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Incubus of overseas debt*
Peter Brain, Executive Director, NIEIR
Abstract
This paper considers the role of overseas debt in financial crises, including the Asian financial
crisis, and the experience of other debt-afflicted countries since 1997. Recent trends in
Australian overseas debt are compared with the equivalent trends in Asian countries in the years
leading up to the Asian financial crisis, and the performance of economies recovering from debtinduced collapse is considered. Australia does not fare well in this comparison. Indonesia, for
instance, with a fraction of the living standards of Australia, showed sustained discipline to hold
growth in living standards in check for the benefit of debt reduction, whereas Australia chose to
maximise growth in consumption expenditure, totally disregarding the growth in foreign debt
that this produced. Australia currently has most of the symptoms of impending debt-induced
collapse, and insists on pursuing policies that are likely to lead to collapse and maintains a
mindset that will seriously hinder recovery from collapse.
Introduction
For many decades Keynesian economists have held that external balance is a very important
macroeconomic target. It is imperative to control the current account deficit to avoid the
unsustainable build-up of foreign debt. If external balance is not sustained, there is a serious risk
that international confidence in the ability of the economy to repay foreign debt will evaporate.
When this happens, the flow of credit which has been supporting the economy suddenly ceases,
forcing a substantial fall in GDP: a debt-induced collapse.
Australia came close to economic collapse during the Asian financial crisis of 1997 and was at
the back of my mind when I wrote Beyond Meltdown (Brain, 1999). Financial markets have short
memories, so this article is written to remind Australians of the role of overseas debt in financial
crises, including the Asian financial crisis, and the experience of other debt-afflicted countries
since 1997. In particular, we compare recent trends in Australian overseas debt with the
equivalent trends in Asian countries in the years leading up to the Asian financial crisis and also
consider the performance of these economies in recovering from debt-induced collapse.
The following discussion on the Asian economic crisis draws on Responding to Financial Crisis – Lessons from
Asia Then, the United States and Europe Now, edited by Changyong Rhee and Adam S. Posen, a co-publication of
the Asia Development Bank and Peterson Institute for International Economics, Washington, DC.
*
Australia does not fare well in this comparison. It currently has most, if not all, of the symptoms
of impending debt-induced collapse. Worse, Australia insists on pursuing policies that are likely
to lead to collapse and maintains a mindset that will seriously hinder recovery from collapse.
Australian governments, both Labor and Liberal, have for years aimed to avoid budget deficits.
So far so good; international creditors approve. However, when it comes to debt-induced
collapse, the budget deficit is a minor consideration. What matters is the balance of payments
deficit: the level of overseas borrowing by the economy as a whole. If not specifically invested in
export generation, overseas borrowing and the consequent accumulation of overseas debt
undermines the prosperity it initially supports.
Up until the 1980s, and especially during the post-war period of rapid economic growth,
Australian governments kept a wary eye on the balance of payments and took care to ensure that
the nation borrowed overseas prudently. They endeavoured to limit borrowing to that which
could be repaid from prospective export earnings and more than once took steps to curb imports
in order to keep overseas borrowing within prudent limits: steps which generally involved
dampening the growth of domestic incomes.
During the 1980s Australian governments fell into a river of American snake oil. The original
19th-century snake oil was a peculiarly American elixir, a cure-all remedy for all bodily ills. (It
had its Australian equivalents, most of which seem to have been medicinal excuses for
teetotallers to drink alcohol.) By the 1980s the health authorities of most countries, including the
USA, had banned snake oil and similar panaceas, but there was no equivalent ban on cure-all
economic nostrums. The particular nostrum which the USA was promoting in the 1980s was a
20th-century revival of a 19th-century belief cherished by American capitalists, the doctrine that
free competitive markets can be relied upon to achieve the best possible outcomes for all
concerned. This doctrine, coming with its impressive Washington imprimatur, persuaded
Australian governments that they need no longer worry about the balance of payments: market
forces could be relied on to determine the external accounts, including such variables as the
current account balance and the level of foreign debt. To assess the dangers inherent in this
policy, it is important to become familiar with Australia’s capital account with the rest of the
world, including its history over the past two to three decades. We will then be in a position to
compare Australia with countries that have suffered debt-related crises and so assess the
potential for an Australian collapse.
Definition of a debt-induced collapse
The natural volatility experienced by countries over the economic cycle regularly generates
events that are described as crises. Mostly, however, these events are mere fluctuations in the
growth rate associated with the addition of 1 to 3 percentage points to the annual inflation rate
and an increase of 1 or 2 percentage points in the unemployment rate. At worst, GDP growth
may fall to negligible levels before recovering in the next year or so.
A debt-induced collapse is worse than this. It may be defined as an economic event (as distinct
from a war or natural disaster) that causes a decline in GDP of at least 4 per cent and generally
much more. Our interest lies in crises of this severity generated in indebted countries due to the
reversal of the inbound flow of credit. Such crises begin when the creditors of the indebted
country lose confidence in its ability to repay the debt. Both foreign and domestic investors rush
to remove their capital from the indebted country, causing financial turmoil. Except in countries
like Greece, which are members of a currency union, the exchange rate plummets.
