15 March 98 DRAFT "asiafin" Comments welcome: 212-750-6084, [email protected].
Citation: Forthcoming, World Development, August 1998.THE ASIAN DEBT-AND-DEVELOPMENT CRISIS OF 1997-? : CAUSES AND CONSEQUENCES
Robert Wade
How on earth did the Asians get caught in the debt trap? In the 1980s much of the rest of the world was caught�not only Latin America and some African states, but also European social democratic regimes that faced great pressure to reduce budget deficits and cut back social welfare programs. Asia, however, sailed free, except for Korea. But Korea had very fast growth of exports from which to service its debt.
The devaluation of the Thai baht in July 1997 precipitated a wave of currency crises or financial instability from Thailand, to the rest of Southeast Asia, to Taiwan, to Hong Kong, to Korea, to the Philippines, to Russia, to Brazil, to Estonia, to Australia and New Zealand. Commodity producers around the world have suffered. The IMF has mounted refinancing efforts on a scale that makes the Mexican bail-out of 1994-5, the biggest in the IMF�s history to that date, look small, yet the run has continued, the panic feeding upon itself. As of February 1998 the Thai baht and the Korean won have lost almost half their value against the US dollar since July 1997, and the Indonesian rupiah has fallen by three quarters.
The debt crisis has become a full-fledged development crisis. Output and living standards plummet as unemployment rises and the effects of huge devaluations work through into higher import prices. Many millions of poor people are at risk, and many millions who were confident of middle class status feel robbed of their lifetime savings and security. It is not a humanitarian tragedy on the scale of North Korea, but the loss of security and productivity is a tragedy nonetheless, almost as cruel as war. South Korea, Thailand and Indonesia could be sliding into depressions comparable to those that gripped Europe and North America in the 1930s. If popular anger comes to be focused on the overseas Chinese business elites, we may yet see repeats of the Indonesian anti-Chinese pogroms of 1965.
Interpretations of the crisis in the West have coalesced around two rival themes. One is the "death throes of Asian state capitalism". The other is "investor pullout/debt deflation in a sound but under-regulated system".
THE DEATH THROES OF ASIAN STATE CAPITALISM
The crisis, according to the death throes view, reflects excessive government intervention in markets, especially financial markets; and it marks the beginning of the end of the outmoded state-directed Asian system, opening the way for a properly modern (read Anglo-American) free market system. The chairman of the US Federal Reserve, Alan Greenspan, is the most prominent, if not most eloquent, exponent of this idea. Talking to the New York Economics Club in early December 1997, he said,
"The current crisis is likely to accelerate the dismantling in many Asian countries of the remnants of a system with large elements of government-directed investment, in which finance played a key role in carrying out the state�s objectives. Such a system inevitably has led to the investment excesses and errors to which all similar endeavors seem prone�
"Government-directed production, financed with directed bank loans, cannot readily adjust to the continuously changing patterns of market demand for domestically consumed goods or exports. Gluts and shortages are inevitable�"
Greenspan warmed to the triumphant America theme in his testimony to the Senate Foreign Relations committee in mid February 1998. One of the most fundamental effects of the Asian crisis, he said, was a worldwide move towards "the Western form of free market capitalism", instead of the competing Asian approach that only a few years ago looked like an attractive model for nations around the world. "What we have here is a very dramatic event towards a consensus of the type of market system which we have in this country".
Steve Hanke, advocate of laissez faire and currency boards, said much the same thing in an interview with Forbes magazine at the end of December 1997.
"FORBES: Some say it [the financial crisis] is an example of free enterprise gone berserk; that we need more regulation.
HANKE: No. These economies were government directed. More regulation by government isn�t a proper solution. Government is the problem�"
A correspondent for the International Herald Tribune put it this way in late January 1998: "As Asia�s economic crisis has intensified, it has been widely noted that most of the urgent short-term remedies prescribed by the international financial community are labeled "Made in America". Only now is another point beginning to sink in: The upheaval is likely to bolster America�s global influence over the longer term, too. The sudden collapse of Asia�s house of cards is beginning to be seen as the end of an outdated economic and political system�based largely on the mercantilist, government-run Japanese model�much as the fall of the Berlin Wall symbolized the demise of communism".
George Soros, the international financier, advised the Korean government what to do on Korean television. "You must invite foreign companies to come in and be direct investors and owners of Korean companies", he said. "And companies that can�t meet their obligations must be allowed to go bankrupt." Korea must establish a proper market system.
Stanley Fischer, deputy managing director of the IMF, described the Asian problems as mostly "homegrown". He listed as causes such things as: failure to dampen overheating, maintenance of pegged exchange rates for too long, lax financial regulation, and insufficient political commitment. The whole IMF strategy assumes that the crisis reflects basic institutional deficiencies of Asian markets.
The tone of voice ranges from gloating, to sanctimonious, to schoolmasterly. It is not hard to imagine the offense of Japanese, Korean, and other Asian policy-makers at the triumphalism of westerners who picture the Asian political economy as a system whose movement towards America-without-the-ghettoes the current crisis has simply accelerated.
Offense aside, how does this interpretation square with the facts? In contrast to Latin America in the 1980s, East and Southeast Asia�s debt is mostly private; the debt has been incurred by private borrowers and private lenders, with little government direction. Prior to 1997 the macroeconomic "fundamentals" looked fine--and difficult to reconcile with Greenspan�s picture of the gluts and shortages inevitably caused by large elements of government-directed investment.
Growth was fast. East and Southeast Asia accounted for a quarter of world output but half of world growth over the 1990s and almost two thirds of world capital spending. Savings rates were very high. Fiscal accounts were balanced. Inflation was low. Educational levels were deepening. Firms throughout the region make products that sell in the most demanding markets�if the exchange rate is right. Korea, by mid-1997 the world�s 11th biggest economy, was growing at 8 percent a year over the 1990s, with low inflation and low unemployment. Indonesia was also growing fast, with a balanced budget and inflation at less than 10 percent. Its current account deficit was less than 4 percent of GDP through the 1990s. Thailand, at 8.6 percent, was about the fastest growing economy in the world over 1985-1994, and had one of the highest savings rates in the world (36 percent of GDP in 1995). It had run sizable current account deficits over the 1990s, but most of the corresponding capital inflow went for investment at a rate even higher than the high rate of domestic savings. A good part of it was direct investment by Japanese manufacturing firms.
There were, however, serious internal obstacles to the continued fast growth and upgrading of the Southeast Asian economies. The economies have continued to engage in the world industrial economy largely as subcontractors, largely for Japanese firms. They have experienced relatively little technology spillover from the export-oriented subcontractors to the rest of the economy, so much so that their industrialization has been characterized as "technology-less", in the sense that even adaptive technology continues to come from abroad. Shortages of skilled people have grown "from a crisis to a critical emergency", according to a Thai analyst. Thailand�s gross enrollment ratio at secondary school level languished at only 37 percent in 1992, less than half of Taiwan�s in 1978 when Taiwan had the same per capita income as Thailand in 1992. In Malaysia, too, the skills shortage has become so acute that some prominent foreign companies long operating in the country have moved production elsewhere, mainly to China and Indonesia. Throughout the region infrastructure is chronically congested, attested to by electricity blackouts, traffic paralysis and rising cost of water. In short, serious problems in the "real" economy have been building up, even if they are problems of success. But the calamity unleashed on the region is hugely disproportional to the severity of the problems in the real economy.
