Asia: The causes of the crises

The Trade and Development Report 1998 argues that the East
Asian crisis is only the latest one in a string of financial
crises rocking the global economy in the post-Bretton Woods
era. The root of these crises can be traced to imprudent
financial liberalization and the subsequent failure to
adequately manage and control the resultant capital surges.
Moreover, conditions in the East Asian economies were
exacerbated by the international community's orthodox policy
responses to the crisis.

by Chakravarthi Raghavan

GENEVA: The crisis in East Asia, and the dramatic turnaround in
the economic fortunes of these economies do not stem from the
"East Asia model" or the resistance of these countries to a
globalizing world and the discipline of market forces. Rather,
says UNCTAD's Trade and Development Report (TDR), the crisis
occurred because governments failed to manage integration into
global capital markets with the same prudence and skill they
had earlier shown in managing trade liberalization. Throwing
caution to the wind, the voices of orthodoxy ordained even
larger doses of financial liberalization, and wrong assessments
of the roots of the crisis and the remedies put forward on this
basis have been responsible for worsening the crisis, the
report brings out.

From the beginning, says Yilmaz Akyuz, the author of the
report, "our assessment of the crisis and causes [was]
different from those of orthodox assessments which concentrated
on certain institutional and socio-economic characteristics of
the regions, including the weaknesses of the Asian model."

This ignores the fact that the crisis in Asia does not
differ in essential features from other crises that have
occurred in industrial and developing countries, which have
different social characteristics.

In what it calls a common-sense view, the report says that
a few lessons are evident. First, the worst time to "reform"
a financial system is in the middle of a crisis. Second, when
currency turmoil is associated with financial difficulties,
raising interest rates may simply worsen the situation by
bringing about widespread corporate and bank insolvencies.
Finally, currencies should not be left to sink while funds are
used to bail out the international creditors.

Looking back on the crisis and its handling, says Akyuz, it
is clear it was not well-handled. The orthodox policy measures
advocated by the international community aggravated the
financial difficulties. Market confidence was further
undermined by the initial allegations of corruption and
cronyism. And closing down the banks to reform the financial
system in the midst of the crisis undermined confidence.
Instead of supporting the currencies of the affected countries,
the international community was seeking free capital flows and
bailing out the lenders. These are the main factors that
aggravated the situation.

Potential backlash

The events of the past year, says the TDR, should serve to
underline the warning in last year's TDR of a potential
backlash against the contradictions of a globalizing world.

Asks the TDR: "When a colossal global market failure and
measures taken to bail out creditors are paid for at the
expense of the living standards of ordinary people, and of
stability and development in the debtor developing countries
concerned, who is to say that justice has been served?"

In East Asia, the trend of decades of rising incomes has
been reversed, and unemployment, underemployment and poverty
are reaching alarming levels. Many of the lost jobs have been
in sectors that had helped to reduce poverty by absorbing low-
skilled workers from the countryside. Rising food prices and
falling social expenditures have further aggravated social
conditions and contributed to growing poverty. Even on
conservative estimates, the proportion of the Indonesian
population living on incomes below the poverty line in 1998 is
expected to be at least 50% greater than in 1996. Similarly,
poverty in Thailand can be expected to increase by at least

"As the crisis drags on, it will be increasingly difficult
for the new poor to recover from deprivation and return to
their previous occupations and living standards. Moreover, the
social harm could persist long after economic recovery is
achieved. Judging from the mounting evidence of growing child
malnutrition and declining primary school enrolments, the
impact of the crisis on human resources will spill over into
future generations."

"Safety net measures can act as palliatives to cushion the
impact of the crisis on poor and vulnerable groups, but they
are in no way a lasting solution. Only the resumption of rapid
and sustained growth can bring unemployment and poverty levels
back down to pre-crisis levels. Policy should turn from
deflation to reflation, supporting the unemployed by lowering
interest rates, expanding liquidity and raising public
expenditure, thus breaking out of a vicious circle that could
do incalculable harm."

Challenging orthodox views on the origins of the crisis, the
TDR points out that the East Asian crisis is only the latest in
a string of financial crises which have disrupted the global
economy since the breakdown of the Bretton Woods system.

Such crises have been occurring with increasing frequency in
both industrial and developing countries. In industrial
countries, the episodes of financial instability have involved
either banking or currency crises; but in developing countries,
they have typically been a combination of the two, and have
been accompanied by difficulties over external debt service.
These differences reflect divergences in net external
indebtedness as well as the increasing dollarization of the
economies of developing countries.