What happens next depends on the country’s debtors. When the debtors are ordinary private
businesses (as can easily happen if there has been a boom and bust in a dominant industry) the
debtors go bankrupt. Their overseas creditors line up alongside the domestic creditors to await
what the receiver can do for them. Nobody is happy, but it is accepted that business is risky and
that bankruptcies can happen. The credit rating of the country’s businesses will collapse and they
will lose access to international credit but the episode can be concluded reasonably quickly.
If the debtor is the government, the process is inevitably more political. Governments differ from
businesses in that they cannot be closed down and their assets realised to repay their creditors.
Instead, creditors seek access to the tax revenues of the debtor country. In the 19th century the
creditor powers would send in the gunboats and as recently as 1936 Newfoundland lost its
sovereignty to its chief creditor (Britain), who forced it into federation with Canada. Now that
military threats are unfashionable, creditors not only exclude defaulting governments from
further credit but, more seriously, warn defaulting countries that they will be denied access to the
various agreements which govern world trade. The result is that default on government
international debt is usually accompanied by heavy negotiation. Loans may be rescheduled or
rolled over into loans from agencies such as the International Monetary Fund. Whatever
happens, the creditors make it very difficult for the taxpayers of the indebted country to escape
their demands.
If the debtors are businesses in the finance sector of the indebted country, technically the rules
for the bankruptcy of private businesses should apply. However, creditors have had considerable
success in claiming that finance sector debt, particularly bank debt, is government-guaranteed.
Once the guarantee is exercised the process is as for government debt. Short of this, if the
banking sector has been active as a transmission mechanism for foreign loans and has significant
foreign liabilities on its balance sheets, a balance of payments crisis will be associated with a
banking crisis and a severe contraction in the availability of credit. There is likely to be a public
sector bail-out of one or more major banks which transfers private debt into public debt.
Since 1970 there have been over 60 debt-induced crises of the type described above. Some
countries such as Argentina have suffered multiple crises. The countries that have experienced a
debt-induced crisis since 1970 are listed in Table 1. Not all these crises were severe, but a
worrying proportion met the definition of debt-induced collapse.
Table 1
Country
Argentina
Argentina
Argentina
Belize
Brazil
Brazil
Brazil
Countries experiencing a collapse related to external debt by date: 1970 to
2012
Year
1982
1995
2001
2006
1983
1999
2001
Country
Korea
Korea
Latvia
Malaysia
Mexico
Mexico
Morocco
Year
1980
1997
2008
1998
1982
1995
1981
Chile
Chile
Costa Rica
Cyprus
Dominican Republic
Dominican Republic
Dominican Republic
Ecuador
Ecuador
Ecuador
Egypt
Greece
Hungary
Iceland
Iceland
India
Indonesia
Israel
Italy
Jamaica
Jamaica
Jordan
Jordan
Jordan
Korea
1972
1983
1981
2012
1982
2003
2009
1983
1999
2008
1984
2010
2008
1976
2009
1984
1998
1976
1975
1978
2010
1989
1997
2002
1975
Pakistan
Pakistan
Pakistan
Panama
Peru
Peru
Philippines
Philippines
Poland
Portugal
Portugal
Romania
Serbia
South Africa
Thailand
Thailand
Thailand
Turkey
Turkey
Turkey
Ukraine
Ukraine
Uruguay
Uruguay
Venezuela
1981
1998
2008
1983
1978
1982
1976
1983
1981
1977
2011
2009
2009
1985
1981
1985
1997
1976
2000
2008
1998
2008
1983
2002
1983
Source: Catao and MiLesi-Ferretti (2013). Note the Cyprus case has been added.
The crises listed in Table 1 may be designated as systemic because they mark a fundamental
change in economic direction. For example, for many years after a serious crisis no new foreign
capital may be available to the defaulting country other than overseas aid and loans from
multinational agencies, so that its level of economic activity is totally determined by its capacity
to export and to replace imports. Due to these factors, serious crises (debt-related collapses) are
marked by significant peak-to-trough declines in GDP (say 20 per cent or more) and lengthy
periods before the previous GDP peak is regained (say 3 to 8 years). There is likely to be a ‘lost
generation’ of jobless. The resumption of growth is likely to require fundamental change to the
economic structure and policy processes of the country and when growth is resumed it is likely
to be tentative and far less exciting than before the collapse.
An economic collapse brought on by inattention to the balance of payments is not the only type
of crisis that can cause such trauma. A collapse precipitated by difficulties in servicing overseas
debt inevitably includes a financial crisis, but not all financial crises begin with overseas debt;
some, like the Great Financial Crisis in the USA in 2008, may have their origin in the domestic
finance sector. Where the crisis is of domestic origin, it is usually generated by a plague of bad
debts resulting either from foolish lending to private sector borrowers or from public-sector
borrowing beyond the capacity of the government to raise tax revenue to service the debt. By
contrast, a crisis originating in the balance of payments is not necessarily due to poor lending
standards; it arises because of a shortage of foreign exchange to repay debts contracted overseas.
