East Asia in Crisis. Edited by Ross H. McLeod and Ross Garnaut. From being a miracle to needing one? London and New York

Transcription

1 East Asia in Crisis From being a miracle to needing one? Edited by Ross H. McLeod and Ross Garnaut London and New York

2 East Asian crisis 12 CONTAGION The term contagion came into frequent use in the third quarter of 1997, to describe the rapid spread of financial instability through East Asia. Stock market indexes fell sharply in all East Asian economies. Floating currencies fell in value. Currency pegs to the US dollar were tested severely, and successively abandoned in all East Asian economies other than China, Vietnam and Hong Kong. Contagion had three sources (Garnaut 1998). One was the realisation that presumed government guarantees of currency parities, and in various ways of bank solvency and the profitability of other enterprises, could not be taken at face value. If they could be withdrawn in Thailand, they could be withdrawn elsewhere. This was important for domestic and international investors alike. The second source of contagion was the realisation by investors that they had a poor understanding of the workings more generally of the economies to which they were exposed. Investors had been surprised by the dramatic falls in currency and asset values in Thailand. If they knew so little about Thailand, how much did they not know about conditions in neighbouring economies? This concern was strongest in Thailand s own region, Southeast Asia, but important throughout Asia a tendency reinforced by early popular reference to the Asian financial crisis. This source of contagion was most important amongst distant international investors, whose ignorance was greatest. This caused a sudden and large increase in the required risk premia on investment throughout developing East Asia. It gradually eased in economies with more transparent and effective corporate and financial regulatory systems, such as Hong Kong and Singapore. The third source of contagion was the diminished opportunities for gains from trade with, and investment in and by, regional economic partners. Throughout the long boom from the mid-1980s, the large majority of the increase in trade and direct investment for developing East Asian economies was within East Asia; in 1996, about half of East Asian exports were to other countries in the region (Figure 1.3). Economic crisis in the region would lead to slower intraregional trade growth. In addition, real depreciation in some East Asian economies meant greater competition in third country markets for others. For all East Asian economies, the falls in value of regional currencies and assets pointed immediately to slower expansion of trade and investment, lower economic growth, and domestic currency and asset values lower than they otherwise would be. Each of these sources of contagion contributed to the pressure on fixed exchange rates and, after the abandonment of established pegs, to the large falls in currency values.

3 The east asian crisis 13 Figure 1.2 Stock market performance (31 March 1997 = 100) Source: Datastream.

4 East Asian crisis 14 PRESSURE ON FINANCIAL INSTITUTIONS Falls in asset values in all East Asian economies, and in currency values in most, put pressure on financial institutions. In cases where this exposed underlying weaknesses, it disturbed the flow of funds to potentially profitable business, and compounded the reduction in real economic activity. In turn, falls in economic activity gave rise to a proliferation of non-performing loans, even in well-managed banks. When borrowers default, banks must rely on the value of their security. But in the context of falling asset values, deficiencies emerge in the security backing for loans. In well-managed banks, depositors and other creditors are protected by a high ratio of equity capital to risk assets, which allows bad loans to be written off without threatening the solvency of the bank; a soundly based and transparent system of prudential regulation and supervision reinforces good banking practice such as this. Transparency generates confidence in sound financial institutions, providing assurance to depositors and other creditors that their assets (the banks liabilities) are safe. Events in the second half of 1997 revealed crippling weaknesses, however, in regulatory systems and financial institutions, in Thailand, Korea and Indonesia in particular. A conspicuous feature of the East Asian financial crisis is the extent to Figure 1.3 Export destination shares, 1996 (% of total exports) Source: Direction of trade, IMF; IEDB, ANU.

