Asian Financial Crisis, Volume 1: Financial, Structural, and International Dimensions (International Finance Review)

LIST OF CONTRIBUTORS Zafar U. Ahmed

Professor of Marketing and International Business, Office # East Hall 245, College of Business, Sacred Heart University, Fairfield, Connecticut 06432-1000, USA. Fax: 203-365-7538. E-mail: ahmedz @sacredheart.edu

Ilan Alon

Assistant Professor of International Business, Department of Economics and Business, 221 Netzer Administration Building, State University of New York College at Oneonta, Oneonta, NY 13820, USA. Fax: (607) 436-2543; E-mail: [email protected]

Frank L. Bartels

Deputy Director, MBA Program in Intemational Business, Nanyang Technological University, Singapore. Fax: 65-791-3697; E-mail: aflbartels @ntu.edu.sg

Anindya K. Bhattacharya Assistant Professor of Business, Department of Economics, Brookly College, The City University of New York, 2900 Bedford Avenue, Brooklyn, New York 11210, USA. Fax: 718-951-4867; E-mail: abhattao @stern.nyu.edu Christopher Bilson

Assistant Professor, Faculty of Economics and Commerce, the Australian National University, Canberra 0200, Australia. Fax: 61 2 6 249 5005; E-mail: Chris.Bilston @anu.edu.au ix

S. J. Chang

Professor of Finance, College of Business, Campus Box 5480, Illinois State University, Normal, IL 61790-5480, USA. Fax: 309-438-5510; E-mail: [email protected]

Tung-lung Chang

Assistant Professor of Management, School of Business, Long Island University, 720 Northern Boulevard, Brookville, NY 11548, USA. E-mail: [email protected]

Woon- Youl Choi

President, Korea Securities Research Institute, 33 Yoido-Dong,Youngdungpo-Ku, Seoul, Korea, 150-010. Fax: 822-786-6154; E-mail: ksril @ksri.org

Young Back Choi

Associate Professor of Economics, Department of Economics and Finance, St. John's University, 8000 Utopia Parkway, Jamaica, NY 11439, USA. Fax: 718-990-1868; E-mail: [email protected]

James W. Dean

Professor of Economics, Simon Fraser University (since 1969) and Kaiser Professor of International Business, Western Washington University, Bellingham, WA 98225-917, USA. E-mail: [email protected]

John R. M. Gordon

Professor and Alcon/NSERC/SSHRC Chair in Management and Technology, Queens School of Business, Queens University, Kingston, Ontario, Canada K7L 3N6. Fax: 613-549-5679; E-mail: gordonj @qucdn.queensu.ca

Vince Hooper

Senior Lecturer, School of Banking and Finance, University of New South Wales, Kensington, Sydney, Australia. Fax: 61 2 9385 6730; E-mail: [email protected]

xi M. Faizul Islam

Adjunct Associate Professor, Department of Management Studies, Southeastern University, 500 1 Street, S.W. Washington, D.C. 20024, USA. Fax: (202) 488-8093

Martin Jaugietis

Financial Analyst, Towers Perrin, Level 10, 101 Collins Street, Melbourne, Australia. Fax: 61 3 9270 8199; E-mail: [email protected]

Sung-Hee Jwa

President of Korea Economic Research Institute, FKI Building, 28-1, Yoido-dong, Youngdeungpo-ku, Seoul, Korea, 150-756. Fax: 82-2-785-0270/1.

Hisanori Kataoka

Researcher, Columbia University's APEC Study Center, 3-16-19-303 Naka-cho, Musashino-shi, Tokyo 180-0006, Japan. Fax: 81-422-60-2828; E-mail: kataoka @qg7.so-net.ne.jp

Edmund A. Kellerman

Lecturer in Speech Communication, William and Grace Dial Center for Written and Oral Communication, Rolfs Hall 414, P.O. Box 113072, The University of Florida, Gainesville, FL 32611. Fax: (352) 392-5420; E-mail: [email protected]

Daesik Kim

Professor of Finance, Department of Business and Economics, Hanyang University, Seongdong-Ku Haengdang-Dong 17, Seoul, 133-791, Korea. Fax: (822) 2296-9587; E-mail: [email protected]

Phil Sang Lee

Professor, School of Business Administration, Korea University, 5-1 Anam-dong, Sungbukku, Seoul, Korea 136-701. Fax: 822-922-7220; E-mail: phillee @kuccnx.korea.ac.kr

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Ungki Lim

Professor of Corporate Finance & Securities, Department of Business Administration, Yonsei University, Seoul, Korea 120-749. Fax: 2-2648-0314; E-mail: ungkilim @base.yonsei.ac.kr

Christopher Lingle

Professor of Economics, Universidad Francisco Marroqufn, Apartado Postal 632-A, Guatemala 01010. Fax: (502) 334-6896; E-mail: [email protected]

ReuvenMondejar

City University of Hong Kong, Tat Chee Avenue, Kowloon, Hong Kong

Jaeha Park

Associate Professor, Department of Marketing, Korea Institute of Finance, Myung-Dong 1 Ga 4-1, Chung-ku, Seoul, 100-021, Korea. Fax: 82-2-3705-6304; E-mail: jhpark @sun.kif.re.kr

Kyung Suh Park

Associate Professor, School of Business Administation, Korea University, 5-1 Anamdong, Sungbuk-ku, Seoul, Korea 136-701. Fax: 822-3290-1950; E-mail: kspark @kuccnx.korea.ac.kr

Peter Ping Li

Assistant Professor of Management, School of Business Administration, California State University, Stanislaus, 801 West Monte Vista Avenue, Turlock, CA 95382, USA. Fax: (209) 667-3020; E-mail: [email protected]

Jung-Hwan Seo

Research Fellow, Korea Economic Research Institute. Fax: 82-2-785-0273; E-mail: [email protected].

Tan Teng-Kee

Nanyang Business School, Nanyang Technological University, Singapore

xiii

Yeong-Ho Woo

Vice President, Korea Securities Research Institute, 33 Yoido-Dong,Youngdungpo-Ku, Seoul, Korea, 150-010. Fax: 822-786-6154; E-mail: [email protected]

Jiawen Yang

Associate Professor of International Business, School of Business and Public Management, The George Washington University, 2023 G Street, N.W. Washington, D.C. 20052, USA. Fax: (202) 994-7422; E-mail: [email protected]

ABOUT THE EDITOR J. (Jongmoo) Jay Choi is Laura H. Camell Professor of Finance and International Business at Temple University. He is a graduate of Seoul National University (BBA) and New York University (MBA, Ph.D.). Previously on the faculty of Columbia Business School, and an international economist at Chase Manhattan Bank. Visiting faculty at Pennsylvania (Wharton), NYU (Stem), Korea Advanced Institute of Science and Technology, and International University of Japan. He teaches corporate finance, capital markets, and international finance, and is a doctoral director of international business and a former chair of finance at Temple. He is a recipient of Musser Aaward for Excellence for Leadership, a former president of Korea-America Finance Association, and a trustee of Multinational Finance Society. He has over fifty books and articles in major journals. In addition to his work as a series editor of International Finance Review (JAI/Elsevier), he is a section editor of Journal of Economics and Business, and is on editorial boards of six journals. Listed in Harvard Business School Directory of International Business Scholars, and others.

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EDITORIAL ADVISORY BOARD Michael Adler, Columbia University Warren Bailey, Cornell University Ian Cooper, London Business School John Doukas, Old Dominion University/European Financial Management Gunter Dufey, University of Michigan Vihang Errunza, McGill University Robert Grosse, Thunderbird Business School Campbell R. Harvey, Duke University Yasushi Hamao, University of Southern California Robert Hawkins, Georgia Institute of Technology James E. Hodder, University of Wisconsin, Madison Maurice Levi, University of British Columbia Dennis E. Logue, Dartmouth College James Lothian, Fordham University/Journal of International Money and Finance Richard Marston, University of Pennsylvania Richard Roll, University of California at Los Angeles Anthony Saunders, New York University Richard Sweeney, Georgetown University

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THE ASIAN FINANCIAL CRISIS" MORAL HAZARD IN MORE WAYS THAN ONE Jongmoo Jay Choi The Asian financial crisis of 1997 jolted the world economy like no other economic event since the World War II. The effect of the crisis was both deep and broad. Countries used to decades of 8 - 1 0 % positive annual real economic growth saw their growth plunge up to a negative 15% (Table 1). Hundreds of

Table 1.

