CHAPTER 2
THE FINANCIAL AND ECONOMIC CRISIS:
EVOLUTION, CAUSES AND LESSONS LEARNED
A. East Asia’s Historic
Economic Success
B. Evolution of the
Asian Financial and Economic Crisis
1. The Origins of the Crisis in
Thailand
2. The Emergence of
Contagion Effects in the Region
3. Economic and Policy
Stagnation in Japan
4. Developments in China
C. Causes of the Crisis
D. Lessons Learned
E. Impacts of the
Crisis on Regional and Global Economies
THE FINANCIAL AND ECONOMIC CRISIS: EVOLUTION, CAUSES AND LESSONS LEARNED
Prior to the events of 1997, the East Asian region was characterized by an abundance of economic success. Dr. Saywell told the Committee that whereas East Asia contributed a scant 4% of global economic output in 1960, and North America 37%, by the year 1997 the two regions shared virtually the same proportion of global economic output (25%). Recent events, however, have cast doubt on the prediction of some authorities that by about 2020 the world economy would be led by Asian countries.
A. East Asia’s Historic Economic Success
East Asia’s economic rise had been truly remarkable, starting with the Japanese economic miracle. Shattered by the Second World War, Japan began rebuilding its economy with U.S. aid soon after the war ended. Japan’s real economy grew by an average of 9.2% per year between 1950 and 1970, before moderating to slightly less than 5% per year between 1970 and 1990. As a result of this tremendous growth performance, Japan’s share of Organization for Economic Cooperation and Development (OECD) countries’ GDP rose from under 2.5% in the early 1950s to almost 23% in 1995; its share of world exports increased from US $9.8 billion in 1966 (or 5.1% of world exports) to US $443.1 billion in 1995 (or 8.8% of world exports). After the United States, Japan remains the world’s second largest economy.
Japan, too, played a key role in East Asia’s economic development, first as a market for the region’s raw material exports, and later as a source of foreign direct investment and a market for labour-intensive products. Mr. Yozo Yamagata (Member, Canadian Advisory Board, Marsh & McLennan Limited) explained to the Committee how the yen’s strong appreciation during the 1980s accelerated Japanese manufacturers’ shift of operations offshore, especially to Asian countries. These investments served to hasten the region’s economic development and to increase intra-regional trade. Mr. Yamagata also noted that Southeast Asia has been Japan’s largest export market since 1991, surpassing the United States in that regard.
Following Japan’s example of export-led growth, the newly industrialized economies (NIEs) of Hong Kong, Taiwan, South Korea, and Singapore began developing in earnest in the 1960s. As Japanese wages rose, the NIEs initially became the source of labour-intensive manufactured products, such as footwear, clothing, and textiles. Later, the NIEs were able to compete with Japan in other areas, first in heavy industries such as chemicals, steel making, and shipbuilding, and then in transportation vehicles and consumer electronics. Taken together, the four NIEs averaged real GDP growth of over 8.5% per year between 1960 and 1988. Exports from the four NIEs increased from US $3.2 billion in 1966 (or 1.7% of world exports) to US $528.7 billion in 1995 (or 10.5% of world exports). Hong Kong and Singapore continue to enjoy living standards comparable to those of the world’s industrialized nations.
Four of the Association of Southeast Asian Nations (ASEAN) economies ¾ Malaysia, Thailand, Indonesia, and the Philippines ¾ represent another wave of Asian industrialization. These economies first began producing agricultural products and raw materials, such as oil, rubber, and tin. The ASEAN economies were able to capitalize on their large populations to manufacture labour-intensive products, such as clothing and textiles; later, electronics and electrical products became important manufactures. Like Japan and the NIEs, the ASEAN economies relied on an export-led strategy to achieve high economic growth rates, with merchandise exports rising from US $3.4 billion in 1966 (or 1.8% of world exports) to US $193.4 billion (or 3.9% of world exports) in 1995.
The next wave of developing East Asian economies included Vietnam, Laos, and Cambodia. As wage rates rose in Malaysia and Thailand, labour-intensive manufacturing began to shift away, to Vietnam in particular. Vietnam’s economy grew by about 9% in 1996 and foreign companies invested US $2.3 billion in the country that year. Vietnam’s accession to ASEAN and to APEC was also designed to hasten that country’s development.
The fastest-growing, and potentially the largest, economy in East Asia is that of China. Between 1978 and 1987, the Chinese economy grew by an average of 9.5% per year; most years since then it has expanded by double-digit amounts. In fact, since China’s authorities began to reform the country’s economy in 1979, it has increased in size by an astounding 475%. While many of the country’s 1.2 billion citizens remain in poverty, the sheer size of the population, combined with extraordinary rates of economic growth, meant that a sizeable Chinese middle class was beginning to develop. China’s exports grew from US $2.7 billion in 1966 (or 1.4% of world exports) to US $148.8 billion (or 3.0% of world exports) in 1995.
Analysis by the World Bank suggested that the high economic growth rates experienced in East Asia up to 1997 could be explained by a number of factors:
- substantial private domestic investment in physical capital;
- investment in education and training policies;
- solid macroeconomic management, providing a stable environment for private investment;
- policies designed to encourage private savings;
- slower population growth;
- policies that kept price distortions to a minimum and welcomed foreign technology; and
- policy interventions targeting certain industries, including measures promoting exports.
B. Evolution of the Asian Financial and Economic Crisis
Over three decades, the East Asian region displayed strong economic growth (see Table 1), reasonably low rates of inflation, sound fiscal positions, and high foreign capital inflows. In 1996, however, economic imbalances began to be noticed by the international financial community. These imbalances took the form of sizeable current-account deficits; property and equity bubbles; excessive dependency on external borrowing, fuelled by global investors’ search for high yields, to finance long-term investments; and a rapid deterioration of banks’ loan portfolios.