There were few signs of impending crisis, such as rising interest rates in the G-7 countries or a sudden suspension of capital flows to developing countries after the baht devaluation. The Japanese government�s de facto credit rating agency, the Japan Center for International Finance, gave Korea one of its highest credit ratings for any developing country in June 1997; and the World Economic Forum rated Korea the fifth best investment site in the world. The IMF and the World Bank lavished praise upon the governments of the region through 1997. Only three months before Korea�s December 1997 crisis the IMF annual report said, "Directors welcomed Korea�s continued impressive macroeconomic performance (and) praised the authorities for their enviable fiscal record". The report called for financial sector reform in general terms, but gave no hint of alarm, and made no mention of breaking up the chaebol or allowing foreign ownership of banks or strengthening banking supervision�issues that are now central to the IMF�s program for Korea. The same report praised "Thailand�s remarkable economic performance and the authorities� consistent record of sound macroeconomic policies"�shortly before the collapse of the Thai currency.
For all its popularity, the death throes interpretation falls down if not at the first nudge then at the second.
INVESTOR PULLOUT/DEBT DEFLATION IN A SOUND BUT UNDERREGULATED SYSTEM
According to Jeffrey Sachs, director of the Harvard Institute for International Development and a prominent exponent of the second view, "There is no �fundamental� reason for Asia�s financial calamity except financial panic itself. Asia�s need for significant financial sector reform is real, but not a sufficient cause for the panic, and not a justification for harsh macroeconomic policy adjustments. Asia�s fundamentals are adequate to forestall an economic contraction: budgets are in balance or surplus, inflation is low, private saving rates are high, economies are poised for export growth.
"Asia is reeling not from a crisis of fundamentals but a self-fulfilling withdrawal of short-term loans, one that is fueled by each investor�s recognition that all other investors are withdrawing their claims. Since short-term debts exceed foreign exchange reserves, it is �rational� for each investor to join in the panic". "Instead of dousing the fire the IMF in effect screamed fire in the theater".
Joseph Stiglitz, now chief economist at the World Bank and winner of the American Economics Association�s John Bates Clark medal for outstanding work by an under 40 year old economist, spells out the argument. The contrast with the views of Greenspan, Hanke and others of the first camp could scarcely be sharper. "For the past 25 years East Asian economies [to include what we describe as Southeast Asian] have grown more than twice as fast as the average rate for the rest of the world�.These successes have been fostered by sound fiscal policies, low inflation, export-driven growth, and effective institutions, which in turn helped make East Asia the world�s leading recipient of foreign investment. Moreover, the region�s high savings rate, more than one third of gross domestic product, is six times foreign investment. These savings have made possible a high and increasing level of investment�
"Recent developments, however, underscore the challenges presented by a world of mobile capital�even for countries with strong economic fundamentals. The rapid growth and large influx of foreign investment created economic strain. In addition heavy foreign investment combined with weak financial regulation to allow lenders in many southeast Asian countries to rapidly expand credit, often to risky borrowers, making the financial system more vulnerable.
"Inadequate oversight, not over-regulation, caused these problems. Consequently, our emphasis should not be on deregulation, but on finding the right regulatory regime to reestablish stability and confidence."
Stiglitz� statement is remarkable in that it comes from the chief economist of the World Bank. It is implicitly a critique of the IMF�s approach.
More indirectly still, the Japanese government has also voiced opposition to IMF and American prescriptions for the Japanese economy. Eisuke Sakakibara, Japan�s vice minister for international finance, popularly known as "Mr Yen", said on Japanese national television in late December:
"We should make clear to the public that we will not allow banks to fail. [ He cited the Hokkaido Takushoku Bank as one the government should not have allowed to fail, as it did in early December.] We should not let securities companies of considerable size fail either. The United States and the United Kingdom have not done it either. This is the global standard." He went on to say that it is up to politicians not to let banks fail, and up to banks not to let big companies fail.
Sakakibara�s statement can be read as an act of defiance of the broad IMF approach to the Asian crisis, that calls for some banks and companies to be let go bankrupt as part of a comprehensive market liberalization.
The crisis, as this roundup of views shows, has rekindled fundamental debates about the role of governments and markets, both national and international. And it has exposed a basic incompatibility in the interaction between Asian and western financial systems. The difference in policy "ethos" between Asia and the West are caught in a minor news item from early January 1998. The Japanese government announced plans to rein in stock speculators and punish market manipulation more vigorously, intended to help halt the fall in the stock market. Western analysts called the measures "Mickey Mouse", as "misguided at best and damaging at worst". The Japanese government thinks of how to get more effective regulation, many western analysts consider this the opposite of what is needed.
HISTORY OF THE CRISIS
The following history provides an interpretation consistent with the second theory. It shows the build up of stocks of mobile capital in East and Southeast Asia, and then the outflow after July 1997. The outflow grew into a panic-stricken and region-wide run on a scale that launched a debt deflation, that has in turn torn at the fabric of whole societies.
The Capital Push Into Asia
The starting point is the Plaza Accord of 1985, that caused a rise in the value of the yen against the US dollar. Japanese companies sought a new cheaper manufacturing base in a US dollar zone. Southeast Asia was the obvious choice�close to Japan, currencies pegged to the US dollar, cheap and well educated workers. Very cheap credit in Japan, and strong Japanese government encouragement helped to stimulate a Japanese-led investment and export boom in Southeast Asia. Rising exports supported more borrowing, more equity issues and more foreign direct investment.
Meanwhile, Japan experienced stock market and real estate bubbles in the late 1980s (aggravated, western commentators should note, by US pressure on Japan to stimulate its domestic demand and act as a locomotive for the world economy, thereby mitigating the US�s hemorrhaging current account deficit). When the bubbles burst in 1990 they left a legacy of bad debts in the banking system, which has been at the root of Japan�s very slow growth. Japanese firms and banks have been carrying very high levels of debt, while Japanese households have been saving a high proportion of household income. (Japan�s gross domestic savings amounted to 31 percent of GDP in 1995.) With consumption depressed, Japan has been running a large current account surplus�the other side of which is capital export. Capital exports redoubled Japanese loans and foreign direct investment (FDI) in Asia. Of Japanese bank lending to developing countries, 84 percent has gone to Asia, making the Japanese economy heavily exposed there.
Moreover, the central bank of Japan has pursued an expansionary monetary policy, pushing money into the economy in an attempt to revive the spirits of consumers. But consumers have been slow to react. The central banks of the continental European countries have also pursued monetary expansion and for the same reason of very low growth in the 1990s; there too consumers have been slow to react. The result has been excess liquidity in the world system at large. The excess liquidity has spilled over into financial asset markets world-wide, driving up prices. Much of the money ended up in the hands of financial institutions in the US, Japan and Europe. They invested in the US stock market, creating the long rise in US equity prices, and they also scoured the world looking for higher returns. They invested heavily in Asia.
In a situation of excess liquidity worldwide and with very low inflation at home, lenders in the core countries have been prepared to lend to East and Southeast Asia at nominal rates even lower than the cost of domestic borrowing, and borrowers in East and Southeast Asia have been prepared to borrow abroad to take advantage of the lower nominal rates. ( With domestic inflation commonly of the order of 6 percent a year, nominal domestic interest rates have been of the order of 10 percent, compared to 5 percent or less for foreign borrowing.)
Much of this inflow took the form of what is known as the carry trade. Banks, investment houses and insurers borrow in yen and dollars and invest in short-term notes in Southeast Asia that were paying far higher rates. These are the carry trades. Both domestically-based and foreign-based companies and banks participated.