Economic Growth of Asian Countries (% Real G D P Growth Rates)

Country

t995

1996

1997

1998

Indonesia Korea Thailand Malaysia Philippines Singapore Hong Kong Taiwan China Japan

8.2 8.9 8.8 9.5 4.8 8.7 3.9 8.0 10.5 2.4

8.0 7.1 5.5 8.6 5.7 6.9 4.6 5.7 9.6 1.7

4.6 5.5 -0.4 7.8 5.1 7.8 5.3 6.9 8.6 0.9

-15.3 -5.8 -8.0 -7.5 -0.5 1.5 -5.1 4.0 7.8 -2.9

2.3

3.4

3.9

3.5

USA

Source: IME International Financial Statistics; Hong Kong Monetary Authority; CEPD for Taiwan

Asian Financial Crisis, Volume 1, pages 3-14. 2000 by Elsevier Science Inc. ISBN: 0-7623-0686-6

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Table 2.

JONGMOO JAY CHOI Devaluation in Stocks and Currencies: Asian Financial Crisis 1997

Country Indonesia Korea Thailand Hong Kong Japan

Stock

Currency

-44.7% -33.3% -35.4% -42.8% -16.7%

-69.3% -44.7% -51.9% 0.0% -10.9%

Source: Institute of International Finance, Inc.

firms and factories closed shops and millions of people lost their jobs. Stock prices as well as currency values plunged by half within days after the crisis (Table 2). Thus a minor currency crisis that started with an attack on the Thai Baht in July 1997 quickly consumed the entire country and precipitated a global contagion not only in Asia but also well beyond. There is an ongoing debate as to the role of finance in both economics and business. The literature on macroeconomic policy, for instance, relegates the role of financial markets to the background on the ground that only real factors matter. Similarly there is a tendency in business literature to afford a predominant role to operational or strategic factors, with finance playing only a subordinate role. Ironically, the Asian financial crisis is an incident that 'proves' that such a view is wrong and that finance is essential for country as well as for business. To describe the crisis, a popular magazine has carried a cover page containing a picture of people demonstrating in the street of Bangkok, carrying a banner of 'finance closed', 'industry closed', and 'country closed'. The banner succinctly summarizes the nature of the crisis: it started as a financial crisis but became of a crisis of industry and country as a whole in no time. In Korea, the economic planning minister pronounced, as late as November 1997 - several months after Southeast Asia has already fallen and less than a month before Korea had to seek assistance from the IMF - that Korea would not fall because of strong macroeconomic 'fundamentals'. Confident in the apparent relative strength of such traditional fundamentals such as growth or inflation, he did not take such financial or liquidity indicators as high shortterm borrowing and dwindling international reserve assets seriously. In a peculiar way, this episode suggests an important lesson that just like a firm squeezed by cash flow problem, nations should ignore finance at their own peril.

The Asian Financial Crisis: Moral Hazard in More Ways Than One

5

The crisis was as unpredictable as it was painful. Government officials could not imagine how their own tiger economies could not simply ride out any of the problems that may come in their path of continued high growth and economic success. Or perhaps that was the reason. The over-confidence and complacency brought about by success may have caused them to be blind to what is actually going on in the outside world and thus they were unable to innovate and change even when the world market environments are fundamentally changing because of globalization and technology.

MULTI-FACETED REASONS FOR THE CRISIS Given the scarcity of an international finance specialist with an Asian background, I was asked to speak on this topic on various occasions. One question I almost never fail to get is: since there are so many smart (Westerntrained) people in these countries, how did they all fail to see it coming and how come did they all let it happen? In answering the question, I often refer to a case of a firm that shows positive earnings yet went into bankruptcy (See Fig. 1). Despite positive earnings and equity, a firm can go under if it does not have cash flows to meet upcoming debt

"Profitable"

+

Bankruptcy

Transparency

I Liquidity/ Cash Flow

St~al

I FX Reserves ST Debt

Ri~dityl

Fundamental Factors

Fig. 1.

6

J O N G M O O JAY CHOI

obligations. It can attempt to obtain credit, but the lender may not be so inclined when the financial conditions of the firm is deteriorating. I then point out that the cash flow or liquidity problem is usually an indication of structural problems, which must be addressed to save the firm. Of course, it is also possible that earnings or equity reported in financial statements may not be transparent or even distortive, so it is important to investigate accounting as well. I then conclude that a basic answer for bankruptcy is simply management failure. This example of corporate bankruptcy suggests a lot about the causes of the Asian financial crisis. Just like a case of corporate bankruptcy, financial factors are at the forefront. However, the causes of the Asian financial crisis are also multi-faceted. They include structural and management problems as well as finance. In addition, there is a question of transparency and the role of capital markets in disciplining the management. Regarding the question of whether smart people should have predicted it, the predictability of the Asian financial crisis is an open issue that requires further empirical investigation. Some western observers such as Paul Krugman, however, sensed - as early as 1995 - that the Asian economic miracle was rapidly losing steam. The traditional source of economic growth - the availability of relatively low-cost high-quality labor was disappearing fast in Asia, and new source of growth such as technology was not easily in sight. The average hourly wage rate in Korea, for instance, has risen by 502% over the period of 1985-95 while it has increased only by 32% in the U.S. for the same period (Table 3). Clearly the resulting decline in international competitiveness had something to do with the crisis. Of course, the basic premise of Asia having many 'smart' people may not hold up upon close examination. However, if the premise is accepted (the Asian countries consistently rank highest in the number of students studying in U.S.

Table 3. Country Korea Taiwan Singapore Japan U.S.A. Source: Wall Street Journal

Hourly Wages in Manufacturing Sector 1985 $1.23 1.50 2.47 6.34 $13.01

1995

% Change

$7.40 5.82 7.28 23.66 $17.20

502 288 195 277 32

The Asian Financial Crisis: Moral Hazard in More Ways Than One

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universities after all), then the only plausible answer is that it did not matter. Apparently, the presence of many smart Western-trained engineers, MBAs or economists in corporations, government or universities did not help the countries in preventing the crisis. In Indonesia, Korea and Thailand (three countries who received assistance from the IMF), the government is run by domestic elites who passed highly competitive civil service exams and westerntrained officials are often cast outside of its inner circle. In corporate settings, top decision-makers do not consult the views of western-trained MBAs because of an organizational rigidity that does not promote broad, open participation. Asian firms have rigid hierarchy and a top person exercises exclusive authority on all major decisions. Moreover given the family control of a business conglomerate, major decisions are deferred to the group 'owner' beyond the chief executive office of a single firm. In the West, capital markets and institutions monitor and discipline the management in the case of poor performance. However, given the underdeveloped capital markets and institutions, investors or creditors are unable to play such a role. Hence, there is nothing that can effectively monitor, influence or discipline the management or group owners either internally or externally. Then the fortune of the firm depends on the vagary and wisdom of the group owner. Of course, the Asian managers do not necessarily have greater or smaller proclivity to make bad decisions than Western ones. However, they are more susceptible to make overly ambitious suboptimal investment decisions because of their reliance on debt capital (as well as the lack of market discipline). Korean finns had a debt-equity ratio of over 300% on the average (some even more than 1000%) before the crisis (Table 4). Corporate finance theory indicates that a firm heavily leveraged with debt capital tends to make overinvestment decisions well beyond the optimal level. If the firm is heavily debt-financed, there is a built-in incentive to 'gamble' with other people's

Table 4.

Financial Leverage of Asian Firms

Country

Debt to Equity

Korea Taiwan Japan

317.1% 85.7% 206.3%

U.S.A.

159.7%

Source: Chosun Ilbo, 1997

8

JONGMOO JAY CHOI

money when the firm is facing potential bankruptcy risk, which will rise with leverage. Easy bank loan made available by 'relationship banking' and the government-guided 3B trilogy (bureaucrats, bankers, and businessmen) of 'the Asian business model' is also a major contributing factor. An interesting related issue pertains to the quality of information. Some of the statistics on external debt and international reserves released by the Korean government prior to the crisis was wrong or misleading, as it was forced to revise them later. Similarly the financial statements released by firms massage the real effects of cross-stock ownership, intra-group transactions and the like and are much removed from mark-to-market accounting. To sum, there is no shortage of suggestions for the reasons of the Asian financial crisis. In the spirit of David Letterman's top 10 - or should it be 21 quizzes since there are so many: Reasons for the Asian Financial Crisis (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21)

Victims to international speculative capital Victims to conspiracy Crony capitalism and corruption Decline in international competitiveness Failure of the Asian business model Government control and interference (including bailing out of bankrupt institutions) Inadequate government monitoring and regulation Lack of transparencies regarding government policies and accounting Family control of business groups Excessive corporate borrowing Underdeveloped domestic capital markets and institutions Current account deficit and excess consumption Rising external debt Low international reserve assets Liquidity problem due to high ratio of short-term debt Non-sustainability of 'fixed' exchange rate policy International contagion Lack of global perspectives Authoritative decision making structure Ego and stupidity of top business and government officials in charge Moral hazard problems.