Table 1
Economic Growth Rates Of East Asian Countries (Real GDP)
(%)
| Country | 1990 | 1991 | 1992 | 1993 | 1994 | 1995 | 1996 |
| Indonesia | 9.0 | 8.9 | 7.2 | 7.3 | 7.5 | 8.2 | 7.8 |
| Malaysia | 9.6 | 8.6 | 7.8 | 8.3 | 9.2 | 9.5 | 8.2 |
| Philippines | 3.0 | -0.6 | 0.3 | 2.1 | 4.4 | 4.8 | 5.5 |
| Singapore | 9.0 | 7.3 | 6.2 | 10.4 | 10.1 | 8.8 | 7.0 |
| Thailand | 11.6 | 8.1 | 8.2 | 8.5 | 8.9 | 8.7 | 6.4 |
Source: International Monetary Fund, World Economic Outlook, October 1997
For about a year, capital markets pummelled certain East Asian currencies and equity markets, with declines ranging from 20 to 75% during the second half of 1997. The collapse in asset prices, the slowdowns in economic growth throughout the region, and the extent of financial and corporate insolvency have been far worse than was expected. Despite massive international intervention, few signs of lasting economic recovery have been observed.
In recent months, Russia and Brazil have also caught the "Asian flu", as investors have become increasingly disillusioned with the world’s emerging markets. The Russian stock market has declined sharply, the rouble has come under considerable downward pressure and domestic interest rates have soared. All these events have combined to raise political instability there. Closer to home, growth forecasts for the North American economies have been repeatedly revised downwards.
1. The Origins of the Crisis in Thailand
"Beginning in about 1993 or shortly after, imbalances begin to appear in the Thailand economy. Growth and demand were excessive. We began to see a rise in inflation pressures and a growing current account deficit. Moreover, some of the growth was unbalanced in the sense that these massive capital flows tended to be intermediated by the banking system which was, in retrospect one could say, too loosely regulated or supervised so that much of this money ended up being invested in the real estate sector, so there was a real estate boom in Bangkok in particular."
(Mr. Bruce Rayfuse, Acting Director, International Finance and Economic Analysis Division, Department of Finance)
Box 1
CHRONOLOGY OF THE CRISIS IN EMERGING ASIA
1997 |
|
14-15 May |
|
27 June |
|
2 July |
|
11 July |
|
14 July |
|
14 August |
|
20 August |
|
20-27 October |
|
31 October |
|
1 November |
|
17 November |
|
3 December |
|
8 December |
|
1998 |
|
6 January |
|
12 January |
|
23 January |
|
27 January |
|
28 January |
|
13 February |
|
26 February |
|
4 March |
|
23 March |
|
Source: OECD Economic Outlook, June 1998, Box 1.2
As Box 1 illustrates, the financial crisis in East Asia was first observed in Thailand in July 1997. Government authorities in that country had failed to deal effectively with an overvalued currency and an overheated economy, the symptoms of which could be noticed in terms of a growing current account deficit that increasingly was being financed by unhedged foreign currency-denominated borrowing, overinflated equity and property values (i.e., bubbles) and rising domestic inflation. Thailand’s current account deficit had exceeded 4% of the country’s GDP since as far back as 1990, with that of 1996 attaining a full 8%. Even so, foreign creditors continued to be satisfied with relatively high interest rates on baht-denominated deposits, as well as with the perceived guarantee of a continuation of an exchange rate anchored to that of the U.S. dollar. The money markets also observed that the foreign borrowing was being used primarily to increase investment, perceived to be a more desirable use of the borrowed funds than strictly consumption. The country’s debt to foreign banks increased from US $29 billion in 1993 to US $69 billion in mid-1997, with 70% of this debt being of the short-term variety.
Regrettably, Thailand experienced a large exchange-rate devaluation as international and local financial interests speculated that the existing exchange rate level could no longer be sustained in the face of high current-account deficits, rapid inflation, high rates of economic growth, and, perhaps most importantly, a 35% decline in the Japanese yen relative to the U.S. dollar during the 1996-97 period. This latter factor was especially damaging: it made Thai exports more expensive, and therefore less desirable, for Japanese purchasers. As the market lost confidence in the baht, the capital inflows that had fuelled economic activity quickly turned to outflows, with the baht coming under severe downward pressure from the actions of both foreign speculators as well as local investors.
In its futile efforts to support the plunging baht, the Thai central bank secretly ran down its usable financial reserves to near-depletion levels. Out of corrective options, the Thai government had no choice but to let the baht float and to request the assistance of the IMF. In response, a US $17 billion emergency lending program was hastily arranged.
2. The Emergence of Contagion Effects in the Region
What then followed was a case of Asian contagion or what is sometimes referred to as "bahtulism." The currency crisis that began in Thailand spread almost overnight to Malaysia, Indonesia, the Philippines, and other neighbouring countries as panicky investors rapidly lost confidence in the region’s economies and began targeting the currencies and equity markets of these three neighbouring countries. Even though current-account deficits in Indonesia, Malaysia, and the Philippines were smaller than that of Thailand, and foreign direct investment more substantial, all countries experienced a deep depreciation of their currencies (see Figure 1).
Figure 1
Source: The Economist, July 18, 1998
In part, what drove the speculative attack on the other currencies was those countries’ perceived lack of competitiveness when measured against Thailand, whose currency had just depreciated. More significantly perhaps, what the markets saw when they examined these other countries more closely were many of the same problems being experienced in Thailand, especially in their financial systems. "In each country, weak financial systems, excessive unhedged foreign borrowing by the domestic private sector, and a lack of transparency about the ties among government, business, and banks all contributed to the crisis and complicated efforts to defuse it."(2) Like Thailand, Malaysia, Indonesia, and the Philippines also maintained fixed exchange rates relative to the dollar; these had to be abandoned as the currency crisis hit. However, even the International Monetary Fund admitted that "markets overreacted and the extent of the exchange rate adjustment exceeded any reasonable estimate of what might have been required to correct the initial overvaluations of the affected currencies."(3)
The sudden declines in domestic currency values added dramatically to the external debt burdens of private sector borrowers, who attempted to cover their foreign (i.e., dollar) liabilities by purchasing foreign exchange. Predictably, this rational response on the part of investors, largely Asian, served to accelerate the pressure on the various currencies, forcing them downward even farther.