Capital flows to developing countries overall grew from $46 billion in 1990 to $236 billion in 1996. Flows to South Korea, Indonesia, Malaysia, Thailand and the Philippines rose from $47 billion in 1994 to $93 billion in 1996. Of this, the flow of private commercial bank lending jumped from $24 billion in 1994 to $56 billion in 1996. The flow of borrowed money had a self-reinforcing effect on confidence, investment and economic growth. There was less and less compulsion on the part of lenders, borrowers or governments to improve financial supervision or control bank asset quality.
The foreign borrowing and lending to East and Southeast Asia was premised on the assumption that the exchange rate would hold. If the value of domestic currency fell the advantages might be wiped out as repayments increased in domestic currency and foreign lenders faced higher risks of non-repayment. Similarly if interest rates for yen or dollars should rise.
Capital liberalization
The Asian countries (excluding Japan and, partially, Korea) operated fixed-exchange-rate regimes, their currencies pegged to the US dollar. It has been a reasonable assumption in most of East and Southeast Asia that the peg would hold. Their domestic inflation was somewhat higher than that in Japan and the US, but their productivity growth was also higher.
At the same time, these countries have undergone radical financial deregulation over the 1990s, including near-removal of restrictions on the inflow and outflow of mobile capital. The deregulation happened with little attention to the new kinds of regulation that would be required and with only a thin base of financial skills (much thinner than in manufacturing). Banks and finance companies still operate in much of East and Southeast Asia as family businesses, with management structures unable to cope with the complexity of present-day finance. The deregulated financial systems enabled inexperienced private domestic banks and firms to take out large, dollar-denominated loans from foreign lenders and on-lend with generous spreads. High profits for those with access to much cheaper foreign credit was the chief reason firms and banks, both national and international, pressured governments to undertake financial deregulation, their pressure converging with that of the IMF and the World Bank.
Thailand, where the crisis first hit, fueled its fast expansion over the 1990s with heavy foreign private borrowing, over half from Japan. The Bank of Thailand undertook radical capital liberalization and financial deregulation just as it was overwhelmed with other complex issues and political strife.
In Korea the government of President Kim Young Sam that came to power in 1993 proclaimed financial deregulation as an important policy objective, partly in order to facilitate its acceptance into the OECD. It marginalized and then abolished the pilot-agency Economic Planning Board, and abandoned its traditional role of coordinating investments in large-scale industries. This made it easier for market failure to manifest itself in excess capacity in automobiles, shipbuilding, petrochemicals, and semiconductors. Also in the name of financial liberalization, the government relaxed its monitoring of foreign borrowing activities. Korea�s external debt ballooned from very little in 1990 to around $150 billion in 1996. On top of all this, the government bought the monetarist view that inflation control should be the overriding priority of macroeconomic policy and that the exchange rate should be an "anchor" for inflation control. This caused a significant overvaluation of the currency, hurting exports.
High Savings and High Debt
Meanwhile, well before the huge inflow of foreign funds and continuing through it, Asian households saved. Gross domestic savings are typically one third of GDP or more, about the highest in the world, giving East and Southeast Asia the world�s biggest pool of savings. (Korea�s gross domestic savings amounted to 36 percent of GDP in 1995, as did Thailand�s; China�s equaled 42 percent. In contrast, US gross domestic savings amounted to 15 percent in 1995, down from 19 percent in 1980; the UK figures are the same.) We normally think of high-income countries as capital-abundant and low-income countries as capital-short (an assumption at the heart of the post-Second World War international aid regime and the sub-discipline of development economics). But East and Southeast Asia is a lower-income region where capital is in a sense more "abundant" than in higher-income regions of North America and Europe.
A large part of the savings come from households, and thanks to a relatively equal income distribution a high proportion of households are net savers. (Compare the US, where only the top 10 percent or so of households are net savers. The US household sector overall is a big net borrower.) Asian households� risk preferences are such that the savings are for the most part deposited in banks rather than invested in equities. Banks must therefore intermediate a huge inflow of savings, and these countries tend to have a high level of bank deposits to GDP ( a "deep" banking system).
Some of the savings are invested abroad, but most are invested at home. Government is not a major borrower ( in contrast to most of the G-7 countries). Since households and government are non-borrowers, the borrowers must be firms and other investors. Hence the system is biased towards high ratios of debt to equity in the corporate sector, the other end of their high savings.
Firms with high levels of debt to equity are vulnerable to shocks that disturb cash flow or the supply of (bank or portfolio) capital�for debt requires a fixed level of repayment while equity requires a share of profits. The higher the debt-to-equity ratio the more likely that any depressive shock will cause illiquidity, default and bankruptcy. Therefore banks and firms must cooperate to buffer systemic shocks, and government must support their cooperation. The need for government support gives the government a powerful instrument for influencing the behavior of both firms and banks. This is an economic rationale for the pattern of "alliance capitalism", derogatorily called "crony capitalism", that is often said to characterize East and Southeast Asia and that is usually understood in political terms, such as corruption and the survival strategies of rulers.
Countries of the region vary in how the government uses its influence over banks and firms. At one end are the developmental states of Japan (1935-1980), South Korea and Taiwan, where the state coordinated, directed, and collaborated with firms entering major world industries. In some of the new industries the state assisted firms with cheap credit, tax breaks and other forms of subsidy, helping them to amass resources on the scale needed to undertake rapid upgrading and disciplining the allocation of help with criteria related to international competitiveness, such as export performance. In some dying industries the state helped firms to exit or move offshore. At the other end of the scale are states such as Thailand and Indonesia, which have made no more than sporadic efforts at public sector directional thrust or public-private collaboration in sectoral development. Much of the directional thrust of their industrialization came from the strategies of Japanese firms operating in close collaboration with the Japanese government. In the middle is Malaysia. It has, in Business Week�s words, "copied Japan�s aggressive partnership between government and the private sector. In the Malaysian version of Japan Inc., government officials meet formally with representatives of industry and commerce to decide how much funding will go to each sector before the national budget is drafted....Not surprisingly, Japanese companies, such as Matsushita Electric and Mitsubishi Motors, have robust operations in Malaysia, which imports more from Japan than from anywhere else".
For all the variation in the role of the state, relatively deep debt structures, with their vulnerability to external shocks, are common to the region.
Pre-conditions for the Crisis
These, then, are the pre-conditions of the Asian crisis: (1) Very high rates of domestic savings, intermediated from households to firms via banks, creating a deep structure of domestic debt. (2) Fixed-exchange-rate regimes, with currencies pegged to the US dollar (apart from Japan, and partially, Korea), that created the perception of little risk in moving funds from one market to another. (3) Liberalization of capital markets in the early to mid 1990s and deregulation of domestic financial systems at about the same time, without a compensating system of regulatory control. (4) Vast international inflows of financial assets, coming from excess liquidity in Japan and Europe being channeled through financial institutions scouring Asia for higher returns and lending at even lower nominal rates than domestic borrowers could borrow from domestic sources, creating a deep structure of foreign debt.
Towards the tipping point
The movement towards crisis began with inflationary pressure. The inflow of financial capital and foreign direct investment to Southeast Asia in the 1990s, combined with the fixed exchange rate regime, forced an increase in domestic money supply (because under the rules of the fixed rate system the central bank has to buy the foreign currency and issue domestic money in exchange). This fueled inflation at around 6 percent in the past few years, when inflation in Japan and the US had become much less.
Then came major shifts in exchange rates. First, the US dollar has appreciated against the yen by 50 percent in the past two years as the Japanese economy languished in recession. Second, China devalued the yuan in 1990 and again in 1994, while keeping inflation low and productivity growth high. The combination of yuan devaluation, low inflation and high productivity growth made the yuan the most undervalued currency of any major trading nation. For the fixed-exchange-rate countries of East and Southeast Asia, the Japanese and Chinese devaluations against the US dollar were a double blow, squeezing them from above and from below.