Reflecting the multi-faceted nature of the crisis, the list is diverse and multidimensional. The first two are suggestions based on victimhood and represent

The Asian Financial Crisis: Moral Hazard in More Ways Than One

9

views often heard in the Asian media. Reasons 3-6 regarding the shortcomings of the Asian business are ones often suggested by Western analysts and media. Next two questions, 7 and 8, are suggestions from a regulatory standpoint. Corporate finance provides reasons 9-11. Items 12-17 cover the international dimensions, while culture provides items 18-20. The challenge for research is sorting them out in terms of their relative importance. A holistic issue is whether it is possible to put all these factors together in some coherent conceptual framework. Moral hazard - the last item 21 - provides such a possibility. It provides a general conceptual framework since it encompasses financial and real factors as well as questions regarding transparency and management.

MORAL HAZARD IN MORE WAYS THAN ONE Moral hazard is a jargon in finance and microeconomics that refers to an inefficiency created by an inability of insiders to convey accurate information to the market or outsiders because of uncertainty and information asymmetry. This inefficiency is an increasing function of leverage beyond a certain optimal level. A firm financed by debt is likely to make suboptimal investment decisions. As applied to the Asian financial crisis, moral hazard highlights the fact that the origin of the crisis is financial, but the eventual cost of such outcome is magnified by structural factors. And the impacts are society-wide beyond economics. Elementary financial theory suggests that while the use of leverage can be beneficial at good times, the potential loss is far greater with leverage at bad times. Hence, the leverage increases the level of risk in all cases. This simple rule is violated in Asia, and the Asian financial crisis is a natural outcome. At the macro level, it is clear in Table 5 that three countries that sought assistance from the IMF (Indonesia, Korea, and Thailand) as well as other countries that suffered severely in the crisis (Malaysia, Philippines) had much higher level of current account deficit and external debt - and much of it is short term - relative to the size of their economies than others that escaped the crisis (Hong Kong, Singapore, China and Taiwan). The level of international reserve assets is also very low for these countries, while, unlike Mexico and other Latin American countries that faced crises earlier, they did not have deficit in government budget. (The latter factor illustrates that the origin of the Asian crisis was more in the private sector than public although the government might have wielded its influence behind the scenes.) At the same time, the government basically maintained a fixed exchange rate system, which may be untenable with domestic and external financial constraints they faced.

JONGMOO JAY CHOI

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Table 5. Country

Indonesia Korea Thailand Malaysia Philippines Singapore Hong Kong Taiwan China Japan

Financial Constraints of Asian Countries, 1996

Current account (% GDP)

-3.4 -4.8 -7.9 -4.9 -4.7 15.0 -2.5 3.8 0.9 1.4

Government budget (% GDP) 0.0 ~).2 2.3 0.7 0.3 13.9 1.5 1.6 ~.8 -3.9

Externald e b t (% GDP)

International Reserves (months of imports)

38.9 11.2 19.8 28.8 50.9* N/A N/A 0.1 15.0 N/A

6.1 2.8 6.6 4.3 4.4 7.0 10.9 10.3 9.1 8.5

N/A =not applicable. * 1995 figure. Source: Hong Kong Monetary Authority; CEPD for Taiwan, APEC.

At the micro level, many Asian firms borrowed heavily from home and abroad. The debt ratios of major industrial firms are often several times higher than either the norm in the U.S. or any calculation of optimal leverage ratios. Thus, it is a matter of elementary finance that these firms faced severe financial risk, and it is a matter of market conditions whether any of them will fail. Of course it is possible that financial leverage will actually be beneficial if market conditions are favorable. However, if the market turns unfavorable, the firm that has expanded with borrowed funds will face the risk of bankruptcy. Clearly the global business expansion will not work as a risk management strategy, as the failed Daewoo Group in Korea has painfully found it out. Much of the borrowing is made available in a system of the 'Asian business model' that cements the relationship between bureaucrats, bankers and businessmen. Bureaucrats provide directives to bankers so that they can lend out m o n e y to business on the basis of relationship, collateral or government guidance rather than an analysis of risk or business potentials. Firms in turn make political contributions and other payments to win friends and to facilitate transactions. Bankers find no reasons to innovate or to be competitive. In this system, the risk of bankruptcy of a particular firm can be shifted to the group (such as the Korean chaebol) if another company in the group provided a collateral or repayment guarantee. The risk of bankruptcy can also be shifted to the bank since bank loans provide a bulk of outside financing. The

The Asian Financial Crisis: Moral Hazard in More Ways Than One

11

result is the weakening of the group as well as the bank. The risk of failure of the group or bank, in turn, can be shifted to the government by implicit social contract ('too big to fail', or 'banks do not fail') or by an explicit injection of public money. However, the risk shifted is not the risk eliminated. It only reduces the risk perceived by one firm; it does not reduce the actual risk for the system as a whole. Sooner or later there is a day of reckoning, and the reckoning will come when the market environments worsen. Leverage raises bankruptcy risk, but the finn does not perceive it as so because of the belief that it will be bailed out - by the group, the bank or the government. In this situation, the perceived risk is much lower than actual risk. Even though the risk is very large for the country as a whole given the deteriorating macro financial indicators, any individual decision maker in a firm or a bank would not behave as if the risk is big. Ultimately the risk is shifted to the government or people as a whole. Clearly it is possible that some of the risk can be shifted overseas if additional financing can be arranged abroad. However, if foreign creditors refuse to provide credits, or even to renew existing ones, because of worsening economic conditions of the country or unfavorable world market conditions, the massive collapse of those overly leveraged firms would be inevitable. Moral hazard is also harmful because it leads to overly ambitious suboptimal investment decisions. Levered firms on the verge of bankruptcy will have an incentive to expand even when such decision is not warranted objectively by business potential. The reason is asymmetry of the reward to risk structure. If the project is a success, it will save the company and the manager/owner from bankruptcy. If the project is a failure, it just means that creditors will suffer more. The value of equity is zero regardless of whether the firm undertakes the project or not if the firm goes into bankruptcy. The moral hazard problem is present in the case of levered firm in any country. However, it is a much larger problem in Asia because of the Asian business model that encourages excessive use of leverage, because of industrial organization that is controlled by family owners, and because of the lack of market discipline. The problem is exacerbated by the lack of transparency and insufficient regulatory monitoring. More importantly, the cost of moral hazard in Asia is not confined to economics. It permeates the entire society. The system of awarding business based on relationship or government directives (rather than merit) raises the question of integrity and fairness. It encourages factionalism and perpetuates the family control of business. It legitimates corruption and questionable payments as an accepted norm. It destroys incentive to innovate and hinders open, democratic decision-making. It thereby permeates the societal culture

12

JONGMOO JAY CHOI

and undermines the fabric of a civic society. In that sense, moral hazard though created in a technical economic context - if unchecked, can lead to a crisis of moral decay in the society. An interesting dimension of moral hazard is related to asymmetry of information. It is generally assumed in corporate finance that insiders would have superior access to relevant information pertaining to the firm. However, the situation may be the reverse in the case of the Asian financial crisis. As it turned out, foreign analysts and media were correct on their judgment of the risk of the Asian borrowers while the government officials in Asia - the ultimate insider - failed to assess the situation accurately. This, however, may be more a function of whether they have an access to quality information rather than whether they are 'smart'. Anybody who has traveled in these countries more than casually would be struck by the fact that timely international news is generally hard to come by. Local news media often provides only a cursory (and sometimes biased) treatment to major international economic and political developments. If so, it is reasonable to suppose that even the 'smart' Western-trained economists or government officials may lack an access to objective, international viewpoints because they are not easily available from local sources. It is true that, in the immediate pre-crisis period, local talents were generally unaware of critical commentaries reported overseas. I hasten to add that the global information technology innovation that is now going on may reduce the extent of information asymmetry in the post-crisis period.

RESEARCH QUESTIONS Research on the causes, consequences and implications of the Asian financial crisis has just begun. Given the nature of empirical research that requires historical data, the minimum level of historical data are now available which should encourage research and investigation of many facets of the Asian financial crisis. Consistent with the previous list of 21 questions regarding the causes of the Asian financial crisis, here goes another 21 regarding the potential research issues pertaining to the Asian financial crisis. Research Questions on the Asian Financial Crisis (1) Was the Asian financial crisis predictable? (2) How did the crisis spread? (3) Is the pattern of internal or external transmission consistent with market integration? (4) To what extent is the contagion motivated by economics or psychology?

The Asian Financial Crisis: Moral Hazard in More Ways Than One

13

(5) How is the Asian financial crisis similar or different from other financial crises such as the Latin American crisis (or the U.S. savings and loan crisis)? (6) What differentiates the crisis-stricken Asian countries from non-crisis countries? (7) Could the crisis have been averted if the flexible exchange rate system had been in place? (8) To what extent is foreign speculative capital to blame for the crisis? (9) To what extent are different economic sectors of the country (household, business, government) responsible for the crisis? (10) What is the role of capital markets in the crisis? (11) Was the crisis financial or real? (12) Was the cause of the crisis domestic or international? (13) Was the cause of the crisis transitory or permanent? (14) What role did the Asian business model play in the crisis? (15) Who bore the burden of the crisis? (16) Was the IMF policy prescription appropriate? (17) Could the currency board have worked in Asia? (18) Could they have recovered without the IMF assistance? (19) How do you prevent and cure moral hazard problem without letting the country fall? (20) How do you develop early warning and risk management systems? (21) To the extent that corruption and the lack of transparency had been the norm, what is the sense in which it 'caused' the crisis?

