The Financial Crisis in East Asia: A Background Note by
UNCTAD Secretariat

The following is a Background Note prepared by the UNCTAD
Secretariat providing an analysis of critical issues and
questions on the Financial Crisis in East Asia. The Note was
publicly released at the end of January 1998.

1. To what extent does the financial crisis in East Asia
differ from earlier crises?

This is perhaps the most serious financial crisis since the
breakdown of the Bretton Woods system in the early 1970s, in
terms of both its scope and its effects. Its impact is much
more global than that of the financial crises we have seen in
the past two or three decades, including those in Latin
America. Today, global financial integration is much more
pervasive, and the East Asian countries have a much higher
share of world trade and production. For the first time, a
financial crisis in the South has had a profound impact on
capital markets in the North. It is also expected to cause a
significant drop in global growth.

2. What are the roots of the crisis?

Although different influences have been at play in different
countries in the region, a common feature is that the crisis
has its origin in the private sector and has taken the form of
a major market failure. One can describe it either as
excessive borrowing abroad by the private sector, or as
excessive lending by international financial markets. In any
case, as pointed out by Alan Greenspan, Chairman of the US
Federal Reserve Board, it is clear that more investment monies
flowed into these economies than could be profitably employed
at modest risk. Hence, there is a failure of free financial
markets to produce an optimal global allocation of capital.
There was a similar episode in the Southern Cone of Latin
America in the late 1970s and early 1980s. The private sector
was allowed unrestricted access to external finance in the
belief that, for private firms, the difference between domestic
and external debt was not significant, since they were expected
to assess carefully the costs and benefits on which their
survival depended. The result was private over-borrowing and
a debt crisis, necessitating subsidized debt servicing via
preferential exchange rates and eventually the nationalization
of private external debt and a de facto socialization of the
banking system.

3. What is the role of governments in the crisis?

Perhaps one could fault governments for failing to prevent
market failure. But what they might have done is a complex
question. According to one view, the problem is not
liberalization as such but the absence of effective prudential
regulation and supervision of the banking system. There can be
little doubt that prudential limits on bank lending, capital
adequacy requirements and currency matching conditions for
assets and liabilities that are properly enforced can help
prevent excessive risk-taking by banks, thus containing the
adverse effects of widespread defaults. However, it is not
easy to prevent domestic credit expansion when capital inflows
lead to a rapid liquidity expansion. As long as capital
inflows and liquidity expansion remain unchecked, lending will
eventually spill over from the financing of safe and productive
investments to risky and speculative assets. This in turn
raises the collateral values of the assets financed by such
lending, thereby encouraging belief in the appropriateness of
these values. Such a process was experienced not only in Asia
but also in Mexico in the early 1990s and in the US in the
In this process, as the investment boom continues, growth
remains strong and the external balance deteriorates. But
eventually loans become non-performing and banks are weakened.
Thus, deterioration of the external balance and weakening of
the financial sector are two sides of the same process of
excessive capital inflows. The basic problem is the absence of
instruments to restrict capital inflows and contain their
impact on macroeconomic and monetary conditions. It is
difficult to check this process solely through prudential
banking regulations. In any case, such regulations cannot
prevent excessive non-bank private borrowing abroad. This is
not always appreciated, even though in East Asia an important
part of private borrowing from international banks is by non-
bank firms: one-third in the Republic of Korea, around 60 per
cent in Malaysia and Thailand, and even more in Indonesia. Nor
do international financial markets impose the right kind of
discipline over private borrowers in developing countries. All
too often they manifest in herd-like, pro-cyclical behaviour in
both giving and cutting back loans. The global reverberations
of this boom-bust character of finance are further enhanced by
greater integration of markets and increased mobility of
capital. This is why governments need to be prepared to use a
broad range of policy instruments, including but not restricted
to prudential regulations.

4. What is the role of external factors?

Quite apart from the overreaction of financial markets in
lending and calling back loans, two external factors seem to
have played a major role. First, the appreciation of the
dollar led to the appreciation of the currencies in the region,
as they were pegged to the dollar. The regional division of
labour in East Asia (in the context of the so-called flying
geese process) presupposes a stable pattern of exchange rates,
and this may be an important reason why individual countries
were not willing to devalue vis-a-vis the dollar and hence vis-a
-vis each other. Second, a glut has emerged in markets for a
number of manufactures produced in the region, such as
electronics, leading to sharp declines in their prices.
Attention has focused on over-investment in some areas, but
such over-investment also reflects sluggish global demand - a
phenomenon that UNCTAD has been constantly warning about in
recent years in opposition to the widespread complacency
regarding growth in the world economy. In any case, less than
10 years ago there was much talk about a shortage of savings in
the global economy. Now, however, the refrain has changed, and
the new culprit is excessive global investment at a time when
unemployment in the North is on the rise and poverty in the
South remains unabated.