The appreciation of currencies tied to the US dollar, coupled with domestic inflation at rates higher than those of trading partners, made for a squeeze on exports and a cheapening of imports. Thailand had the biggest problem: its current account deficit exceeded 4 percent of GDP every year since 1990. By 1996 all four Southeast Asian economies ran current account deficits of between 4 and 8 percent of GDP, Thailand�s being the biggest of all.
Responding to high savings, domestic inflation higher than trading partners�, and reduced prospects for export-oriented manufacturing, investors in Southeast Asia invested in real estate. Property speculation flourished, and went on flourishing as foreign currency continued to pour in and the domestic money supply continued to expand. As people expected inflation to continue, property investment continued to look the best hedge. For several years in the first half of the 1990s, property prices in Bangkok rose at more than 40 percent a year. Notice that excessive real estate investment was undertaken by private agents, and not with government encouragement.
Thailand over the brink
Thailand�s private-sector-generated property bubble burst in 1995, and the stock market crashed in mid 1996. The property market, like the stock market, is a market where small withdrawals can have a big effect on prices and leave the banking system in the sort of danger that makes depositors withdraw their money. When the property market crash came, it ripped through the whole financial sector and on into the foreign exchange market as foreign investors saw that domestic borrowers were less able to meet the now much more expensive debt service charges on their short term foreign loans. Economic growth and export growth slowed sharply. With the prospect of a baht devaluation in sight (a breaking of the peg), companies in Thailand, both foreign and domestic, tried to sell their baht for dollars. There were runs on the baht in mid 1996 and again in early 1997. The Thai central bank tried to buy up baht to prevent the price fall, but eventually gave up as reserves fell to dangerously low levels.
Then in early May 1997, Japanese officials, concerned about the decline of the yen, hinted that they might raise interest rates. The threat never materialized. But the combination of the threat of a rise in Japanese interest rates in order to defend the yen, plus the worries that were circulating about Thailand�s currency, raised fears among commercial bankers, investment bankers, and others about the safety of big investment positions throughout the region that were predicated on currency stability.
The investors scurried to sell holdings in local currencies, and especially in Thai baht. In early July 1997 the Thai baht was floated and sank. The IMF stepped in in August 1997 with a support package and "conditionality" measures that included the freezing of many finance companies. This was the start of what Sachs calls the IMF�s screaming fire in the theater. The freezing of finance companies sent uninsured depositors into a panic.
The contagion
One of the mysteries of the Asian financial crisis is how the widely acknowledged real estate problems of Thailand�s banks could have triggered such far-reaching financial contagion. The fact that there were few signs of impending crisis is, it has to be said, par for the normal course of financial crashes. Historically, financial crashes have occurred in the industrial economies not when the economy was in trouble by the usual measures, but when everything seems to be going well�when economic growth is strong, inflation low, and optimism high (to paraphrase Alan Greenspan�s description of the current US economy).
Refocusing of risk
During the boom years of the 1990s international investors and the international rating agencies (Moodys, Standard and Poors) focused on macroeconomic factors like budget deficits, debt/GDP ratios, and export growth. After the shock of the Thai devaluation, investors suddenly began to reevaluate risk and focused on different risk factors. They paid much more attention than before to microeconomic risks such as the volume of dollar debt maturing in the next twelve months, the debt/equity ratios of the corporate sector, and the currency denomination of external liabilities. Not only that. They had lent to highly indebted Asian firms even though western prudential guidelines should have prohibited such lending, and they now applied their traditional prudential criteria. The Japanese banks, struggling with bad debts at home, especially tried to call in their loans. The credit problems of Japanese banks weigh on the Asian financial crisis like the post-World War One reparations weighed on central Europe.
From this new perspective, all the Southeast Asian currencies suddenly looked vulnerable, since all the economies had a significant overhang of short-term dollar debt whose repayment looked problematic if exchange rates were to collapse. Investors and domestic companies began to sell local currencies in order to hedge their dollar liabilities. In response to the selling pressure first Thailand and then Malaysia let their currencies float.
Indonesia and Thailand
Then Indonesia startled investors by letting its currency float too, despite the fact that it already had a much wider target band than the others. The Indonesian decision confirmed investors and local companies in thinking that a competitive devaluation in Southeast Asia was underway, the rational response to which was to sell as much local currency as possible�thereby fulfilling the prophecy. Money managers in the rest of the world began to think of "Southeast Asia" as a homogeneously dangerous place.
The announcement of the IMF package for Thailand in August 1997 briefly boosted confidence and slowed the contagion, because it seemed to indicate a concerted international effort. But then it became apparent that the US had contributed virtually nothing to the bail-out fund because of congressional restrictions on such help imposed after the Mexican crisis of 1994, and that Japan had contributed only $4 billion despite its heavy exposure in Thailand and despite its statements in the preceding months that it would play a big role in promoting financial stability in the region. Suddenly the IMF�s Thailand package seemed to show the limits of international action rather than its promise. Also, the conditions of the IMF funds required Thailand to undertake structural and institutional reforms that were not closely related to restoring Thailand�s ability to repay its debt, which signaled to international investors that the whole economy was in a much deeper mess than they had assumed.
Taiwan, Hong Kong and Korea
Then came Taiwan�s devaluation in mid-October. Though small in size (about 12 percent), it came as a shock because Taiwan is famous for its towering foreign exchange reserves. That Taiwan could devalue led the owners of mobile capital to fear that Hong Kong might do the same, and Korea too.
Taiwan acted as a fire bridge from Southeast to East Asia. After Taiwan the conceptual category of "Asian financial crisis" came into being. Capitalists began to sell the Hong Kong dollar and the Korean won. Both cases are surprising. Hong Kong is an autonomous region of a country, China, running a huge current account surplus, an economy going from strength to strength. But on October 23 the Hong Kong stock market fell by more than 10 percent, though the peg to the US dollar held. The Korean economy was performing well, with 8 percent growth, low inflation, low unemployment, with a (published) debt to GDP ratio of only 30 percent, one of the lowest of the developing countries, and a small and shrinking current account deficit.
Indonesia
Meanwhile, Indonesia and the IMF announced an IMF program of emergency finance, and the governments of Singapore and Japan also intervened on behalf of the rupiah. The US was able to make more of a contribution to the IMF�s Indonesia program for Indonesia because by this time the congressional restriction on the post-Mexico use of US funds for such purposes had lapsed and Congress had begun to take on board the threat to US interests posed by the Asian crisis. All this boosted investor confidence--temporarily. But then came reports of a sharp deterioration in the health of Indonesia�s long-time ruler, President Suharto. Indonesia�s wealthy Chinese elite, that controls much of the business sector, has long benefited from close ties to the Suharto family. Reports of his decline induced them to sell more rupiah and store assets offshore. The rupiah continued to plunge.
Korea
By this time, around October and November 1997, the whole region was awash with panic. Investors began to pay attention to the term structure of Korea�s foreign debt. They estimated short-term debt at $110 billion, more than three times Korea�s official foreign exchange reserves. Rumors circulated that President Kim (like President Salinas of Mexico before him), not wanting to finish his term embroiled in crisis, might be inflating the true level of the exchange reserves and concealing some of the debt. Investors scrambled for the exit, accelerating the fall of the won.
Korean banks had borrowed low-cost foreign funds and then invested heavily in "junk" bonds, with high yields and high risks, in an essentially speculative way, always on the assumption that the exchange rate would hold. They held large amounts of Russian bonds and Latin American "Brady" bonds. As the won fell, the banks began to sell foreign securities in order to boost liquidity. Their sell-off helped to spread the financial contagion, as the holders of equivalent junk bonds saw their value collapse with the Korean sell-off.