In this case, lending that might have been sound had it been purely domestic goes bad due to the
additional requirement that it be serviced in foreign currency.
Reinhart and Rogoff (2009), in their book on financial crises since medieval times, This Time is
Different: Eight Centuries of Financial Folly, disregard the distinction between crises of
domestic origin and those precipitated by overseas borrowing and instead distinguish two major
types of crisis: a banking crisis, in which lending to the private sector goes bad and banks and
other financial institutions default, and a sovereign debt crisis, in which governments default.
Default includes rescheduling of debt and also the effective repudiation of debt through high
inflation. The two types of crisis are related in that a banking crisis often turns into a sovereign
debt crisis as debt guarantees are exercised, but responsibility for the crisis is different: a banking
crisis is generated by private-sector decisions (though governments may culpably fail to
supervise the banking system) whereas sovereign debt crises are due more directly to
government financial mismanagement. Crises with the additional complication of overseas
borrowing can be of either of these two types.
Australia’s current position is that the government accounts have been conservatively managed
but the banking system is exposed to overseas creditors. Accordingly, it is of interest to note the
antecedents to banking crises identified by Reinhart and Rogoff. These include financial
liberalisation (deregulated banks tend to adventurousness), asset price bubbles (particularly in
housing) and, of particular relevance to debt-induced collapse, capital inflow bonanzas during
which international lenders vie to make loans to the banks of whichever country is the flavour of
the month. In each case the fragility of the financial system increases, but a crisis is unlikely to
occur until it is precipitated by an unforeseen event, such as a reassessment of the borrowing
country’s export prospects.
In addressing the issue of Australian financial fragility, the first question concerns the current
structure of the foreign capital account, that which is officially designated as the ‘Rest of World
Capital Account’ in the Australian National Accounts.
Australian foreign capital account
In the Rest of World Capital Account foreign obligations are divided into equity capital and
fixed-interest borrowing. Equity capital arises from direct investment by foreign individuals and
institutions in Australian enterprises and takes the form of investment in listed or unlisted shares.
Unlisted shares include shares held by a foreign parent company in an Australian subsidiary and
the imputed shares attributed to the overseas owners of a local branch. Fixed interest borrowing
includes foreign debt in the form of bonds, deposits, loans, derivatives, bills of exchange and
other non-equity financial instruments issued by Australian institutions (both government and
private) and held by foreigners. Total foreign obligations are the sum of the two components. As
a counterpart to these obligations, Australian individuals and institutions have invested in foreign
financial assets. These Australian assets again include equity assets (listed and unlisted shares)
and debt obligations owed to Australia by the rest of the world.
Figure 1 profiles Australia’s foreign obligations. Between the end of fiscal year 1988 and the end
of fiscal year 2014 total Australian foreign obligations rose 10-fold, from $254 billion to $2,600
billion. The foreign debt component rose 13-fold, from $130 billion to $1,700 billion. By 2014
this fixed-interest debt component constituted two-thirds of Australia’s total foreign obligations.
Between the two benchmark years total Australian foreign obligations rose from 63 per cent of
annual GDP to 165 per cent, including an increase in fixed-interest debt from 40 to 107 per cent
of GDP (Figure 2).
These increases in foreign obligations have been partially offset by growth in Australian foreign
financial assets (Figure 3). Total Australian foreign financial assets rose from 23.6 per cent of
GDP in 1988 to 110 per cent by 2014, including an increase in Australian foreign lending from
10 to 52 per cent of GDP (Figure 4).
Offsetting these foreign assets against the financial liabilities recorded in Figures 1 and 2, net
Australian foreign obligations increased from 40 per cent of GDP in 1988 to 55 per cent in 2014.
Net foreign debt rose from 30 to 55 per cent, implying that by 2014 Australian foreign equity
assets equalled Australian foreign equity obligations (Figure 5).
Figure 1: Australian foreign financial obligations ($bn)
3
Figure 2: Australian foreign financial obligations (per cent of GDP)
Figure 3: Australian foreign financial assets ($bn)
Figure 4: Australian foreign financial assets (per cent of GDP)
Figure 5: Net Australian foreign obligations (per cent of GDP)
In 1990 total Australian foreign obligations laid claim to 8.2 per cent of the total value of assets
on the Australian national balance sheet. By 2014 they had increased to 21.6 per cent. Australia’s
overseas financial assets increased from 5.0 to 7.2 per cent, providing an offset.
Although borrowing from overseas on equity produces higher average returns for the creditor, it
is less dangerous to the financial system of the borrowing country because in the event of
bankruptcy the equity owner (the foreign creditor) bears the residual risk. Fixed-interest debt
obligations are much more likely to cause trouble. In 1990 these obligations to overseas lenders
rose from 5.3 per cent of the value of assets on the national balance sheet to 14.0 per cent. After
offsetting Australian fixed-interest lending to overseas the increase was from 2.0 to 7.2 per cent.