To deal with these severe balance-of-payments shocks, the IMF, together with other multilateral as well as bilateral lenders, responded quickly to requests for financial assistance. In addition to the US $17.2 billion given to Thailand, Indonesia was provided with a total of US $42.3 billion in assistance. Malaysia has not yet requested the assistance of the IMF. Prior to the crisis, the IMF had already approved a US $1.0 billion Extended Fund Facility for the Philippines; access to this Fund has been renewed. In October, Hong Kong responded to a speculative attack on its pegged currency by using part of its substantial stock of foreign exchange reserves and by raising its domestic interest rates. While the government’s response proved to be successful in defending the value of the Hong Kong dollar, the financial turmoil had a sobering effect on local equity markets and ultimately the economy, which by then was in recession.
In November, the crisis hit South Korea, Asia’s third most important economy after Japan and China, and at the time the world’s eleventh-largest economy. What was different about this situation was that South Korea did not suffer from excessive imbalances in its current account and its exchange rate. The country’s foreign exchange reserves, however, were quite low compared with the amount of private, foreign short-term debt that had been incurred. In fact, this debt-reserves ratio was by far the highest of any in the region (see Table 2). South Korea’s incidence of non-performing loans was also quite high; estimates pegged this ratio at some 20% of total loans.
When it did come, the crisis hit South Korea hard, with the value of the won recording daily declines of as much as 10%, short-term interest rates rising to 30% and even higher, and the country experiencing high growth in the number of bankruptcies. Once again, the IMF had to come to the rescue, in December 1997, this time with a US $58.2 billion package of assistance for South Korea. Overall, the international emergency assistance extended to the three countries requiring financial help (Indonesia, Thailand and South Korea) totalled US $117.7 billion.
Table 2
Foreign Short-Term Debt And Reserves, Selected East Asian Countries
(US $billions)
Country |
Short-Term Debt |
Reserves |
Debt/Reserves Ratio (%) |
| China | 42 |
141 |
29.8 |
Indonesia |
27 |
28 |
96.4 |
South Korea |
60 |
17 |
352.9 |
Malaysia |
14 |
24 |
58.3 |
Philippines |
15 |
9 |
166.7 |
Taiwan |
29 |
81 |
35.8 |
Thailand |
32 |
20 |
160 |
Source: Robert E. Litan, "A Three-Step Remedy For Asia’s Financial Flu", Brookings Policy Brief Series no. 30: www.brook.edu/PA/PolicyBriefs/pb30.htm, p. 4.
There is no doubt that the economies most seriously affected by the crisis are Indonesia, South Korea, and Thailand. In each a reduction in private foreign financing has combined with large currency depreciations and drops in asset prices to lower domestic demand sharply, to a level, which will not be compensated by, anticipated increases in net exports. The combined force of an initial asset price inflation and then the sudden deflation caused by speculative activity has precipitated a significant rise in the level of non-performing loans in the region, rendering a number of local financial institutions insolvent. Also, the financial crisis has caused serious declines in spending, production, and employment in these countries.
Since July 1997, only these three countries in the region have needed new IMF rescue packages. (4) As the quid pro quo for the provision of this credit assistance, the IMF has drawn up a long list of tough adjustment programs. These require, among other things, the temporary tightening up of fiscal and monetary policy, the restructuring of financial sectors, the deregulation of economies and their opening up to foreign interests, and an amelioration in the quality of governance, including a move towards increased transparency. Failure to implement quickly the IMF-mandated reforms has caused international currency markets to place considerable continuing pressure on certain currencies in the region.
Regrettably, the financial turmoil, combined with structural adjustment, has brought with it significant effects on the livelihoods and savings of millions of residents, and a rise in inflation as subsidies for basic foodstuffs and medication have been cut by governments in the region. The living standard of the poorer segment of society has been eroded and political and labour unrest has escalated, especially in Indonesia and South Korea. In Indonesia, the combination of a dropping rupiah and escalating prices has boosted dramatically the incidence of poverty, unemployment, and ethnic tension. The prevailing economic conditions led ultimately to the riots that brought about the resignation, after thirty years in power, of President Suharto. In South Korea, the official jobless rate rose to a record 7%, placing additional fiscal demands on the government to increase unemployment benefits.
Progress in implementing the crucial financial reforms has been mixed. Both Thailand and South Korea have moved relatively quickly to clean up their financial institutions, by seizing control of large, financially-distressed banks and shutting down certain insolvent ones, by lessening restraints on foreign investors, by increasing banks’ capital thresholds, and by revising bankruptcy legislation to facilitate the recovery of the collateral behind problem debt. On the other hand, corporate debt still remains a sizeable burden, with the remaining banks far from keen to incur costly write-offs.
Malaysia, although not under an IMF-imposed adjustment program, has nevertheless taken tentative reform steps such as the introduction of tighter accounting standards for its banks, standards that force them to expose more of their non-performing loans. Also, the government has forced 39 local finance companies to merge into eight new entities. It has refused to budge, however, on an opening up of its financial sector to outside interests, maintaining its cap of 30% on foreign ownership.