Since Japanese banks, known to be financially fragile, had lent heavily to Korean companies, and since Korean companies competed against Japanese companies in some important industries, investors saw the Japanese yen as vulnerable to a won depreciation. And since Korea competes with Taiwan, Hong Kong, and southern China in many industries, investors also saw risks of a further round of competitive, crisis-driven devaluations of the Hong Kong and Taiwan dollars.
The scale of the crisis is caught in the figures on capital movements. A net inflow of private capital of $93 billion in 1996 (to Southeast Asia plus Korea) became a net outflow of an estimated $12 billion in 1997, a swing in the net supply of private capital of $105 in just one year. This is 10 percent of the pre-crisis GDP of the five economies, a staggering change, and two percentage points higher than the corresponding figure for Latin America in the 1980s.
The IMF�s Korea Strategy
The IMF in December 1997 organized $57 billion from official sources to lend to Korea so that its private companies could repay US, Japanese and European banks as the short-term debt came due. If the Fund�s earlier interventions in Thailand and Indonesia amounted to screaming fire in the theater, then its intervention in Korea amounted to screaming even louder. In Thailand and Indonesia the Fund�s insistence on far-reaching institutional reforms in return for loans signaled that it thought these economies structurally unsound. In Korea the Fund demanded nothing less than an overhaul of the Korean economy, beginning with the financial system and continuing into corporate governance, labor markets, and the trade regime; as well as a contractionary macroeconomic policy of higher taxes, cuts in government spending, and much higher real interest rates. The Fund, talking tough, said it would provide the credit only as Korea altered these central features of its economy. The signal of fundamental unsoundness was even louder than earlier for Thailand and Indonesia.
The Fund�s financial restructuring plans aim to make Korea�s financial system operate like a western one, without actually saying so. Trouble financial institutions are to be closed down or recapitalized; foreign financial institutions are to be able freely to buy up domestic ones; banks are to follow western ("Basle") prudential standards; "international" (read "western") accounting standards are to be followed and international accounting firms to be used for the auditing of the bigger financial institutions. The government is required not to intervene in the lending decisions of commercial banks, and to eliminate all government-directed lending; also to give up measures to assist individual corporations avoid bankruptcy, including subsidized credit and tax privileges.
The Fund also requires wider opening of Korea�s capital account, to enable even freer inflow and outflow of capital, both portfolio capital and direct investment. All restrictions on foreign borrowings by corporations are to be eliminated. The trade regime, too, will be further liberalized, to remove trade-related subsidies and restrictive import licensing. Labor market institutions and legislation will be reformed "to facilitate redeployment of labor".
These requirements go far beyond what is necessary to restore Korea�s access to capital markets. Korea�s foreign exchange reserves continued to worsen after the stand-by agreement with the Fund was announced, partly because the agreement lacked credibility.
The Downward Spiral
We now see a huge contractionary wave propagating itself through the region. International banks have slashed credit lines to all borrowers, including the export-oriented firms that should be benefiting from currency depreciation. Even the big Korean chaebol, with world-wide brand names, are finding it difficult to get even trade credit (letters of credit to cover the import of inputs into export production). This did not happen to the same extent in the Latin American crisis of the 1980s. Latin American companies did not suffer from the same withdrawal of credit, though Latin American countries were far less creditworthy than Asian ones, because companies had debt/equity ratios within western prudential lending limits.
The much higher real interest rates and cuts in domestic demand required by the Fund are tipping many profitable but high debt/equity firms into bankruptcy. Meeting western standards for the adequacy of banks� capital entails a rapid fall in banks� debt/equity ratios and a sharp cut in their lending, causing more company bankruptcies. The resulting financial instability and unrest may cause net capital outflow instead of the inflow that the Fund expects. On the other hand, whole swathes of the corporate sectors of the region are on sale at fire-sale prices, and only outsiders have the capital to buy them up or to recapitalize existing banks. We may be in the early stages of a massive transfer from domestic to foreign ownership. This is not just a transfer of control and profits; it will affect the basic dynamic of the economy. Foreign banks may not lend to high debt/equity local companies, and may not participate in the kind of alliances between government, the banks, and companies that a high debt/equity financial structure requires. If Citibank buys up Korean banks and applies its normal prudential limits (by which lending to a company with a debt/equity ratio of 1:1 is getting risky), it will not lend to Daewoo with a debt/equity ratio of 5:1. The amount of restructuring of Daewoo before its debt/equity ratio comes close to 1:1 is hard to imagine.
It seems particularly unwise for the IMF to insist that companies receive even more freedom than before to borrow on international capital markets on their own account, without government coordination, when it was their uncoordinated borrowing that set up the crisis in the first place. This will make the country more, not less, vulnerable to capital flight.
In short, the IMF approach is likely to generate big social costs long before there is any significant amount of debt reduction, all because of a short-term and unforeseeable run by mobile capital. It aims to dismantle the high debt system, its developmental advantages notwithstanding. And it wants to see a western-type financial system in its place that can only work with a huge reduction in levels of corporate debt. The Fund has not properly weighed the economic and social costs of doing this, nor even the question of whether it has any legitimate business in entering the field of structural and institutional reform. Eventually Asian economies will start to grow again, for their "fundamentals" are strong; but by then their fundamentals will not be as strong. There will be an inner source of instability created by the attempt to integrate the flow of household deposit savings with a financial structure based on western norms of prudent debt/equity ratios. And by then they will have a rather different pattern of ownership, with foreign firms and banks�in particular, US firms and banks�having much more control than before. They will have given up the developmental advantages of a high debt system based on government-bank-firm collaboration in return for somewhat lower risks of financial crashes.
Once the crisis is passed, reneging on IMF agreements may occur. But by that time foreign banks and other financial institutions may be well established, making the high debt/equity system difficult to rebuild.
TURNING POINTS
Any coherent account of the crisis runs the danger of making it look inevitable. In fact, things could have been different. Halting the panic would have required something to restore each lender�s confidence that its own refinancing would be matched by others.
- Had Japan addressed its banking problems earlier by bolstering bank balance sheets through a debt reconstruction program or by preferred stock purchases, Japanese banks would not have had to slash their refinancing to Korean and other borrowers in the autumn of 1997.
- Had the Japanese government pledged $10 billion to the IMF package for Thailand in August 1997, rather than $4 billion, confidence may have been restored.
- Had the US congress (supported by majority US public opinion) had been less isolationist, less opposed to any government largesse abroad�had it had not put a restriction in place after the Mexican crisis on the use of public resources for such purposes as the Thai package, had it not objected to increasing the IMF�s resources (through the New Agreement to Borrow, announced by the G-7 countries in January 1997 but not ratified by the US Congress), had it not declined to provide more funds to the IMF in November 1997 because of a dispute about an abortion-related amendment to the country�s foreign aid program�the US may have been able to pump in more resources.
- Had developing countries liberalized their financial systems more slowly ( resisting western pressure for rapid liberalization), then the domestic lending excesses and vulnerability to outflows of hot money would have been curbed.
- Had developing country political leaders been prepared to check wild real estate investment and speculation in junk bonds (even by the central banks), the vulnerabilities would also have been less. Taiwan is a case where these excesses seem to have been checked.
- Had there had been "sand in the works" of the international financial system (such as a tax on international currency transactions), the build-up to crisis may have been slowed.
- Had the IMF stuck to its mandate of helping countries to cope with temporary foreign exchange shortages and regaining access to international capital markets, its prescriptions might have looked less like screaming fire in the theater. This would have required the Fund to focus less on mobilizing a bail out fund and more on organizing debt rescheduling negotiations between the debtors and the banks.