5. Could the crisis have been anticipated?

Financial instability has become a systemic feature of the
global economy and has been occurring with considerable
frequency since the beginning of the past decade. Accordingly,
such instability is a recurring theme of our annual Trade and
Development Report (TDR). In 1990 we argued that the hands-off
approach to finance was putting serious strains on
international debtor-creditor relations and on the
international payments and exchange rate arrangements. We
warned that although disruptions in financial markets had until
then been contained, "as long as the international monetary and
financial system remained structurally vulnerable, the
potential for an extremely costly crisis would remain". Since
then the world economy has witnessed further bouts of financial
instability, including debt deflation in some major industrial
countries, a currency crisis in Europe, a financial crisis in
Latin America, and now the East Asian crisis. In the early
1990s, the UNCTAD secretariat was among the minority of
forecasters that persistently expressed doubts as to the
sustainability of Mexico's external financial position. On
South East Asia, the TDR 1996 sounded a clear warning, noting
that growth in the region relied excessively on foreign
resources, and that these economies could suffer from loss of
competitiveness and were highly vulnerable to interruptions of
capital inflows. We shall return to this theme in our TDR
1998, to be released in September, with a detailed analysis of
the causes and effects of the crisis, the policy response and
its global implications, and actions needed at the national and
global levels to avert such crises.

6. How should the international policy response be assessed?

Handling a crisis of this kind poses a complex policy
challenge. Indeed, a major disagreement has emerged among
mainstream economists over the appropriateness of the standard
policy package comprising, inter alia, fiscal austerity and
tight money. A main concern is that these could drive the
economies into deep recession. Confidence and stability in
currency markets have so far proved difficult to restore. A
way still has to be found to prevent the undermining of a
positive response to recent shifts in exchange rates by the
effects of high interest rates on the banking sectors and
companies' capacity to meet their financial obligations. The
credit crunch seems to be so deep that, despite favourable
exchange rates, firms are unable to export, as their access to
trade credit has been curtailed. Thus, an important part of
the improvement in the current account balances of the Republic
of Korea and Thailand so far seems to have been due to import
cuts rather than export expansion. Over a longer horizon,
however, increased exports should account for a major share of
the required external adjustment.

7. What is to be done?

A positive adjustment to the crisis should include a number
of components. First, loans should be rolled over and
rescheduled to allow the countries concerned to service them
from future export earnings and not through increased external
borrowing at penalizing rates. This should be combined with
the provision of external liquidity to support the exchange
rate and enable a more accommodating monetary policy to be
pursued while restructuring of the financial sector is under
way. In this respect, there are important lessons to be
learned from the policy response of the US Federal Reserve
Board to the debt deflation of the early 1990s - a response
which played a major role in bringing about one of the
country's longest recoveries following one of its deepest post-
war recessions. Finally, it is necessary to raise global
growth to provide markets in which Asian countries can earn
the foreign exchange needed to pay off their foreign currency
debt. Thus, an important component of the solution is to
remove the deflationary bias in the macroeconomic policies in
those areas of the developed world running large trade
surpluses. Until the surplus countries initiate domestic
demand-led growth and reduce their external surpluses, the
global economy will continue to be vulnerable to the risk of
financial instability and recession, and the crisis in South
East Asia will continue to contribute to the decline in global
growth and to trade frictions.

8. Will the Asian financial crisis dampen world economic

On the eve of the crisis, there was already a major
imbalance in the world economy: virtually all major industrial
countries except the US were expecting faster growth on the
basis of increased exports. The surplus countries (Europe and
Japan) were employing restrictive fiscal policies and
attempting to increase their export surpluses to preserve
growth. With the notable exceptions of China and Taiwan
Province of China, the fast-growing economies of East Asia were
major contributors to global demand, running large deficits
financed by private capital inflows. Perhaps the single
positive contribution of the East Asian crisis is that it has
halted the tendency towards monetary restriction and higher
interest rates in the US and Europe, and hence prevented the
global deflationary gap from deepening further. It has eased
the concern of central bankers over the risk of inflation,
leading Alan Greenspan, Chairman of the US Federal Reserve
Board, to talk of deflation. Japan has also been spurred to
take steps to reflate its economy, while alleviating the drag
on activity resulting from the weakness of its banking sector.
However, the crisis in East Asia will still mean slower growth
of global demand and output. This is recognized by the IMF and
by the OECD, which have revised (downward) their growth

9. Will the Asian crisis affect the launching of the European
Monetary Union (EMU)?

The East Asian crisis may pose an additional challenge for
the EMU. It has been pointed out by several observers that
desynchronization of cycles among the participating countries,
together with restrictions on individual countries' budgetary
policies and the absence of a strong fiscal centre a la US, can
cause frictions regarding common interest rate and exchange
rate policies, particularly since initial conditions with
respect to external payments and labour markets differ widely.
Such frictions are also possible when the EMU community
receives asymmetric external shocks which require different
monetary policy response for the different participants. In
that respect, the coincidence of the Asian crisis with the
launching of the EMU could be a major cause for concern.

