By Martin Khor
Third World Network
The East Asian economic crisis is probably the most important economic event in the region of the past few decades and for the next few decades.
Beyond this, there is yet no unanimity about its root causes nor about the solutions. The differences of views are being debated in academic circles and reflected in the media.
One thing though is certain: the earlier optimistic expectation that it would last only some months has proved wrong. Instead the financial crisis has been transformed into a full-blown recession or depression, with forecasts of GNP growth and unemployment becoming more gloomy for affected countries. Moreover the threat of depreciation has spread from a few countries to many in the region, and is spreading to other areas such as Russia, South Africa, and possibly Eastern Europe and South America.
2. THE CAUSES, PROCESSES AND SOME ECONOMIC EFFECTS OF THE CRISIS
The great debate on causes is whether the blame should be allocated to domestic policies and practices or to the intrinsic and volatile nature of the global financial system.
In the first phase of the crisis, as it spread from Thailand to Malaysia, Indonesia, the Philippines, then to South Korea, the international establishment (represented by the IMF) and the G7 countries placed the blame squarely on domestic ills in the East Asian countries. They cited the ill judgment of the banks and financial institutions, the over-speculation in real estate and the share market, the collusion between governments and businesses, the bad policy of having fixed exchange rates (to the dollar) and the rather high current account deficits. They studiously avoided blaming the financial markets, or currency speculation, and the behaviour of huge institutional investors.
This view was difficult to sustain. For it implied that the "economic fundamentals" in East Asia were fatally flawed, yet only a few months or even weeks before the crisis erupted, the countries had been praised as models of sound fundamentals to be followed by others. And in 1993 the World Bank had coined the term the East Asian Miracle to describe the now vilified economies.
However, there rapidly developed another view of how the crisis emerged and spread. This view put the blame on the developments of the global financial system: the combination of financial deregulation and liberalisation across the world (as the legal basis); the increasing interconnection of markets and speed of transactions through computer technology (as the technological basis); and the development of large institutional financial players (such as the speculative hedge funds, the investment banks, and the huge mutual and pension funds).
This combination has led to the rapid shifting of large blocks of short-term capital flowing across borders in search of quick and high returns, to the tune of US$2 trillion a day. Only one to two percent is accounted for by foreign exchange transactions relating to trade and foreign direct investment. The remainder is for speculation or short-term investments that can move very quickly when the speculators' or investors' perceptions change.
When a developing country carries out financial liberalisation before its institutions or knowledge base is prepared to deal with the consequences, it opens itself to the possibility of tremendous shocks and instability associated with inflows and outflows of funds.
What happened in East Asia is not peculiar, but has already happened to many Latin American countries in the 1980s, to Mexico in 1994, to Sweden and Norway in the early 1990s. They faced sudden currency depreciations due to speculative attacks or large outflows of funds.
A total of US$184 billion entered developing Asian countries as net private capital flows in 1994-96, according to the Bank of International Settlements. In 1996, US$94 billion entered and in the first half of 1997 $70 billion poured in. With the onset of the crisis, $102 billion went out in the second half of 1997. The massive outflow has continued since.
These figures help to show: (i) how huge the flows (in and out) can be; (ii) how volatile and sudden the shifts can be, when inflow turns to outflow; (iii) how the huge capital flows can be subjected to the tremendous effect of "herd instinct," in which a market opinion or operational leader starts to pull out, and triggers or catalyses a panic withdrawal by large institutional investors and players.
In the case of East Asia, although there were grounds to believe that some of the currencies were over-valued, there was an over- reaction of the market, and consequently an "over-shooting" downwards of these currencies beyond what was justifiable by fundamentals. It was a case of self-fulfilling prophecy.
It is believed that financial speculators, led by some hedge funds, were responsible for the original "trigger action" in Thailand. The Thai government used up over US$20 billion of foreign reserves
to ward off speculative attacks. Speculators are believed to have borrowed and sold Thai baht, receiving US dollars in exchange.
