Asia's financial crisis
There is no basis for the claim that the Asian financial crisis was due to a lack of sound economic fundamentals. The currencies of the affected countries were forcibly devalued and their financial systems were brought to ruin by the activities of speculators. The crisis has, however, revealed one glaring weakness: the absence of a lender of last resort for the region.
by Chandra Hardy
THE Asian financial crisis was not caused by macroeconomic imbalances. The fundamentals of Malaysia, Indonesia, Philippines and Korea were and are sound. These economies have high domestic savings and investment rates, high rates of output growth, strong export performance, low inflation and more egalitarian economic policies than any other region.
Many knowledgeable commentators can be cited who have said that the size and the pace of capital outflows from the fast growing economies of East Asia had nothing to do with fundamentals.
The Director of the World Bank's office in Indonesia went so far to say, as he watched the decline in the value of the currency caused by the rapid pace of capital outflows, that 'This has nothing to do with economics.'
The President of the World Bank characterised the crisis as a 'hic-cup' in September, and the head of the International Monetary Fund (IMF) said in May that the government of Thailand was taking courageous steps to address the problems of the financial sector, and doing exactly what is needed to be done to prevent a Mexican-type crisis, and that he 'did not see any particular reason for this crisis to develop further.'
A real estate bubble burst in Thailand. The bubble had been created by huge inflows of external capital. Private capital flows into Thailand between 1988 and 1995 totalled 52% of GDP. The government took all the recommended measures to control the impact of these large inflows on the economy. The most commonly used measures were designed to reduce the expansion of the domestic money supply through sterilised intervention. However, these measures did not reduce the scale of capital inflows which continued throughout 1996. Investment rates jumped to over 40% of GDP.
But no country can productively absorb such large inflows in such a short period.
The experience accumulated by the World Bank over a number of decades indicates that the average period to prepare a large investment project is two years and it takes another four years from the start of construction to full production. Economists refer to this as the lumpiness of investment. Consequently, capital inflows averaging 12% of GDP per annum over a seven-year period cannot find productive use, especially when like Thailand, the investment rate is already very high.
The only investments which can be quickly undertaken are in real estate construction, and this explains how the surge in inflows is channelled through the banking system and creates a bubble in the prices of real estate and stocks.
Reports in the Western press paint a picture of the economy of Thailand that is totally negative. It might be helpful to offer some facts.
Thailand is a middle-income country with a population of 60 million, and a per capita GNP of around $3,000 in 1995. The country has experienced output growth of 8% per annum since 1980, low inflation (less than 5% per annum since 1980), and a rate of growth of exports which has increased from 14% per annum in the 1980s to 22% per annum in the 1990s.
A2 bond ratings
This impressive and stable economic performance over the past 15 years had earned Thailand the highest bond ratings among the emerging markets. As of 24 June 1997, the bond rating for Thailand was A2, and the only country in the region which had a higher rating at that time was Malaysia (A1).
The collapse in real estate and asset prices in Thailand left some financial institutions with a large proportion of non-performing loans. But this problem was largely confined to second and third tier finance companies.
The position of the country's major banks was far stronger. At the end of 1996, the non-performing loans as a share of total loans ranged between 4.3 and 8.0% for the five largest banks, and 7.7% for all banks in the country. (J P Morgan, Emerging Markets Watch, February 1997)
These are not figures which suggest a crisis or overall weakness in the country's banking system. Moreover, the government and the Bank of Thailand were taking steps to deal with the problem in the financial sector, as noted by the Managing Director of the IMF.
At the beginning of 1997, none of the macroeconomic indicators of Thailand were worse than at the start of 1996. The share of short term debt to total debt was lower than it was a year ago and the trade deficit was narrowing in the first quarter of 1997.
But beginning in July, there was a run on the currency.
As a result of financial liberalisation, there was a rapid and uncontrolled build up of short term debt by the private sector. The liabilities to non-residents as a proportion of total domestic credit of the banking system was estimated at more than 45%. (J P Morgan, April 1997). These non-resident 'investors' borrowed in local currency and bought dollars knowing that they would be able to repay the domestic loans with fewer dollars after a devaluation. Short term lenders asked to be repaid.