By themselves, these percentages do not look particularly frightening. However, the story
changes when we turn to the cash flow obligations that they generate.
Australia’s international borrowing requirement
The key determinants of the likelihood that overseas debt will trigger economic collapse are
reflected in an economy’s annual foreign borrowing requirement, which, in turn, largely reflects
the short-term foreign debt component of its total financial obligations: that part which has a
maturity of less than 12 months. The greater the economy’s international borrowing requirement,
the more likely that an event arising in the normal volatility of the world economic environment
will trigger a collapse.
The formal definition of an economy’s annual international borrowing requirement is its annual
current account balance plus foreign debt of less than 12 months’ maturity less the country’s
foreign reserve holdings. Ignoring capital outflows, this will represent the maximum the country
will have to borrow to meet its international payment obligations in a year, leaving zero
international reserves at the end of the period.
Australia’s international borrowing requirement is profiled in Figure 6. Australia’s annual
international borrowing requirement has risen from $124 billion at the time of the Asian crisis to
$554 billion at the end of the 2014 fiscal year. Over the period it rose from 21 to 35 per cent of
GDP, despite falls during the mining boom due to the high value of the Australian dollar.
Adjusting back to the purchasing power parity exchange rate with the US dollar, the share in
2014 would have been 41 per cent, although 47 per cent of the short-term debt was in Australian
dollars (Figure 6; Dadush et al., 2000). As the Australian dollar is subsiding from mining boom
levels, the international borrowing requirement is rising to around $650 billion a year.
A further measure of Australia’s vulnerability to debt-induced collapse is its ratio of short-term
debt plus the (annual) current account deficit to reserves, as profiled in Figure 7 along with the
total gross debt-to-reserve ratio. Since the global financial crisis Australian short-term debt has
hovered at around 12 times reserves, while the gross debt to reserves ratio has been steady at
nearly 30 times the level of reserves. The key question is: How do these ratios compare with the
ratios that prevailed in other countries just before they suffered debt-induced collapse?
Figure 6: Australia’s annual international borrowing requirement
Figure 7: Australia’s ratio of debt to reserves
Foreign debt and economic collapse
The key issue here is the link between gross and net foreign debt levels and the occurrence of an
economic collapse. If the low income economies are excluded from the list of countries in
Table 1, the 37 occurrences of economic collapse remain from 1970. Table 2 shows the
distribution of net and gross foreign debt as a percentage of GDP that prevailed just before
collapse. The tables indicate that economies with a net overseas debt to GDP ratio of 50 per cent
or greater, or a gross overseas debt to GDP ratio of 70 per cent or greater, are in the top two
quintiles of economies that suffered collapse. As of 2014, Australia satisfied both conditions. It
had net debt greater than 50 per cent and gross debt greater than 70 per cent of GDP.
Table 2
Distribution of gross and net foreign debt levels preceding economic
collapse
Net
Gross
Debt ratio
Distribution
Cumulative
Distribution
Cumulative
interva
(numbe
distrib
(numbe
distrib
ls (%)
20
30
40
50
60
70
80
90
100
Greater than 100
Total
r)
9
9
5
3
5
2
1
1
1
1
37
ution
(%)
24.3
48.6
62.2
70.3
83.8
89.2
91.9
94.6
97.3
100.0
r)
0
9
8
3
5
3
2
0
2
5
37
ution
(%)
0.0
24.3
45.9
54.1
67.6
75.7
81.1
81.1
86.5
100.0
Table 3 shows the distribution of falls in GDP arising from financial crises originating in the
balance of payments of the 37 countries. Some of the crises were relatively mild but a significant
proportion qualified as economic collapse.
Table 3
0–1
1–2
2–3
3–4
4–6
6–8
8–10
10–14
14–18
18–22
22–26
Economic collapse: Distribution of decline in GDP
Per cent frequency
Cumulative per cent
frequency
18
18
6
24
15
39
15
55
21
76
9
85
0
85
9
94
0
94
3
97
3
100
Across the 37 instances, the average decline in GDP was 5.2 per cent. The decline in GDP has
increased over the past 2 years and this is correlated with the increase in the foreign debt-to-GDP
ratio resulting from the partial or complete deregulation of international borrowing by various
governments over the past 25 years. Figure 8 shows a correlation between the gross overseas
debt-to-GDP ratio and the decline in GDP. Australia’s gross overseas debt-to-GDP ratio is now
approaching levels associated with large declines in GDP. At the end of 2014 the ratio was 117
per cent of GDP and it is continuing to increase as the exchange rate subsides.
Figure 8: Overseas debt-related financial crisis countries decline in GDP versus gross
overseas debt-to-GDP ratio
The book Beyond Meltdown (1999) arose from the Asian economic crisis in 1997. It is
appropriate to consider the experience of the Asian economies most impacted by this crisis.