LESSONS FROM THE ASIAN FINANCIAL CRISIS To summarize, the following points can be drawn: including the perils of financial leverage, the importance of liquidity, transparency, the role of markets, open and democratic decision-making, inefficiencies of family control, and moral hazard. By implication, we can also add the need for risk management, innovation and specialization, as well as global perspectives. Finally, the political leadership is essential if any reform can be carried out effectively. Given the resistance of the affected groups as well as natural inertia, it is essential that the leadership can transcend narrow political considerations and appeal to the people directly about the need to reform. It is also important that the reforms are carried out in a timely manner, so that the momentum for reform is not buried in a sea of convention, bureaucracy, and self-interests. Thus, we have a top ten list for the lessons from the Asian financial crisis: Lessons from the Asian financial crisis

14 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

JONGMOO JAY CHOI Perils of financial leverage An importance of liquidity Transparency in policy and numbers Market rather than relationship Open, democratic decision making in business and government Inefficiencies of family control Beware of Moral Hazard Need for risk management, innovation, and specialized training Global perspectives Political leadership is paramount.

Does this mean that the Asian business model is obsolete? Not necessarily. It is true that the Asian business model has contributed to the creation of many problems of moral hazard. However, it can be reasonably argued that a few years of crisis experience must be judged against decades of economic success that these countries have been able to achieve. Clearly, there are aspects of the Asian model that are good such as hard work, cooperative rather than a confrontational stance, and an emphasis on education, and so forth. The challenge is to sort out the good and bad aspects of the Asian model and to keep the good and throw out the bad. Whatever the specifics of the necessary reform, given the omni-presence of factional self-interest groups, the quality of political leadership appears to be paramount at the present time.

WHICH FAILED: ASIAN CAPITALISM OR INTERNATIONAL CAPITAL MARKETS? James W. Dean ABSTRACT This chapter asks whether the Asian crisis was a failure of Asian capitalism, or a failure of market capitalism. It begins with a stylized chronology of events that is broadly consistent with either hypothesis. It then re-tells the story, first through a 'government failure' lens, and next through a 'market failure' lens. The chapter concludes by reporting what theoretical and policy consensus has so far emerged within the economics profession, as well as the quandries that remain.

1. INTRODUCTION Since the humiliation of Asia, economists may or may not be on the road to Damascus, but as yet, no divine revelation has come their way. On the contrary, they see at best "through a glass darkly. ''1 Worse, they see the Asian crisis through disparate lenses. Some see that Asian 'crony' capitalism has dramatically failed, and interpret the past two years' financial chaos as a final vindication of the West. But others see the very same events through a radically different lens, with Western market capitalism the villain and Asian capitalism

Asian Financial Crisis, Volume 1, pages 15--43. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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JAMES W. DEAN

the victim. In short, where some see a failure of Asian capitalism, others see a failure of Western capitalism. 2 The collapse in currency values suffered by half-a-dozen Asian economies between July and December 1997 was unprecedented in modern history. It was preceded by collapses in other asset values - notably in equities and real estate in Japan a decade earlier - that were almost as dramatic. None of these events was even remotely anticipated by the world's leading financial analysts (Irvine, 1997). Such lack of precedence, drama and surprise all call into question the carefully crafted theories of efficient markets that dominate our profession. The existence of efficient markets in Asia is easy to dismiss, given the murkiness of information and absence of arms-length dealing that seems to characterize the region. But the murkiness and arms-on-dealing was more or less known in advance, and thus we would have expected financial markets that were rational and forward-looking - in other words, that incorporated rational expectations - to have reacted smoothly and gradually as new information was revealed. As I have suggested elsewhere (Dean, 1998a, b), there was no obvious external trigger for the events that followed collapse of the Thai baht in mid-1997. Asian currency and equity markets seemed simply to collapse of their own accord. But as Krugman (1997) has acknowledged, even the most recent theoretical literature on self-sustaining currency crises does not do the job. The existence of efficient international capital markets is also easy to dismiss. Conventional analysis based on open-economy macroeconomics more or less did do the job for the Mexican crisis of 1995-6. When Cline (1995, p. 13) stated that "[t]he Mexican mixture of the sheer scale of the currentaccount imbalance, the short-term nature of the debt, and quasi-fixed exchange rate was unique," he was correct in that none of the Asian crisis economies exhibited these factors in combination on quite the scale as did Mexico. Indeed, in a speech delivered in Mexico City in 1994, Krugman, alone among his peers, actually predicted a Mexican crisis unless the exchange rate was unpegged. But neither Krugman nor Cline nor anyone else predicted the Asian crisis. Cline, in fact, went so far as to assert that "[t]he surprise factor of the [Mexican] peso crisis as the first jolt to the post-Brady capital market cannot, by its very occurrence, be repeated" (Cline, 1995, p. 13). In late 1997 and early 1998, Krugman (1997, 1998a, b) was the first to articulate a revision of the conventional view, which could be characterized as the Asian-failure view, and which I will characterize later in this essay more generally as the government-failure view. Krugman suggested that the missing piece in our ex ante analysis of the Asian economies was their internal financial intermediation. Asian banking systems, as the world now belatedly knows, are

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rife with insider lending and government quasi-guarantees - far rifer than their far-from-pure Western counterparts - and this led to extreme moral hazard and adverse selection. These factors prompted 'Panglossian' valuations of asset values, until, that is, the funds for government subsidization and bailouts simply ran out. At that point the dynamics that had led to overvaluation went into reverse. It is perhaps safe to say that by late 1998, Krugman's lens for viewing the Asian crisis was widely enough shared among professional economists, at least in the West, that his version of events had become neoconventional. By early 1998, a radically different view of the Asian crisis was also being articulated, notably (though by no means exclusively) by Wade (1998) and Wade & Veneroso (1998). The view holds to a model of Asian development that starts from extraordinarily high household savings and relies heavily on intermediation through the banking system. This system, they claim, necessarily led to debt-equity ratios in the real sector that far exceed Western norms. Such a mode of finance was too vulnerable to be left to the vagaries of armslength capitalism. It had to be complemented by a set of triangular, mutually supportive and symbiotic relationships between government, banking and industry - what neo-conventional commentators now call 'crony capitalism'. Subscribers to this view argue further that unrestricted inflows of foreign capital upset this symbiotic system and caused it to come unstuck. This could be characterized as the Western-failure or market-failure lens, through which the Asian crisis is seen by a growing minority. This chapter begins, in Part 2, with a stylized series of events that might be used to organize thought about the 'causes' of the crisis. While greatly simplified and shorn of detail, none of these assertions is, by itself, remarkably deviant from the conventional wisdom that prevailed before the crisis. But conventional wisdom did not predict the crisis because these components were not synthesized into a coherent, semi-chronological story. Although this chronology itself necessarily embodies a point of view, I have attempted to cast widely and neutrally enough that it is broadly consistent with both the Asianfailure and Western-failure versions of events. In Part 3, the chapter proceeds to assess the above chronology twice, first through an Asian- or government-failure lens, and then through a Western- or market-failure lens. Part 4 addresses a critical policy quandary - whether or not to re-regulate capital flows - that arises directly from the two conflicting views, and Part 5 reports the fragile consensus, such as it is, that is now emerging about what national and international policies might avert crises in future. Part 6 concludes.

