Download MAS-ESS Economics Essay Competition 2006

MAS-ESS Economics Essay Competition 2006
The Asian Financial Crisis 10 years on: What has changed and
what have we learnt
By: Nicholas Dominic Lim Zi-Jie and Bryan Cheang Yi Da
National Junior College
Overview
The 1997 Asian financial crisis was a tumultuous epoch that had far-reaching
ramifications. It started out vastly different from previous scenarios such as during the
1990s when both Mexico and Argentina suffered financial crises attributed to
unsustainably high budget deficits and galloping inflation. By contrast, most of the
affected Asian countries, during the years leading up to the crisis had strong economic
growth, low inflation, robust investment and budget surpluses. It came as a shock that it
later entailed a global economic slowdown. This resulted in major changes in policy in its
aftermath, also causing a reassessment of economic policies and the effectiveness of
international economic institutions. Ten years after, the changes that have been
implemented have resulted in improvements and greater economic stability, and this is
attributed to the focused analysis of the factors that led to the crisis itself.
What started out as seemingly isolated currency depreciation in Thailand ended in
other neighboring economies being affected in a contagion. Once a crisis of confidence
was triggered, the subsequent implications were almost unavoidable. This loss of
confidence was triggered firstly by the belief in the money markets that Thailand would
be unable to continue pegging their currency to the US$. Thai exports plunged to a 0/05% per annum growth. It was thus questionable if the reserves were sufficient to
support the currency. In addition, the property bubble burst. The loss in investor
confidence led to panic selling of the currency. This ultimately led to a banking crisis as
depositors rapidly tried to pull out their money. The inherent weaknesses of the banking
system at that time meant that banks were unable to deal with this loss of confidence. The
mismatch of assets and liabilities meant that as investors tried to pull out their money,
there was a classic bank run scenario. The capital exodus was further exacerbated by the
higher interest rates in the US, attracting hot money to be transferred there. As banks
called in their loans, the already highly indebted firms therefore defaulted on them,
causing bankruptcies of two parties, banks and firms.
There are therefore six major issues that will be discussed, all of which having a role
in the AFC; premature capital market liberalization and deregulation that made it easy for
financial vulnerability, weak banking systems and current account deficits that eroded the
government’s ability to fight a crisis of confidence, fixed exchange rates that gave the
illusion of stability in the economy, and speculative investment coupled with a weak
corporate sector that brought the economies forward to the edge of the precipice. This
analysis is followed by the steps taken by the East Asian economies to tackle these issues,
the resulting impacts and lastly the lessons learnt.
Premature capital account liberalization and deregulation
A chief focus is that on liberalization, which is one of the important factors that led to the
crisis, if not the most important. The Washington Consensus pressured the Asian
Economies to liberalize their financial markets and open their economies to foreign
capital, and this resulted in a freedom of movement for hot money into and out of the
Asian Economies. With freer capital markets and fewer distortions in the financial sector,
foreign capital flooded in, typically as short-term loans to banks; by 1996, capital inflows
had grown to $93 billion1.
1997 saw foreign investors not only stopped flooding these countries with capital, but, in
fact, reversed course and pulled capital out over $12 billion of outflows from an initial
$93 billion of inflows. This explains the liquidity crisis similar to “run on the bank”,
where depositors’ fears about insolvency become a self-fulfilling prophecy as their
massive withdrawals depletes the banks’ cash reserves. In the case of the East Asian
economies, foreign investors may have lost confidence in their fundamental soundness,
given the failures of the Korean chaebols Hanbo and Sammi Steel and Thai non-bank
financial institutions. This volatility facilitated the loss of confidence which manifested
itself through panic selling of the currency. The downward pressure on Asian asset prices
ultimately led to the deterioration in economic fundamentals2.
1
Radelet and Sachs (1998). These inflows correspond to 8.32% of GDP for the five Asian nations in 1996
(based on World Development Indicators)
2
See Chang and Velasco (2000), which analyzes the Asian financial crisis by building directly on old
models of bank runs.
