Why have we not learnt more from the 1997-98 East Asian financial crises?
Different, often contradictory lessons have been drawn from the 1997-98 East Asian crises. Ideological implications and political differences involved have generally complicated the possibility of drawing shared lessons from the crises. Finally, vested interests supporting existing international financial governance arrangements have continued to impede implementing lessons.
Jomo Kwame Sundaram
THE East Asian crises which began two decades ago in July 1997 gave rise to various attempts to explain the unexpected events in terms of mainstream theories of currency crisis. Proponents made much of current account or fiscal deficits, real as well as imagined. When this line of reasoning clearly proved to be wrong, inadequate or unpersuasive, a second approach was to turn the preceding celebration of the purported East Asian miracle on its head by suggesting that key elements, such as government intervention and ‘social capital’, were responsible for the crises. Those promoting this condemned ‘social capital’ as cronyism (government favouritism towards politically well-connected business interests) compromising corporate governance. These were real problems, but largely irrelevant to causing the crisis. Finally, there was also some grudging acknowledgment of poor or wrong sequencing of financial liberalisation, rather than of financial liberalisation per se.
Learning from crises ensures that their most important lessons are not lost, that the tragic does not become farcical. Recurrence of crises implies that important lessons have not been appreciated. Unfortunately, erroneous lessons drawn – by orthodox economists, financial analysts and the media – have obscured important policy lessons. They have also diverted attention away from the intellectual and ideological bases of the erroneous analyses and policies responsible for the crises. Many such ideas were due to so-called ‘Washington Consensus’ advocacy of economic liberalisation at both national and global levels. Hence, drawing correct lessons could undermine the analytical and policy authority of the interests and institutions behind this Consensus.
Although there was a consider-able volume of work critical of the East Asian miracle, none actually anticipated the 1997-98 financial debacle. While certain aspects of the crises were common to all four East Asian economies most adversely affected – Indonesia, the Republic of Korea, Malaysia and Thailand – others were not.
Dominance of manufacturing, especially the more technologically sophisticated and dynamic variety, by foreign transnational corporations subordinated domestic industry in the region, allowing finance, both domestic and foreign, more influence. Finance, in turn, developed complex symbiotic relations with politically influential rentiers. Southeast Asian financial interests were quick to identify and secure new possibilities for capturing rents from arbitrage as well as other opportunities offered by international financial integration. Thus, transnational dominance of Southeast Asian industrialisation facilitated the ascendance of finance and politically influential rentiers.
Malaysia and Thailand also wanted capital inflows to finance current account deficits. These were primarily due to service account deficits (mainly for imported financial services and investment income payments abroad), growing imports for consumption, speculation abroad and excessive real estate investments. Such capital inflows did not significantly accelerate economic growth, especially of exports. Instead, they contributed to asset price bubbles.
After months of international speculative attacks on the Thai baht, the Bank of Thailand let its currency ‘float’ from 2 July 1997, allowing it to suddenly drop in value. By mid-July 1997, the currencies of Indonesia, Malaysia and the Philippines had also fallen precipitously after being floated, with their stock market indices following suit.
In the following months, currencies and stock markets throughout the region came under pressure as easily reversible short-term capital inflows took flight in herd-like fashion. In November 1997, despite Korea’s different economic structure, its won also collapsed. Most other economies in East Asia were also under considerable pressure, either directly (e.g., the attack on the Hong Kong dollar) or indirectly (for instance, to remain competitive against devalued currencies).
From miracle to debacle
Rapid economic growth and structural change in the region, mainly associated with industrialisation, can generally be traced back to the mid-1980s. Currency devaluation, deregulation of onerous regulations as well as new targeted subsidies and incentives helped attract relocation of production facilities to Indonesia, Malaysia, Thailand and China from Japan and other first-generation newly industrialising economies such as Korea, Singapore and Taiwan, which were experiencing currency appreciation, tight labour markets and rising production costs.