Proximate causes of the Asian economic crisis: The Washington Consensus
With the election of President Ronald Reagan in 1980 US politics abandoned Keynesian
economics (which had always been suspect due to its British origins) and reinstated the
neoliberal theories that had been discredited by the Great Depression. Because of the United
States’ central role in their governance structure and funding, it was inevitable that there would
be harmonisation between the United States’ domestic political agenda and the views of the
world’s leading economic institutions; namely, the International Monetary Fund, the World Bank
and the Organisation for Economic Cooperation and Development. The move towards freemarket solutions was also, in part, a response to the administrative shortcomings of various
developing countries revealed in the Latin American debt and inflation crisis in the first half of
the 1980s (as indicated in Table 1) and was strengthened after 1989 by the collapse of
communism in Eastern Europe and Russia.
The policies advocated in the institutions’ research papers by the late 1980s were designated the
Washington Consensus and can be summarised as:
(i)
fiscal discipline with budget surplus the preferred option;
(ii)
withdrawal of government intervention in industry development with ending or scaling
back of subsidies, tariffs, goods and services industry regulation, barriers to trade and
barriers to direct foreign investment, and the privatisation of government enterprises;
(iii) low marginal tax rates; and
(iv) deregulation of the financial sector and the external capital account, ending barriers to
capital inflows and the adoption of market determined interest and exchange rates.
In other words, policy aimed to reduce the role of the state and enhance the role of markets.
East Asia is a long way from Washington and its experience of economic development was
disregarded in the formulation of the Washington Consensus. The position in East Asia during
the 1980s was that Japan had achieved rapid economic growth and prosperity through a policy of
export-led growth implemented under strong state leadership; the Asian ‘tigers’ were following
and China was just beginning to follow its own version of the same path to prosperity. The
efficiency of state intervention varied (e.g. in Indonesia and Thailand many of the government
interventions served the interests of the domestic elite rather than the national interest) but on the
whole the region abstained from the various Latin American mismanagements which convinced
the Washington institutions that markets gave better results than government interventions.
After the emergence of the Washington Consensus, the Asian tiger economies implemented
policies that at least partially deregulated the financial sector and the external capital account.
Thailand went farthest in this direction and Korea the least far. This move towards financial
deregulation no doubt reflected pressure from the United States to adopt elements of the
Washington Consensus after the collapse of communist Russia in 1990. The United States could
point out that it had tolerated the tigers’ interventionist governments due to their role as frontline states in the Cold War. Faced with American pressure, the tiger economies elected to leave
their industry policy architecture largely unchanged: it was too strongly embedded in national
political culture and, in any case, it did not seem to worry the Americans, perhaps because they
did not understand it. Instead, they responded to the pressures from Washington by moving
towards financial deregulation, especially as it affected foreign borrowing and lending.
In moving towards the deregulation of foreign borrowing and lending, the tiger economies were
also influenced by expected benefits as lauded in IMF and World Bank policy documents. The
expected benefits included transfer of capital from capital-rich to capital-poor economies, lower
costs of equity and loan capital, a wider range of financial products increasing risk management
efficiency thereby lowering overall interest rates, and better allocation of service investment
resources and enhanced financial market discipline on governments to ensure that they kept their
borrowing in check and pursued inflation targets in particular. The capital transfer and risk
reduction benefits (at least) would have appealed to the tiger economies (Sundaram, 2009).
As would be expected, financial sector deregulation, especially the deregulation of capital
transfers, led to increased capital inflows, which in three of the four economies most severely
impacted by the subsequent crisis (Malaysia, Indonesia and Thailand) increased the ratio of
foreign debt to GDP (Table 4). The exception was Korea, which had experienced an earlier crisis
in 1979 and, therefore, had a policy objective of reducing foreign debt in order to avoid a repeat.
In the move towards capital account deregulation the prudent rule that developing economies
should hold official international reserves to match their short-term foreign debt obligations was
overlooked. By 1996 the ratio of the current account deficit plus short-term foreign debt to
foreign reserves reached 155 per cent in Thailand, 127 per cent in Korea, 138 per cent in
Indonesia and 55 per cent in Malaysia (Sundaram, 2009). Although the debt-to-reserve ratio for
Malaysia should have prevented a crisis, trouble developed quickly because capital flight rapidly
eroded the effective protection provided by the high ratio of reserves to short-term debt.
The second contributing factor to the crisis of 1998 was the policy of pegging Asian currencies
to the US dollar, or (in the case of Korea) to a controlled appreciation against the dollar (see
Table 4). From 1980 to 1996 borrowers and lenders became accustomed to these policies and,
therefore, perceived little risk in borrowing in dollars. The borrowings were, therefore,
undertaken mostly in foreign currency and were largely unhedged.