Stiglitz argues that the IMF preached a highly minimalist role for the government which
went against the trends that fuelled the “Asian miracle” in the first place. Savings rate in
the region were high and there was no particular need for foreign investment. While
gradual opening of markets have been the key to growth in the region, the IMF insisted in
rapid opening. This came before legal institutions were implemented, without proper
banking laws and regulations that would have cushioned the crises effects. It has been
already recognized that capital account liberalization greatly increases the risk of capital
surges, investment distortions, crises, and collapses, especially in countries that lack
robust financial systems.
The inability of the IMF to grasp the reality of the situation is evident in the annual IMF
meeting in 1997, when they out more pressure on developing countries to liberalize their
capital markets. This liberalization left the East Asian countries with fewer tools to cope
with the strains imposed by the surge of capital inflows in the 1990s, itself partly a result
of the liberalization.
Capital account liberalization represents “risks without reward”, however, this measure
was rapidly and prematurely adopted by some nations. Thailand, Indonesia and Korea
were the main countries that had IMF-supported programs. The reversal in Thailand
amounted to 7.9 percent of GDP in 1997, 12.3 % of GDP in 1998 and 7 % of GDP in the
first half of 1999.
The following figure illustrates the concentration of private capital flows that was
accumulating in the Asian countries:
In this regard, managing short-term inflows was particularly problematic. After
the onset of the crises, the scale of the difficulties that arose in individual economies
depended upon macroeconomic policies and the soundness of the financial systems of the
economy. Since in the PRC and Vietnam, foreign direct investment (FDI) flows
dominated net private flows, there was little cause for concern. Conversely, there were
substantial short-term in-flows in Indonesia, Korea, Malaysia and the Philippines. Their
level was dangerously high in Thailand, amounting to 7 to 10 percent of the GDP over
the 1994-96 period. An over-whelming large proportion of these short-term capital flows
came from European and Japanese banks (IMF, 1997). Since the financial systems were
weak, credit analysis was poor, prudential and supervision norms were highly inadequate,
consequently the quality of investment suffered.
This should be contrasted by countries which firstly did not follow IMF advice, and other
countries who simply had strong fundamentals. Malaysia risked the wrath of the IMF by
implementing capital controls and maintaining low interest rates.
They also entered the crisis with stronger fundamentals (See table below); Malaysia's
short-term debt stood well below its foreign exchange reserves, which made it less prone
to a run by foreign creditors. At the same time, as a country with a very high level of
indebtedness overall, Malaysia was quite vulnerable to turnarounds in general market
sentiment that would be reflected in an increase in interest rates or reduction in credit
availability.
It is now largely recognized that premature liberalization would not be in the best
interests of the countries involved, especially for the financial markets. The biggest
change we have seen is the perpetuation of debates and discussion about the role of the
international institutions. There are intellectual currents that have already identified the
importance of the IMF in coordinating global approaches and shown the scope of its
influence.
Empirical studies have also shown that IMF policies that were implemented in the
immediate aftermath of the crisis did more harm than good. They pursued excessively
contractionary policies that go against conventional wisdom of Keynesian theory during
depression times. In fact, the IMF also felt that greater liberalization will restore the
shattered business confidence. This is in fact a blatant attempt to worsen the problem that
has been outlined. Whether conscious or not, premature policies and approaches still dog
the IMF till today.
Pegged Exchange Rates
Also, there was a prolonged maintenance of pegged exchange rates, in some cases at
unsustainable levels, thus subjecting to speculative attacks when markets perceive that
the true value of the currency is misaligned with its pegged value when reserves do not
match up to the value placed. This complicates the response of monetary policies to
overheating pressures and which can be seen as implicit guarantees of exchange value,
encouraging external borrowing and leading to excessive exposure to foreign exchange
risk in both the financial and corporate sectors
Speculative attacks on pegged exchange rate appeared to spread throughout Asia via the
“contagion”. The attack on the Korean won that occurred shortly after the Thai baht
Taiwanese dollar fell. This is attributed to trade competitiveness when there were
speculations of depreciating the Korean won for it to remain competitive relative to the
region.