No other country in the region has been as hard hit as Indonesia, with its currency having depreciated by an outstanding 80% in just over one year. The country’s financial sector suffers from weak supervision, historically tight links between borrowers and lenders, and directed lending on the part of state-owned banks. Indonesia has also been by far the slowest in undertaking financial reforms. The Indonesian government and the IMF have been working on a fourth agreement designed to stabilize that country’s deteriorating economy. Three others have broken down because it was determined that the government had not, in each case, lived up to its reform promises. It is thought by some that this failure to deliver on reform pledges has significantly aggravated the economic situation in Indonesia.
3. Economic and Policy Stagnation in Japan
"Our current assessment is that the most serious issue in Asia may not be directly related to Southeast Asia at all, but whether the largest economy, Japan, will be able to emerge from its prolonged period of slow growth."
(Ms. Ingrid Hall, Director General, South Asia and Southeast Asia Division, Department of Foreign Affairs and International Trade)
Many developing Asian countries had hoped that Japan would provide economic leadership in the wake of the crisis, but this leadership did not materialize. Owing to its own internal economic troubles, Japan has not been able to serve as the engine for the resumption of regional economic growth, in the same way the United States served during the Mexican peso crisis in 1994-95.
There is no question but that Japan is far and away the region’s wealthiest economy. The world’s second largest economy, it accounts for almost 20% of global GDP and over 50% of total Asian GDP. Moreover, Japan’s GDP is over five times that of China, and its multinational firms are leaders in investing capital and in transferring technology. Its recurring current-account surpluses have made the country the largest capital exporter in the world, accounting for almost US $200 billion in outward FDI and portfolio investment flows in 1995 alone.
On the other hand, Japan has been struggling economically for much of this decade: its output fell by 0.5% in 1997 and the country is now in recession. Although Japan’s wealth suggests that it is not likely to implode as a result of the Asian crisis, the country’s close ties to an economically weakening East Asia has caused it to suffer from the contagious effects of the Asian flu. Already, the dramatic slowdown in other countries in the region is imposing adverse effects on Japanese economic growth. This result should not be of much surprise given the fact that the rest of Asia serves as the market for almost one-half of Japan’s exports. In turn, Japan’s neighbours in East Asia have not been able to export their way to recovery, owing to a large extent to the continuing stagnation of the Japanese economy and its inability to absorb a greater share of Asian exports.
Policy inaction on the part of what is often described as ineffective government has, up until now, continued to hamper economic recovery in Japan(5). Considerably greater effort is required to revive the economy: up to this time the government’s attempts to reflate the economy by fiscal and monetary policies have not met with much success. With central bank interest rates now extremely low (in the vicinity of 0%), the use of monetary policy to boost domestic demand is not currently an option. Therefore stimulating demand will have to come from fiscal policy initiatives. As Ms. Huber (Director General, North Asia and Pacific Bureau, Department of Foreign Affairs and International Trade) suggested to the Committee, what is required to increase internal consumption is a large-scale tax stimulus of a kind that Japan’s cautious consumers will view as permanent.
As is the case with other East Asian countries, the weaknesses in Japan’s financial system have been exposed by the financial crisis. The Japanese banking sector is plagued by a credit shortage brought about by the existence of massive numbers of non-performing loans. Instead of cleaning up its debt-burdened banking system in the early 1990s in the wake of the bursting of its "bubble economy," the Japanese government chose a course of gradualism. In the end, the necessary financial reforms were not implemented. Although the country’s debt problem is different from that of other countries in the region, in that the debt is primarily domestic in nature, the Japanese authorities have, until recently, been unable to bring in the necessary financial sector reforms.
Owing to a serious lack of confidence in Japan’s ability to make the critical policy decisions needed to turn around a sluggish economy and to cure a sick banking sector, international currency markets have brought about a significant decline in the value of the yen. Concerns about the slumping yen have been so great that the Japanese authorities have deemed it necessary to request financial assistance from the United States, which provided U.S. $2 billion to support the value of the currency. But this monetary intervention came with strings attached: the implementation of a badly needed restructuring of the financial sector to deal with Japan’s bad-loan problem and overcapacity in the banking sector, and changes to the country’s tax system. What the U.S. insisted on as the quid pro quo for its aid was a permanent income tax cut of some 10 trillion yen (about US $72 billion), a reduction in the country’s corporate tax rate of 46%(6), and, most importantly, an overhaul of the banking system.
The Japanese government had no choice but to respond to the demand for banking-sector reform. Late in June 1998, it announced plans to write off the bad debts of failed financial institutions while not terminating lines of credit with healthy borrowers, using the services of government-owned "bridge banks". This strategy came under immediate attack, with critics arguing that this scheme would not reduce capacity in the financial system, since the assets of the most troubled banks would likely just be transferred from the private to the public sector and not liquidated. Moreover, problem loans would not be written off as quickly as expected and new lending from the newly-created public sector banks to what could be a host of undeserving firms would crowd out private lending. (7)
Fortunately, an improved financial sector assistance package has now been approved by the Japanese legislature. This massive program consists of two parts. First, it sets up a system to identify and, through the creation of a new organization, take control of insolvent banks, then disposing of their loans while protecting depositors and good borrowers.
The second part of the plan involves a sizeable injection of public funds (over US $500 billion) into viable banks, so as to provide stability to the financial sector and stimulus to the nation’s economy. One of the issues remaining to be resolved involves the placement of conditions on those banks receiving the additional capital. For example, it is not yet clear to what extent the banks will be held accountable for their losses.