In general terms, in 1996 Thailand was the weakest economy of the four and ran a current
account deficit of 8 per cent of GDP, following a series of similarly high deficits incurred over
the previous 6 years. As a result, the Thai Baht came under pressure and the fixed exchange rate
policy had to be abandoned. This immediately imposed exchange rate losses on domestic
borrowers. Losses in the finance sector triggered at worst bankruptcies and at best reductions in
the supply of credit as banks struggled to strengthen their balance sheets. Investment and
construction expenditure declined sharply. The fall in the currency also triggered capital flight in
expectation that the currency would fall further. As a consequence, demand for new loans
evaporated either because of economy-wide demand-side collapse or high (sometimes realised)
risk of counterparty failure. The crisis then spread to Indonesia, judged by investors to be most
like Thailand, and then by contagion dynamics to Malaysia and Korea. Contagion dynamics
occur when ill-informed overseas investors lump countries together irrespective of their
economic fundamentals. The contagion occurred, it would seem, for no better reason than the
four economies were previously fast-growing Asian economies. The main indicator of weakness
for Korea was its short-term debt to reserve asset ratio. If it was not for this, the Korean economy
would have probably escaped unscathed as should have Malaysia.
The data in Table 4, being in terms of span year averages, disguises the severity of the collapse
in the early months of the crisis. Between June 1997 and July 1998 the Thai baht depreciated by
40 per cent, the Indonesian rupiah by 83 per cent, the Malaysian Ringgit by 39 per cent and the
South Korean won by 34 per cent. These depreciations drove the gross foreign debt-to-GDP
ratios of each country up to peak at over 100 per cent. The immediate response, on Washington
principles, was to raise interest rates and cut government expenditure to close the current account
deficits and to raise large-scale foreign loans to finance the outflow of capital and so restore
confidence. Thailand borrowed $20 billion from the IMF, Indonesia borrowed $23 billion and
Korea borrowed $35 billion. Second lines of credit were also put in place by arrangements with
other countries and international institutions.
Table 4
The Asian crisis economies and Australia: Pre-crisis and post-crisis
economic indicators
Indonesia
Korea
Malaysia
Thailand
Australia
Broad money-to-GDP ratio growth (per cent per annum)
1970-1990
7.36
0.50
2.68
4.21
1.15
1990-1996
4.49
1.25
10.96
1.91
2.50
2001-2012
−2.14
1.66
0.18
4.69
3.44
Change in exports of goods and services (2005 prices) – per cent of GDP growth
1990-1996
35.6
28.1
121.3
57.0
46.2
1998-2012
33.7
80.5
90.1
103.8
18.9
Export share of GDP
1990
25.3
25.9
74.5
34.1
15.1
1996
25.8
25.7
91.6
39.3
18.9
2012
24.3
56.3
85.3
75.0
21.3
Average annual GDP growth rate by span years
1990-1996
7.8
7.8
9.6
8.2
2.7
1996-2001
−0.1
4.7
2.9
−0.3
3.8
2001-2012
5.6
4.2
5.1
4.4
3.1
Average annual CPI growth rate by span years
1990-1996
8.8
6.0
3.9
5.0
2.5
1996-2001
18.6
3.8
2.7
3.4
2.3
2001-2012
7.6
3.1
2.3
2.8
2.8
Gross foreign debt-to-GDP ratio (per cent)
1980
25.0
49.7
29.2
25.6
9.0
1990
63.2
17.5
38.3
32.8
40.9
1996
58.4
26.4
42.6
57.2
48.0
2001
84.9
24.8
52.7
52.9
59.4
2011
23.3
35.0
49.8
24.8
75.7
Net foreign debt-to-GDP ratio (per cent)
1980
19.9
40.7
14.4
22.1
6.5
1990
54.6
10.9
15.7
30.0
34.4
1996
52.4
12.8
25.3
53.0
38.2
2001
75.4
12.7
30.7
37.0
44.0
2011
19.1
19.2
25.4
8.7
46.5
Ratio of gross foreign debt to reserves (per cent)
1980
4.0
10.9
1.6
5.3
8.7
1990
9.6
3.2
1.7
2.1
8.1
1996
7.3
4.4
1.6
2.8
14.1
2001
5.0
1.2
1.7
1.9
12.5
2011
1.9
1.3
1.1
0.5
26.4
Average over-valuation of exchange rate (+)/under-valuation (−)
PPP $US exchange rate relative to $US market exchange rate
1980-1990
−71.28
−36.83
−57.32
−63.29
−2.22
1990-1996
−76.33
−17.41
1996-2011
−78.17
−30.19
Cumulative current account balance (per cent of GDP)
1980-1990
−24.16
−4.38
1990-1996
−16.31
−5.91
1996-2011
26.73
37.68
−60.82
−64.23
−60.60
−69.11
−1.52
−3.03
−27.46
−36.25
156.89
−47.04
−46.79
45.69
−47.92
−28.37
−69.63
The IMF funds were paid over fixed timelines with continued payments conditional on the IMF’s
monetary and fiscal policy settings being achieved as well as on other structural reforms,
generally involving further market liberalisation, especially in banking and financial markets,
including further capital account liberalisation.
Malaysia did not request IMF involvement. Instead, the government introduced strict capital
controls and kept the ringgit pegged to the US dollar.