This sustained export-oriented industrialisation in Southeast Asia well into the 1990s, accompanied by the growth of other manufacturing, service and construction activities. High growth was sustained for a decade, during which fiscal surpluses were maintained, monetary expansion was not excessive and inflation was otherwise kept under control. Until 1997, savings and investment rates were high and rising in the Southeast Asian economies. Foreign savings supplemented high domestic savings in all four East Asian crisis economies, especially Malaysia and Thailand. Unemployment declined, while fiscal balances generally remained positive until 1997. The flood of financial investments inevitably meant declining returns and asset price bubbles, especially in property and share markets.
Foreign borrowing implied ‘currency mismatch’, especially when US dollar borrowings were invested in activities that did not generate foreign exchange. As a high proportion of the debt was short-term in nature and deployed to finance medium- to long-term projects, a ‘term mismatch’ problem also arose. Most serious analysts now agree that the crises essentially began as currency crises of a new type, different from those previously identified with either fiscal profligacy or current account deficits. Starting as currency crises, they quickly became more generalised financial crises, eventually affecting the real economy. Reduced financial liquidity, inappropriate official policy responses and ill-informed, herd-like market responses worsened this chain of events.
Financial liberalisation favoured ‘short-termist’ investments over more long-term productive investments in manufacturing and agriculture, worsening the economies’ current account deficits. Thus, foreign savings supplemented already-high domestic savings, increasingly invested in unproductive activities due to growing foreign domination of new industries, giving rise to macroeconomic concerns by the mid-1990s when the yen, rising from after the September 1985 Plaza Accord, was finally allowed to depreciate. The savings-investment gap was thus increasingly financed by greater reliance on foreign direct investment (FDI) and foreign borrowings.
Both FDI and foreign debt, in turn, implied investment income outflows abroad. As the current account deficit was increasingly financed by short-term capital inflows, reversal of such flows could only have disastrous consequences. Meanwhile, foreign portfolio investments increasingly influenced stock markets in the region. In the face of superficial information, large portfolios, short-term investment horizons and fund manager incentives, foreign financial investments were more prone to herd behaviour. Private sector debt exploded in the 1990s, not least because of ‘debt-pushers’ from abroad keen to secure higher returns from the booming region. Meanwhile, East Asian commercial banks’ foreign liabilities also rose quickly.
Ostensibly prudent financial institutions often prefer to lend for real property and stock purchases, and thus secure assets with rising values as collateral, rather than to provide credit for more productive uses. While foreign banks were more than happy to lend US dollars at higher interest rates than were available in their home economies, East Asian businesses were keen to borrow at lower interest rates than were available domestically.
Meanwhile, as foreign exchange risks rose, dollar currency pegs – introduced by central banks to reduce foreign exchange volatility – increased their vulnerability. The pegs encouraged much un-hedged borrowing by influential debtors with strong stakes in maintaining the pegs regardless of their adverse consequences. (Unlike Korea, Southeast Asia lacked a politically influential export-oriented industrial community to lobby for floating or depreciating their currencies instead.)
Thus, despite their adverse consequences for international cost competitiveness, after pegging their currencies to the US dollar from the late 1980s, most Southeast Asian central banks resisted downward adjustments to their exchange rates. To make matters worse, the 1997-98 East Asian financial crises saw tremendously disruptive ‘overshooting’ in exchange rate adjustments for a year.
Although East Asia’s financial systems were quite varied and hardly clones of the Japanese ‘main bank’ system (as often wrongly alleged), they nevertheless also became prone to asset price bubbles, albeit for different reasons. Rapid growth, based on export-oriented industrialisation from the late 1980s, gave rise to accelerated financial expansion, involving asset price bubbles, including property booms.
Clearly, investor panic was the principal cause of the Asian financial crises. The tightening of macro-economic policies in response to the panic served to exacerbate rather than to check the crises. While cronyism is wrong, it was not the main cause of the East Asian crises. The crises showed that even sound macro-economic fundamentals do not guarantee immunity from contagion and crisis. With the currency collapses, assets acquired in the region depreciated in value from the perspective of the foreign investor, precipitating an even greater sell-off and panic, causing herd behaviour and contagion to spread across national borders.