CAPITAL OPENING AND THE WALL STREET-TREASURY-IMF COMPLEX
Perhaps the single most irresponsible action in the whole crisis was capital account liberalization without a framework of regulation. This exposed economies built for patient capital to short-term financial pressures, and allowed the private sector to sidestep domestic monetary restrictions via foreign borrowings, helping to cause currency overvaluation. The blame is shared between national governments and international organizations. But it has to fall disproportionately on the IMF, that for several years now has been pushing hard for capital account opening.
Why has the Fund been pushing capital account opening, and why in the present crisis has it gone so far beyond its traditional concern with balance-of-payments adjustments? Partly because it had already crossed the line in dealing with the former Soviet Union and Eastern Europe, legitimizing an expanded agenda in that context. Those countries clearly needed advice about the creation of basic market institutions, and the Fund was able to get its advice accepted because it brought vital financial rewards. In its next great intervention, in Asia, the Fund has continued to operate over this much wider jurisdiction, seeking to impose on Thailand, Indonesia and Korea institutional free-market reforms as comprehensive as those imposed on Russia�even though such reforms in the Asian case are not necessary to restart the flow of funds.
The legitimizing precedent of the former Soviet Union and Eastern Europe is one thing. But the deeper answer involves the interests of the owners and managers of international capital. The reforms sought by the Fund are connected in one way or another with further opening up Asian economies to international capital. Why is the Fund insisting on capital account opening in countries that are awash with domestic savings? Why has it done so little to organize debt rescheduling negotiations, preferring to seek additional bail out funds from G-7 governments and then give them out in return for structural and institutional reforms? The short answer is contained in a remark by James Tobin, the Nobel laureate in economics. "South Koreans and other Asian countries�like Mexico in 1994-95�are�victims of a flawed international exchange rate system that, under U.S. leadership, gives the mobility of capital priority over all other considerations". Martin Feldstein, professor of economics at Harvard University and president of the National Bureau of Economic Research, similarly observes that "Several features of the IMF plan are replays of the policies that Japan and the United States have long been trying to get Korea to adopt�[The IMF] should strongly resist pressure from the United States, Japan, and other major countries to make their trade and investment agenda part of the IMF funding conditions."
Jagdish Bhagwati, professor of economics at Columbia University and champion of free trade, takes the argument further. Asked why the IMF was seeking to open financial markets he replied, "Wall Streeet has become a very powerful influence in terms of seeking markets everywhere. Morgan Stanley and all these gigantic firms want to be able to get into other markets and essentially see capital account convertibility as what will enable them to operate everywhere. Just like in the old days there was this �military-industrial complex�, nowadays there is a �Wall St.-Treasury complex" because Secretaries of State like Rubin come from Wall Street.... So today, Wall Street views are very dominant in terms of the kind of world you want to see. They want the ability to take capital in and out freely. It also ties in to the IMF�s own desires, which is to act as a lender of last resort. They see themselves as the apex body which will manage this whole system. So the IMF finally gets a role for itself, which is underpinned by maintaining complete freedom on the capital account." Bhagwati goes on to observe that many countries have grown well without capital account convertibility, including China today and Japan and western Europe earlier. "In my judgement it is a lot of ideological humbug to say that without free portfolio capital mobility, somehow the world cannot function and growth rates will collapse."
Bhagwati�s "Wall St.-Treasury complex" is more accurately called the "Wall St.-US Treasury-US Congress-City of London-UK Treasury complex". US and UK financial firms know they can gain hugely against all comers in an institutional context of arms-length transactions, stock markets, open capital accounts and the new financial instruments. Their respective Treasuries are deeply responsive to their needs and Jesuistic in their commitment to the neoclassical "Washington Consensus". The US Congress backs the US Treasury. The Senate has passed a bill saying that no US funds may be made available to the IMF until the Treasury Secretary certifies that all the G-7 governments publicly agree that they will require the Fund to require of its borrowers (a) liberalization of trade and investment [no mention of qualifications to do with environmental protection, labor standards, and so on], and (b) elimination of "government directed lending on non-commercial terms or provision of market distorting subsidies to favored industries, enterprises, parties or institutions" [including, presumably, subsidies for energy conservation, low-income housing, and the like].
This extended complex has over the past year led the process of amending the IMF�s articles of agreement to require member governments to remove capital controls and adopt full capital account convertibility. The extended complex has likewise worked to promote the World Trade Organization�s agreement on liberalizing financial services being hammered out in 1996-97. Many developing country governments, including prominently several Asian ones, opposed the WTO�s efforts to liberalize financial services. In response, "Executives of groups including Barclays, Germany�s Dresdner Bank, Societe Generale of France and Chubb insurance, Citicorp, and Ford Financial Services of the US, � agreed discreetly to impress on finance ministers around the world the benefits of a WTO deal". Then came the financial crisis that richoceted around the region from one country to another. By December 1997 the Asian leaders agreed to drop their objections, and on 12 December 1997, more than 70 countries signed the agreement that commits them to open banking, insurance and securities markets to foreign firms. By then the Asian holdouts (including Thailand and Malaysia) saw no choice: either they signed or their receipt of IMF bail-out funds would be complicated. Meanwhile the OECD has been pushing ahead quickly with the negotiation of the Multilateral Agreement on Investment, that liberalizes all direct foreign investment restrictions, requiring signatory governments to grant equal treatment to foreign as to domestic companies. It will preclude many of the policies of the developmental state.
These events�the revision of the IMF�s articles of agreement, the WTO�s financial services agreement, and the OECD�s Multilateral Agreement on Investment�are the expression of a Big Push push from international organizations, backed by governments and corporations in the rich countries, to institute a world-wide regime of capital mobility that allows easy entry and exit from any particular place. If the agreements are ratified and enforced, they will ratchet up the power and legitimacy of the owners and managers of international capital in the world at large. This will in turn help to secure the predominance of the Anglo-American system. That system, based on maximizing returns through the optimal allocation of the existing stock of capital and savings, is better suited to maintaining stability when incomes are high and growth and inflation low. The Asian system, focused on the accumulation of capital and deliberate creation of Schumpeterian rents through the acquisition of new technology, is better suited to fast growth. As long as the Asian system operates on the basis of long term relationships and patient capital, Anglo-American capital is at a disadvantage in these markets. Therefore the Asian system must be changed.
Yet for all their implications for sovereignty, democracy, and social stability the capital-favoring agreements are being negotiated with scarcely any public debate. They have been protected from public concern partly because the champions of the wider movement towards free capital movement and lifting of government regulations have managed to harness to their cause the most self-justifying of slogans, "stopping corruption". Capital freedom, we are invited to believe, checks corruption (as in Asia�s "crony capitalism"), and is therefore self-evidently a good thing. The next step will be an international agreement to deregulate labor markets, intended to make them more "flexible" (code-speak for freedom to hire and fire) while stopping short of open migration. This would further consolidate the global governance of capital.
There is always a fine line to be trod between an interest-based theory and a conspiracy theory (for all that everyone accepts the former and hardly anyone accepts the latter). It is difficult to know to what extent and at what point some events in the Asian crisis were deliberately encouraged by those who stood to gain from the sudden loss of resources by Asian governments and from the opportunities to gain control of Asian companies at knock-down prices. Certainly the role of the US Treasury in stiffening the IMF�s insistence on radical financial opening in Korea is documented. The Treasury made it clear that Korean financial opening was a condition of US contributions to the bail-out, on the understanding that financial opening would benefit US firms that would in turn give political support for US contributions.
