More than a year after the Asian currency crisis started in July 1997, the world economy has never been more fragile. East Asia including Japan, is in recession. Latin America appears to be headed for a major economic slowdown if not a recession. The US economy, which is already in its seventh year of economic expansion, is being sustained by high consumer spending and is susceptible to a major downturn in the stock market. Europe continues to grow but its recovery has been export-based while domestic spending continues to be hobbled by the high unemployment rate.
All over the world, nervous investors are running for cover and moving out of risky assets into treasury bonds. Indeed, with the collapse of the Russian rouble in mid-August, the financial crisis has now infected all emerging markets. Spreads on emerging market bonds have risen to stratospheric levels. Latin America is desperately trying to fend off a run on its economies. Today it is tottering on the brink of a financial collapse, a situation not unlike that of East Asia a year ago. Even the mature markets of the US and Europe have not been spared by the flight to quality.
Short-Term Capital and Premature Liberalisation
Only a few years ago, these same investors from the G7 countries were bullish on East Asia. Their optimism was not unfounded. East Asias fundamentals were strong: high growth and low inflation, with government budgets in balance or in surplus, and high savings rate. Compared to G7 home markets, where interest rates had fallen as inflationary pressures subsided, East Asia offered higher returns on capital.
Since the mid-1980s, East Asia has benefited from Japanese capital flowing into the region in search of low-cost production bases. The rising tide of Japanese foreign direct investment or FDI had lifted all the economies in the region: FDI created manufacturing jobs, upgraded technology, enhanced productive capacity, and opened up export markets for East Asia.
East Asias positive experience with foreign capital inflows whetted its appetite for more. By the early 1990s, however, information technology and financial innovation and liberalisation were bringing a different type of capital into East Asia. G7 international banks and institutional investors poured into Asia in search of higher returns on their investment, because their own economies were in recession. G7 capital flows to emerging markets increased five-fold from US$40 bn in 1990 to over US$200 bn in 1996. Asia absorbed almost half of these net private flows between 1994 to 1996.
With hindsight, East Asia should have taken measures to fend off and control these massive capital inflows. After all, their own domestic savings were high enough to finance most of their investment needs. Thailand, Indonesia, Malaysia and Korea had savings rates averaging more than 30% of GDP in the 1990s, much higher than the 18% in Latin America. All they needed was to supplement their considerable savings with FDI, which could bring technology, management expertise, and access to export markets.
Moreover, East Asia was already running at or near full capacity. Growing current account deficits in the mid-1990s and declining unemployment rates were clear signs of overheating. They did not need the extra boost from large short-term capital inflows. What they needed was the opposite: to slow down and cool their economies while they built up their productive capacity and strengthened their institutional framework to manage the problems of integrating with the global financial market.
However, they were encouraged by multilateral institutions like WTO, IMF and WB and the finance ministers of the G7 to open up their capital accounts and liberalise their financial systems in order to reap the full benefits from a globally efficient allocation of capital. Analysts from these international institutions, and rating agencies in both US and EU assured these countries that with their strong macroeconomic fundamentals, there was negligible risk from a further liberalisation of their capital accounts. On their side, these countries found the prospect of easy access to cheap foreign funds irresistible.
Between 1990 and 1994, Thailand undertook three rounds of foreign exchange control liberalisation, essentially removing most controls on capital inflows, leaving some restrictions on outflows. The Bangkok International Banking Facility or BIBF, established originally to promote Bangkok as an offshore banking centre, became instead a channel for offshore funds into Thailand.
Indonesia had opened its capital account in the early 1970s, when the international capital markets were not as sophisticated. But it was only in the 1990s that domestic corporations and banks began tapping international capital markets in a big way. Because they had no exchange control, Indonesian authorities had not set up any system for monitoring capital flows. Nobody knew that Indonesian corporations had run up so much short-term foreign debt. It was the same story in Thailand. By 1997, both Thailand and Indonesia had more short-term external debt than they had foreign reserves.
Korea had a more nationalistic industrial policy, maintaining tight control on its capital account into the 1990s. But it came under international pressure to liberalise. As part of the process of joining the OECD in 1996, it accelerated the liberalisation of its capital account. Ironically, Korea eased controls on short-term capital to permit external borrowing by Korean banks, including greater access to trade credit, but kept controls on medium and long-term capital to protect its industries. This made for a rapid build-up of short-term external bank debt, leading to the November 1997 crisis.
Domestic corporations in Thailand, Indonesia and Korea borrowed from abroad because interest rates on the US dollar were much lower than their domestic interest rates. This led to a massive increase in external debt. Many of these companies made the fundamental mistake of borrowing short-term for long-term projects. They could not have done so with such impunity if their capital accounts had not been so open.
