Asia: New study for "more prudent approaches" to liberalization

In his recently-published book, Filipino economist Manuel Montes attributes the Asian financial crisis in large part to the failure of regional economies to manage the "twin liberalizations" of the domestic financial system and the capital account. The attendant linkages among asset markets, particularly in the case of exchange rates, heightened the vulnerability of these economies to the vagaries of short- term capital.

by Chakravarthi Raghavan

GENEVA: The "currency" crisis in Asia is a case of "asset markets" dominating the "real markets" - in exports, imports and production - and setting exchange rates, leading to attacks on other currencies, and both Asia and the world must learn to deal with such crises, both in the response and in the prevention mode, according to a new study.

In a just-published book, Currency Crisis in Southeast Asia, Manuel F. Montes, a Filipino economist working at the Institute of Southeast Asian Studies (ISEAS) in Singapore, argues that the regional economies failed to manage the process of "twin liberalizations" - of the domestic financial system and of the opening of their capital accounts. Hence, the solutions to such crises when they occur and measures to prevent them lie other than in standard adjustment packages.

Montes ridicules hindsight attempts to lay the blame on poor prudential supervision and "Asian values", and says this would be tantamount to blaming the US Savings and Loans Association disaster in the US in the 1980s on "a surfeit of Asian values in the USA."

Written in October 1997 based on the situation then, and updated on 1 March 1998, before publication, Montes notes that at the time of the original analysis, Thailand was in the grip of the crisis and Indonesia was approaching the IMF in what was then thought to be a "pre-emptive move". The general judgement then was that the "asset markets" would be efficient enough to conclude that the currency devaluations would provide a hefty boost to exports, providing a floor below which currencies could not fall, and that the contagion and panic effect in the region could be contained and other countries with sound macroeconomic data and information, such as Malaysia and Singapore, would not be affected.

Magnitude of crisis

But subsequent events showed that "asset markets" had taken charge of setting currency rates, leading to further currency attacks on the Hong Kong dollar, the Korean won, the Japanese yen and other currencies.

Montes says the October analysis, locating the crisis in the weaknesses in the financial systems, magnified by the international contagion effects traceable to incomplete information, still applies. That analysis had warned that falling currency values and high interest rates have the effect of further weakening domestic financial systems, which were the focus of the crisis in the first place.

But, Montes says, his analysis then failed to capture the quantitative extent of the unfolding crisis and had been too optimistic that the eventual export-competitiveness of Asian economies and their high savings rates would prevent the contagion effect from knocking currency values so low that a second crisis would emerge.

This has now occurred in Indonesia, and has the potential of appearing elsewhere as long as currency values are not stabilized, Montes warns. The values of Asian currencies have fallen considerably since the initial efforts to stabilize them were undertaken in July-August last year. By end January this year, the baht had fallen by 55%, the Indonesian rupiah by 80%, the Korean won (which came under attack in December) by 50%, the Malaysian ringgit by 45%, the Philippine peso by 40% and the Singapore dollar by 19%.

Montes noted that the Asian crisis is the third to occur in the 1990s - the earlier ones were the generalized attack on European currencies in the Exchange Rate Mechanism (ERM) in 1992-93 which forced the UK and Italy out of the system, and the 1994-95 crisis sparked by the Mexican devaluations, when the Argentine and Brazilian currencies came under attack.

Such crises, he argues, follow on or are justified by weaknesses in domestic banking systems - following an episode of vigorous external capital inflows - and can be attributed to the failure to manage the "twin liberalizations" - of the domestic financial markets and opening the capital account.

The liberalization of domestic financial markets, and the credit boom that followed, in Thailand resulted in a significant proportion of credit being channelled to property development. But the asset bubble in Indonesia was not as pronounced. In Indonesia, the liberalization process (which began in 1983) provided an incentive for Indonesian corporations to accept significant, US dollar-denominated obligations, creating the conditions for a crisis if the rupiah were to be devalued precipitously.