Financial crises have always caused transfers of ownership and power to those who keep their own assets intact and who are in a position to create credit, and the Asian crisis is no exception. Whatever their degree of intentionality and their methods of concerting strategy, there is no doubt that western and Japanese corporations are big winners from the Asia crisis. The transfer to foreign owners has begun, as noted earlier, the spirit of euphoria nicely caught in the remark by the head of a UK-based investment bank, "If something was worth $1bn yesterday, and now it�s only worth $50m, it�s quite exciting". Indeed, the combination of massive devaluations, IMF-pushed financial liberalization, and IMF-facilitated recovery may even precipitate the biggest peacetime transfer of assets from domestic to foreign owners in the past fifty years anywhere in the world, dwarfing the transfers from domestic to US owners that occured in Latin America in the 1980s or in Mexico after 1994. One recalls the statement attributed to Andrew Mellon, "In a depression, assets return to their rightful owners".
The crisis has also been good for the multilateral economic institutions, including the IMF, the World Bank, and the WTO. Amongst the owners and managers of capital they gain great centrality, both as organizations that can get them out of the crisis without serious losses and as organizations that can cajole Asian governments to reshape their domestic economies in line with western models. True, the IMF in particular has attracted much criticism. But compared to those who see it as the spearhead of their interests, the critics have no power.
THE FUTURE
Asia
We are now seeing the playing out of a familiar four-step sequence of crisis. Step one is the exchange rate collapse. Step two is an upsurge of bank failures and company bankruptcies as a result of the now much higher cost of servicing unhedged foreign debt. Step three is domestic recession, with falls in consumption and investment and rises in unemployment. Step four (and these steps are not necessarily sequential) is political reaction to the slump, including civil unrest and anti-foreign sentiment.
This is the likely sequence in each case, but we have little idea of how things will interact between the countries. We can be confident that real spending will contract by more than at any time since the mid 1970s, when the first oil shock hit. Much will depend on what is agreed by way of debt restructuring of countries� corporate sectors (whether in the form of a debt moratorium or government bond offering). If Korea is unable to regain access to international credit markets within the next few months, the degree of disruption and civil unrest is likely to be high, pushing the government towards debt default. Ethnic conflict could be kindled in many countries of the region as Chinese business elites come to be blamed. How would China respond?
It will be difficult to repair the relations of trustworthiness between government, business and banks, and between foreign (especially Japanese companies) and domestic companies, that have underpinned the Asian model. High debt/equity ratios may be more difficult to sustain in future. On the other hand, the crisis means that savings mobilization through the stock market is even less likely an option than it was before. It may take 10 years before the stock market becomes a serious option for transferring savings. Yet Asian households are likely to redouble their savings, putting them into bank deposits. This in itself gives impetus to restore the model of guided markets with inter-firm cooperation and government support for deep structures of bank intermediation.
The crisis will leave a legacy of resentment towards the west. The Malaysian prime minister Mahathir Mohamad is quite explicit. At the end of December 1997 he told Malaysians that they must be willing to make sacrifices in defending the nation�s currency or risk being "recolonized" by foreign powers. "�the fall in our currency�s value has made us poorer, exposing us to the possibility of being controlled by foreign powers. If this happens, we will lose the freedom to run our country�s economy and with it our political freedom also. In short, we will be re-colonized indirectly�.We cannot give up and surrender. We must be willing to face challenges, willing to sacrifice in defending our freedom and our honor." Other Asian leaders have been more circumspect in public but express sympathy in private. Both senior Malaysian and Indonesian leaders have invoked a Jewish conspiracy as cause of the capital outflow, perhaps hoping to deflect public anger away from the local Chinese.
The Chinese government has also been highly critical of the IMF and the US. An article in the Chinese People�s Daily said, "By imposing harsh terms of financial aid to troubled Asian nations, the United States was forcing into submission economic rivals in the region. China�s Communist Party mouthpiece [said the Reuters� report] portrayed US intervention in the Asian currency crisis in cynical terms� �By giving help it is forcing East Asia into submission, promoting the US economic and political model and easing East Asia�s threat to the US economy�. The newspaper said the United States was stressing the authority of the International Monetary Fund (IMF) during the crisis to further its own strategic interests."
Henry Kissinger, former US Secretary of State, recently warned, "Even [Asian] friends
whom I respect for their moderate views argue that Asia is confronting an American campaign to stifle Asian competition." "It is critical that at the end of this crisis", he went on to say, "when Asia will reemerge as a dynamic part of the world, America be perceived as a friend that gave constructive advice and assistance in the common interest, not as a bully determined to impose bitter social and economic medicine to serve largely American interests".
For all the resentment, Asia�s regional response to the crisis has been weak, exposing the thinness of the existing regional structures. There is an interesting story yet to be told about the Japanese proposal, in summer 1997, to establish a largely Japanese-financed Asian bail-out fund for the purpose of refinancing short-term debt�an attempt at long promised but not delivered international leadership. The US Treasury, including Secretary Rubin and Deputy Secretary Summers, reacted to this proposal with public displeasure and private anger, saying that the crisis was something for the IMF to manage. In the event, the Japanese proposal more or less died. Would the Japanese really have gone ahead with it had the US not objected so strongly? Did they see it as a backdoor route to doing something the Ministry of Finance had long wanted to do, namely to establish a public agency to bail out the Japanese banks similar to that which the US established, to good effect, for the savings and loans institutions in the 1980s? An earlier Ministry of Finance proposal to this effect had been torpedoed by Japanese politicians, responding to strong public sentiment against the use of public money to bail out financial institutions. The Ministry of Finance may have seen the establishment of an Asia fund as a way to help Japanese banks avoid exposure to mounting loan losses in their Southeast Asian debt portfolios. On the face of it, one would expect the US to welcome such an initiative since its costs to the US taxpayer would be negligible, even less than in the case of an IMF bail out. Perhaps the Treasury opposed to idea so strongly out of concern not to see Japan shore up its weakening politico-economic position in Southeast Asia and not to see Japan divert its capital from the purchase of US Treasury bonds. The Japanese agreed to desist in a November 1997 meeting in Manila. Japan and some other Asian countries are continuing to press for the creation of a contingency fund with which to support countries in trouble, whereas the US continues to want the establishment of lines of credit rather than pay up front; but this debate is now being conducted discreetly inside the IMF, with the Asians in a weak bargaining position.
A mini-step towards a regional response was the special meeting of ASEAN leaders in early December 1997 in Kuala Lumpur at the invitation of the Malaysian Prime Minister. Significantly, it was a meeting of "ASEAN plus other Asians", excluding the Americans. The Japanese Prime Minister, Ryutaro Hashimoto, returned from the meeting and announced a substantial fiscal stimulus to the Japanese economy without prior approval from the governing party. Barely noticed in the western press was the fact that China�s political head attended, President Jiang Zemin himself. At the conference his government negotiated a loan to Indonesia. On the whole, though, ASEAN has distinguished itself by sheer impotence.
China�s leaders now understand more emphatically than before the need to move slowly towards a convertible currency and other financial market openings. The yuan remains inconvertible, and the banks remain mostly state-owned. The central bank can protect the state-owned commercial banks from deposit runs through domestic monetary policy. If China had a fully convertible currency it would be difficult for her to protect the banks through monetary policy without encouraging capital flight. China will now proceed more slowly in abolishing exchange controls than her policy makers were talking about only six months ago.