If Japan does not successfully follow through with its planned reforms, its recession will surely be prolonged and the global economy will continue to be dragged down. "The critical question for Japan is whether it will proceed with or even accelerate implementation of its own planned financial reforms in the face of the current Asian crisis, or whether it will instead use the crisis as an excuse to extend the protection it has long provided to inefficient firms, particularly in the financial sector. If Japan continues to waffle and to defer needed reforms, then the long-term consequences of the Asian crisis may be severe indeed for Japan. Other Asian competitors will eventually emerge from the crisis, leaner and meaner and more open than ever before. How Japan responds now will largely determine its long-term well-being and its relative position in a rebounding Asia."(8)
Up to this point in the evolution of the Asian financial crisis, China has escaped the worst of the crisis that has pummelled the stock and currency markets of East Asian countries. The first explanatory factor is that the renminbi’s lack of convertibility on the capital account protects it from attacks by currency speculators suspicious that the currency is overvalued. China has been able to insulate itself from the region’s economic turmoil precisely because its currency is not openly traded in world capital markets: rather, the government fixes its value. The financial crisis in East Asia, coupled with the need for China to carry out important structural reforms in its economy so as to avoid a banking sector collapse, is causing delays in the move to make the domestic currency fully convertible.
Second, unlike the situation in South Korea and Thailand, China enjoys the luxury of having little in the way of short-term foreign debt, (9) a current-account surplus, and, according to Ms. Karen Minden (Principal, Asia-Pacific Associates), between US $130 billion and US $145 billion in official reserves. Also, foreigners are sharply restricted in the types of shares they can trade on China’s two stock exchanges.
Although Chinese statistics are notoriously unreliable, China’s economy officially recorded another year of high growth in 1997, with real GDP rising at an 8.8% year-over-year clip. This result contrasts with the 9.7% increase registered for 1996. Inflation is being held in check, with year-end 1997 results indicating an inflation rate of less than 3%.
Early indications are that the performance of the Chinese economy in 1998 has worsened, and that the government’s target of 8% growth will not be met. Typically, international trade and investment have been the prime drivers of Chinese economic growth; yet it must be recognized that these two main pillars of the country’s recent remarkable economic performance have displayed weakness. All in all, the country faces its bleakest prospects since the late 1980s.
In the wake of the region’s financial and economic difficulties and the increased competition posed by countries whose currencies have depreciated, China must cope with a distinct contraction in trade. A severe reduction in China’s export growth from the annual 20% gains of recent times would certainly have serious repercussion on the country’s economic growth at a time when domestic demand is weak.(10) Already, there is evidence of a cooling down of the rapid export growth experienced earlier. China’s exports to Japan, South Korea, and Southeast Asia have fallen dramatically, and while new markets have been found (e.g., Australia), overall growth in export demand in the first half of 1998 has declined to the 7.6% mark.
As well, there are signs that foreign investors are dampening their enthusiasm towards China. Ms. Margaret Huber (Director General, North Asia and Pacific Bureau, Department of Foreign Affairs and International Trade) told the Committee that her Department expected foreign direct investment in China to drop from US $45 billion in 1997 to US $30 billion in 1998. She went on to say that this result could be largely attributed to a pulling back from China of East Asian investors, who are themselves seriously affected by the equity and currency crisis and who are unable to invest any additional funds in that country. With the spread of the crisis to Japan and elsewhere, a growing general reluctance to invest within the region itself has also developed on the part of many non-Asia based investors.
One benefit that can be derived from the East Asian economic turmoil is the signal it sent to China’s leaders of the need to accelerate economic and institutional reforms. The government in China began to devote much attention to economic issues in its determined move toward a "socialist market economy." Dramatic economic reforms were proposed, including the restructuring of over 300,000 state-owned enterprises (SOE); the overhaul and downsizing of an inefficient public sector burdened with a sizeable debt load; the reform of a banking and financial sector plagued by non-performing loans; and the adoption of a more outward-oriented trade and investment policy. In view of the current economic difficulty that the country is in, China has postponed its reform initiative. Failure to eventually achieve a successful reform of the Chinese economy will, however, impose far-reaching bad effects on the country’s economic performance.
State-owned enterprises have historically been an important factor in Chinese society, accounting for a full one-half of urban employment. They represent a tremendous fiscal burden to the state, however, with some 60% of them operating at a loss and most saddled with high levels of debt. The state sector sucks in 80% of the country’s investment, thus clogging the banks with bad debt, while starving private firms of cash. Government subsidies to these largely inefficient organizations account for two-thirds of China’s budget deficit.
The SOE reform program, when completed, should result in the privatization of many of the old government-owned companies. Those that remain will no longer be expected to provide health care, education, and housing for their employees. Successful completion of the reform program will also require the implementation of bankruptcy legislation (failing companies will be allowed to go bankrupt) and the establishment of a national social security system to deal with the needs of the millions of workers who will be displaced. Official estimates of existing unemployment in China are in the order of 15 million in urban areas and 130 million in rural regions. The additional unemployment from SOE restructuring will worsen the existing unemployment situation even more and could lead to social unrest.
The Chinese economy also displays many of the financial-sector problems that have afflicted its neighbours. For example, much of China’s inefficient and state-owned industry is propped up by government-directed loans from the large state-owned banks. Not only are many of these loans "non-performing" – 20 to 40 percent by most accounts, exceeding the corresponding figure for Japan, South Korea, and Thailand – they serve to crowd out lending to private firms.
In terms of capital adequacy, profitability, and bad-loan ratios, China’s banks are probably the most fragile in Asia. Poor management and excessive lending during the boom years of the early 1990s has eroded the leading banks’ capital base to the point where the asset-equity ratios of the top four state-owned banks(11) do not meet the Bank of International Settlements’ eight-per-cent capital-adequacy standard. The overhaul of the banking system, which the government had initially hoped to accomplish over a three-year period, is an imposing undertaking.
The financial turmoil elsewhere in the region has impressed upon the Chinese leadership the need, at a more opportune time, to reform the country’s financial sector. The authorities realize that a weak, non-transparent banking system, distorted by cronyism and political favouritism, is a recipe for disaster. At the top of the priority list is the clearing out of poor loans, the shutting down of insolvent or weak financial institutions, the move to lending based on strictly commercial terms, and the removal of the banks’ duty to provide continuous financial support to the weak SOE sector. These reforms were regarded as necessary parallel moves for the government’s decision, announced in February 1998, to issue 270 billion renminbi (approximately US $33 billion) worth of bonds in order to recapitalize the four largest state banks.