The capital account liberalizations provided domestic financial companies access to foreign banks and investment funds. In Thailand, the Bangkok International Banking Facility (BIBF) played a mediating role in the enormous inflow of funds in response to the opening of the capital account. In Indonesia, there had been minimal controls on capital account transactions since 1972, but there were implicit controls located in banking rules. But the liberalization of these rules in 1988 opened up numerous possibilities for short-time flows into Indonesia. The effects on Indonesia and Thailand are contrasted with those in Singapore (which has been successful in becoming an international financial centre with off-shore banking, introduced in 1972), where the monetary authority has strict regulations to separate domestic from offshore operations, and has the means and power to regulate the domestic purposes to which offshore funds are applied.

In Korea, the weakness in the domestic banking system was not spawned directly from dependence on short-term capital inflows for a credit boom. There were restrictions on portfolio and investment inflows into equity markets, and these were due to be phased out (over a period) due to Korea joining the OECD.

But as a result of the financial crisis, these restrictions are being rapidly dismantled as part of its (IMF-conditioned) adjustment package and "it remains to be seen if this sudden opening of the capital account will set the stage in a more distant stage for a Thai-style currency crisis," Montes comments.

Korea was drawn into the crisis because its business groups, chaebols, which were investing in domestic industrial development, were also expanding their overseas operations and raising resources from international banks. "But a significant proportion of these foreign borrowings were offshore in a different sense: they were borrowed by their offshore operations from international banks operating under regulatory rules of the foreign country."

With the same banks also providing the chaebol-related Korean banks with trade credits, critical for import-export activities, and with confidence in the Korean corporate and banking system beginning to falter, the international banks terminated the renewal of short-term trade credits, setting in train the Korean currency crisis.

Classic financial crash

The unprecedented knockdown of currency, equity and property values since July 1997, testifies to the enormous flight of assets denominated in Asian currencies to US dollar-denominated assets; even economies with relatively healthy banking systems, like Singapore and Taiwan, have witnessed significant losses in their stock exchanges and depreciated currencies. "Their own banking systems now have to expect servicing difficulties on the part of their clients in the economies whose currencies have devalued faster than theirs, especially in loans denominated in US dollars."

The Asian region has thus fallen into a classic financial crash - characterized by "euphoria" preceding financial crises - credit booms fed by intense investor interest and rising asset values, followed by panic taking over and prices entering a downward spiral.

Based on the Asian experience, Montes believes that currency crises may occur in a cycle of 18-24 months and the world, not just Asia, would have to learn to deal with these crises, both in response and in prevention modes.

In such crises, forces driving currency value changes do not arise out of flow deficits, but largely out of asset flows. If unsustainable current account deficits were the conventional source of currency attacks in the Asian crisis, there were no egregious flow deficits, especially in the public-finance area. Even the elevated deficits in Thailand and Malaysia (before the crisis) would have been sustainable on long-term considerations.

There is also a strong linkage in asset prices across different economies, many of them quite different in terms of real sectors. But the key asset price is the current exchange rates, and any possible change in exchange rates in one of the economies affects the exchange rates of others, seen by asset markets to be linked.

As for responses, Montes argues that the first step should be a recognition of the features of the crisis. In a generalized asset crisis, there is overall loss of confidence in the soundness of domestic banking systems. In Asia, where the real sectors and export sectors were quite robust, it is a genuine "Quinicine-style" crisis in which developments in asset markets can seriously undermine output and employment, and adjustments in asset prices (such as exchange rates) could be quite extreme and out of line with reasonable economic recovery.

Information shortcomings

The experience of Asia has also exposed the many "inadequacies in the information-gathering and dissemination industry," Montes says. Fund managers and currency traders begin their days with a frantic reading of newspapers and wire-service reports, which contain countless and commonplace errors - such as reporting the total debt of a country as the amount by which the debt increased.

The media, with their time and space constraints, have an understandable preference for "simple-minded soundbites" - some from other fund managers themselves, sometimes as anonymous 'analysts' - and rumours and opinions become news in the crisis landscape. It also became the province of analysts - more adequately trained in economics than in politics - to make pronouncements on the political, constitutional and cultural reforms appropriate to Thailand, Indonesia or Asian governments in general.

While such publications proved that business analysts enjoyed freedom of expression in Asia, they tended to emphasize the potential depth of the crisis, "ignoring that many of the problems Asia was experiencing in the management of investment had occurred even in industrial countries."