Their governments also did not appreciate the moral hazard problem of pegging their exchange rates when they no longer had restrictions on capital flows. Thailand and Indonesia had their currencies closely linked to the US dollar. This led their private corporations to believe the stable exchange rates were their governments guarantee that there would be no currency exchange risk. So they borrowed in US dollars, assuming that exchange rates would remain more or less the same when the repayment time came. As a result, they did not hedge their foreign exchange exposure.
Funds in international capital markets were deceptively cheap, only because the true risks were not fully priced in. If these countries had floating exchange rates, borrowers would have been more aware of the risk they carried of a possible depreciation as against the benefit of a lower interest rate. And foreign lenders would not have been so confident the borrower could repay if exchange rates were subject to sudden changes.
Liberalisation should have been Calibrated
Thailand, Indonesia and other East Asian countries would have been better off if their capital accounts had been liberalised more gradually, in tandem with the strength of their financial systems and institutional capability. At the minimum, they needed a system to monitor, check and control the flow of short-term speculative funds and to ensure that the maturity of the debts and investment were properly matched. As it was, large amounts of short term funds flowed in to finance long term investment. A significant proportion went into the asset markets: stocks and properties, office blocks and condominiums. These stocks and properties were in turn used as collateral for borrowing, further inflating the asset bubble.
It is widely accepted that free trade in goods and services where countries specialise in producing what they have a comparative advantage in, and gain by trading what they produce beyond their needs produces efficiency gains. The G7 countries were right to advocate trade liberalisation. The G7 countries should have been more cautious in pressing for more liberalised financial markets and free capital movements. There is an on-going dispute among financial experts whether free capital mobility is an unalloyed good. There are inherent dangers in today's globalised financial markets, when massive amounts can flow in or out at the touch of a computer button.
Capital account liberalisation should have been more carefully calibrated according to the level of soundness and sophistication of each country's financial system. Countries that are not ready for the risks should have installed circuit breakers controls to cope with any sudden inflow or outflow of funds. Chile, for example, imposes a tax on foreign borrowing, and requires portfolio investors to put a portion of their funds in non-interest bearing deposits with the central bank, to discourage volatile short-term inflows. Of course controls restricting capital mobility will increase the cost of capital. Growth may be slower, but it will be more stable and sustainable in the long run.
Are Capital Controls the Way Out?
Are capital controls the way forward in East Asia? Paul Krugman, the MIT economist, has argued that "Plan A" of IMF orthodoxy - high interest rates, and austerity in monetary and fiscal policies - has failed in East Asia. He suggested that it was time to try "Plan B" of capital controls. With controls, an economy could plug capital outflows that result from a loss of confidence, while pursuing expansionary monetary policies, like cutting interest rates, without hurting its currency.
Dr. Mahathir is now implementing Plan B in Malaysia. On 1 Sep 98, Malaysia imposed capital controls. Malaysian ringgit deposits held offshore must be repatriated within a month, or become worthless. Foreigners who sell Malaysian shares cannot take out the proceeds for a year. Malaysian exports and imports must be settled in foreign currency. The ringgit was fixed at 3.8 to the dollar, a 10% premium to the traded rate before controls.
Malaysias capital controls can offer a temporary window of opportunity to stimulate and reform its economy. The government has sharply lowered interest rates, reduced bank reserve requirements, and instructed banks to maintain their lending growth at 8%. This could reverse the decline in economic growth. However, excessive expansion in domestic demand could lead to a deterioration of their trade balance, a loss of foreign reserves, and capital flight. Capital controls provide the opportunity to carry out banking reform and corporate restructuring without the pressures of a volatile currency that has to be propped up by high interest rates.
Experts are not in agreement on the merits of capital controls. A growing view is that regulations over short term capital flows can be useful in shielding developing countries against the volatility of capital flows in today's globalized financial market. However, comprehensive capital controls are administratively cumbersome and can lead to corruption. They induce a false sense of security and result in loose macroeconomic policy and weak financial discipline. Open economies like Singapore cannot afford to consider capital controls. Such controls will irrevocably damage our reputation as an international financial centre.
No country in the region, however strong its fundamentals, can insulate itself from the effects of the financial turmoil. Singapore has also suffered from the fallout. Tourism from Korea, Japan and Southeast Asia has declined, and our exports and imports with the region have fallen. However, Singapore has escaped the brunt of the crisis because we maintained tight macroeconomic discipline and constant vigilance over the banking system. As a result of sound macroeconomic policies, our interest rates were lower than US dollar interest rates, and Singapore companies had little reason to borrow in US dollars. Our banks are strong and well-supervised. Thus, even though Singapores financial system is more open than those of our neighbours, we have weathered the crisis better.
What can be done?
The Asian crisis caused heavy losses to investors, but was a tragedy for the countries they had invested in. It has wiped out years of growth and development in Indonesia and other affected countries. The Indonesian rupiah today is worth only 20% of its value in June last year, although they have not printed five times the amount of money.