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2. A STYLIZED CHRONOLOGY OF EVENTS LEADING TO THE ASIAN CRISIS HIGH DOMESTIC SAVINGS RATES LED TO RAPID PHYSICAL AND HUMAN CAPITAL FORMATION AND HIGH GROWTH It is probably safe to surmise that by the late 1990s, conventional wisdom among informed economists no longer held to the 'myth of the Asian miracle', if it ever had. Extravagant popular projections such as John Niasbitt's Megatrends Asia (1996), and equally extravagant claims for a neo-Confucian productivity advantage, had been put to rest rather decisively by Paul Krugman's (1994) widely-read article entitled 'The Myth of Asia's Miracle'. Based on empirical work by Alwyn Young (1992, 1994a, b), Krugman argued that the Asian tigers' growth rates could be accounted for almost entirely by growth in inputs of physical and human capital, and thus that rumors of a mysterious unexplained Asian "residual" were false. Put another way, Young and Krugman purported to document that Asian growth had involved no appreciable increases in total factor productivity. Superior technology, innovation, organizational or managerial methods, cultural kinship - none of these seemed to have played a role. Naturally, this message - that growth had been achieved by "perspiration, not inspiration" - was unpopular in Asia. But it made sense to most Western-trained economists. Hence economists, lead by Krugman, at least had it half right based on conventional theory and empirical technique: Asian growth was no miracle and would ultimately slow down because it would be subject to diminishing returns. Nevertheless, Asian growth was an achievement unparalleled in human history. Neither Britain nor America nor any newly industrialized country had in the past grown so rapidly. What Japan followed by the 'tigers' achieved in decades or less took Britain and America half a century or more. The combination of very high savings rates, long hours of hard work, and a strong emphasis on education (at least in the Chinese and Japanese communities) translated into high rates of investment in physical and human capital. In fact to deny that this mobilization of capital was aided and abetted by culture, organization and the like is to deny credit where credit is due. The lasting legacy of the Young and Krugman message is not that nothing remarkable happened, but rather that no endogenous productivity enhancement was evident once all inputs had been measured. In fact in some cases, notably Singapore, when the very high investment rates were compared with real GDP growth, the

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productivity of capital appeared to be very low by the standards of developed economies. This suggested that capital might be both misallocated and overinvested, a theme that is expanded below. Asia's growth, based as it was on capital accumulation, might have slowed down naturally and gradually in the early 1990s as the large but nevertheless limited supply of domestic savings confronted diminishing returns to capital. Interest rates might have risen and marginal returns to investment projects fallen until the rate of investment equilibrated at a lower rate than it actually did. But this did not happen. Interest rates did not rise to choke off investment because foreign capital was readily available. And expected returns to investment did not fall because of a perception - by both domestic and foreign lenders - that they would be bailed out by domestic governments, and if not, by the IME In the 1990s, capital inflows accelerated in part because of widespread deregulation of capital accounts. Perceptions of domestic bailouts were an intrinsic part of what I will call Asian capitalism. The next three sections deal with these topics.

CAPITAL A C C O U N T L I B E R A L I Z A T I O N A D D E D TO H I G H G R O W T H E N C O U R A G E D R A P I D CAPITAL INFLOWS 3 Deregulation of capital flows to and from developed countries - notably Western Europe and to a lesser extent Japan - was complete by the early 1980s, after a post-World War II legacy of exchange rate inconvertibility and capital movement restrictions that took more than four decades to dismantle. Similar liberalization came to Eastern Europe and the Former Soviet Union after the fall of the Berlin Wall in 1989. The spread of liberalization to developing countries was sporadic and often serendipitous. Small island economies were frequently induced to open up their external and financial sectors by the twin carrots of membership in free trade agreements and potential for offshore banking (Dean, 1993). Others were prodded or even panicked into liberalization by balance of payments crises (Haggard & Maxfield, 1996). In the 1990s, increased opportunities for cheap foreign money and high domestic returns prompted both borrowers and lenders to push for deregulation. On the surface, rapid and early deregulation by certain developing countries is puzzling, as it proceeded further than in most developed countries at the time, and in retrospect was often premature. For example Argentina, Chile and Uruguay all liberalized during the late 1970s, and later suffered dire consequences (Edwards & van Wijnbergen, 1986; Corbo & de Melt, 1985).

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More recently, in late 1994 and early 1995, Mexico's liberalization seemed to some as premature. Although the appropriate sequencing of economic de-control may even then have been clear to those with common sense and no self-interest in the outcome, and although the lessons for sequencing are by now well documented (for example, McKinnon, 1991; Sachs, Tornell & Velasco, 1996), deregulation in practice is subject to pressure from the forces of realpolitik. Of course realpolitik often operates in opposing directions. Freeing up capital flows stands to harm private sector lenders and dealers in black market foreign exchange whose rents would be eroded by foreign competition (Grosse, 1994). Governments often have even more to lose, benefiting as they do under capital controls from the ability to run fiscal deficits financed by monetary creation without discipline from international lenders. Governments also stand to lose powers of patronage toward sectors of the economy they may, for good reasons or bad, care to favor. On the other hand as liberalization in the developed world proceeds, with the consequent increase in global economic integration, the balance of realpolitik begins to shift. The opportunity cost of controls on the private sector increases, as do opportunities for evading such controls. Increased external trade leads to greater incentives and occasions for under- and over-invoicing. Banks in their turn see opportunities for tapping international sources of savings, and are tempted to open branches or subsidiaries abroad, particularly in New York and in the London Eurocurrency market. Over the last decade, Korean banks, for example, have engaged in this process with a passion. Governments find such operations increasingly difficult to monitor. Witness the South Korean government's apparently honest confusion, in October and November of 1997, over the external liabilities of overseas branches of Korean commercial banks. These monitoring difficulties are exacerbated by enhanced communications and travel possibilities. Indeed cheap air travel alone has made the enforcement of capital controls on individuals almost impossible. Finally, foreign firms and financial institutions see opportunities for profit in markets that are as yet relatively closed, and begin to lobby for looser controls on entry. Although these trends might ultimately lead to liberalization in and of themselves, their force has typically been strengthened by a balance of payments crisis. This might seem paradoxical, since a crisis should surely prompt government to tighten capital controls rather than loosen them. Yet between 1985 and 1990, when much of the developing world was mired in sovereign debt crisis, developing countries consistently and increasingly liberalized their capital accounts: the number of liberalizing measures increased from twenty-two in 1985 to a peak of sixty-two in 1988 before falling

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off to forty-nine in 1990 (Haggard & Maxfield, 1996). To be sure, in some cases (for example in Argentina, Mexico and Venezuela) the initial response to the debt crisis in 1982-83 was to tighten controls against capital flight, but these responses were soon reversed. Why should a balance of payments crisis prompt loosening, rather than tightening, of capital controls? The answer is that the political position of those interests that favor liberalization is suddenly strengthened. Such interests include holders of foreign exchange, exporters, foreign creditors and investors, foreign financial intermediaries, and the international financial institutions (IFIs): in short, the owners, earners and potential lenders of foreign exchange. Only if the capital account is liberalized will foreign exchange holders desist from (illegal) capital flight, exporters desist from false invoicing, and potential creditors be prepared to resume lending. The extended balance-of-payments-cum-debt crisis of the 1980s was resolved by the Brady Plan, under which from 1989 - 95, creditor commercial banks essentially wrote off about one third of the $211 bn long term debt of some twenty four severely indebted middle income countries, mostly but not exclusively in Latin America. 4 The Brady Plan triggered an abrupt end to the prolonged international debt crisis in the sense that by 1990 capital flows to Latin America had resumed with a vengeance. And the inflow to East and Southeast Asia was already well underway. Lenders were motivated by the alluring triple prospects of high returns, sharply lowered country and exchange rate risks, and deregulated and privatized domestic environments. Borrowers for their part chose foreign over domestic sources of funds because on the margin (and the margin was large), foreign funds carried substantially lower interest rates. Where capital account liberalization was not complete, particularly in Asia, such prospects for profit motivated both lenders and borrowers to push for closure, with strong encouragement from the IFIs. As Wade (1998, p. 9) puts it, " . . . [in East and Southeast Asia during the 1990s] firms and banks, both national and international, pressured governments to undertake financial deregulation, their pressure converging with that of the IMF and the World Bank." Why was foreign capital so cheap? Two factors were paramount. First, contrary to conventional opinion, which focuses solely on low inflation, monetary policy in the developed world has been rather expansionary. In Japan and Europe this reflected largely unsuccessful attempts to revive lagging growth; in the U.S. it reflected Alan Greenspan's concern to keep the good times rolling. With slow real growth and low inflation in Japan and Europe, excess funds flowed into financial assets around the world: into the fabled U.S. stock market, of course, but also into Asia. The bulk of foreign bank claims on

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the crisis Asian economies are from Japan and Western Europe, not the U.S. But from the U.S., where nominal growth throughout its sustained boom has rarely exceeded 4%, broad money growth of 10% and above has flowed substantially into asset markets, including Asia's. Of course lenders ignored default risk, for reasons that we will attend to shortly. The second reason that foreign capital was so cheap in Asia is that borrowers ignored foreign exchange risk. As any beginning student of international finance knows, interest rates on yen- or dollar-denominated loans can only be different from those denominated in domestic currency if expected changes in exchange rates are ignored. Otherwise, if international capital markets are deregulated and otherwise unencumbered, perfectly mobile capital will ensure that expected (risk adjusted) interest rates equalize internationally (uncovered interest parity), or that actual (risk adjusted) forward-hedged interest rates equalize (covered interest parity). Asian borrowers in effect assumed that exchange rates would not be devalued.