While the Chinese government is eventually committed to reforming the banks and the SOEs, doing so requires a healthy, growing economy to absorb the pain, a circumstance which the present government does not enjoy. If the economy does not keep growing at a 7%-8% rate, it will not be possible to create employment in sufficient quantities for the growing army of laid-off workers, who have an insufficient welfare net to fall back on, to be absorbed back in the work force. The regime in Beijing is intent on dovetailing its reform plans with a return to healthier economic growth patterns.
Also, China continues to lack the economic clout required to play an effective leadership role in the region(12). For example, it is not yet economically robust enough, nor does it have the financial, technical or managerial resources, to serve as the locomotive to pull the region out of its economic and financial miseries. Indeed, it is likely to serve, in the near term, as a competitor to the other regional economies, rather than as the engine of growth.
Notwithstanding this reality, China has derived from the crisis considerable goodwill within the Asian region. This it has done by providing unconditional financial assistance, (in the order of US $4 billion) to crisis-plagued neighbours. More significantly, China has acted with admirable restraint throughout Asia’s financial troubles. It has pledged not to devalue the renminbi as it did in 1994, perhaps realizing that its previous devaluation had contributed to last year’s regional economic miseries.
The fears that many China-watchers have is that the government will decide to devalue rather than lose export markets to countries in the region whose goods are now cheaper as a result of currency depreciation(13). Certainly the Chinese regime will be under pressure to do just that, because China’s exports have become relatively less competitive owing to other countries’ exchange rate changes. The real danger is that a decision to support the slumping Chinese economy through a devaluation at this time would prompt another round of globally destabilizing competitive devaluations throughout the East Asian region. Such action almost certainly would aggravate regional economic woes and possibly subject other parts of the world to additional contagion effects.
"On the export side, there is no need for devaluation in China because the export industries are already highly competitive…. On the other hand, through imported energy and foods, the potential inflationary consequences of a devaluation will be much more widespread throughout the economy…. They are gaining politically by not devaluing, and there is no reason for them to devalue."
(Ms. Catherine Mann, Senior Fellow, Institute for International Economics)
On the optimistic side, several factors give hope that a devaluation will not occur. These include:
- devaluation of the renminbi would negatively affect inflows into China of direct foreign investment;
- devaluation could bring about a return of inflationary pressures;
- devaluation would make the Hong Kong dollar peg more vulnerable; and
- devaluation would jeopardize relations with the U.S., which already is running a sizeable merchandise trade deficit with China.
The Committee views China as a key influence in the post-crisis Asia; yet we are concerned that China may take unilateral action such as a devaluation of its currency or certain trade restrictive action to better its own economic and social prospects. We believe that there is scope for western governments such as that of Canada to encourage China to adhere to international rules of trade and investment. The Committee therefore recommends:
Recommendation 1 :
That the federal government continue to engage China in a dialogue on the importance of a successful integration of that country into the global economy and its adherence to international rules of commerce. As part of this dialogue, the Chinese authorities should continue to be advised of Canada’s conviction that a devaluation of China’s currency would have destabilizing effects on both the regional and global economies.
"The Committee is well aware of the proximate causes of the financial crisis in Asia. These include large growing current account deficits, a reliance on short-term capital to finance these deficits, overvalued exchange rates, weak financial systems and, in some cases, ‘crony capitalism’."
(James Powell, Deputy Chief, International Department, Bank of Canada)
As Mr. Powell told the Committee succinctly, a number of factors can be identified as having contributed to this financial crisis. First, a combination of de facto fixed exchange rates, liberalized capital accounts, and high domestic interest rates generated excessive capital inflows as cheaper foreign capital became increasingly attractive. With exchange rates pegged to another currency, and the local government promising to do its utmost to support its own currency (i.e., to ensure that the peg held), borrowing in foreign currency was not viewed as inherently riskier than borrowing in one’s own currency.(14) With foreign interest rates typically lower than those found within Asian economies, and with the exchange rate risk removed in the eyes of market participants, many borrowers took advantage of this interest-rate differential. East Asian banks failed to take steps to protect themselves against future currency devaluation. Local industrialists also borrowed at lower interest rates in foreign currencies, and often were the first to remove their funds from the local market in order to pay off their foreign-currency denominated liabilities.(15)
From a quality perspective, the mounting capital inflows were not always wisely allocated by the banks and finance companies: the money was not always channelled to the most profitable ventures. With the exception of Hong Kong and Singapore, institutional development in East Asian countries’ financial sector had lagged by a considerable margin the progress attained in the real economy. The rapid economic growth experienced in the region masked financial weaknesses.
The under-supervised and over-guaranteed financial sector extended loans excessively, particularly for non-productive, speculative purposes. Imprudent lending, often directed by government officials to uncreditworthy firms and industries (e.g., some of the chaebols in South Korea), combined with a relative lack of banking supervision, led to an allocation of financial resources to unproductive investments: to real estate, to industries owned by relatives and close personal friends of the banks’ owners, and to unwise government-supported capital projects.(16) Non-transparent practices, in the form of weak disclosure of institutions’ true balance sheets and insider relations, hid these poor investments. In planned economies such as South Korea, Indonesia, and, to some extent, Japan, the idea that banks would evaluate risk and credit following sound banking practices gave way to the notion that banks were merely policy arms of the government.(17)
Regrettably, those financial institutions that did not use traditional forms of risk analysis have become saddled with an ever-increasing number of non-performing loans. Many of the non-performing loans were of the short-term, foreign variety, whose repayment requires the use of foreign exchange, principally U.S. dollars. The continued demand for dollars with which to repay the loans provides a major explanation of the relentless downward pressure that the Asian currencies have faced. Given the potential for foreign investors calling their loans, borrowing short-term for long-term investments was an especially risky strategy, even if the investments were of sound quality.
