East Asian Crisis: A Short Note

East Asian Crisis: A Short Note

Sam Choon Yin (2003)

 

            The Asian crisis was resulted partly from exchange rates fluctuations. Exchange rates fluctuations create business uncertainty. Firms were not able to determine to some acceptable degrees of certainty the costs of production and total receipts from their transactions with other countries. Poor governance in private corporations and financial institutions exacerbated the problems.

            It may be useful to trace the origin of the crisis. One of the earliest troubles reaching Asian countries was the appreciation of Japanese yen against the US dollar following the Plaza Accord agreement in 1985. The appreciation of the Japanese yen led to rapid outflow of capital from Japan to Korea and Taiwan. By late 1980s, there was tremendous pressure from the Korean and Taiwanese governments to revalue their currencies. These led to an increased in their money supply. The massive monetary expansion ultimately led to a fall in interest rates. The next round of capital flows followed. This time, capital flows out from Korea and Taiwan to southeast countries like Indonesia. Thailand and Malaysia. In Indonesia for example, foreign direct investment in Indonesia increased six-fold from USD1,482 million in 1991 to USD7,960 million in 1996. Strong capital flows sped up financial liberalization process of the crisis-hit countries. With the benefit of hindsight, most of these countries had perhaps liberalized too hastily. It might be wise to have certain controls to limit flows of capital at least until the institutions have gains sufficient experience to govern themselves more effectively. On this issue, it may be useful to quote Joseph Stiglitz’s views (see also Chang, 2002; Mahani, 2002).  He writes the following in his book ‘Globalization and its Discontents’:

 

Some might say that it’s not fair to insist that developing countries with a barely functioning bank system risk opening their markets. But putting aside such notions of fairness, it’s bad economics; the influx of hot money into and out of the country that so frequently follows capital market liberalization leaves havoc in its wake. Small developing countries are like small boats. Rapid capital market liberalization, in the manner pushed by the IMF, amounted to setting them off on a voyage on a rough sea, before the holes in their hulls have been repaired, before the captain has received training, before life vests have been put on board. Even in the best of circumstances, there was a high likelihood that they would be overturned when they were hit broadside by a big wave (Stiglitz, 2002, p. 17).

 

The IMF and the US Treasury believed, or at least agreed, that full capital account liberalization would help the region (East Asia) to grow even faster. The countries in East Asia had no need for additional capital, given their high savings rate, but still capital account liberalization was pushed on these countries in the late eighties and early nineties. I believe that capital account liberalization was the single most important factor leading to the crisis (Stiglitz, 2002, p. 99).

 

The governments were accepting the views that financial liberalization was good to the countries. Following the advice from the west, they thought that financial liberalization would enhance efficiency in their financial systems and bring their people out of poverty. The governments were of the view that financial repression would hinder investments and savings. The intentions were good. Unfortunately, they were not prepared to face the onslaught of currency speculators and dynamics of capital flows. The decision to open up the financial sector was not accompanied by improving market discipline, lowering corruption problems and raising the standards of corporate governance. Financial liberalization instead was accompanied by excessive lending. There was a lack of careful risk assessment. This was partly a result of increased competition among financial institutions. They were very keen to lend. Loans were offered to construction companies. Property sector was booming as more people were upgrading to larger houses and offices. There was also excessive borrowing from other private sector companies to fund their investment plans. While profits were observed in the short-run, the situation deteriorated very quickly when the crisis hit. Borrowers were not able to repay their loans. Non-performing loans were high among financial institutions in crisis-hit countries (Llewellyn, 2003, p. 450).

Strong economic performance in Asian countries and their strong potential growths led to massive inflows of short-term capital in the pre-crisis years. Because there were short-term capitals, they could move out of the country relatively easy as exemplified during the crisis. Devaluation of Chinese renminbi in 1994 worsened the situation as more funds were diverted away from Southeast Asian countries to China. In East Asia, the net outflow in 1997 and 1998 surpassed the total inflows before the crisis (Mahani, 2002, p. 6). Clearly, investors investing in the countries had little regards on the countries’ economic fundamentals. Herd-like behaviour was observed. Investors got panic and withdraw their funds quickly when others did so too.