FIXED EXCHANGE RATES ADDED TO RAPID CAPITAL INFLOWS LED TO RAPID MONETARY GROWTH Most East and Southeast Asian countries (with the notable exception of Japan) pegged their currencies to the U.S. dollar, or to a basket of currencies dominated by the U.S. dollar. This had two consequences. First, net capital inflows (unless 'sterilized', a losing proposition in the long run 5) were automatically added to foreign exchange reserves, and thence monetized turned into domestic currency. In short, rapid capital inflows led to rapid monetary growth. The second consequence followed from the first. Monetary growth in excess of real output growth was translated into inflation. Hence real exchange rates rose even though nominal exchange rates were pegged. Overvalued real exchange rates then led to widening trade deficits. Added to growing debt service on accumulating foreign debt, this meant widening current account deficits, financed of course by ever-larger capital inflows: that is, ever-larger capital account surpluses. This process proceeded much further in Thailand, Indonesia and Malaysia than it did in South Korea, although it was underway there too. Conventional wisdom circa 1996, at the end of the Mexican crisis, was that this circumstance alone - fixed exchange rates and easy money - was necessary but not sufficient to precipitate an exchange rate crisis. Conventional wisdom was right in principle, but wrong in practice. The implicit assumption behind the comfort accorded countries like Thailand, Indonesia, Malaysia and Korea was that, unlike most of their Latin American counterparts, these were

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economies that invested rather than consumed borrowed funds, and furthermore that invested funds wisely and productively. Hence current account deficits of the order of 8% of GDP were sustainable since GDP would continue to grow and debt-to-GDP ratios would stabilize or decline. In practice this assumption was at least half-wrong. To be sure, these were economies that invested heavily; but in retrospect they over-invested. Worse, they misallocated their investment: a large part of it proved unproductive. The reasons for both over-investment and misallocation are intimately related to imperfect financial intermediation.

IMPERFECT FINANCIAL INTERMEDIATION ADVERSE SELECTION AND MORAL HAZARD ADDED TO RAPID MONETARY GROWTH, LED TO BOTH MISALLOCATION AND OVER-INVESTMENT OF CAPITAL 6 Financial intermediation is necessary because some direct financial markets are imperfect, even in the most advanced economies. Were direct financial markets universally efficient, intermediation would be unnecessary to transfer funds from savers to borrowers: equity and bond markets would suffice. But given that intermediation is often necessary, its efficiency can in principle be improved via judicious supervisory and regulatory systems. Yet in practice no economy has yet devised, let alone implemented, banking or other intermediation systems that align the incentives of lenders and borrowers as closely as do the world's major and more efficient equity and bond markets. We begin this section by reviewing very briefly the reasons that all monetary economies employ financial intermediation, and the reasons that it is by nature imperfect. We then examine the nature of financial intermediation in the Asian crisis economies. Finally, we draw the connection between imperfect financial intermediation, capital inflows, and misallocation and over-investment of capital in these economies. Why All Economies Employ Financial Intermediation

Financial intermediation is a response to asymmetric information. Borrowers usually know more about the risks and returns associated with the projects in which they wish to invest than do savers. Banks and other intermediaries capitalize on economies of scale to pool risks as well as investigate and monitor both risks and returns. Banks thus act as agents for depositors. Hence all economies employ financial intermediation in order to reduce the costs of

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asymmetric information below what they would be were the task of matching savers and borrowers left solely to direct financial markets. But however diligent bankers may be in pooling, investigating and monitoring risks, they are never in practice completely successful in eliminating two consequences of asymmetric information: adverse selection and moral hazard. Why Financial Intermediation is Imperfect

Adverse selection (Stiglitz & Weiss, 1981) refers to the fact that riskier borrowers self-select themselves. Banks and other financial intermediaries attempt to limit adverse selection ex ante by discriminating among borrowers and pricing loans accordingly (Diamond, 1984). But even with the best ex ante discrimination in the world, enough asymmetric information remains that banks are unable to set interest rates on bank loans that fully discriminate according to risk. Hence, among bank borrowers, inferior investment projects are over-represented, and superior projects under-represented. Lower risk borrowers disproportionately choose to obtain direct finance, or finance themselves, because bank loans are overpriced from their point of view. All this derives from asymmetric information between borrowers and savers. A second consequence of asymmetric information is moral hazard. This refers to the fact that ex post, after a contract is in effect, the insured have incentives to act against the interests of the insurer. In order to attract savers, borrowers must offer them some compensation for risk. In an ideal world of symmetric information, savers know as much about investment projects as do borrowers and thus they are able to price risk accurately by charging riskier borrowers appropriate risk premiums. As we have seen, in our less than ideal world of asymmetric information, banks and other financial intermediaries are able to add value over and above direct financial markets because they are better able to act as agents for savers. They do this ex ante by discriminating among borrowers, charging them appropriate risk premiums, and passing these risk premiums on to depositors (savers) as higher interest rates. They also act as agents ex post by monitoring and influencing borrowers' behavior (Stiglitz & Weiss, 1983). Hence they are able to combat moral hazard as well as adverse selection. Nevertheless, in the real world, banks' ability to monitor is limited. In practice, moral hazard remains because borrowers know more about projects than banks. Government

Notably, we have yet to mention government. In a nutshell, current conventional wisdom has made government indulgence of banking the primary

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scapegoat for Asia's crisis. Conventional wisdom would have it that Asian governments greatly exacerbated adverse selection by underwriting foreignexchange-risk-free interest rates, and moral hazard by implicitly assuring banks and bank depositors of bailouts. 7 It is hard to dispute this view, either on factual or theoretical grounds. Yet it may be a half-truth: all governments indulge commercial banking and for good reason. Ideally, governments should intervene so as to reduce rather than exacerbate the adverse selection and moral hazard inherent in financial intermediation. Unfortunately this is not necessarily the case, even in the arms-length Anglo-American systems that have come so much into vogue in the 1990s, when continental Europe and now Asia demonstrably under-performed America. The reason that government intervention in banking faces a dilemma is that banks not only play the role of reducing information asymmetries between savers and borrowers, they also provide the economy's money supply. Commercial banks supply economies with highly liquid deposits. Thus added to the value that commercial banks add to economies by reducing information asymmetries is the value that they add by providing liquidity. The reason that commercial banking attracts government assurance is that this liquidity acts as the economy's means of payment, and is thus a public good. Governments are mandated to ensure the economy's supply of public goods. The supply of bank deposits is vulnerable because deposits are contractually redeemable at par whereas their value derives largely from assets that at short notice can be cashed only at a discount. Hence a bank's contract with depositors is good only as long as net withdrawals of deposits do not exceed its liquid assets. As long as net withdrawals proceed within statisticallypredictable boundaries, bank deposits can be backed up by a statistically-predictable quantity of liquid assets. But if there is a shock to depositors' confidence, and withdrawals accelerate beyond those boundaries, and if depositors are denied cash, it becomes rational for any and all individual depositors to try to withdraw as well. Thus the initial shock develops into a run and not only a run on the original bank but a run on other banks that might otherwise have been sound. A useful abstraction is to consider that before the run, deposits retained value because each individual depositor was able to free ride on the willingness of other depositors to refrain from withdrawing. Conversely, after the run, deposits lose value because free rider behavior goes into reverse. This phenomenon has of course been long understood, although the modern literature has analyzed it in new frameworks with new names. 8 The supply of bank deposits is thus not only a public good - in fact a market economy's most fundamental and valuable public good - but a public good that

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is vulnerable to disruption. Thus governments in all developed economies underwrite commercial banks: implicitly by proffering lender of last resort facilities from a central bank, and sometimes by limiting competition, and often explicitly as well, by providing deposit insurance. However, such comfort from government is a double-edged sword. While on the one hand it is designed to preserve the economy's liquidity, on the other hand it increases banks' susceptibility to adverse selection and moral hazard, the former by suppressing risk premiums on interest rates, and the latter by interfering with banks' role as agents who transmit the true riskiness of loans to depositors. As a consequence, governments' assurances to banks typically lead them to over-allocate funds to risky projects; it may lead them to over-investment in the aggregate as well. Our argument thus far has run as follows. The Asian 'miracle' economies translated high savings rates into high investment rates and high growth. This was complemented in the late 1980s and early 1990s by rapid liberalization of their external capital accounts, which led in turn to rapid capital inflows. Throughout this period, these Asian economies by and large ran fixed exchange rate regimes; thus capital inflows were mostly translated into monetary growth. This monetary growth had two negative consequences. First, it was intermediated (from savers to borrowers) imperfectly; adverse selection and moral hazard led to misallocation of capital as well as over-investment in the aggregate. Second, moral hazard in conjunction with rapid growth in credit led to asset inflation, as will now be explained.

