.)

² Martin Feldstein, "Refocusing the IMF," Foreign Affairs April 1998

³ Jeffrey A Frankel, "The Asian Model, the Miracle, the Crisis and the Fund," paper delivered at The U.S. International Trade Commission, 16 April 1998 (Internet resource)

⁴ Nouriel Roubini, "The Asian Currency Crisis of 1997: An Empirical Analysis" in Part 5 of An Introduction to Open Economy Macroeconomics, Currency Crises and the Asian Crisis, 1998:21 (Internet resource)

⁵ Marcus Noland, "The Financial Crisis in Asia," statement before the House International Relations Committee Subcommittee on Asian and Pacific Affairs, and International Economic Policy and Trade, 3 February 1998 (Internet resource)

    To Noland's list of causes we might add cyclical factors: boom and bust, implying misallocation of resources and over-investment, as well as mismanaged debt (excessive leverage, foreign currency exposure and maturity mismatch).  But much of this is a universal phenomenon, not unique to Asia.  The Asian "miracle" countries watched Japan's bubble economy rise and fall less that a decade earlier and seemed to have learned very little.  When will we ever learn?

    Dean (op cit) suggests the boom-bust of the Asian Crisis was exacerbated by the dual problem of bank dominance and moral hazard.  The close bank- government- industry relationships obviated risk assessment.  Massive foreign inflows swamped this system.

⁶ Instability in the world’s second largest economy may still portend the worst trauma yet. Japan’s economic slump, which had commenced at the beginning of the decade, still persisted into 1999. When in mid-June 1998 Japan officially entered its first recession in 23 years, Asian currencies plummeted along with the Japanese yen to new lows, and share markets fell worldwide.

    Other ominous possibilities also remain:  Much will still depend on events in China, particularly another devaluation of the Chinese yuan.  In autumn 1998 the crisis in emerging economies threatened to become a global meltdown; the potential is still there.

⁷ Noland, op cit

⁸ interview with the Straits Times 8 February 1998

⁹ Peter Drucker, "The Global Economy and the Nation-State," Foreign Affairs, Sept/Oct 1997

¹⁰ Larry Wee, "Why Hedge Funds Cheer as Asian Rates Explode," Business Times 28/10/97:p1

¹¹ International Herald Tribune, "The Shock Troops of the International Economy", 31/3/98, pp 11,15

¹² For example, see Ishihara Shintaro, (author of A Japan That Can Say No), "Behind the Asian Crisis,"Asiaweek, 16 October 1998.

¹³ Jeffrey Sachs, "IMF a Power Unto Itself," Financial Times 11 December 1997 (Internet resource:p1)

¹⁴ Martin Khor, "IMF Policies in Asia Come Under Fire," Asia House Essen 22 January 1998 (Internet)

¹⁵ Sachs, op cit

¹⁶ Feldstein, op cit

¹⁷ This idea was reflected in a G-7 declaration at the beginning of November 1998, calling on the IMF to create a contingency fund for immediate credit without conditions attached to the loan.   The result was the "Contingency Credit Line" introduced at the World Bank and IMF annual meeting at the end of April 1999. 

¹⁸ Henry Kissinger, "The IMF's Remedies are Doing More Harm Than Good," The International Herald-Tribune, 5 October 1998

¹⁹ The Economist, "Towards a New Financial System," 11/4/98, pp 62-4

²⁰ Frankel, op cit, p3

²¹ A commission of inquiry compiled a 205-page report on the misjudgments of the Bank of Thailand in the failed defense of the Thai baht during 1996-7. It castigated former Prime Minister Chavalit and members of his government for spending foreign reserves "as if the reserves had no value". Thailand’s reserves dropped from US$38.7 billion at end-1996 to US$2.8 billion in July 1997, mostly committed through swap contracts which peaked in June 1997 at US$29 billion. "Resorting to swap contracts was just like giving more weapons and petrol bombs to speculators and hedge funds to re-enter and torch our country, because it gave easier access to the baht...," the commission said.

    The Nukul Commission was set up on December 16, 1997 by the Chuan Leekpai government and submitted its report to the cabinet in early May 1998. Quotes are in Business Times, 5/5/98, p7.

²² The Timor car, a joint venture announced early in 1996 in conjunction with Kia Motors of South Korea, was a pet project of the president’s youngest son "Tommy" Hutomo and received tax and tariff benefits. Japan, the USA, and Europe complained to the World Trade Organization about trade discrimination. The US$2 billion development of a passenger aircraft was actively promoted by BJ Habibie, Research and Technology Minister and soon-to-be-nominated vice-president.

²³ This reform was imposed by the IMF, and Bulog was to be dismantled; the reforms were later reversed, again at the insistence of the IMF.  The stabilization scheme never seemed entirely set, as both Jakarta and the IMF backtracked.