10. How will the crisis affect other developing regions?

There are three channels of influence. First, contagion and
capital flight: we have not seen much of it so far, but it
cannot be ruled out. Second, the crisis is expected to
influence policies in other developing countries with large
external deficits. They may be inclined to cut their imports
and external deficits to reduce their vulnerability to an
interruption of capital flows. This happened after the Mexican
crisis when, for instance, Brazil tried to reduce its external
deficits despite continuing capital inflows. This would
certainly be deflationary for the countries concerned and for
the global economy. Finally, other developing regions will be
adversely affected by changes in exchange rates. Given their
sensitivity to inflationary pressures, Latin American and
Central and Eastern European countries may not be able to
adjust their exchange rates to restore their competitiveness in
world markets.

11. Is there a danger of competitive devaluations?

This was a major concern for the architects of the Bretton
Woods system, and that concern increased after the collapse of
the system in the early 1970s. However, it receded when
inflation became a major problem. Because of the implications
for price stability, countries were unwilling to use their
exchange rates to export unemployment. The threat of
competitive devaluations is much more serious now than at any
time since then, because the danger now is deflation, not
inflation, as we already pointed out in TDR 1995. There were
some signs of it during the currency crisis in Europe a few
years ago when some countries pulled out of the EMS and
devalued to import some demand. If the crisis deepens global
deflation, there may be more action of this kind. This is why
it is important to have expansionary policies in the countries
with external surpluses.

12. Is this a situation which might tempt industrialized
countries to protect their markets?

UNCTAD has always maintained that international monetary and
financial instability is the principal enemy of free trade.
Certainly, increased trade imbalances and reduced growth will
provide humus to protectionist sentiments and such pressures
may intensify, as much in countries with slow growth and high
unemployment as in those with large trade deficits. Moreover,
these pressures could succeed in attaining their goals if
surplus countries do not pursue expansionary macroeconomic
policies as developing countries start cutting their trade

13. Is the crisis a setback for the process of globalization?

There are some positive sides to it. It has long been
maintained by many observers that it is not possible to speak
of a "system" of international money and finance in the way we
refer to the trading system. There is indeed a vacuum
regarding global governance of finance. The East Asian
financial crisis has increased awareness of the need for
greater management of international money and finance so as to
prevent the recurrence of similar crises. Indeed, the
international community will undoubtedly be forced to think
about whether or not existing arrangements regarding
international payments and finance are compatible with
stability and growth.

14. What are the issues?

The main problem is that, even though financial markets are
much more integrated than product markets and capital is much
more mobile than other factors of production, there is no
global governance of international financial transactions
analogous to that found in the area of trade. Moreover, the
present international arrangements are not only inadequate but
also asymmetrical; they are designed to discipline borrowers
rather than regulate lenders. This stands in sharp contrast
with the way national financial systems are designed.
Moreover, international arrangements are designed to manage
rather than to prevent crises. And the measures to stave off
international banking crises tend to be at the expense of
living standards, stability and development in debtor
developing countries.
Second, with greater financial integration, the global
impact of interest- and exchange-rate policies has become much
more important. This is true not only for the major industrial
countries but also for many developing countries where policies
are seen to have had serious regional or global repercussions.
There is no effective surveillance in these areas and there
is no way of preventing "beggar thy neighbour" policies
affecting key monetary and financial variables. Moreover,
there is no mechanism for dispute settlement regarding
macroeconomic and financial policies, such as exists for trade
policies. If a country puts up its tariffs on imports of cars
from its neighbour, the latter can go to the WTO and complain,
but no forum exists where a country can make analogous
representations about a rise in a major country's interest
rates and a consequent increase in its debt burden, or about a
devaluation which has the same effect on its exports as higher
Third, there are no effective, rule-based and adequately
funded arrangements for the provision of liquidity by an
international lender of last resort.
Finally, there is a need for a system of orderly work-outs
based on rules and bankruptcy procedures governing
international debtor-creditor relations. Several proposals to
fill these gaps are worth considering. The international
community needs to turn its attention to these issues as part
of efforts to improve the governance of international finance.

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