When the baht fell, they needed much less dollars to repay the baht loans, thus making large profits.
A report in Business Week in August 1997 revealed that hedge funds made big profits from speculative attacks on Southeast Asian currencies in July 1997. In an article titled "The Rich Get a Little Richer," the business weekly reported on the recent profit levels of US-based "hedge funds", or investment funds that make their money from leveraged bets on currencies, stocks, bonds, commodities. According to Business Week, in the first half of this year, the hedge funds performed poorly. But in July (the month when the Thai baht went into crisis and when other currencies began to come under attack) they "rebounded with a vengeance" and that most types of funds posted "sharp gains." The magazine says that a key contributing factor for the hedge funds' excellent July performance was "the funds' speculative plays on the Thai baht and other struggling Asian currencies, such as the Malaysian ringgit and the Philippine peso." As a whole, the hedge funds made only 10.3 percent net profits (after fees) on average for the period January to June 1997. But their average profit rate jumped to 19.1 percent for January-July 1997. Thus, the inclusion of a single month (July) was enough to cause the profit rate so far this year to almost double. This clearly indicates a tremendous profit windfall in July.
In some countries, the first outflow by foreigners was followed by an outflow of capital by local people who feared further depreciation, or who were concerned about the safety of financial institutions. This further depreciated the currencies.
The sequence of events leading to and worsening the crisis included the following.
(a) Financial liberalisation
Firstly, the countries concerned carried out a process of financial liberalisation, where foreign exchange was made convertible with local currency not only for trade and direct-investment purposes but also for autonomous capital inflows and outflows (i.e. for "capital account" transactions); and where inflows and outflows of funds were largely deregulated and permitted. This facilitated the large inflows of funds in the form of international bank loans to local banks and companies, purchase of bonds, and portfolio investment in the local stock markets. For example, the Bangkok International Banking Facilities (BIBF) was set up on March 1993, to receive foreign funds for recycling to local banks and companies, and it received US$31 billion up to the end of 1996. South Korea recently liberalised its hitherto strict rules that prohibited or restricted foreign lending, in order to meet the requirements for entering the OECD. Its banks and firms received large inflows of foreign loans, and the country accumulated US$150 billion of foreign debts, most of it private-sector and short-term. In Indonesia, local banks and companies also borrowed heavily from abroad.
(b) Currency depreciation and debt crisis
The build-up of short-term debts was becoming alarming. What transformed this into crisis for Thailand, Indonesia and South Korea was the sharp and sudden depreciation of their currencies, coupled with the reduction of their foreign reserves in anti- speculation attempts. When the currencies depreciated, the burden of debt servicing rose correspondingly in terms of the local- currency amount required for loan repayment. That much of the loans were short-term was an additional problem. Foreign reserves also fell in attempts to ward off speculative attacks. The short- term foreign funds started pulling out sharply, causing reserves to fall further. When reserves fell to dangerously low levels, or to levels that could not allow the meeting of foreign debt obligations, Thailand, Indonesia and South Korea sought IMF help.
(c) Liberalisation and debt: the Malaysian case
Malaysia also went through a process of financial liberalisation, with much greater freedom for foreign funds to invest in the stock market, for conversion between foreign and local currencies, and for exit of funds to abroad.
The Central Bank however retained a key control: private companies wanting to borrow foreign-currency loans exceeding RM5 million must obtain the Bank's approval. This is generally given only for investments that would generate sufficient foreign exchange receipts to service the debts. Companies are also not allowed to raise external borrowing to finance the purchase of properties in the country. (Bank Negara Annual Report 1997, p53-54). Thus there was a policy of "limiting private sector external loans to corporations and individuals with foreign exchange earnings" which according to Bank Negara "has enabled Malaysia to meet its external obligations from export earnings." According to a private-sector leader, this ruling saved Malaysia from the kind of excessive short-term priavte-sector borrowing that led the other three countries into a debt crisis.
