Wheels Within Wheels: Rethinking the Asian Crisis and the Asian Model

Robert Wade

A.  Introduction

1.  Countries include: South Korea, Thailand, Malaysia, and Indonesia

2.  1997 currencies and stock markets of several East Asian economies plunged, banks failed, real interest rates shot up, exports fell, firms shut down, unemployment

3.  Same economies had constituted the “east Asian Miracle”

4.  1980’s, Asia seemed to become an equal of the “tripolar world” with North America and Europe

5.  The causes were “homegrown”, the problems lied in the economic structures, more in the microeconomic than the macroeconomic, more in the private than the public sector

6.  Crises associated with an open capital account and large foreign capital inflows, producing a “credit bubble”

B.  The Failure of the Asian governance” Theory

1.  Reasons for private capital inflows being excessive

  1. “lack of transparency” in the bank accounts
  2. institutional investors could not know truth about their borrowers
  3. “weak prudential regulation” by monetary authorities
  4. allowed banks to lend to heavily indebted companies
  5. “poor” exchange rate management
  6. commitment to a fixed exchange rate, making foreign borrowing to cheap
  7. “moral hazard”
  8. investors expected that banks and fifirmsm that were lending would be bailed out by the Asian governments

2.  consequences of East Asian “cronyistic” relationship – system of economic governance

  1. banks rather than capital markets intermediate finance
  2. banks, big firms, and governments have close and long term relations
  3. agreements are made behind the scenes, unmonitored

3.  Radical structural reforms and the need to establish “sound” institutions and policies in banking, capital markets, corporate governance, labor markets

4.  Anglo American model of a free market economy

  1. Arms-length relations between banks, firms and government
  2. Regulation by formal contracts enforced in courts of law
  3. Capital market as the basis of the financial system

5.  theory implies thaqt more transparency is needed in corporate and governmental accounts; IMF should exercise closer surveillance of developing countries

6.  Golden Rule: capital markets will be stable and deliver big net benefits to developing countries open to them

  1. This is the key assumption of the failure-of-Asian-governance theory

C.  Evidence for the “Failure of Asian Governance” Theory

1.  Assertions of Theory

  1. Information was lacking on variables that are strongly associated with impending crisis
  2. If investors had know about the information, they would have invested significantly less money
  3. The crisis-affected countries had become significantly less transparent over the 1990’s
  4. The crisis-affected countries were less transparent than non-crisis-affected comparator countries
  5. Financial crises from 1970’s onwards, had low level of transparency associated with crisis and high level of transparency is associated with non-crises

2.  transparency argument does not include the information failures of capital markets

  1. investors were ignorant and were not paying attention to what was available because their incentives to gather and process information on countries as well as returns were low
  2. IMF managing director calls for transparency as the center piece of reform strategy
  3. Basic prudential rules limiting lending to affiliated companies were regularly broken, banks were undercapitalized, and the share of non performing loans in total loans was high or else concealed

3.  ICOR – incremental capital to output ratio

  1. Started rising around 1991, indicating decline in returns to capital

4.  deterioation of investment in the crisis countries

5.  accounting Rate of Return = measure of investment efficiency;

  1. average returns were relatively high from 1988-1994
  2. they fell sharply from 1995-1996

D.  The “Failure of International Financial Markets” Theory

1.  currency or banking crises were much more frequent since 1980

2.  The crises have commonly occurred in response to a “success”

3.  The Asian crisis was regional, with several countries falling into a pile at about the same time

4.  The crisis was unanticipated by those whose job it is to anticipate such things

E.  A General Story of Financial Fragility

1.  the financial system tends to become more fragile, for reason inherent in the upswing process

  1. investment relative to GDP rise
  2. higher corporate debt to-equity ratios make for more financial fragility

2.  tendencies towards financial fragility

  1. government borrows less; more household savings; boosting the corporate debt-to-equity ratio

3.  standard policy response – raising interest rates to slow demand

4.  private capital inflows rise, the central bank’s foreign exchange reserves rise as well

5.  Sterilization ‘s problems

  1. Typically expensive because the interest the central bank has to pay on the bath bonds is higher than the interest it earns from the foreign bonds it buys
  2. sterilization the central bank gets interest income on its US bonds with no interest expenses at all
  3. in a developing country, sterilization may not be feasible because the market for government bonds and bills in the domestic currency is small and the range of the other financial instruments is also small
  4. sterilization does succeed in lowering the money supply relative to the unsterilized level, it raises interest rates; which perpetuates inflows

6.  Capital inflows generate excess liquidity in the form of a domestic credit boom:

  1. A surge in consumer goods imports, which widens the current account deficit
  2. Inflation in consumer good prices (CPI inflation)
  3. A surge in “investment” in asset markets notably real estate and stocks, causing asset price inflation
  4. A surge in industrial investment, reflecting an assumption that the resulting increase in production can be exported if not sold at home

7.  Credit Boom vents itself through:

  1. Increased capital goods imports, justified initially on the grounds that the imports are sustainable
  2. Asset price inflation
  3. Increasingly speculative expansion of industrial capacity fueled by too-cheap foreign borrowing and export optimism

8.  Economy with multiple sources of endogenously generated financial fragility:

  1. A rate of increase of productive capacity above trend
  2. A relatively high and rising ratio of corporate debt to equity
  3. An asset price bubble
  4. A smaller cushion of safety held by all economic agents in the grip of extrapolative expectations
  5. A high and rising current account deficit
  6. A relatively high and rising external debt

F.  The East Asian Model

1.  the change of a successful capitalist economy to a financially fragile and then financially unstable economy

  1. banks, rather than capital markets are the central financial entities
  2. banks, big firms, and governments have close and long-term relations
  3. agreements are made behind the scenes, unmonitored by independent parties