This led to“currency mismatches.” because both domestic banks and their client firms
had been issuing dollar-denominated liabilities to finance their investments, whose
returns were denominated in local currencies. They held these unhedged positionswith
the assumption that the pegs would hold. However, once the pegs collapsed, their balance
sheets deteriorated severely, leaving them unable to service their debt obligations when
their creditors refused to roll over their dollar liabilities.
Asian economies have responded with a shift away from targeting exchange rates and
toward targeting an explicit desired inflation rate. This started with Korea in 1998,
Thailand in 2000 and then Indonesia in 2005. This decreases the propensity of currency
mismatches by encouraging hedging currency positions, while also allowing for greater
domestic flexibility and control when faced with external shocks. Ultimately, it leads to
greater trade competitiveness.
A build-up of reserves to back these exchange rates is also to smooth the effects if
another external shock occurs3. East Asian nations generally have come a long way
towards achieving exchange rate flexibility and price stability compared to where they
were ten years before, and the improved macroeconomic conditions at present are likely
to have played a role in their renewed attractiveness as destinations for foreign direct
investment(FDIs).
Weak Banking System and Current Account Deficits
In the crisis countries, there existed a weak banking system which was unable to defend
against the bank runs that occurred. The two main weaknesses are unsound lending
practices and poor regulation. The policies of risky lending practices by financial
institutions were due to the inadequacy in supervision and regulation of the financial
sectors. Despite regulatory requirements for Thai banks being rigorous, actual
enforcement of those requirements was much less and in others, nonexistent. Rather than
basing lending decisions on sound information about the economic value of investment
projects, banks and other financial intermediaries based them on personal, business, or
governmental connections, this termed as “relationship lending”. As a result, bank loan
portfolios became particularly risky4.
The pre-conceived notion that the Asian governments were ready to intervene to forestall
bank failures led to investors flooding the Asian markets with money, as evident in Korea.
3
Aizenman and Lee (2005) demonstrate that holdings of foreign exchange reserves are more closely
related to country characteristics.
4
Radelet and Sachs (1998)
The lending boom fuelled by the banking sectors can be seen:
In Thailand, the quality of loan portfolios in banks and finance companies was weak. In
banks, nonperforming loans were 7.2 percent of total loans at the end of 1995 and
increased to 11.6% in May 1997. Banks and finance companies also had not put aside
sufficient reserves for their rapidly deteriorating loan portfolios. Loan classification and
loss provisioning was only tighetend in March 1997. There was also a lack of prudential
limits on loan concentration, and in its absence, banks built up excessive exposure to
particular sectors such as the property market. There was also excessive lending based on
collateral rather than proper credit assessment; thus, when the asset bubble burst,
banksfaced rapid declines in the value of their collaterals.
This is mirrored in Indonesia where lending was largely concentrated to the real estate
and property sector, which increased to about 20 percent of total outstanding loans in
early 1997. There were no strict limits. In Indonesia, the dangers of loan concentration
were heightened by difficulties in seizing and realizing collateral.
There was a concentration of speculative activities in the property market at that time and
the bursting of its bubble led to numerous loan defaults as borrowers were unable to
make good on them. The amount of non-performing loans in the various countries is
reflected as follows:
The Asian Crisis was essentially a case of international illiquidity evidenced by sharply
rising ratios of hard currency short term-liabilities to liquid assets. This explains the
vulnerability to a reversal capital inflows, made even easier by the above-mentioned
liberalization.
The creation of large current account deficits can be traced back to the revaluation or the
Yen in 1985. This saw an increase in the value of the Yen, and led to a shift in investment
in foreign investment elsewhere. SEA was a primary beneficiary of this shift. While this
accelerated the industrialization of the SEA Economics, it started to become problematic
when it started to be financed by short term portfolio investment. In Thailand, short term
portfolio foreign investment was at US$4.2 billion, more than 2x the value of FDI.