5 The east asian crisis 15 which financial institutions and other enterprises were exposed to foreign exchange risk. A high proportion of foreign liabilities had relatively short maturities. In normal conditions of continuing growth and economic stability, such loans would easily have been rolled over, but in the crisis conditions of the second half of 1997, lenders insisted on immediate repayment at the crisis exchange rates. (The Philippines had one advantage over its Southeast Asian neighbours in this respect. It came later to internationally oriented reform and high levels of capital inflow and, as a latecomer, it had a smaller accumulation of foreign liabilities.) Uncovered foreign liabilities generated immense losses as exchange rates fell in the most deeply troubled economies. Soesastro (1998) estimates, for example, that with an exchange rate of Rp 10,000 to the US dollar, currency losses had entirely wiped out the aggregate net assets of all companies listed on the Jakarta Stock Exchange. Large, uncovered foreign currency liabilities can bankrupt a business if the exchange rate moves far enough. Many firms were rendered insolvent in this way. And, even if not holding exposed positions themselves, banks incurred additional losses on loans to enterprises that were themselves exposed to exchange rate risk. The accumulation of large, uncovered foreign liabilities reflected imprudence on the part of several parties: borrowers and their owners; domestic banks and other lenders; and foreign lenders and portfolio investors. How was imprudence possible on such a large scale? Lack of transparency about corporate financial affairs and the ineffective prudential supervision of banks both contributed. So did the presence of implicit official guarantees on exchange rates, bank safety, and sometimes other business parameters. Moral hazard might have played a role, influenced by an expectation that public international support would become available to offset losses that might be incurred in the worst of circumstances. Differences in the quality of the financial systems and institutions across East Asian economies generated large differences in the economic impact of the contagion shocks. The weaknesses in financial systems, and the economic consequences of the shocks, were moderate in Singapore, Hong Kong, Taiwan and the Philippines, somewhat greater in Malaysia, severe in Thailand and Korea, and catastrophic in Indonesia. Financial systems in other countries less open to capital flows were not tested in the same way. PRESSURE ON ECONOMIC POLICY The crisis demanded policy decisions in three areas as matters of great urgency: the exchange rate and external payments regimes; the settings of macroeconomic policy; and the management and rehabilitation of the financial system. The pressure of capital outflow forced Malaysia, the Philippines, Indonesia and Korea to follow Thailand in floating their currencies, at least for the time being. Choices as to the most appropriate exchange rate regimes for the future have yet to be made. There is now widespread debate about free convertibility on the capital account (Jomo 1998; Montes 1998). In Malaysia and Thailand, capital account liberalisation in the early 1990s is seen as having facilitated both the speculative inflows of the boom times and the panicky outflows of the crisis. Both countries briefly reimposed elements of controls at the onset of crisis but to no avail, and possibly exacerbating outflows by further raising risk premia. Korea found that capital controls were of minimal assistance in stemming the

6 East Asian crisis 16 inflow in good times or the outflow in crisis: there were enough open channels to facilitate large movements of capital in response to changes in perceptions of opportunity and risk. For the time being the regional crisis has increased the desire for caution in relation to capital account liberalisation in China and Vietnam. The second area for urgent policy decision was the setting of macroeconomic policy. If inflation, relatively large current account deficits, and recent real exchange rate appreciation had required some contraction of demand and nominal depreciation in the troubled countries, the crisis delivered a great deal of both. The huge currency depreciations reduced the real exchange rates of troubled countries to the lowest levels they had seen since rapid growth began. Private consumption fell sharply, through the wealth and income effects of the crisis. Private investment collapsed, with high risk premia and disruption of the financial system. Monetary policy was tightened within IMF packages, or independently, with rising interest rates intended to stem capital outflow. The main unresolved questions of macroeconomic policy relate to adjustments of the fiscal settings. There seemed to be discordance between good policy, on the one hand, and international market perceptions of good policy, on the other (Jomo 1998). With rapid demand growth prior to recession mostly having its origins in private activity, there seemed to be a strong economic case for letting the automatic stabilisers work that is, allowing budget revenues to fall as incomes began to fall. A contrary view was that fiscal policy in reality had not been as trim as it appeared at first sight. Governments contingent liabilities arising from explicit and implicit official guarantees to banks and other entities were not recorded much less quantified in conventional budget accounts. Notwithstanding the prevalence of balanced or surplus budgets, governments were becoming increasingly more heavily exposed to potential high outlays in the future as a result of such guarantees; this became painfully obvious as the crisis evolved and banks and other enterprises began to be propped up with government funds. The appropriate remedy in this case, however, was not to cut actual spending or raise actual revenues, but to minimise contingent liabilities by the denial of guarantees for private entities of all kinds. Whatever the requirements of good policy, the financial markets reacted negatively to fiscal deficits during the crisis. The Malaysian stock market and currency fell in response to an October budget that was thought to be insufficiently contractionary (Jomo 1998). Failure of the first Indonesian budget in January 1998 to meet an IMF surplus target, and criticism to that effect, precipitated the sharpest and largest rupiah depreciation of the crisis period; a revised budget had to be formulated almost immediately. The third area of urgent policy decision, the management and rehabilitation of financial systems, was critical to recovery. In particular, greater transparency, better regulatory arrangements, and quick action in relation to unhealthy financial institutions were all important to restoring the confidence of depositors and other creditors, at home and abroad. These were major elements of the three IMF country programs, and some steps along these lines were taken in Malaysia as well. Where failures of financial institutions were extensive, it was necessary to facilitate the injection of new equity, including from foreign sources. The effectiveness of government response in this third area of policy decision became a principal determinant of the severity of economic decline. The response was least effective in Indonesia, and the consequences of inappropriate policy response have been severe.