Common characteristics of crises

A greater understanding of the causes and nature of financial
crises is essential for their better management as well as for
designing policies to reduce their likelihood. While each
episode of financial instability has had its own special
characteristics, a number of common features stand out, says
the TDR:
* They have typically been preceded by financial
deregulation and - where there was currency instability - by
liberalization of capital transactions;
* Banking crises have been associated with excessive lending
on certain categories of assets such as property and stocks,
and with speculative bubbles, frequently following a large
movement by banks into certain types of financing for the first
time. Such lending has often, but not always, taken place in
the context of weak financial regulation and supervision;
* Currency crises have typically been preceded by periods
of sharply increased capital inflows attracted by a combination
of an interest rate differential and relatively stable exchange
rates. These act as an incentive to borrow abroad, but at the
same time they increase exposure to currency risk;
* There is no known case in any country, developed or
developing, of a large increase in liquidity in the banking
sector resulting from capital inflows that did not lead to an
over-extension of lending, a decline in the quality of assets
and increased laxity in risk assessment;
* The inflows generate tendencies to currency appreciation
and deterioration of the balance on the current account. When
there are excessive capital inflows, the worsening of external
balances and the weakening of the financial sector are often
two sides of the same coin;
* of the impetus for the increased capital flows is
related to the crisis of commercial banking in the major
industrial countries. The pressure on banks to find alternative
sources of business to increase returns, and the greater
competition in the financial sector brought about by
deregulation, have been an important cause of increased
international financial instability;
* Reversals of capital flows are often associated with a
deterioration of macroeconomic conditions resulting from the
effects of the inflows, rather than with shifts in policies.
But almost all major episodes of capital outflows and debt
crisis in developing countries have been associated with rising
international interest rates. The consequent currency
depreciation leads to capital losses among those with unhedged
exposures, and may become a force transforming the depreciation
into a free fall owing to the rush for foreign exchange.

Other features of currency crises have varied. They have
occurred under rather diverse conditions with respect to types
of financial flows, borrowers and lenders. For example, they
have been preceded by borrowing by the private and public
sectors in different proportions. Likewise, the most important
form of capital flows in many recent crises (including that in
East Asia) was international bank lending, but in the Mexican
crisis, a large share consisted of portfolio investment in
equities and in the paper of the Mexican Government.

Liberalization, interest rate differentials and nominal
exchange rate stability have been the main factors attracting
capital inflows; and rapid liberalization often gives rise to
expectations of improvements in economic fundamentals and large
capital gains as well as perceptions of reduced risks. The
existence of massive arbitrage flows taking advantage of large
international interest rate differentials appears to be an
important element in each currency crisis in the post-Bretton
Woods period. And while in traditional concept, arbitrage
opportunities are not permanent and eventually get eliminated,
international interest rate arbitrage flows tend to be self-
reinforcing rather than self-eliminating, thus making it more
difficult to sustain domestic policies. And in the absence of
controls, capital inflows generally result in an unfavourable
combination of appreciating real exchange rate, rising foreign
deficit and rising fiscal deficit.

Constant factor of volatility

Analyzing the various types of flows - FDI, portfolio
investments, bank lending - and the maturity of the flows and
so on, the report challenges the view that one particular form
is better than the other or prevents crises. The likes of Asia,
Latin America and elsewhere have in their experiences gone
through a full circle of bank loans, bonds, FDI and portfolio
flows. But "there is one constant factor, namely extreme
volatility of flows in periods of crisis."

"The divergences in the form of the flows received by a
country do not seem to have made a substantial difference to
the impact of these flows on domestic conditions and their
subsequent reversal."

Nor is the distinction between private and public borrowing
borne out. The experience of the post-Bretton Woods system
shows that the nature of the borrower does not significantly
alter the probability of a crisis. And financial sector
competition, caused by deregulation, is as much a cause of
increased financial instability as anything else. Large capital
flows lead to an overextension in bank lending that is exposed
when flows are reversed, resulting in instability or collapse
of the banking system, says the TDR.

The TDR notes there is now a tendency to relate these to
inappropriate domestic regulation or lax supervision, and to
emphasize the importance of sequencing liberalization with an
effective system of prudential regulations. This is a welcome
but delayed response, says the TDR, which points out that among
the ten lessons drawn by the World Bank on the tenth
anniversary of the Latin American debt crisis, there was no
mention of sequencing or prudential regulations, and that
"there is also a limit to what prudential regulations can

Outlining what it calls a "typical post-Bretton Woods
crisis", the TDR says that such a crisis involves increased
interest rate differentials, often associated with tight
monetary policy aimed at attaining or maintaining price
stability. Financial market deregulation and capital account
liberalization are introduced alongside currency regimes
maintaining nominal exchange rate stability. These combine to
produce arbitrage margins large enough to attract liquid and
short-term capital and reinforce the stability of the exchange
rate peg. Liberalized and deregulated banks are free to expand
into new areas of business internally, and domestic firms are
free to borrow abroad, avoiding higher domestic interest rates
and building up foreign currency exposures. The combination of
success in controlling inflation and exchange rate stability
tends to cause a real appreciation of the currency, and weakens
the foreign balance. Attempts to sterilize the impact of these
capital flows on domestic credit expansion lead to greater
pressures on interest rates. And since domestic bonds are
issued to finance sterilization of inflows held as reserves in
foreign currency at lower interest rates, the fiscal position

Eventually, either the foreign balance or fiscal balance
gets out of control, domestic financial conditions deteriorate
and there is extreme vulnerability to changes in perception,
rise in foreign rates and rapid outflows, breaking the exchange
rate peg, leading to capital losses for banks and firms
carrying unhedged foreign currency exposure.

Such a process can occur under varying conditions, and
starts not with unsustainable policies but with those designed
to maintain macroeconomic stability and integrate the economy
into the global system to take advantage of global market
opportunities. And in the absence of effective controls, the
impact of capital flows distorts the effect of policies, making
it very difficult to attain the objectives. (Third World
Economics No. 193, 16-30 September 1998)

Chakravarthi Raghavan is the Chief Editor of the South-North
Development Monitor (SUNS)from which the above article first appeared.