CEILINGS ON PRICE INFLATION ON FLOWS OF GOODS AND SERVICES, ADDED TO RAPID MONETARY GROWTH AND MORAL HAZARD, LEADS TO ASSET INFLATION Consistent with the above remarks, Krugman (1998b) tells a tale of misallocation and over-investment under conditions of rapid capital inflows that confront adverse selection and moral hazard once they are intermediated through the banking system. His tale assumes that the supply of capital goods is perfectly elastic. Krugman then continues his story by reversing this assumption and replacing it with one of complete price inelasticity in the supply of assets. Assets in this context refer not only to capital goods in quasifixed supply but also to financial instruments such as equity shares, real estate, works of art and any other assets that readily attract investment and are in fixed supply for significant periods of time. The assumption of price inelasticity, in conjunction of course with the unrealistic "Panglossian" assessments of returns

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that are induced by moral hazard - what Krugman calls "Panglossian" expectations - adds price-inflation in fixed assets to quantity-inflation in reproducible assets. In short, it leads to asset price bubbles. Asset price inflation can be thought of as produced by an inelastic supply of assets in conjunction with an elastic supply of money. Only if money and credit expands readily to the Panglossian demand for investment can the latter be translated into asset bubbles. Why wasn't the supply of money checked? We have already given part of the answer: unrestricted capital inflows together with a credibly pegged exchange rate lead to rapid monetary growth. But why didn't the Asian economies check their monetary growth? A partial answer is that they tried but failed. Sterilization efforts were largely abandoned by 1995 because of their quasi-fiscal costs (Dean, 1996). But a deeper answer is that there seemed no need. Inflation in goods and services prices was low - at least under 10% - and well within 'Washington consensus' limits. Central banks have learned to target product inflation but not asset inflation. Moreover Asian central banks faced the dilemma that under fixed exchange rate regimes, tightening credit and raising domestic interest rates would have drawn in more foreign capital and imposed quasi-fiscal costs of sterilization. The second dilemma that they faced was that raising rates would have risked bringing down financial institutions and also pricking the stock-price bubble, as Thailand was already discovering to its dismay by early 1997. Hence monetary growth and asset inflation proceeded more or less unchecked. 9

FISCAL LIMITS ON BANK BAILOUTS TURNS ASSET INFLATION INTO ASSET DEFLATION The next step of Krugman's argument is crucial. Asset inflation proceeds only so long as banks maintain their Panglossian views. As the likelihood of bailouts declines, so too do asset prices. This outcome is fairly obvious if the change in the bailout regime is-assumed to be exogenous: the election of a new government that no longer tolerates 'crony capitalism', or intervention by the IME The outcome is less obvious when change is endogenous. Krugman (1998b) models this by assuming that implicit guarantees continue only until they turn out to be too expensive. In the context of a simple three period model, this is tantamount to the proposition that creditors of financial intermediaries will be bailed out only once. If asset returns are 'bad' (less than Panglossian) in period 2, bank depositors will have to be bailed out, and future depositors can no longer expect the same. Hence the banks will collapse immediately, in

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period 2, because the book value of their assets now exceeds its market value, and they will be able to attract new depositors only up to market value. If, however, asset returns in period 2 are 'good' (that is, Panglossian hopes are indeed realized), the one-time bailout option will not be exercised, implicit government assurance will continue, as will inflated land values and the ability of banks to attract deposits up to these values. Banks will not fail. The most interesting possibility is that despite good returns in period 2, depositors' expectations about bailouts change: they no longer expect future bailouts in case of less-than-Panglossian realized asset values. In that case banks will no longer be able to attract funds beyond the assets' actual market values, and thus they will fail. This outcome is what Krugman characterizes as 'self-fulfilling' and uses it as the basis for a story about self-fulfilling financial crises. It is an important story because it differs fundamentally from previous stories about self-fulfilling financial crises based on self-fulfilling currency crises (reviewed in Krugman 1997, 1998a). This is, by contrast, a story that is based on self-fulfilling asset crises that result from diminished expectations about bailouts. As Krugman points out, the story nicely addresses several puzzles associated with the Asian crisis: the absence of macroeconomic or external-account indicators of unsustainable currency pegs; the boom-bust cycles in asset prices that preceded the crises (particularly in Thailand); the absence of sharp external (or internal) shocks; and apparent contagion to countries not strongly linked through trade or capital flows. That the crisis hit several economies almost simultaneously with neither a common external shock nor contagion is consistent, Krugman argues, with the view that they were already "in a sort of 'metastable' state . . . highly vulnerable to self-fulfilling pessimism" (1998b, p. 9).

HIGH DEBT RATIOS ADDED TO ASSET DEFLATION LEADS TO DEBT SERVICING DIFFICULTIES AND EXACERBATES CURRENCY CRISES The story that burst asset bubbles and collapsed financial institutions leads to currency crises is missing a link. The link is high ratios of external debt, and debt service obligations, to export earnings. If the asset and investment boom was sustained in part by an inflow of foreign capital that was mostly borrowed by domestic banks, which have now failed, the inflow will slow down or perhaps turn into an outflow. If in addition the inflow had been sustained for some time, it would have resulted in a considerable accumulation of external

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debt, with associated debt service obligations. Thus the likelihood that an inflow turns into an outflow is enhanced. The depth of the affected countries' currency crises should be related to their debt ratios, both internal and external, including, crucially, the debt-equity ratios of private firms, especially large conglomerates. Moreover, such countries are vulnerable to a dilemma: if interest rates are raised to stem capital outflow, they will simultaneously increase the debt service burden. But if interest rates are not raised, currency values will drop and the debt service burden will increase in local currency terms. Our stylized 'explanation' of Asia's crisis is now complete. The essence of the story is that Asian capitalism and unrestricted capital flows did not mix well. In fact they proved to be an extremely volatile combination, much more volatile than anyone had suspected. A basic issue not yet addressed is whether it is Asian capitalism that must go, or unrestricted capital flows. This issue has, over the past year, become a litmus test that rather reliably divides 'salt water' from 'fresh water' economists. 1° But before addressing it, let me attempt to classify economists' perceptions of East Asia more fundamentally: according to whether they perceive the tale I have just told through a lens of government failure, or one of market failure.

3. GOVERNMENT FAILURE OR MARKET FAILURE? GOVERNMENT FAILURE Those who attribute the crisis to government failure see unwarranted intervention by the state at every stage of the logical chronicle just recounted. Savings rates were too high in Asian countries because of extra-market government policies that encouraged or even forced savings. In fact Singapore's 'Provident Fund' and its counterpart in Malaysia not only forced savings (for retirement), it also forced government investment of the proceeds. This phenomenon was often cited to rationalize Alwyn Young's (1992) findings that Singapore's average growth rate was no higher than Hong Kong's, even though the latter has had substantially lower rates of saving and investment. Hong Kong's higher returns on investment are rationalized as the result of its heavier reliance on mobilization and allocation of savings by the private sector. Rapid capital inflows were the product of easy money in the developed world combined with government guarantees of investment outcomes in the developing world. Although developed-world inflation rates have been low throughout the 1990s, so have interest rates. This has prompted an exodus of

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investment funds to emerging markets. Attractive nominal rates of return in emerging markets partly reflected attractive real and risk-adjusted returns, but were partly illusory because they failed to take account of both exchange rate and default risk. Both types of risk were masked by implicit but widelycredited government guarantees: guarantees of exchange rate pegs, and guarantees to financial intermediaries. Imperfect financial intermediation was the result of government interference with banking at every level. Ultimate borrowers, typically large conglomerates, were prompted and implicitly underwritten by national industrial strategies. The banks through which they borrowed were comforted by assurances of government bailouts, or at least lax supervision and regulation. This led to moral hazard and its classic consequences. One consequence was overinvestment in the aggregate, since down-side risks were discounted. A second was misallocation of investment, since funds were directed by government plan or, worse, by 'cronyism' between borrowers and banks. Both over-investment and misallocated investment meant that risk-adjusted rates of return were bound to be sub-normal. Asset inflation was the combined product of rapid capital inflows, government's failure to sterilize the impact of those inflows on domestic money supplies, and implicit government assurances of bailouts. Rapid monetary and credit growth, combined with Panglossian expectations, resulted not only in high rates of expenditure on reproducible capital, but also in speculative spending on fixed and quasi-fixed assets such as real estate and equity shares. The result was overvalued real estate and stock markets: bubbles that were set to burst at the first sign the river of money was about to dry up. This phenomenon, not incidentally, had already manifested itself in Japan in the late 1980s, but in that case as a result of easy money that was domestically generated rather than the product of capital inflows from abroad. Asset deflation was the result of government's unwillingness, and ultimately inability, to bail out banks and borrowers under on-going regimes of misallocation and over-investment, combined with inflated asset prices. The trigger for the Asian crisis was Thailand, where asset prices began to sag once the first financial intermediaries failed, or even before, when borrowers in default were first held to account and easy credit ceased. Currency collapse, in the view of those who ascribe Asia's crisis to government, was a culmination of the above factors, and was triggered by the banks' inability to meet their foreign currency obligations. Borrowing banks' illiquid assets and short-term liabilities combined with lending banks' reverse free rider behavior turned what might have been temporary illiquidity into virtual bank insolvencies. Short term lines of credit from foreign lenders were

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simply not rolled over. As the net flow of foreign funds into East Asian economies turned increasingly negative, currency values plummeted below any conceivable long term equilibria. Finally, IMF intervention, in this view, has exacerbated the crisis and sowed the seeds for yet more moral hazard in future by bailing out both delinquent borrowers and imprudent lenders.