As a result of these controls, Malaysia's external debt has been kept to manageable levels. Nevertheless the debt servicing burden in terms of local currency has been made heavier by the sharp ringgit depreciation.
The relatively low debt level, especially short-term debt, is what distinguishes Malaysia from the three countries that had to seek IMF help. The lesson is that it is prudent and necessary to limit the degree of financial liberalisation and to continue to limit the extent of foreign debt, and moreover to, in the future, keep the foreign debt to an even much lower level.
(d) Local Asset Boom and Bust, and Liquidity Squeeze
The large inflows of foreign funds, either as loans to the banking system and companies directly, or as equity investment in the stock
markets, contributed to an asset price boom in property and stock markets in East Asian countries.
With the depreciation of currencies, and expectations of a debt crisis, economic slowdown or further depreciation, substantial foreign funds left suddenly as withdrawal of loans and selling off of shares. Share prices fell. Thus the falls in currency and share values fed each other. With weakened demand and increasing over-supply of buildings and housing, the prices of real estate also fell significantly.
For the countries afflicted with sharp currency depreciations and share market declines, the problems involved:
** The much heavier debt servicing burden of local banks, companies and governments that had taken loans in foreign currencies,
** The fall in the value of shares pledged as collateral for loans by companies and individuals, and the fall in the values of land, buildings and other real estate property. This has led to financial difficulties for the borrowers.
** The higher interest rates caused by liquidity squeeze and tight monetray policies have caused added financial burdens on all firms as well as on consumers that borrowed;
** As companies and individuals face difficulties in servicing their loans, this has increased the extent of non-performing loans and weakened the financial position of banks, and
** Higher inflation caused by rising import prices resulting from currency depreciation.
Moreover, in order to reduce the current account deficit, or in following the orthodox policies of the IMF, governments in the affected countries reduced their budget expenditure. The main rationale was to induce a reduction in the current account deficit, which had been targetted by currency speculators as a weak spot in the economy. Added to the higher interest rate and the tightening of liquidity, this budget cut also added to recessionary pressures.
(e) The fall in output
In the region, the financial crisis has been transformed to a full- blown recession in the real economy of production. Worst affected is Indonesia with a 6.2% fall in GDP in the first quarter 1998, and a newly projected negative growth for 1998 of 15%, inflation of 80% and expected unemployment of 17% or 15 million. South Korea's GDP fell 3.8% in the first quarter 1998. Thailand's 1998 GDP is expected to drop 4 to 5.5 percent in 1998. Hong Kong's GDP fell 2% in the first quarter. Singapore enjoyed 5.6% growth in the first quarter but is expected to slip into negative growth sometime in the second half of 1998. In Malaysia, real GDP fell 1.8% in first- quarter 1998 (compared to 6.9% strong growth in 4th quarter-1997).
A bright spot for the region is a turnaround in the current account of the balance of payments. However this improvement came with a heavy price. The increased trade surplus was caused more by a fall in imports than by a rise in exports, especially in real (or volume) terms. Thus the trade surplus indicates the effects of recession on falling imports, rather than an expansion of exports. Another point to note is that an improvement in the current account need not necessarily mean a healthy overall balance of payments position unless there is also a positive development in the capital account. A possible weakness here could be an outflow of short- term funds, by either foreigners or local people. To offset this, a repatriation of funds owned by local companies or people back to the country should be encouraged.
(f) Easing of fiscal and monetary policy
Recently there has been an easing of fiscal and monetary policy in the affected countries in response to the depth of the recessionary conditions. These actions would hopefully have the effect of improving economic conditions and ease recessionary pressures.
3. THE RECENT DEBATE ON THE ROLE OF THE IMF
As the East Asian crisis continues to deepen, the debate on the role of the International Monetary Fund's policies has heated up. The IMF's top officials continue to defend their macroeconomic approach of squeezing the domestic economies of their client countries through high interest rates, tight monetary policies and cuts in the government budget. Their argument is that this "pain" is needed to restore foreign investors' confidence, and so strengthen the countries' currencies.