The risky financing of current account deficits had a major part to play in the crisis as
well. Most deficits at that time were increasingly being financed by short term loans
which could be pulled out quickly. Such deficits become unsustainable once accumulated
foreign debt becomes large. After a few years of financing substantial current account
deficits with short term borrowing, a number of Asian countries found that they had
accumulated a large stock of short-term external debt .
The current account deficit in Malaysia widened and there was a massive surge in public
investment related to prestigious infrastructure projects. The economy was overheated,
although consumer price index did not show it because several key prices were controlled.
High interest rates at the end of 1996 led to a surge in short-term capital inflows. When
foreign creditors refused to roll over their short-term loans, capital inflows were quickly
replaced by capital outflows. Korea also experienced a dramatic widening of current
account deficit in 1996, leading to accumulation of short-term debt. The 1996 growth rate
of industrial production was half of that in 1995, and export growth rate decelerated
dramatically.
Across these ten years, Korea, Malaysia, Thailand, and Indonesia have gradually
improved banking supervision and regulation and introduced increased market discipline.
For instance, Korean commercial banks have also adopted Western-style board
governance systems with executive stock option programs geared towards tying
compensation more closely to bank performance and cleansed their balance sheets of
nonperforming loans5.
Supervision and accounting transparency also improved. Banks in Thailand, Malaysia,
and the Philippines have succeeded in ridding their balance sheets of nonperforming
loans. Still, there can be room for improvement with respect to enforcement.
Nevertheless, compared to 1997, significant progress has been made overall. Indonesia
has rebuilt ruined banking sector, Malaysian banks’ new emphasis on lending to
consumers and small and medium-sized enterprises that are promising has moved them
away from relationship-based lending (that was the characteristic of non-performing
loans) and Thailand has brought its previously unregulated finance companies under
central bank supervision.
Weak corporate sector and crony capitalism
5
Choe and Lee (2003)
The banking systems in the countries were inherently weak in the first place, lending
excessively to various firms, which led to a serious lack of sufficient liquidity. Nonperforming loans resulted eventually.
With reference to Appendix 1, it can be seen that there was the lack of foreign assets that
did not match the large foreign liabilities of the banking sector. In Thailand, in 1996, the
ratio of foreign liabilities to foreign assets of Thailand’s banks was 700%. The prospects
of these countries being able to service their foreign debts were bleak. Therefore, when
these foreign liabilities had to be discharged quickly-which it did following the Thai baht
devaluation-the banks would be placed under great pressure.
The poor policies and weak banking systems were a result of a weak corporate sector and
crony capitalism. Corporate governance in many industrial firms were weak and there
was a lack of transparency in the operation of firms. Frequent government bailouts gave
firms the impression that they would not be allowed to go bankrupt. Instead, these
companies encourages firms to take on high-risk ventures and to expand into areas that
were far removed from their core businesses.
As a result, the private sector debt in Thailand Indonesia and Malaysia were increasing to
very high levels, greater than public sector debt themselves.
The poor corporate governance reached levels that eventually undermined the economic
and financial systems. This reflected a larger sense of a lack of transparency that existed.
The following shows comparatively the risk of corruption of those countries before the
crisis years:
However, empirical studies according to Radelet and Sachs concluded that transparency
was a weak explanation for the crisis, though it was a journalistic attraction. Nonetheless,
transparency in the domestic as well as international context would have allowed for a
greater diversity of opinion.
Over the last ten years, political developments have shaped the economic landscape of
the countries. In the case of Thailand, we can see that the many military coups have
landed Thais with a government that is willing to pressure external investors to withdraw,
as in the case of the issue with Temasek holdings. Therefore, in some countries, the level
of transparency and quality of governance has not changed much. Thailand’s recent coup
threatens to strip away the tiger-like improvements in the economy that Thaksin managed
to gain.