Meanwhile, liberalising the capital account essentially guaranteed investors ease of exit besides lifting limitations on nationals holding foreign assets, thereby inadvertently facilitating capital flight. Thus, financial liberalisation allowed lucrative opportunities for taking advantage of falling currencies, exacerbating regional currency and share market volatility. All this, together with official responses, caused the collapse of the currencies and the stock markets aggravated by herd behaviour and contagion.
Little was achieved by officials insisting that the crises should not have happened because economic fundamentals were fine, even if true. Official denials sometimes even exacerbated the problem, especially when authorities did not do what market opinion makers deemed appropriate. Governments cannot liberalise the capital account and then complain when short-term portfolio investors suddenly withdraw. Capital controls can make rapidly with-drawing capital from an economy difficult, costly or both. Many governments treat FDI quite differently from portfolio investments.
Not surprisingly, conventional wisdom has continued to blame the crises on poor government policies. Citing currency crisis theories, macroeconomic, especially fiscal, policies were condemned as inappropriate. In fact, most East Asian economies had been maintaining budgetary surpluses for some years at least. The International Monetary Fund (IMF) and others, including the international business media, called for spending cuts and other pro-cyclical policies (such as raising interest rates) which exacerbated the downturns. Adopted in much of the region from the end of 1997, they precipitated economic collapse instead. Thus, currency and financial crises triggered crises of the real economy.
From early 1998, however, as conventional macroeconomic explanations were found wanting, a new line of criticism focused on the political economy of the region. Cronyism in corporate governance was condemned as the source of the regional financial crises. US Federal Reserve chair Alan Greenspan, US Deputy Treasury Secretary Lawrence Summers and IMF Managing Director Michel Camdessus led a fast-growing chorus criticising Asian corporate governance from late January.
By the second quarter of 1998, however, it was clear that such policy recommendations and conditionalities had actually worsened rather than ameliorated the deteriorating economic situation. The failure of fiscal as well as corporate governance explanations of the Asian crises was evident not only to heterodox economists in the region. Eminent Western economists more familiar with the affected economies conspicuously challenged the orthodoxy, helping to turn the tide. Then World Bank senior vice president and chief economist Joseph Stiglitz famously disagreed with IMF Deputy Managing Director Stanley Fischer, while other prominent economists, such as Paul Krugman and Jeffrey Sachs, provided important support for adopting counter-cyclical policies, and some libertarian market economists also challenged the role of the IMF on other grounds.
Meanwhile, heterodox economists emphasised how the transformation of the region’s economies and financial systems from the late 1980s had engendered their increased vulnerability and fragility. Liberalised financial arrangements and institutions attracted massive capital inflows to the rapidly growing region. Much of these came from Japanese and continental European banks as US and UK banks exercised greater prudence in international lending as they continued to recover from the 1980s’ sovereign debt crises. Bank for International Settlements (BIS) regulations also encouraged short-term lending, which was easily ‘rolled over’ indefinitely in good times. But such ‘rolling over’ could be quickly terminated when conditions became less favourable, as happened when the crisis began.
Significant inflows were also attracted by stock market and other asset price booms in the region, transforming them into bubbles. Thus, foreign portfolio flows fuelled stock market manias. But as they were easily reversible, they also enabled panics. In the face of uncertainty and limited information, herd behaviour – especially characteristic of capital markets – exacerbated pro-cyclical market behaviour, blowing up bubbles in ‘good times’ and bursting them with catastrophic effect in times of panic. As financial globalisation enabled such fickle market behaviour to have consequences across national borders, it exacerbated contagion. As more distant foreign, including institutional, investors tended to view things more regionally, their investment decisions were more likely to exaggerate regional neighbourhood effects.