On an annual basis, the peak to trough fall in real GDP was 7.4 per cent in Malaysia, 5.7 per cent
in Korea, 11.7 per cent in Thailand and 13.1 per cent in Indonesia: in each case a collapse rather
than a trade-cycle downturn. However, the official hard currency foreign borrowings (and in
Malaysia the exchange controls) were sufficient to finance short-term capital outflows of US$62
billion from the four countries over 1998. This stabilised their currencies, restored confidence
and allowed their exchange rates to recover, thereby reducing the debt burden and making space
for policies for recovery to be put in place.
Asian Financial crisis: The aftermath
The aftermath of the Asian crisis was a firm determination by the affected governments to ensure
that the crisis did not happen again. They developed strategies to isolate their economies from
the risk of further external crisis while resuming satisfactory growth rates as soon as possible.
These strategies were marked by a return to an updated open-economy Keynesian analysis that
emphasised export-led growth, although they had to be implemented without resort to some of
the old-time Keynesian policy instruments.
Thanks to the reforms initially adopted as concessions to the Washington Consensus and to those
further adopted (except in Malaysia) as IMF conditions, the Asian crisis economies were left
with financial sectors similar to Australia’s. There were no longer any formal quantitative
controls of financial flow allocation. Central banks were left with the traditional controls of
liquidity supply through reserve asset (prudential) requirements and loan-to-valuation ratios
along with the management of the currency by Central bank asset management decisions, such as
investing offshore when there was upward pressure on the exchange rate. However, the retention
of the established industry policy architecture, coupled with strong informal links between
government and business, provided scope to achieve their goals without formal regulation. In
this there is a lesson for Australia. The East Asian countries used the policy tools they had
available to achieve economic growth without incurring overseas debts beyond the dictates of
prudence, whereas Australia has left the relevant policy tools unused in accordance with the
Washington philosophy that ‘the market knows best’.
The post-1997 data in Table 4 shows that the response from the Asian crises countries followed
the classic template of maximising growth within two major constraints or targets, those of
reducing overseas debt and controlling inflation. The international debt target determines the
current account balance target or requirement. From this the level of exports required to achieve
the current account balance target may be calculated in conjunction with the level of imports
required to generate the level of demand growth that is compatible with:
(i)
the GDP growth target;
(ii)
a level of investment in capacity to meet the GDP growth and export targets; and
(iii) growth in general consumption demand.
The exchange rate is then targeted so as not to undermine the competitiveness of industry. Public
and private consumption expenditure is treated as a residual to provide demand–supply balance
after the resource requirements for the export and investment effort. The fiscal policy
instruments of current government expenditure and tax rates are set to achieve demand–supply
balance. The monetary policy instruments remaining after the concessions to the Washington
Consensus are used to regulate the financial sector to generate an exchange rate outcome that
does not undermine the competitiveness of industry. This requires that adequate financial flows
are made available to fund the export and investment effort while ensuring that financial flows
do not spill over to funding private consumption expenditures, thereby undermining the
achievement of the current account balance target. Industry policy settings, including the
industry policy settings in the fiscal budgets, are set in accordance with the export target and
complementary import replacement target.
These policies generated the favourable post-crisis indicators reported in Table 1. The four
countries returned to satisfactory rates of growth, albeit lower than in the pre-crisis growth rates.
The decline in the growth rate is largely explained by the fact that the productivity growth rate
will fall as a country’s per capita GDP (in purchasing power parity terms) approaches that of the
most highly productive economy, the United States.
With continued productivity growth, market-driven exchange rates would have followed the
Balassa–Samuelson effort and approached parity with the US dollar as per capita GDP
approached equality with the United States. However, the post-crisis policy packages ensured
that the East Asian currencies remained undervalued, more so post-crisis than pre-crisis. The
degree of undervaluation of the Korean and Malaysian currencies was particularly important for
explaining export growth, which, in turn, explained the majority of total growth and the high
accumulated current account surpluses which reduced the ratio of overseas debt to GDP.
The case of Indonesia, which also achieved a sharp reduction in foreign debt but with less ‘real’
export growth than the other countries, is explained by the benefit it gained from the high energy
prices (oil and coal) over the second half of the 2000s. These lifted its terms of trade and allowed
the rupiah to appreciate by 100 per cent against the US dollar between 2005 and 2011, which,
given that no current account deficits were allowed to occur over the period, produced a rapid
reduction in the foreign debt-to-GDP ratio. This outcome stands in sharp contrast to the situation
in Australia. Australia in 2005 had a living standard (as measured by GDP per capita in nominal
US dollars) 25 times that of Indonesia but chose to maximise growth in consumption
expenditure, totally disregarding the growth in foreign debt that this produced.
By 2011, and despite the global financial crisis, the Asian economies had achieved what they set
out to achieve. They were now immune from external economic crisis with very low ratios of
gross debt to foreign reserves and similarly low ratios of short-term debt to foreign reserves.