Overall Development over last ten years:
The initial response to the crisis was not as favourable that many had hoped, but between
1999 and 2005, these nations enjoyed average per capita GDP growth of 8.2 percent and
investment growth averaging almost 9 percent, with foreign direct investment growing at
a healthy annual rate of 17.5 percent. Moreover, all of the loans associated with the
International Monetary Fund’s assistance programs during the crisis have been paid back
and the terms of those programs have been fulfilled.
Political Impact
The role of Asean in the crisis unravels the political impact to the region. There was a
coordinated response to the crisis, and the subsequent efforts were a unifying force that
resulted in greater political ties between the different countries.
Asean realized the need for close cooperation with other neighbouring economic forces
like China, Japan and the Republic of Korea. Consequently, Asean issued the Joint
Statement on East Asia Cooperation at the Manila Summit in November 1999, during
which the ASEAN+3 finance ministers, assisted by the ASEAN+3 finance and central
bank deputies, were holding periodic consultations.
On the international plane, there is also a greater consensus regarding the need for
cooperation therefore, ASEAN articulated its common position on reforming the
international financial architecture.
In that statement, ASEAN called for closer and more coordinated monitoring of shortterm capital flows. In particular, it was agreed that there should be global agreement on
the disclosure requirements for such flows and closer collaboration and information
sharing among national and international regulators. Therefore, what has resulted is a
crystallization of a strong united Asian voice that advocates for a greater level of
transparency and accountability of international institutions. Several Asian countries have
raised the idea of the creation of an alternative IMF, one that is Asian in origin and
oriented toward Asian interests.
A little known fact, but it has been criticized by the IMF itself, on the basis that it
undermines its legitimacy in the international level to maintain global stability. This has
led to greater calls to democratize the international financial establishment. Joseph
Stiglitz himself has tracked the evolution of the institutions, and his conclusions are far
from positive, acknowledging that a lot more needs to be done. Greater levels of
representation of minority interests are needed badly.
Lessons Learnt
A Main lesson learnt is the need for wise prudential regulation. This requires a
regulatory authority with clear rules and procedures, staffed by skilled regulators who are
free from political interference and safeguarded from corruption, plus a legal system that
supports effective punishment of those who break the laws, and information systems that
reports regularly and reliably on the operations of all financial institutions and finally an
accounting system and
The role of the international institutions like that of the IMF and the World Bank,
have come under heavy criticism due to the policies implemented, which have
empirically proven to have resulted in economic problems. Market fundamentalism, is a
dogma they have been accused of adopting. The rigid adherence to capital and financial
market liberalization played a major role in the crisis. Premature financial market
liberalization before appropriate regulatory structures are in place, leads to excessively
risky lending by banks. This inadequate financial regulation left bank lending undermonitored. This is a chief lesson that must be internalized.
It is evident that the healthy economic development must be based on a balance of
efficient input and output. A long time imprudent expansionary macro- economic policy
focusing on continues high growth, in the end, results structural imbalance-- overheating
market environment with excess capacity, over- value equity price and risky stock market
etc. It is now recognized that an average 8-10% annual growth for a decade or two is not
sustainable. The East Asian countries should rest their economic policies on a more
moderate rate, especially considering a changed regional and international market
structure and environment in the future.
Facts have shown that market liberalization and high-tech international financial
system make capital flow easy and quick. Nevertheless, massive capital inflow, if mostly
short term capital either through borrowing or portfolio, results high risk of market
destruction. Speculations by hedge funds may cause sudden crush of the financial market,
and the following outward rush of portfolio investment only leads to a destruction of
stock and equity markets. The host country must find the way to control the short term
capital flow, especially the hedge funds, and of course, at the same time to build up a
strong and efficient banking sector together with the effective supervision instruments. At
the same time, the international financial system needs to be reformed to meet the new
challenges.
At present, what makes us worry most is not just the pervasive nature of the
financial and economic crisis in the East Asian region, but also a danger of further
contagion to the other parts of the world, the result-a global crisis. The regional as well as
international communities should act collectively and firmly to build up the confidence
and take effective measures to restore the foundation of economic recovery.
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