In time, investor confidence should return to East Asia. What we saw in East Asia in the past 30 years was not a mirage. Strong growth in their export industries has transformed agricultural communities into industrial nations. The East Asian values of hard work, sacrifice for the future, respect for education and learning, and an entrepreneurial spirit are the underlying strengths which will see these countries through the current crisis, and help them regain their former economic dynamism.
In these decades of development these countries have acquired the infrastructure, technology and management skills that will survive the crisis. The rankings of East Asian countries in international surveys of economic competitiveness have dropped in the past year. But they remain ahead of other developing regions and transition economies. The 1998 World Competitiveness Yearbook, by IMD in Lausanne, finds Singapore, Hong Kong and Taiwan still within the top ten countries in the world where "enterprises are managed in an innovative, profitable and responsible manner". The crisis has shown East Asia areas for improvement, but the development base built-up in the last three decades is still in place.
The pace of recovery will depend on the way individual countries reform their economies. For those under IMF programs, international investors will be watching closely for their compliance with IMF prescriptions. The IMF may have made some mistakes through lack of experience with the type of problems faced by East Asia, because it was more accustomed to dealing with Latin American problems. The IMF has been learning and modifying its policy prescriptions. In any case, IMF endorsement of the economic programmes of a distressed country is essential to restore investor confidence.
With or without IMF help, these countries will have to build up their financial system and the supporting legal framework. Banks will have to be recapitalised, some merged into stronger entities and sold to foreigners, others allowed to go bankrupt. A strong regulatory and supervisory regime has to be established, and proper systems of credit assessment and loan provisioning put in place.
Institutional weaknesses, masked in times of high growth, will now have to be put right. Insolvency laws, drafted for a different age and rarely used, have proved inadequate. Indonesia and Thailand have passed new bankruptcy laws; they now have to follow through with the implementation. Transparency in corporate accounts and protection of minority shareholders, which were ignored when share prices were rising, have now become issues of importance. In todays high-risk environment, greater transparency will prove critical in convincing investors, both domestic and foreign, to buy a stake in a local company.
All these structural reforms take time. In the meantime, the crisis-stricken countries must cope with the social and political consequences of the deepening economic crisis. Unemployment is rising and companies are failing under the burden of high debt and poor business conditions. These countries need to turn around their economies quickly, but they cannot do so without foreign assistance, especially when the external environment remains unfavourable. Hence, the US, Japan and EU can, and must, play their part in facilitating the recovery of the East Asian economies.
As long as Japan East Asias largest economy remains depressed, the whole region will be hobbled. Since 1986, Japan has been the prime mover of the industrialisation of the region. Japan absorbs 12% of East Asia's exports and has been the largest source of FDI in nearly every country in East Asia since the mid-1980s. Japan has been generous in its response to the Asian crisis. It has carried the biggest share of the IMF rescue packages in Korea, Indonesia and Thailand, and has been forthcoming with humanitarian aid. Japan announced during the IMF meeting a new initiative of a US$30 billion package to help the affected countries in East Asia raise funds in the international capital market. Really the best contribution that Japan can make is to get its economy moving again.
Japan is an export powerhouse and a net creditor nation. Its financial problems, the bad debts in the banking sector, were not the result of excessive borrowing from abroad, but home-made. With political will, it can cut the Gordian knot of domestic bad debt and begin its recovery.
The US has a strategic stake in East Asias recovery. The US exports more to East Asia, including Japan, than it does to Europe. In 1997, exports to East Asia accounted for 28% of total US exports. The West Coast states of California, Washington and Oregon sell more than half of their exports to Asia. Among the 50 states, Texas is the fourth largest exporter to Asia. Texas' principal sectors that export to Asia include chemicals, electronics and industrial machinery and computers.
Beyond its commercial interests, however, the US has worked hard to craft and establish the present world economic order based on free market principles. The US must take the lead in managing this crisis. Charles Kindleberger, in a history of the Great Depression published in 1973, pointed to a leadership crisis in the industrial nations as the main cause of the economic slump. The First World War had produced a power shift from Britain to the US. Because the US was unwilling to assume responsibility for stabilising the world economy, there was a leadership vacuum. In the 1930s, Kindleberger noted, "when every country turned to protect its national private interest, the world public interest went down the drain, and with it the private interests of all."
The world has come a long way from protectionist responses like the Smoot-Hawley Tariff Act of 1930, which worsened the Great Depression. Working with the IMF, the US has played the key role in responding to the crisis-stricken Asian countries. However, the US cannot stop there. President Clinton has said recently that the financial crisis is the biggest challenge to the world economy in the last 50 years. I believe he is right. In the coming months, the US will have to take a strong leadership role and work with other major countries to address the immediate problems thrown up by the financial crisis. The crisis has also raised fundamental and complex issues about the architecture of the global financial system. The US would also need to provide enlightened intellectual leadership to address these issues.
Allow me to conclude by saying that it would be short-sighted and potentially disastrous for the US to neglect troubled East Asia when it is an important part of the world. The US must stay engaged, and provide the focus and leadership in an Asian financial crisis that has gone global.