In mid 1997, the problem in the second tier financial institutions in Thailand was being addressed and the crisis could have been contained. Other countries routinely have crashes in real estate and other asset markets without jeopardising the whole economy. The Asian financial crisis should have stopped at the correction in Thailand.
But why did the capital outflow spread to Malaysia which did not have large short term debt or weak banks, and to Indonesia, the Philippines, Singapore, Hong Kong, Korea and Japan in that order?
In November, the Managing Director of the IMF said in Singapore that while the origins of the crisis in Thailand was clear, 'what is less evident and therefore more unsettling' to all who are trying to make sense of broader regional developments is how the crisis spread to Indonesia, Malaysia and the Philippines.
The currencies of strong economies were being forcibly devalued and their banks and financial institutions were being brought to ruin by the unfettered forces of the market. The new dogma says that the market is always right. Many senior officials in the US said that the market was punishing Asia for its lax economic policies but they offered no evidence to support these charges of lax policies.
In the meanwhile, the currency speculators roamed around the waters of East Asia like sharks smelling blood. Hong Kong, Singapore and Taiwan were weakened but may have survived this attack.
The countries whose currencies and well-being were under attack needed large amounts of liquidity. They tried to get help from neighbouring central banks but the neighbours had provided help to Thailand and they were concerned about the level of their own reserves in case of a run on their own currencies.
South Korea is the world's 11th largest economy with an unmatched record of economic success spanning more than four decades. There is probably no economy in the world whose economic fundamentals are stronger.
South Korea's currency came under attack and the country found itself with no lender of last resort in the region or any where else.
The Asian financial crisis has exposed a glaring gap in the economic policy coordination of the region which will need to be remedied as soon as possible. This weakness is the absence of lender of last resort for the region.
The proposal for an Asian Fund which has been around for some years has considerable merit and the delay in putting it into effect will prove to be costly.
The Bank of International Settlements (BIS) is an institution located in Switzerland which was established to promote cooperation among the central banks. But the BIS does not include among its 29 members any central bank from Asia or any of the emerging markets. Of the 29 members of the BIS, 24 are from Europe. The non-European members are the US, Japan, Canada, Australia and South Africa.
Korea appealed to Japan for help, but Japan had already provided help to other countries in the region and there was increasing concern about a run on its own currency. Any indication that Japan did not have liquidity to spare would have set in motion a speculative attack on the yen. Japan had no option in the circumstances but to tell Korea that it could not provide all the liquidity that might be needed.
Imagine a man who has been running a successful factory producing cars, electronics, machine tools, ships etc. He had been enjoying good growth, rapid exports, sound investment and rising productivity.
One day the roof came off his factory in a major hurricane. He needed help but his neighbours had been hit by the same storm. Finally, the man had to go to the bank which is owned by his competitors.
The bank manager said that he would help but that there were some conditions:
First, the man had to reduce his output so that his competitors would regain their market share and then the man had to sell shares in his company to his competitors.
Korea's reluctance to go to the IMF was not simply a matter of pride as some reports in the press indicated. Korea has borrowed in the past and Korea has a good grasp of global economic trends.
Korea's reluctance to go the IMF had to do with the conditions of the loan.
Korea has managed to produce a growth rate of over 8% per annum for the past 30-40 years without advice from the IMF. Why is the IMF demanding that Korea cut its growth rate in half?
Why should a country doing well before a speculative attack on its currency have to deflate its economy?
How is reduced growth in Korea and Asia going to help the region, the developing countries or the world economy?
Why should Korea fix an economy that is not broken?
The IMF should provide an explanation of why the Asian countries are being asked to agree to conditions on financial market liberalisation as a condition of IMF loans.
Why is the IMF using the crisis to get countries to agree to conditions to which they are not willing agree in multilateral or bilateral negotiations? These are all questions that deserve answers. (Third World Resurgence No.89, January 1998)
Chandra Hardy is a retired senior economist of the World Bank. The above is part of her forthcoming larger study on capital flows to developing countries.