At the same time, the relatively inflexible exchange rate systems led to a deterioration in the competitiveness of East Asian exports, particularly as the U.S. currency rose against the yen. There was vigorous resistance on the part of Asian political leaders to the devaluation of their countries’ currencies. They chose instead to bolster their currencies through the use of foreign exchange reserves and interest-rate hikes. The interest-rate increases, in turn, had devastating effects on local equity markets and did not succeed in reversing currency declines. By 1996, a number of potential trouble spots had emerged: expanding current-account deficits; growing weakness in demand for the region’s exports, arising especially from an economic slowdown in Japan; overvalued and unsustainable exchange rates; and overextended financial systems.
The build-up of short-term, unhedged debt left East Asian economies vulnerable to a sudden collapse of confidence. In the end, the confidence that market participants had displayed in Asian government authorities’ ability to protect the peg suddenly evaporated. As concerns mounted over rising current-account deficits, overvalued exchange rates, declining international reserves, and, most importantly, governments’ ability to continue supporting exchange rates, market players initiated a quick reversal of the previous foreign capital inflows. Currency attacks ran down official foreign exchange reserves. Rapid capital outflows and the consequent depreciation of currencies exacerbated the strains on private-sector balance sheets.
The latest survey of such capital outflows by the Washington-based Institute of International Finance reveals that net private capital flows to the five Asian economies most affected by the crisis (Indonesia, Philippines, Malaysia, South Korea, and Thailand) swung from an inflow of US $92.8 billion in 1996 to an outflow of US $12.1 billion in 1997. On the other hand, flows to other emerging countries actually increased.
While total flows to those five countries fell sharply, it is also true that different investors reacted to the crisis in different ways. Those who reacted the least were the direct investors, who went ahead with projects as planned. Foreign direct investment (FDI) inflows in 1997 to the five most-affected Asian countries as a group are estimated to have remained close to the level attained in 1996. This should not come as a surprise, since FDI flows are different from portfolio equity investment flows and bank lending. Most importantly, the time horizon for the former is much longer. Many Asian countries had built up fundamental strengths that make for high long-term growth, such as high domestic savings rates and educated, skilled, and flexible human resources. Typically, these are the factors that drive FDI decision-making.
On the other hand, net foreign portfolio equity investment and private foreign bank lending are estimated to have turned negative. Stockmarket investors panicked, as one would expect. But the financiers with the weakest nerves were the commercial banks. According to the IIF, banks’ net lending to the five countries in question shifted from an inflow position of $55.5 billion in 1996 to an outflow of $21.3 billion the following year, representing a full $76.8 billion turnaround.
A number of important lessons can be learned from the Asian financial crisis. First, it has come to be generally recognized that both the initial inflows of capital and the eventual rapid outflows were on the extreme side. Too little in the way of scrutiny and analysis was performed by foreign banks and investors on the risks attached to the initial investment, and too little attention was devoted to Asia’s long-term prospects on the withdrawal side. For improved risk assessment to occur, business requires timely and accurate information about the countries in the region. Foreign diplomatic posts have an important role to play in enhancing their surveillance and in providing the results of this activity to businesses.
Second, the developments in the region have pointed out the lack of wisdom in mixing liberal foreign capital movements with a strategy of keeping one’s exchange rate pegged to a single, rising currency such as the U.S. dollar. Government intervention in currencies and equity markets should be undertaken as infrequently as possible. Introducing greater flexibility into exchange-rate policy would enable most Asian economies to adjust more appropriately to balance-of-payments deficits.(18) "Too often crises have developed because of an unwillingness of the authorities to recognize that a pegged exchange rate was no longer tenable."(19)
Third, countries running large current account deficits need to pay close attention to the way those deficits are financed. A sustainable financial structure for a country’s current-account would be one that places strong emphasis on FDI, a longer-lasting type of external investment than the short-term flows of the kind that entered the Asian financial markets, and which were vulnerable to market sentiment. FDI flows should be encouraged.
Fourth, there is an urgent need to strengthen financial systems prior to capital-account liberalization. Removal of capital controls "can lead to significant flows of foreign capital into banking systems and, consequently, surges in credit expansion. If banks simultaneously begin to exercise broader powers, and are poorly regulated and supervised, they can venture into little-understood, high-risk types of lending. This is particularly a concern for institutions that prior to liberalization were primarily in the business of lending to governments, or were directed by governments to lend to certain companies or sectors of the economy. Such institutions may have little experience assessing credit risk."(20)
An important goal here is to curb the dangerous lending practices displayed by both domestic and international creditors during Asia’s period of strong growth, when poor accounting standards, weak financial controls, and lax banking supervision were endemic in the region. This objective can be accomplished through the implementation of proper disclosure and accounting requirements; stringent loan classification; rules governing the setting aside of provisions against potential bank losses; and capital adequacy requirements. Greater transparency and accountability needs to be brought to affected countries’ shattered financial systems.
To help ease the current crisis, Asian banking systems need to be fully reformed and revitalized. Insolvent banks need to be closed and/or absorbed by stronger institutions. State-owned banks should be privatized. Investments of questionable quality need to be liquidated. The capital base of the remaining weak financial institutions requires strengthening. Beyond doubt, cleaning up the financial sector will be a difficult and delicate task, requiring technical expertise in corporate restructuring. Regrettably, such expertise seems to be in short supply in many parts of the region.
Fifth, central banks should be depoliticized (i.e., made more independent of government). Certain analysts have even considered replacing central banks with currency boards such as the one in operation in Hong Kong. These would tie the local currency to a major one such as the U.S., and back the domestic currency in question with sizeable foreign exchange reserves. A practical difficulty with this solution is that the affected Asian countries have almost exhausted their stock of such reserves.