²⁴ Harvey Sicherman, "The Asian Panic, Round Two," Foreign Policy Research Institute, 22 May 1998 (email resource)

²⁵ Feldstein, op cit

²⁶ George Soros’ guiding concept is the notion of "reflexivity" --how supply and demand are not independent but are structured through perceptions of market possibilities, which perceptions in turn influence the possibilities. Soros is quoted below:

"I see reflexivity as a two-way connection between what we think and what happens in the world. ...It only happens in society, where we act on the basis of our view of the world and our actions determine the outcome, and so shape what that world actually is. Can you live with such reflexivity?

"...reflexivity is intimately connected with fallibility --that is to say, our view of the world is inherently inadequate, it doesn’t correspond to the world, because we are part of the world in which we live, and being part of it we cannot possibly understand the way it really is...

"All our concepts --both our ideas about the world and our institutions-- are flawed. They are distorted, misconceived, or inadequate in not covering all aspects of the situations; or at least they may be appropriate only at one moment of time.

"This leads to a critical mode of thinking: if you recognize fallibility ...you have to look for the flaw.

"And that works well in the financial markets, because ...it allows you to adjust your position in the markets...

"So where this leads me to is that this open society is a precarious state of affairs, which is threatened from both sides. It’s threatened by the imposition of dogma, fundamentalism, and chaos on the other side.

"As I said, there is a question whether we can live with this knowledge of reflexivity, because when you have that knowledge, and everybody else in the market has that knowledge, markets become inherently unstable...

"I’m afraid that the prevailing view, which is one of extending the market mechanism to all domains, has the potential of destroying society....

"We have this false theory that markets, left to their own devices, tend towards equilibrium. It’s not, fortunately, believed in practice...

"So markets get quite far from equilibrium. ...but the system still survives.

 

²⁷In its self-assessment published in 1999, the IMF asserted that their policies should have restored investor confidence. But for only vaguely understood reasons –including perhaps the increasingly negative perceptions of global market players about Asian political developments and Asian capitalism generally-- capital continued to exit. Market reaction, apart from the policies themselves, was a crucial variable.

²⁸The Economist, "Towards a New Financial System," 11 April 1998, pp 62-4

²⁹John Page, "The East Asian Miracle: Building a Basis for Growth," Finance & Development, March 1994, pp 2,3. (John Page was team leader for the World Bank study of the "East Asian Miracle".)

³⁰The most noteworthy example: Paul Krugman, "Saving Asia: It’s Time to get Radical," Fortune Vol 138 No 5, 7 September 1998, pp 32-38.

³¹See for example: Jagdish Bhagwati, "The Capital Myth," Foreign Affairs May-June 1998.

³²A regression analysis by Dani Rodrik (1998) found no evidence that capital mobility helped growth. Rodrik, Dani (1998), "Where Did All the Growth Go? External Shocks, Social Conflicts, and Growth Collapses," NBER Working Paper #6350, Cambridge, Mass.: National Bureau of Economic Research

³³George Soros was interviewed in The New Statesman in May 1997, extracts republished in The Business Times, 1 November 1997, p3.

³⁴Ayres, Robert U (1998), Turning Point: The End to the Growth Paradigm, London: Earthscan Publications

³⁵The East Asian Miracle: Economic Growth and Public Policy, World Bank Policy Research Report, New York: Oxford University Press, 1993

³⁶The flying-geese model has been used to depict the shift of industries from more advanced countries to less-developed ones (and the dynamic change in capital and trade flows), motivated by technological progress and the search for lower production costs. It was particularly applicable to describe economic development in Asia spurred by Japanese investment. (See Akamatsu, K, 1962, "A Historical Pattern of Economic Growth in Developing Countries," Developing Economies (March-September): 3-25; also Kwan Chi Hung, 1996, "A New Wave of Foreign Driect Investment in Asia," in Dilip K Das (ed), Emerging Growth Pole: The Asia-Pacific Economy, Singapore: Prentice Hall)

³⁷William Koh, panelist at a seminar organized by Faculty of Business, National University of Singapore: The Road to Asia’s Recovery: New Markets and Opportunities, 29 October 1998

³⁸Other options include currency boards or currency unions, which both seem unlikely for most Asian countries, according to "A Survey of Global Finance: Time for a Redesign?", The Economist, 30 January 1999 p17.

³⁹"IMF-Supported Programs in Indonesia, Thailand and Korea: A Preliminary Assessment," January 19^th 1999

⁴⁰Discussion draws on "A Survey of Asian Finance", The Economist, 12 November 1994, 14 pp.

⁴¹"Asian Banking and Finance", International Herald Tribune (Sponsored Section), 30 April 1996: I

⁴²"What's Under Asia's Mattress?" The Economist, 18 November 1995, 97-98.

⁴³    The Bank of Thailand ranked 10th in foreign-exchange reserve holdings in November 1995 with over US$30 billion, increasing to US$40 billion just prior to the speculator-driven crisis in the Thai baht during the summer of 1997. However, news accounts at the height of the crisis reported that central bank reserves has been used up defending the baht in both the spot and forward markets, down to only US$4 billion left.

⁴⁴PK Basu, panelist at The Road to Asia’s Recovery: New Markets and Opportunities, op cit

⁴⁵Phuah Eng Chye, panelist at The Road to Asia’s Recovery: New Markets and Opportunities, op cit.