However, some economists had already warned at the start of the IMF "treatment" for Thailand, Indonesia and South Korea that this set of policies is misplaced as it would transform a financial problem that could be resolved through debt restructuring, into a full- blown economic crisis.
The prediction has come true, with a vengeance. The three countries under the IMF's direct tutelage have slided into deep recession. Partly due to spillover effects, other countries such as Malaysia and Hongkong have also suffered negative growth in the year's first quarter. Even Singapore is tottering on the brink of minus growth.
The three affected countries had faced initial problems resulting from currency depreciation and stock market decline, such as debt repayment and a great financial weakening of the corporate and banking sectors. But then came a second set of problems resulting from the high interest rates and tight monetary and fiscal policies that the IMF imposed or advised.
For companies already hit by the declines in the currency and share values, the interest rate hike became a third burden that broke their backs.
But even worse, there are many thousands of firms (most of them small and medium sized) that have now been affected in each country. Their owners and managers did not make the mistake of borrowing from abroad (nor did they have the clout to do so). The great majority of them are also not listed on the stock market.
So they cannot be blamed for having contributed to the crisis by imprudent foreign loans or fiddling with inflated share values.
Yet these many thousands of companies are now hit by the sharp rise in interest rates, a liquidity squeeze as financial institutions are tight-fisted with (or even halt) new loans, and the slowdown in orders as the public sector cuts its spending.
In Thailand, "domestic interest rates as high as 18 percent have been blamed for starving local businesses of cash and strangling economic growth," according to a Reuter report of 3 June. In South Korea, thousands of small and medium companies have gone bankrupt as a result of high interest rates. Although the country has about US$150 billion in foreign debts, its companies in January also had double that (or more than US$300 billion) in domestic debt. According to the Wall Street Journal (9 Feb), the Korean economy was facing fresh agony over this huge domestic debt as thousands of companies file for bankruptcy as they find it harder to get credit. "To blame for the tighter liquidity are higher interest rates, a legacy of the IMF bailout that saved Korea's economy from collapse, and a sharp economic slowdown." In Indonesia, whilst top corporations with foreign currency loans have been hit hardest by the 80 percent drop of the rupiah vis-a-vis the US dollar, the majority of local companies have been devastated by interest rates of up to 50 percent. The rates were raised as part of an IMF agreement and were aimed at strengthening the rupiah. However the rupiah has not improved from its extremely low levels, whilst many indebted companies are unable to service their loans.
In Malaysia, which has fortunately not had to seek an IMF loan package, interest rates were lower than the three IMF client countries. Nevertheless they also went up during the first year of the Asian crisis. The interest rate hike and the reluctance of many banks to provide new loans caused serious difficulties for many firms and consumers. However, after the imposition of capital controls in September 1998, interest rates have gone down significantly, by about four percentage points. This has eased the financial position of debtors and banks. The capital controls were thus able to lay the condition for enabling interest rates to go down without this affecting the exchange rate.
Without making use of capital controls, countries subjected to currency speculation face a serious dilemma. They have been told by the IMF that lowering the interest rate might cause the "market" to lose confidence and savers to lose incentive, and thus the country risks capital flight and currency depreciation.
However, to maintain high interest rates or increase them further will cause companies to go bankrupt, increase the non-performing loans of banks, weaken the banking system, and dampen consumer demand. These, together with the reduction in government spending, will plunge the economy into deeper and deeper recession. And that in turn will anyway cause erosion of confidence in the currency and thus increase the risk of capital flight and depreciation.
A higher interest rate regime, in other words, may not boost the currency's level but could depress it further if it induces a deep and lengthy recession.
It is also pertinent to note that a country with a lower interest rate need not necessarily suffer a sharper drop in currency level. Take the case of China. Since May 1996, it has cut its interest rates four times and its one-year bank fixed deposit rate was 5.2 percent in May (according to a Reuters report). But its currency, which is not freely traded due to strict controls by the government, has not depreciated.