7 The east asian crisis 17 ECONOMIC CONSEQUENCES The individual country case study chapters tell widely different stories about the effects of financial disturbance on economic activity, and about future prospects. Recovery in the troubled countries will be led by the tradable sectors, which have received a huge boost in competitiveness from currency depreciation; the scope for growth in net exports has also been encouraged by weakness in domestic demand. But the timing and strength of the anticipated tradables-led recovery will be constrained by the process of financial system rehabilitation. Export-oriented firms are now potentially much more profitable than ever before, but the breakdown of the banking system has severely constrained the availability of working capital finance to them, especially if they are heavily reliant on imported inputs. Where early progress is made on financial rehabilitation and in mid-1998 there was promise of this in Malaysia, Thailand and Korea amongst the troubled economies the recovery led by net exports is likely to be powerful, although there are risks of delay in the continued stagnation and decline of activity and imports throughout East Asia. The combination of enhanced competitiveness and weak domestic demand in East Asia, and continued economic expansion and an extremely strong dollar in the United States, is bound to generate large trade and current payments surpluses across the Pacific. Although these will necessarily be accompanied by an offsetting worldwide shift of new investment activity, there is a danger that this will generate negative political responses in the United States, complicating the task of maintaining an open framework for Asia Pacific trade relations. Recovery can be expected to be accompanied by a reduction of risk premia on investment, some renewal of capital inflow, and substantial real appreciation of exchange rates back towards pre-crisis levels; indeed, as already noted, a partial recovery of nominal rates had already been observed in several countries, although this process was interrupted in mid-1998 by political events in Indonesia and continuing economic woes in Japan. In the meantime, recession in some economies and slow growth in others will reverse the reductions in poverty that were associated with the years of rapid growth, and place great strain on social and political systems. In countries in which this strain generates political instability or lurches in economic policy, recession may worsen as in Indonesia, or give way to stagnation rather than recovery. What effect will the crisis have on longer-term economic growth and structural change? The crisis has disrupted the use of resources, but it has not negated the years of human and physical capital accumulation and institutional development. Although it is impossible to make confident predictions in relation to Indonesia, given the political upheaval it has been going through, in the other countries many of the conditions that supported sustained rapid growth are likely to remain in place: high savings and investment; a strong emphasis on education; acceptance of a major role for markets in resource allocation; deep integration into the international economy; and, after a while, the self-reinforcing character of internationally-oriented growth across neighbouring economies. It is possible, but not certain, that the international orientation of East Asian economies will have been enhanced by the crisis. The initial round of crisis-induced policy reform, reinforced by the IMF programs, will make markets more effective in

8 East Asian crisis 18 allocating resources. In Indonesia in particular, the market-oriented reforms within the IMF agreements are far-reaching although, of course, it remains to be seen to what extent they will be implemented. And even if reforms are carried out, the question then is whether they will survive recovery, or whether they will be discredited as arrangements imposed from outside when the East Asian developing economies were in a position of weakness. Two of the preconditions of growth in the old East Asian style obviously have been lost for the time being: a reasonable degree of macroeconomic stability; and political coherence around the growth objective. If the current stabilisation programs are successful, the prospects for future economic stability will have been enhanced. Exactly the same mistakes will not be made again. There will be greater caution at signs of asset booms, and there will be a re-evaluation of alternatives to the hybrid exchange rate regimes that were in place at the onset of crisis. Restoration of political coherence and stability around the growth objective is facilitated by constitutional and political arrangements that support reasonably smooth political change in Thailand, Korea and Malaysia. The challenge is far greater in Indonesia. The shock of 1997 is a defining event in the economic history of East Asia. Like the Great Depression in the West, it has the capacity to change thought about economic development and economic policy in fundamental ways. The lessons that will be drawn from the crisis depend on whether the current stabilisation programs in Thailand, Korea and Malaysia lead to early recovery and to restoration of strong growth. If they do not, the recent commitments to competitive markets and transparency will be viewed sceptically. For the whole of Southeast Asia, the future of political cohesion and economic development in Indonesia will strongly influence the lessons that are drawn from the crisis of ; but that big story is still unfolding. Now it is time to look more closely at particular countries and issues. NOTE 1 From the point of view of foreign investors, the US dollar values of shares are of greater interest. A summary of movements in these values from the beginning of 1996 through to mid is presented in Table Table 1.1 Real GDP growth (% p.a.) Indonesia Thailand Korea Malaysia Philippines Singapore Hong Kong Taiwan