2.  banks are treated as akin to public utilities, serving public purpose even when privately owned

3.  corporations finance their investments by borrowing from banks

4.  banks need to develop because securities markets are thin

5.  Institutional Arrangements

  1. Tendency toward financial instability in an economy experiencing high levels of investment and high corporate debt-to-equity ratio
  2. Long term relations between banks and firms provide buffer so banks don’t call their loans
  3. Government gets support by an industrial policy that seeks to promote certain investments ahead of others

6.  Long term relations between banks, firms, and governments help to prevent one of the strengths of the East Asian Model

  1. High investment sustained by high corporate debt-to-equity ratio
  2. Restricted movement of financial capital across the national borders

7.  East Asia able to grow fast through 1980’s, reaping the gains of

  1. high debt-to-equity ratios
  2. coordinated investments
  3. low average transaction costs

G.  The Surge in World Capital Markets and the Emerging Market’s Boom and Bust

1.  US financed it’s external deficits by attracting capital inflows, in the form of foreign purchases of US government debt

2.  East Asia experienced two rounds of rising reserves in surplus which led in some cases to excessive credit creation

  1. 1980: Japan
  2. ran large currentn account surplus with the US; surpleses had become so large, that Japan could not export enough capital to the US
  3. 1990: Korea and Southeast Asia

3.  since the dollar was no longer linked to gold, there was no fixed rate

4.  1990’s US still running large external deficits financed by capital inflows, domestic economy was in recession

5.  Europe: low growth, high unemployment; recession throughout OECD(Organization for Economic Co-operation and Development) world

6.  inflow of foreign funds would bring greater stock market price stability in emerging markets

7.  strong correlation between the capital inflows to different emerging market countries; despite the diversity of policies pursued by those countries

H.  The Build-up to Crisis in East Asia

1.  Financial Opening

  1. East asian governments lifted most restrictions on capital mobility
  2. Free inflow and outflow of foreign capital, eased restrictions on entry of foreign banks and investment houses
  3. Restrictions lifted on neoliberal assumption that if the foreign borrowing was private-to-private it could be presumed to be safe and productive

2.  Capital Inflow

  1. As east asian governments liberalized and opened financial systems, foreign capital flooded during 1990

3.  Financial Fragility

  1. Inflow of foreign funds increased the rserve assets of domestic financial systems
  2. Domestic financial systems not able to offset or sterilize the increased foreign exchange reserves
  3. Three major sources of financial fragility
  4. fragile corporate finances
  5. banks that were fragile because of lending against bubble driven asset alues
  6. balance of payments that was fragile because of excessive short-term foreign claims relateve to liquid foreign assets
  7. East Asia’s high growth rates during the 1990’s concealed a change in the source

4.  Conjunctrual Shocks

  1. Investment in US rose, making emerging markets less attractive
  2. Appreciation of dollar against the yen, was a major blow to exports
  3. Long term problems
  4. sustaining the growth of leading sectors in the face of growing excess manufacturing capacity worldwide
  5. catching up as East Asian Countries approached the technological frontier

5.  Maintaining the Peg

  1. Devaluation would have hurt those in the political elite; because they had borrowed abroad with out taking out protection against a devaluation
  2. Breaking the currency peg might disrupt the inflow of short term capital, and the thai economy
  3. Old strategy had been based on a highly competitive export sector

6.  More Financial Fragility

  1. Private and foreign inflows continued to rise, and at decreasing risk premiums up to mid 1997

7.  The Costs of Overinvestment

  1. Crisis of overinvestment; in real estate and stockes, manufacturing
  2. Asian credit boom vented itself more in excess investment, reflecting high savings propensities
  3. an excess consumption crisis
  4. excess investment crisis
  5. severity of Asia’s crisis was the other side of it’s developmental strength relative to latin America

8.  Recovery

  1. Combination of debt reduction and increased foreign exchange earnings
  2. Squeeze solution
  3. rescheduling, faster growth, or inflation; reduce imports and shift more resources into export production
  4. the revocery of production and incomes looked fragile and uneven

I.  Causality

1.  is culprit private investment inflow which blows out a credit boom?

  1. Private capital inflows to developing countries grew, and grew twice, while each surge was followed by a financial crisis
  2. Bank regulation and enforcement of prudential limits becomes difficult in the face of capital inflow surge
  3. The financial system of the typical emerging market economy is no bigger than an average American regional bank

2.  Asian governments are deeply implicated in the crisis for opening the financial system quickly in 1990’s with out linking the pace of the opening to build up effective rule based governance

3.  deeper causes of crisis lie in the economies and governments

J.  A Political Science Agenda

1.  comparative politics

  1. between those whose interests remain rooted in the national territory

2.  led manufacturers to press for more state help for industrial upgrading

3.  long term trend for average transaction costs to rise as the economies become more complex and open

4.  international political economy

  1. credit bubble
  2. rotating around the developed and emerging market countries
  3. bubble driven by excess world liquidity generated in core economies

5.  solution is to curb inflows

  1. great configuration of financial interests in the west; int’l regimes grown as excess liquidity has grown
  2. international political economy agenda merges into American political Agenda

6.  GATT/WTO Multilateral Agreement on Investment, APEC

  1. Cloak objectives with multilateral legitimacy and spread the costs over other states
  2. US led campaign for free capital mobility worldwide
  3. Dominance of wall street = realignment

7.  solutions

  1. capital controls
  2. large scle changes
  3. new system of international payments
  4. each country pay for currency in order to pay for goods or repay borrowings
  5. growth of global wages in line with global output and limit the tendency towards excess capacity should be encouraged