It has also been pointed out by UNCTAD's chief macroeconomist Yilmaz Akyuz that "although Indonesia and Thailand have kept their interest rates higher than Malaysia, they have experienced greater difficulties in their currency and stock markets." According to Akyuz, there is not a strong case for a drastic reduction in domestic growth (as advocated by the IMF) to bring about the adjustment needed in external payments.
Indeed it is very strange that the IMF as well as the leaders of Western countries are shrilly criticising Japan for not doing more to reflate its ailing economy. They are calling for more effective tax cuts so that Japanese consumers can spend more and thus kick the economy into recovery.
The yen had been sharply dropping, causing grave concerns that this will trigger a deeper Asian crisis or world recession.
Yet neither the IMF nor the Western leaders have asked Japan to increase its interest rate (which at 0.5 per cent must be the lowest in the world) to defend the yen. Instead they want Japan to take fiscal measures to expand the economy.
This tolerance of low interest rates in Japan as well as the pressure on the Japanese government to pump up its economy is a very different approach than the high-interest austerity-budget medicine prescribed for the other ailing East Asian countries.
Could it be that this display of double standards is because it is in the rich countries' interests to prevent a Japanese slump that could spread to their shores, and so they insist that Japan reflates its economy whilst keeping its interest rate at rock bottom? Whereas in the case of the other East Asian countries, which owe a great deal to the Western banks, the recovery and repayment of their foreign loans is the paramount interest?
In the latter case, a squeeze in the domestic economy would reduce imports, improve the trade balance and result in a strong foreign exchange surplus, which can then be channelled to repay the international banks.
This is in fact what is happening. The main bright spot for Thailand, South Korea, Indonesia and Malaysia is that as recession hits their domestic economy, there has been a contraction in imports resulting in large trade surpluses.
Unfortunately, this is being paid for through huge losses in domestic output and national income, the decimation of many of the large, medium and small firms of these countries, a dramatic increase in unemployment and poverty, and social dislocation or upheaval. A price that is far too high to pay, and which in the opinion of many economists (including some top establishment economists), is also unnecessary for the people of these countries to pay.
They argue that instead of being forced to raise interest rates and cut government expenditure, the countries should have been advised by the IMF to reflate their economies through increased lower interest rates and increased government spending.
Recently the Financial Times (London) carried a strongly worded opinion article entitled "Asian water torture" with this sub- heading: "Unless the IMF allows the region's economies to reflate and lower interest rates, it will condemn them to a never-ending spiral of recession and bankruptcy."
Written by Robert Wade, professor of political economy in Brown University (US), the article notes that the IMF imposed very high interest rates on the basis that a sharp shock rise in rates would stabilise currency markets, dampening pressures for competitive devaluations and making it easier for client governments to repay foreign creditors. The argument has a theoretical basis, says Wade, but it assumes conditions not present in Asia. When financial inflows did not resume, the Fund's response was to give it more time and make the pain sharper.
"Investors on the contrary took the high rates as a signal of great dangers ahead, making them all the more anxious to get out and stay out," says Wade. "High rates and the associated austerity policies have caused so much damage in the real economy as to validate the perception of great dangers."
Wade blames the IMF for failing to grasp the implications of imposing high interest charges on Asian companies that are typically far more indebted than western and Latin American companies. "High rates push them much more quickly from illiquidity towards insolvency, forcing them to cut back purchases, sell inventories, delay debt repayment and fire workers. Banks then accumulate a rising proportion of bad loans and refuse to make new ones. The IMF's insistence that banks meet strict Basle capital adequacy standards only compounds the collapse of credit. The combination of high interest rates and Basle standards is the immediate cause of the wave of insolvency, unemployment and contraction that continues to ricochet around the region and beyond. The uncertainty, instability and risk of further devaluations keep capital from returning despite high real interest rates."