9 The east asian crisis 19 China Vietnam India Australia Japan Source: Data for 1996 and 1997 and estimates for 1998 are from APEG Data for are from World Bank 1997b. Taiwan data are from CEPD (various years). Table 1.2 Inflation (CPI, % p.a.) Indonesia Thailand Korea Malaysia Philippines Singapore Hong Kong Taiwan China Vietnam India Japan Australia Source: Data for 1996 and 1997 are from APEG Data for are from World Bank 1997b. Taiwan data are from CEPD (various years). Table 1.3 Export growth (US$, % p.a.) Indonesia Thailand Korea Malaysia Philippines Singapore Hong Kong

10 East Asian crisis 20 Taiwan China Vietnam India Japan Australia Source: Data for 1996 and 1997 are from APEG Data for are from World Bank 1997b. Taiwan data are from CEPD (various years). Table 1.4 Import growth (US$, % p.a.) Indonesia Thailand Korea Malaysia Philippines Singapore Hong Kong Taiwan China Vietnam India Japan Australia Source: Data for 1996 and 1997 are from APEG Data for are from World Bank 1997b. Taiwan data are from CEPD (various years). Table 1.5 Current account (% of GDP) Indonesia Thailand Korea Malaysia Philippines Singapore

11 The east asian crisis 21 Hong Kong China Vietnam India Taiwan Japan Australia Note: Negative values represent deficits. Source: Data for 1996 and 1997 are from APEG Data for are from World Bank 1997b. Taiwan data are from CEPD (various years). Table 1.6 Government budget surplus (% of GDP) Indonesia Thailand Korea Malaysia Philippines Singapore Hong Kong Taiwan China Vietnam India Japan Australia Note: Negative values represent deficits. Source: Data are from APEG Taiwan data are from CEPD (various years). Table 1.7 Investment growth (% p.a.) Indonesia n.a. Thailand Korea Malaysia n.a. Philippines n.a. Singapore n.a. Hong Kong Taiwan

12 East Asian crisis 22 China India n.a. Japan n.a. Australia Source: IMF 1998d. Taiwan data are from CEPD (various years). Data for 1997 are from APEG Table 1.8 Money supply (M2) growth (% p.a.) Indonesia Thailand Korea Malaysia Philippines Singapore Hong Kong n.a. n.a Taiwan China Vietnam n.a. India Japan Australia Source: Data for 1996 and 1997 are from APEG Data for are from World Bank 1997b. Taiwan data are from CEPD (various years). Table 1.9 External debt (% of GDP) Indonesia n.a. Korea Malaysia Thailand Philippines n.a. n.a. Taiwan China Vietnam n.a. n.a.

13 The east asian crisis 23 India Australia n.a. n.a. Source: Data for 1996 and 1997 are from APEG Data for are from World Bank 1997b. Taiwan data are from CEPD (various years). Table 1.10 International reserves (months of imports) Indonesia Thailand Korea Malaysia Philippines Singapore Hong Kong n.a. Taiwan China Vietnam India Japan Australia Source: Data for 1996 and 1997 are from APEG Data for are from World Bank 1997b. Data for Hong Kong are from Hong Kong Monetary Authority. Taiwan data are from CEPD (various years). Table 1.11 Stock market price indices (US$) 1 Jan Jun Jan Jun Jan Mar Jun 1998 Indonesia Thailand Korea Malaysia Philippines Hong Kong Singapore Taiwan China

14 East Asian crisis 24 India n.a Japan Australia Note: 1 January 1996 = 100, except India, 28 June 1996 = 100. Source: Datastream.