Sixth, destructive policies and practices on the part of some governments in the region, in essence poor governance, were endemic in the region. Many governments failed to create an adequate institutional and legal framework, as well as to implement an open and transparent political system to reduce the incidence of bribery and corruption. Political cronyism repeatedly blocked those banking and monetary reforms that threaten long-established local monopolies.
In essence, here, as elsewhere, good governance is essential to the economic success of a nation. Asian economies typically suffered from archaic economic and political structures that rewarded the politically well-connected instead of genuine entrepreneurs. Asian crony capitalism, the collusion between the state, banks, and business, should be abandoned by immediately severing the links between governments, industry, and the banking community. Moreover, accountability of government should be improved to reduce corruption, and anti-corruption laws introduced and enforced. As Chapter 7 will stress, there is an urgent need for Asian countries to respect the rule of law and to establish totally independent judiciaries. It is hoped that the financial crisis will have a silver lining in that it will result in greater democracy for the region, more transparency, greater fairness, and the removal of inefficient economic managers and politicians.
Another lesson to be learned is that the widespread adoption of the "Japanese model" of economic growth, which depended upon centralized economic planning and thereby undermined accountability and corporate governance among Asian banks and firms, may not have been as desirable as once was thought. In these planned economies, bureaucrats placed much attention on corporate size as an effective guarantee of economies of scale in production. The result of this strategy was the emergence of large and powerful business conglomerates. Hong Kong, Singapore, and Taiwan, on the other hand, did not allow themselves to become dominated by huge business entities, and have weathered the financial storms much better.
A final point is that large-scale investments by government that attract significant quantities of imports should be curtailed, and large, inefficient state monopolies dismantled.
E. Impacts of the Crisis on Regional and Global Economies
With many East Asian economies and their financial sectors remaining in recessionary mode and several recording record rates of unemployment, the prospects of a rapid economic recovery has become bleak. This is especially the case now that the Japanese economy is in recession, and that the U.S. economy may be slowing down. Asia’s leading industries are experiencing serious overcapacity problems, and the region is still seized with horrific bad-loan problems. The recession is proving to be both more severe and of longer duration than originally had been expected. The economic troubles in Japan and Hong Kong have also raised the prospect of an even wider spread of the Asian flu. Moreover, concern has grown about the deepening social impacts and the consequences of the crisis for political stability in the region.
Economic forecasts for East Asia are becoming almost obsolete as soon as they are printed. In his appearance before the Senate Foreign Affairs Committee in March of this year, Mr. Tim O’Neill (Executive Vice-President and Chief Economist, Bank of Montreal) shared with us his prediction of a 3.0% decline in economic growth in 1998 for both Thailand and South Korea, a 6% drop for Indonesia, a 7.3% increase for China, a 0.1% hike for Japan and an overall 1.8% drop for East Asia excluding Japan and China. It was expected that countries in the East Asian region other than those mentioned would also suffer declines in GDP. The May 1998 World Economic Outlook contained forecasts of economic contractions in 1998 of 3.1% in Thailand and a full 5% in Indonesia.
According to John McCallum (Senior Vice President & Chief Economist, Royal Bank), First Quarter 1998 results show the economies of Indonesia (-24.2%), Malaysia (-23.5%) and South Korea (-19.3%) all recording drastic declines in GDP.(21) Equally bad is the fact that consensus forecasts for this year and next consistently have been revised downwards during the past twelve months, with little sign of a reversal of direction. Experts are projecting drops for this entire year’s (1998) GDP of as much as 13% in Indonesia, 4% in South Korea, and 6% in Thailand.(22) In his bank’s monthly economic report, Mr. McCallum also points out that the IMF’s own analysis indicates that countries that have suffered from both a currency and banking crisis have required over three years to experience economic recovery.(23) Thus, the prospects for an early resumption of growth do not appear promising.
The region’s export performance will be harmed by the fact that a full 40-50% of Asian trade is of the intra-regional variety, and thus is affected by deteriorating regional economic conditions. In the short term, Southeast Asian exporters’ difficulties in securing trade finance will also offset part of the potential competitive advantage from currency depreciation. While export volumes, especially to non-Asian markets, have risen, the value of exports from the countries in serious difficulty, as measured in U.S. dollars, has not. The growth in the quantity of exports that has occurred already is leading to protectionist pressures within sensitive sectors and industries in industrialized importing countries (e.g. U.S. steel).
On the other hand, imports into the region are likely to decrease because of reduced growth and a drop in purchasing power. This decline in imports will be tempered, however, by the continued necessity for East Asian countries to have raw material and intermediate inputs for their own production facilities.
The IMF is predicting rapid improvement in countries’ net trade and current account positions. For example, the aggregate current account of Thailand, Malaysia, Indonesia, the Philippines, and South Korea is expected to show a US $20 billion surplus in 1998, compared with deficits of US $54 billion and US $27 billion in 1996 and 1997 respectively.(24) However, much of this improvement should come from a decline in imports, not from a surge in the value of the region’s exports.
According to the IMF’s October 1998 World Economic Outlook, the financial turbulence in Asia is contributing to a reduction in expected world economic growth, to a level of 2% in 1998. If this projection proves accurate, the increase in global economic activity would represent the lowest annual rise during the past five years. It would also represent a decrease from the forecasted amounts included in the December 1997 and October 1997 versions of the IMF document, which were 3.5% and 4.25% respectively.
From the above numbers, one can conclude that the effects of the crisis seem to be more severe than they appeared initially. At the same time, however, it would appear that the world as a whole will continue to experience a certain degree of economic growth, albeit with considerable reduction in performance. As Chapter 4 will suggest, this conclusion also applies to Canada.