China may be looked upon as a model by other countries, whose governments draw on China�s experience to justify slowing down financial liberalization. China�s competition with Japan for influence in Southeast Asia may explain why China was unwilling to cooperate with Japan�s idea of an Asia Fund, which would seem to require at least tacit Chinese support. Asked recently about such Chinese support, the Chinese finance minister, Zhu Ronghi, is reported to have replied that one co-prosperity sphere in his lifetime was enough. This is the voice of a China that sees itself as the rightful center of the Asian economy. Japan, on the other hand, has seen a serious erosion of its leadership position in the region. In response it is covertly helping some ASEAN countries, notably Indonesia, to handle the IMF, seeking to build up its position in ASEAN in order to counter the strengthening China-US-Taiwan axis.
European banks have lent more to Asia than either Japanese or US banks. Yet European governments and the European Union have been conspicuously quiet, leaving the Americans and the Japanese to make the public running.
Collective action theory teaches that a solution to collective action problems�such as the Asian crisis of refinancing�is most likely when one or two players see it as being in their own interests to act, even if others do not. This is what happened in the Mexico crisis of 1994: The US, seeing great costs to its own interests, intervened decisively to organize a rescue package (with concessions about the restructuring of the Mexican economy highly favorable to the US). The Asia crisis of 1997 shows only too clearly the power vacuum in Asia, with none of the major countries�Japan, China, the US, Europe�willing or able to act in the same way, while there is within the region a swelling tide of antagonism towards the "foreign" forces that have, apparently, been the cause of the downfall.
The international financial regime
The IMF has gained centrality but at the cost of renewed scrutiny. It has expended so much money to Asia that it will need additional funding to contain contagion effects in other parts of the world. And the questioning of its basic prescription for Asia may give impetus towards reconsidering its whole approach to financial crises. If the Asian program, with the Korean program as the acid test, restores private capital flows as quickly as they were restored to Mexico in 1995 ( within three months), the IMF�s approach, and the IMF as an institution, will emerge as a more credible regulator of the world economy. But even if this happens questions about the IMF�s role remain. Above all, does the IMF encourage lenders and borrowers to be careless, believing that they will be bailed out with little loss; does it encourage "moral hazard", as so many critics claim? Almost certainly not, although the opponents of the IMF have managed to convince many American congressmen that the Mexican bail out in 1995 helped to create the conditions for the Asian crisis. The opponents assume that the prospect of IMF support was an important reason for large-scale lending to Asia. More likely, the perception of Asia as a growth machine attracted the funds, not expectations of IMF support.
The crisis should provoke a Bretton Woods II, a fundamental debate about the character of the international financial regime in the post Cold War world. The debate should focus on questions like: Should we make a sharp distinction between free trade and free capital movements, seeking to encourage the former while constraining the latter? Are international financial markets "efficient", can they fail, can speculation be destabilizing? Has the growth of derivative markets and other forms of leverage created the preconditions for aggressive intermediaries, such as hedge funds, to disrupt the financial markets of smaller countries? Does the growing securitization of credit in response to the emergence of pension funds and mutual funds require the development of new forms of financial supervision comparable to those which have long existed for banks? How can developing countries obtain the benefits of international lending�in terms of investing more than they save�while limiting their exposure to the costs of unstable flows? Given that the least affected Asian countries�China, Hong Kong, Taiwan, Singapore�all have towering foreign exchange reserves, should developing countries all try to raise their reserves? At what cost to their development? We should keep at the forefront of discussion the absence of empirical evidence that capital account convertibility is good for developing countries, and the abundance of historical evidence that free international capital markets are prone to excesses that inflict huge social costs.
Indeed, Eisuke Sakakibara, Japan�s top financial diplomat, has just proposed a new Bretton Woods agreement, saying that a return to something like the 1944-1971 regime of fixed exchange rates and temporary financing facilities should be one of the options. US Treasury and IMF officials have poured cold water on the latter idea, making "plain that any ideas being studied stopped well short of a Bretton Woods-style fixed exchange rate system". And not surprisingly, given the earlier discussion of the Wall Street-Treasury-IMF complex. Constraining financial markets by means of something like a fixed exchange-rate regime would be deadly for its power and profit. Vast profit opportunities, including those of the foreign exchange markets and the derivatives markets, would shrink, hundreds of thousands of employees would be laid off. And the US government would loose one of the great assets of hegemonic status: the ability to create enough credit to sustain domestic expansion and project military force abroad at the same time, without raising taxes or interest rates.
This paper has presented the crisis not as a symptom of the weakness of "Asian state capitalism" but as the result, on one level, of a collective action problem, in which each lender tries not to refinance for fear that others will not also refinance. At a deeper level, the crisis is a symptom of the weakness of a regime of international credit creation with insufficient limits and rules, in which such crises are endemic. We saw the symptoms in Latin America in the 1980s, in Mexico in 1994, and very much in the country that now lectures Asia on the insufficiency of its financial regulation, the United States--with its commercial real estate, junk bond and savings and loan crises of the 1980s. In each case excessive credit is created and the government then squeezes the "real" economy (some groups more than others) in order to repay the creditors. Developing countries should be able to derive much benefit from large-scale international lending, because it allows them to investment more than they save. But the ability to put the inflows to good use is a function of their stability. When the swing from net inflows to net outflows equals 10 percent of pre-crisis GDP, as in Asia between 1996 and 1997, the social fabric itself is torn asunder.
We must now learn the lesson. The solution has to involve regulation of international credit creation and of short-term capital movements--a new regime of international finance. In the words of Martin Wolf, columnist for The Financial Times, one of the three main organs of world capitalist views, "[I] is impossible to pretend that the traditional case for capital market liberalization remains unscathed. Either far greater stability than at present is injected into the international monetary system as a whole or the unavoidably fragile emerging countries must protect themselves from the virus of short-term lending, particularly by�and to�the banks. After the crisis, the question can no longer be whether these flows should be regulated in some way. It can only be how." The how question, however, is made doubly difficult by the growth of private debt tied to occult derivative contracts that escape established methods of bank regulation. The successes of the international regime for tracing drug money perhaps offer grounds for hope.
It is possible that several years from now the Asia crisis will be looked back on as "the crouch before the leap". We should bear in mind the history of a decade ago. In the late 1980s Japan was resurgent, soon to be "number one", and the US was in trouble and keen to learn from the Japanese model. Then the Japanese stock market and property bubbles burst, the US became resurgent, and talk of the Japanese model faded away. Will the cycle repeat itself? The US is now probably in the last stage of its own stock market and currency bubbles. If they burst and if the Asian liquidity problems are overcome, the Asian model may look to have more staying power than most commentators now think, and be more influential in setting norms for international economic and financial regimes.
On the other hand, one has to remember that world income distribution has been remarkably stable over the past several decades, both in its trimodal distribution and in the position within it of individual countries. Very few countries have increased their per capita income sufficiently to move from the lower zone to the middle or from the middle to the upper. Several Latin American countries looked to be well on the way into the middle zone in the 1960s and 1970s�until the debt crisis of the early 1980s pushed them back down. The current Asia crisis, with its huge devaluations, has pushed Korea from the lower bound of the upper zone back into the middle, and pushed Thailand and most dramatically Indonesia from the middle into the lower. To what extent is the crisis-- beyond a collective action problem of liquidity and beyond a symptom of the weakness of the international financial regime--a reassertion of the stability of world income distribution? To what extent is it a structure-restoring adjustment to the seismic shocks of China�s rise through the lower zone? The crisis, according to this interpretation, is less a crouch before the leap than a replay of Latin America�s nosedive in the early 1980s. A decade from now we will be able to see whether the Asia crisis of 1997-? was a blip on an upward Asian trajectory that changes the structure of world income distribution, or a restoration of the status quo.
Copyright © 1998 The Russell Sage Foundation. Email us at [email protected].