Wade finds the IMF's contractionary approach "puzzling" as the United States authorities after the 1987 stock market crash had acted to keep markets highly liquid whatever the cost, yet in Asia the Fund acted to contract liquidity.
"Is this because it knows only one recipe? Or because it is more interested in safeguarding the interests of foreign bank creditors than in avoiding collapse in Asia?"
Concluding that the IMF's approach is not working, Wade calls on governments in the region to change tack away from the current approach of very low inflation, restrained demand and high real interest rates as the top priorities. "They need to take a tougher stance in the rescheduling negotiations with the creditor banks, lower interest rates to near zero, and step on the monetary gas," he says.
This proposition might be found by many to be too bold. What if the markets react negatively and the local currency drops further? To take this into account, Wade complements his proposal with another: that the governments have to reintroduce some form of cross-border capital controls. They should then channel credit into export industries, generate an export boom, and let the ensuing profits reinforce inflationary expectations and reflate domestic demand.
The West, meanwhile, should stop pushing developing countries to allow free inflow and outflow of short-term finance as they are simply not robust enough to be exposed to the shocks that unimpeded flows can bring. There should also be reconsideration of the constitution of money funds (whose priorities are short- term results) and over-guaranteed international banks, which lie at the heart of the problem of destabilising international financial flows.
"Until Asian governments lower interest rates, take control of short-term capital movements, and cooperate within the region, the crisis will go on and on like water torture. That will bring poverty and insecurity to hundreds of millions and turn parts of Asia into a dependency of the IMF and the US, its number one shareholder."
The Wade article is the latest in a series of increasing academic articles calling for a change in IMF policies.
The Harvard professor, Jeffrey Sachs, has been attacking the IMF ever since early November 1997, when he predicted that the bailout packages for Thailand and Indonesia, if tied to orthodox financial conditions like budget cuts and higher interest rates, could "do more harm than good, transforming a currency crisis into a rip-roaring economic downturn."
The predicted downturn has now turned out to be much worse than anyone imagined.
Another prominent critic is Martin Feldstein, economics professor at Harvard University, president of the National Bureau of Economic Research and formerly chief economic advisor to the US government.
In the "Foreign Affairs" journal (March/April 1998), he says the IMF's recent emphasis on imposing major structural and institutional reforms, rather than focusing on balance-of- payments adjustments, will have short-term and longer-term adverse consequences.
The main thrust of his article is that the IMF has strayed from its mandate of helping countries resolve their balance of payments problems (which could be best done by organising debt rescheduling exercises between the countries and their foreign creditors) and instead has been imposing conditions relating to their economic, financial and social structures which are not relevant to resolving the debt and balance of payments problems at hand.
This is a subject that needs separate treatment.
However, Feldstein also criticises the IMF's short-term macroeconomic policies for Korea, which calls for budget deficit reduction (by raising taxes and cutting government spending) and a tighter monetary policy (higher interest rates and less credit availability), which together depress growth and raise unemployment.
Asks Feldstein: "But why should Korea be required to raise taxes and cut spending to lower its 1998 budget deficit when its national savings rate is already one of the highest in the world, when its 1998 budget deficit will rise temporarily because of the policy-induced recession, and when the combination of higher private savings and reduced business investment are already freeing up the resources needed to raise exports and shrink the current account deficit?"
Feldstein notes that under the IMF plan, the interest rate on won loans was 30 percent whilst inflation was only 5 percent (at the time the article was written, earlier this year).
"Because of the high debt typical of most Korean companies, this enormously high real interest rate of 25 percent puts all of them at risk of bankruptcy," he says.
"Why should Korea be forced to cause widespread bankruptcies by tightening credit when inflation is very low, when the rollover of bank loans and the demand for the won depend more on confidence than on Korean won interest rates, when the failures will reduce the prospect of loan repayment, and when a further fall in the won is an alternative to high interest rates as a way to attract won-denominated deposits?
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