Government efforts to add to this information may prove futile, but it is the best that can be done in such a situation - it might not be possible to prevent the emergence of erroneous interpretations, but it might at least be possible to prevent them hardening.

It was also a curious phenomenon in the region that private fund managers, judged by their pronouncements, were "more Catholic than the Pope" in measuring the magic of IMF programmes based on their strictness and on religious adherence to the regimen.

But the IMF programmes themselves are only based on the best information available at the time, and there is "nothing necessarily magic about them or their contents."

Exchange rates in emerging economies seem now to be more strongly linked than before, even without a formal exchange link, and a devaluation in one can trigger attacks on other related currencies.

This means single-country IMF programmes will be insufficient, and will be overtaken by external events in such asset crises. "Coordinated exchange rate intervention or intention to carry this out on the part of affected central banks appear to be an unavoidable add-on to single-country adjustment programmes."

The standard IMF package is not oriented to the rehabilitation of the domestic banking system but to domestic demand contraction. This has proven wanting, Montes points out, referring to the Indonesian experience. With a "not-unsound" current account deficit of about 4%, the required IMF demand- contraction package would have been, at most, a modest one, and the economy would already have been contracting anyway when the banking system buckled under currency devaluation and investment funds dried up. What was at stake was the ability of domestic banks and corporations to service foreign debt, a specially trade credits.

Possible preventive measures

An alternative adjustment package (to the IMF one) in a banking-triggered currency crisis would immediately recognize this trade credit problem and provide resources specifically for this purpose, based on best estimates of what would be required, Montes says.

On proposals for preventing future crises through stronger supervision of banks and strengthening the capacity of public authorities to supervise banks, Montes points out that developing countries have more limited abilities to supervise bank operations relating to international transactions or the creation of new financial instruments such as derivatives. Hence, action by developing countries to impose higher capital adequacy and liquidity ratios should not be interpreted as attempts by public authorities to undermine the liberalization process. This should also apply to the imposition or re- imposition of bank reserve requirements. Even though they increase financial repression, reserve requirements help authorities to manage liquidity creation out of external capital inflows.

Laying the blame, in hindsight, for failed liberalization programmes on poor prudential supervision, is naive, Montes points out. So is heaping the blame for poor supervision on "Asian values", when these kinds of problems have arisen in all banking failures following liberalization.

"To say these kinds of weaknesses are specifically Asian in character, is tantamount to blaming the Savings and Loans Association disaster in the US in the 1980s to a surfeit of Asian values in the US," Montes says.

Various measures to insulate the development of the domestic banking system from dependence on short-term external funds seem called for, Montes says. But because of the large scope for regulatory evasion, a combination of capital controls, regulatory practice and taxes may be needed.

Referring to various proposals for taxing and regulating short-term flows (like the Tobin-tax idea or George Soros' idea of an international credit insurance corporation, guaranteeing loans to each country for a modest fee), Montes points out that domestic financial institutions, especially in the industrialized economies, are regulated in their local operations but are quite unregulated in their international lending activities. "The imposition of taxes or fees for the guarantee of loans is a first step in regulating these activities," he says.

Asia, Montes says, is the latest victim of volatility, both in the inflow and in the outflow phase, in short-term investment flows. Its experience and situation make it well- placed to participate in efforts to improve international capital arrangements.

The aftermath of the crisis, he predicts, will see Asia's real economies damaged, but not devastated. Asia's high savings rates and robust fiscal finances make it less dependent on short-term international investment funds - both to close current account deficits and to finance development ambitions.

Asia does not really need to compete internationally for these funds and can afford to accept such funds on its own terms. Asian economies basically require adequate hedging facilities to provide some predictability of exchange rates for goods they trade internationally.

And Asia's own private financial and banking companies, beneficiaries of high domestic savings rates, are only beginning to internationalize and have no vested interests in sustaining unstable international capital movement rules that could put at risk Asia's own savings.

Asia has adequate capability and a clear interest in reforming international financial arrangements. But reform must begin at home with more prudent approaches to liberalization. Still, it remains to be seen whether governments and the private sectors in Asia will seize the opportunity to decisively influence international reform efforts. (Third World Economics No. 183, 16-30 April 1998)

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