Most of the borrowings by financial and non-financial entities were largely unhedged and short term in nature. They were extremely vulnerable to exchange rates risks.  Their lending on the other hand was long term. There were at least three reasons why borrowers did not hedge their borrowings. First, the international environment provided large supply of funds. Therefore, at that time, the borrowers perceived that the cost of borrowing was low. Second, financial deregulation in many countries and liberalization of capital accounts in East Asian countries meant easier access of funds from foreign markets to domestic institutions’ investments. Third, the fixed exchange rate of some crisis-hit countries like Thailand and Indonesia (pegged closely to the US dollar) reduced perceived risks in investing in these countries. As at end 1996, short term liabilities as percentage of foreign reserves was 181 percent in Indonesia, 47 percent in Malaysia, 77 percent in the Philippines, and 213 percent in Korea. In Indonesia, a bulk of these liabilities was borrowed by private corporate sector (from foreign banks). The proportion of total liabilities attributed to non-bank sector was consistently more than 50 percent in Indonesia and about 20 percent in Malaysia, the Philippines and Thailand (Sam, 1998).

As Mahani Zainal Abidin correctly pointed out in her interesting book, there were essentially mismatches of both currency and project financing. They were believed to have partly caused the crisis. She said:

 

‘In the first mismatch, many companies used foreign borrowings to finance their domestic projects. Unfortunately as those projects generated revenue in domestic currency, the foreign debt burden became insupportable in a depreciated currency. The second mismatch occurred when investors borrowed short-term for projects with a long gestation period. They were thus unable to bear short-term interest rate variations’ (Mahani, 2002, pp. 6-7).

 

            Some of the reasons the companies prefer to borrow short term were first, lower rate of interest incurred and second, the ability to borrow a larger amount of loans. This proved to be a bad strategy particularly when the loans were exposed to currency and interest rate risks. The situation appeared worse with the intervention of the International Monetary Funds. Some observers criticized the IMF approach. See for example Mahani (2002) and Stiglitz (2002). The IMF used the monetary approach to influence the countries’ exchange rates. It supported contractionary monetary policy (cutting money supply) to shore up interest rates. The purpose was to attract capital flows into the countries and in the process, revalue the countries’ currencies. The approach did not seem to work. Funds were not coming in because investors were expecting the currencies to weaken further. Investors took into consideration social problems and political uncertainty in determining where to locate their funds. Investments at that point were not responsive to higher interest rates. Apparently, the IMF put too much emphasis on economic issues (while lack of care was given to social issues and political uncertainty). Domestic businessmen did not welcome high interest rate policy. They were already suffering from lower income and poor business prospect. Many had started their businesses through borrowings since many of them had little savings. Higher interest rates meant higher costs of doing business. Those near-dead businesses soon died from lacking in working capital. Non-performing loans in financial institutions continued to rise. Bank panic soon followed.

            Malaysia was one of the critical opponents of the IMF prescriptions. She undertook the unorthodox approach and established capital controls in September 1998. Many observers (including IMF Chief and prominent economists like Joseph Stiglitz and Paul Krugman) praised the Malaysian approach in handling the problem. See (Mahani, 2002, Chapter 4) and (Stiglitz, 2002, Chapter 4) for more details.

            The East Asian crisis showed that the government could make a difference - a positive difference. The crisis was essentially attributed to a lack of adequate regulation of the financial system. The liberalization efforts were done too hastily. They should be carried out at a pace which is more comfortable to the respective countries. The nations themselves should decide on the right sequences and pace to undertake with advices from international institutions. Outsiders should not decide the fate of their own peoples. It has been generally agreed that financial liberalization must be accompanied by strong standards of corporate governance. Weak corporate governance can lead to bad lending and borrowing practices which adds to instability in the financial system.

 

Reference

1.                              Chang, Ha-Joon (2002) Kicking Away the Ladder: Development Strategy in Historical Perspective. Anthem Press (London).

2.                              Llewellyn, David (2003) ‘Some Lessons for Bank Regulation from Recent Financial Crises’, in Mullineux, Andrew and Murinde, Victor (editors) Handbook of International Banking. Edward Elgar (Great Britain).

3.                              Mahani, Zainal Abidin (2002) Rewriting the Rules: The Malaysian Crisis Management Model. Prentice Hall (Malaysia).

4.                              Sam, Choon Yin (1998) Economic and Financial Crises in Indonesia, their impact on Singapore, and the role of the IMF (unpublished manuscript).

5.                              Stiglitz, Joseph (2002) Globalisation and its Discontent. Allen Lane/ The Penguin Press (Great Britain).