A year after the crisis began in July 1997, US President Bill Clinton acknowledged the need for a new international financial architecture in a speech in mid-1998, triggering international discussion for a brief time. The apparent spread of the crisis to Brazil and Russia added grist to the mill. The collapse of New York-based Long-Term Capital Management (LTCM) following the Russian crisis led the US Federal Reserve to coordinate a private sector bailout of the hedge fund in a successful pre-emptive effort to contain the problem.
This initiative legitimised government efforts in East Asia to intervene to ensure functioning financial systems and liquidity to fund economic recovery. The Malaysian government’s establishment of bailout institutions and mechanisms in mid-1998 and its imposition of capital controls on outflows from September 1998 also warned that other countries would go their own way if nothing was done. When the US Fed lowered interest rates soon after, capital flowed to East Asia once again.
Ironically, the relatively rapid ‘V-shaped’ economic recoveries in the region from the last quarter of 1998 may well have reduced pressure to reform the international financial system. Talk of Clinton’s new international financial architecture rapidly faded as rapid regional recovery was seen as proof of international financial system resilience. Interest in crisis avoidance, crisis management, development finance, international financial system governance and regional financial cooperation, among other topics, was revived by the 2008-09 global financial crisis, but has since receded again despite the limited reforms which have been put in place, mainly at the national level.
The Japanese government’s offer of $100 billion to the region to manage the crisis during the third quarter of 1997 was blocked by the US government, some of its allies and the IMF. Later, a smaller amount was made available under the Miyazawa Plan, allowing for more modest facilities, institutions and instruments. From around 2000, following a regional meeting of finance ministers in Chiang Mai, Thailand, a series of ‘bilateral’ credit lines emerged, but with the condition of requiring an IMF programme. In May 2007, the finance ministers of Japan, China and Korea agreed to ‘plurilateralise’ the arrangements and to increase resources committed to the credit facility. There have also been other regional initiatives since, including the Asian bond market and the Asian Infrastructure Investment Bank, which have made varying degrees of progress. An earlier idea, similar to the European Investment Bank and the Latin American Development Bank (expanded from the Andean Development Corporation), to mobilise private funds for long-term investments, e.g., in infrastructure, has not progressed as regional cooperation has become increasingly hostage to relations between Japan and China.
Arguably, pragmatism compelled responsible officials to become more Keynesian, at least in responding to the crisis. For a time at least, some authorities adopted counter-cyclical policies. There has also been greater vigilance in pursuing central banks’ prudential regulatory and supervisory responsibilities in preventing financial excesses as well as consequent fragility and vulnerability. Some authorities are also more prepared to intervene to ‘delink’ or isolate markets if necessary in order to limit contagion among market segments as well as from finance to the real economy.
Some insiders insist that such changes are in place despite continuing lip-service to more ‘neoliberal’ preoccupations such as keeping inflation in check. Others, however, claim that such vigilance and preparedness has declined with time and fading memories of 1997-98. Also, as history never repeats itself, it is very difficult to be prepared for future exigencies as financial systems evolve creatively in response to constraints, often creating unexpected new vulnerabilities.
Clearly, various different and sometimes contradictory lessons have been drawn from the 1997-98 East Asian crises. However, the analytical implications and political differences involved have complicated the possibility of drawing shared lessons from the crises. The region’s rapid recovery and improved growth in most developing countries in the new century also meant less interest in and appetite for far-reaching reforms. Although many similar issues were raised by the 2008-09 global financial crisis, eurozone commitments have straightjacketed prospects for European recovery. Meanwhile, powerful interests supporting existing international financial governance arrangements continue to impede progress on that front, with little challenge from recent Western nationalist resurgences. Such interests continue to draw support from conventional market wisdom, reinforced by the business media and its continuing hold on international monetary and financial governance.
Jomo Kwame Sundaram, a former economics professor and United Nations Assistant Secretary-General for Economic Development, received the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought in 2007.
*Third World Resurgence No. 321, May 2017, pp 13-16