From Table 4, by 2011 their average ratio of short-term debt to foreign reserves was 1.2
compared to 26.4 for Australia. The successful recovery from economic collapse of the
economies which suffered in the Asian economic crisis has gone unmentioned in Australia, along
with the facts that the crisis was generated by the partial adoption of Washington Consensus
policies and the subsequent recovery depended on finding policy means to return to a Keynesian
list of economic targets, including balance of payments surpluses. Meanwhile, as the media purrs
its approval, the Australian Government continues to implement the Washington Consensus and
seems not to have noticed the high vulnerability of the Australian economy to debt-induced
collapse, even compared to the Asian crisis economies in 1996.
Apologists for Australia’s Washington policies will argue that the debt to reserves ratio of 26 or
more is not as alarming as it was for the Asian crisis economies in 1996 for two reasons. First, a
little under half of Australia’s foreign debt at the end of 2014 was in Australian currency,
whereas in 1996 nearly all the overseas debts of the Asian economies were in foreign currency.
Second, risk management hedging against exchange rate risk is now in place.
The points to be made about this are as follows. First, these strategies are also available to the
Asian economies, but after the shock of financial collapse they were not willing to rely on weak
defences; they chose to undertake a rapid reduction in debt. Second, hedging is only a temporary
protection measure and in the run up to a crisis, which would involve a sharp depreciation of the
currency, hedging costs would become unaffordable with the exposure of domestic institutions to
exchange rate risk rapidly increasing. Third, given the scale of Australian foreign debt
obligations, a sharp depreciation of the currency would be likely to induce counterparty failure,
which by itself could trigger a full-blown crisis, just as counterparty failures were important in
magnifying a relatively manageable array of mortgage failures into the global financial crisis of
2008 in the USA. Fourth, in the run up to an external crisis a weakening currency is likely to
increasingly require rollover of debt into foreign currencies. Within the space of a few months
the ratio of short-term debt in domestic currency could easily fall significantly, which would
continue until an external crisis was triggered.
With this level of vulnerability, how is it that Australia has not as yet experienced an external
crisis? This is because external debt ratios are not the only determinant of an external crisis; a
trigger is needed. However, even if the Australian debt to reserve ratio were miraculously
reduced by 60 per cent it would still be very high compared to the Asian crisis economies of
1996.
Occurrence of a crisis: Necessary and sufficient conditions
Australia now has Rest of World gross and net foreign financial obligation levels (that is
including net foreign investment) that are consistent with countries which in the past have
suffered debt-induced economic collapse. The European Commission’s threshold of 35 per cent
has been exceeded by Australia since the early 1990s. The IMF’s threshold of 50 per cent, in
terms of net debt, has been exceeded considerably since the mid-1990s. The ratio of the
international borrowing requirement to GDP has exceeded the 25-per cent benchmark since
1998. The gross short-term debt to reserves ratio was 4 in the 1990s, 6 in the mid-2000s and at
the end of 2014 was just under 10, having subsided from a peak of 16 reached just before the
global financial crisis. If the trend up to the global financial crisis had continued it may well have
produced an external crisis. China’s stimulus policies drove the exchange rate upwards and
reduced the short-run risk of a crisis.
So far Australia has borrowed heavily but avoided collapse. The reason for this is that high gross
and net debt levels and annual international borrowing requirements create vulnerability, but of
themselves do not produce collapse. A trigger is required, such as the small movement in world
financial market sentiment vis-à-vis Thai borrowing that precipitated the Asian financial crisis.
The trigger could come from within Australia but is more likely to result from the fluctuating
conditions of the world economy, a small change in lender sentiment being sufficient.
Conclusion
When a country like Indonesia, with a fraction of the living standards of Australia, can show
sustained discipline to hold growth in living standards in check for the benefit of debt reduction,
whereas Australia could not do so even in the context of a ‘once in a century’ terms of trade
boom, the rest of the world is unlikely to be at all sympathetic when Australia collapses. It is
instead likely to pursue repayments assiduously. Australia’s best hope lies in its being a
sideshow to some general rebuilding of the world financial system.
References
Catão, L. A. V. and G. M. Milesi-Ferretti (2014), ‘External Liabilities and Crisis’, IMF Working
Paper, May, Washington, DC.
Dadush, U., D. Dasgupta and D. Ratha (2000), ‘The Role of Short Term Debt in Recent Crisis,
December, Volume 37, No. 4, IMF Finance and Development, Washington, DC.
Reinhart, C. M. and K. S. Rogoff (2009), This Time Is Different: Eight Centuries of Financial
Folly, Princeton University Press, Princeton, New Jersey.
Rhee C. and A. S. Posen, eds (2013), Responding to Financial Crisis – Lessons from Asia Then,
the United States and Europe Now, October, Asia Development Bank and Peterson Institute for
International Economics, Washington, DC.
Sundaram, J. K. (2009), ‘Causes of the 1997–1998 East Asian Crisis and Obstacles to
Implementing Lessons’, in R. Carney, ed., Lessons from the Asian Financial Crisis, Routledge,
London and New York.