MARKET FAILURE Those who see the Asian crisis through the lens of market failure rather than government failure see these phenomena quite differently. Savings rates are seen as endogenous, cultural phenomena rather than the result of exogenous government dictate. Government schemes to encourage household saving were expressions of a popular consensus, a consensus that individual free choice is properly subordinated to the national interest. Indeed, East Asia's extraordinary savings and investment rates translated for several decades into a 'growth miracle' that was the envy of the Western world. When properly managed, as in Singapore and Taiwan, domestic saving eventually exceeded domestic investment, leading to net capital outflows rather than inflows, and thus relative immunity from the current crisis. Rapid capital inflows are seen as an unfortunate by-product of premature capital account liberalization: that is, too little government intervention rather than too much. In the 1980s, external liberalization was often adopted under duress by developing countries when they were under the knife of balance of payments crises. Both then and in the 1990s, liberalization was encouraged by advice and pressure from the International Financial Institutions, particularly the IME As well, indirect pressure came from such underwriters and bastions of free market capitalism as the U.S. Treasury and Wall Street investment banks: what has been described by some as the "IMF-[U.S.] Treasury-Wall Street" complex. The alleged market failure that is encouraged by rapid capital inflow could be classified into two types. What might be defined as first-order failure refers to misallocation and over-investment. On the demand side this results from the inability of underdeveloped, under-regulated and under-supervised financial intermediaries to absorb and allocate funds efficiently or even honestly. On the supply side it results from the blindness of foreign investors to the fact that borrowing banks cannot allocate funds efficiently, as well as the tendency of such investors toward herd behavior. Second-order failure could be defined as vulnerability to capital outflows. It too results from tendencies toward herd behavior and related 'inefficient' market phenomena.

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tmperfectfinancial intermediation is seen as a given that invites government intervention, rather than the other way around. This stems from the view that even in advanced economies, financial markets are subject to failure because borrowers and lenders have asymmetric information, leading to adverse selection of borrowers ex ante as well as moral hazard ex post. Compounding this is the risk of a systemic deposit run on the banking system, a risk that almost inevitably prompts government to provide guarantees on bank assets or bank deposits or both, thereby adding to moral hazard. Financial market imperfections are typically so endemic in emerging markets that they turn to hands-on intermediation between lenders and borrowers through the banking system rather than the impersonality of direct financial markets, which operate by trading claims and contracts such as stocks and bonds. But relying on banks does not magically generate the necessary infrastructure of supervision and regulation; nor does it magically generate qualified human capital. In practice the failure of financial markets in Asia has led to a call for more government intervention rather than less, and not just from those who were previously suspicious of markets. The call for stronger bank supervision and regulation is particularly widespread. Interestingly, the private sector in Asia is also calling for advice and intervention and advice from government, think tanks and academia, since the need for analytical skills in risk management and the like, notably absent from the banking sector, is more available in the better-educated public sector.

COUNTERING THE CONVENTIONAL WISDOM ASIAN CRONY CAPITALISM: FINANCIAL INTERMEDIATION IN ASIA

ON

A view of the need for government intervention in emerging market financial systems that is at once more radical and specific to Asia is that there, economic success is derived directly from a symbiotic system that worked well until it was ruptured with the liberalization of its external and internal financial markets. Financial intermediation in the Asian crisis economies differs from that in Anglo-American economies in two important respects. First, there is far more of it, relative to GDP. And second, both the relationships between government and banks, and those between banks and industry, are far more intimate. Since the onset of the Asian crisis, it has become fashionable to refer pejoratively to the Asian system as 'crony capitalism', and to bask in the glory of our 'armslength' financial markets. It is easy to forget that this recently-reviled system is one that produced, or at very least was consistent with, a decade of high and

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sustained real growth such as Western capitalism has never seen. Indeed, it is possible to paint the Asian financial system in a positive light by considering it as a set of reinforcing components. Wade & Veneroso (1998, p. 6) have succinctly described these components as "[h]igh household savings, plus high corporate debt/equity ratios, plus bankfirm-state collaboration, plus national industrial strategy, plus investment incentives conditional on international competitiveness... [that add up to] the 'development state'." Their analysis ~ begins with the observation that saving rates in Asia are much higher than in western economies: one third of GDP or more in Asia, versus 15 or 20% in the west. Moreover the bulk of this saving is done by households and held in bank deposits, rather than in bonds or equities. ~2 Since neither households nor governments are major net borrowers, most of this household saving is channeled, through banks, to firms. This, in combination with relatively undeveloped equity markets, means that firms in East and Southeast Asia have very high debt/equity ratios, especially in Japan and Korea, where the ratios are often two to one or more (in contrast to a norm of less than one in the west). High ratios of financial intermediation (bank deposits and loans) relative to GDP, as well as high debt/equity ratios, make the entire financial system very vulnerable to shocks: for example, reductions in rollovers of bank deposits or increases in interest rates. Until the 1990s, Asian financial systems insulated themselves against such shocks by imposing external and internal controls: externally, restrictions on inflows and outflows of portfolio capital, and internally, ceilings on interest rates. For further insulation, Asian systems enveloped close cooperation between banks and firms, and between both and government. Borrowing from abroad was restricted or at least orchestrated by government, but as a quid pro quo government bailed out banks and firms whose costs or revenues were buffeted by systemic but temporary shocks. Government's intimacy with finance and industry also had a long-term dimension: national industrial strategy. Thus Japan's famous MITI, and to some extent their counterparts in Korea and elsewhere, guided the growth or decline of entire industrial sectors, particularly with an eye to export performance. According to Wade (1998), this system began to unravel when the soon-tobe-crisis-economies rushed to liberalize their external capital accounts in the early 1990s. Wade suggests that blame falls equally on national governments and international organizations. As suggested in Part II, a myriad of domestic interest groups stand to gain from liberalization. So do foreign banks and other lenders: in fact Wade & Veneroso (1998, p. 8) state baldly that "In Korea key people were bribed by Japanese and western financial institutions . . . to do

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something that was counter to the whole thrust of Korean development policy for decades past." The Korean government, eager to join the OECD club of industrialized countries, abolished the Economic Planning Board, which had been the main body for making economic strategy since the 1960s. Once the system of control and coordination was liberalized - or unraveled if one accepts the Wade and Veneroso interpretation - the Korean chaebol and corporate and bank borrowers elsewhere, discovered that they could borrow abroad much more cheaply than at home. This was possible, of course, only so far as potential devaluation of domestic currencies was kept out of the calculation: i.e. the perception of cheapness depended on an assumption that exchange rates were truly fixed. Most of the debt incurred was short term perhaps because of a lingering suspicion that exchange rates just might fall in the long run - and most of it was private. For example, Korea ran up its foreign debt from $39 billion in 1989 to over $160 billion by late 1997. 4. S H O U L D

CAPITAL

FLOWS

BE RE-REGULATED?

Those who argue for what Emmerson (1998) calls (but does not fully endorse) "Americanizing Asia," suggest that the intimacy between finance, industry and government characterizing Asian capitalism must be replaced by AngloAmerican arms-length relationships. But the intimacy of Asian capitalism worked for decades in Japan, and more recently in the 'tigers', to produce the most rapid sustained growth in human history. According to analysts such as Wade & Veneroso, this intimacy was comprised of symbiotic relationships which worked on balance to produce rather than inhibit growth: not, perhaps with ideal allocative efficiency, or a maximum of individual liberty (to save or not to save, for example), but compensated by high investment rates. In this view, the cozy success of Asian capitalism was rudely interrupted by capital liberalization. First-order benefits from foreign capital inflows were minor at best since they were not necessary to finance investment, given the Asian economies' very high domestic saving rates. In fact on balance any benefits turned into net costs due to over-investment and misallocation due to moral hazard. In addition, capital inflows engendered second-order costs given the recipient economies' vulnerability to sudden reversals. This cannot be a universally compelling argument, since some economies are more vulnerable than others. Few, and not Wade & Veneroso I suspect, would argue that the U.S. should restrict capital inflows, or that Japan should restrict capital outflows. Indeed, not all East Asian economies do have dangerously high debt-equity ratios: Taiwan's, for example, is well below 100%, and, not incidentally, Taiwan has weathered the Asian crisis better than

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any economy in the region. The more fundamental basis for Wade and Veneroso's argument is that the highly debt-leveraged keiretsu, chaebol, and konglomerat of Japan, Korea and Indonesia are far more vulnerable than the less leveraged firms of America and Western Europe. In the case of Japan, which is a net exporter of capital, this vulnerability has been buffered by indulgent domestic banks backed by passive domestic depositors, but in the cases of Korea and Indonesia, which are capital importers, the vulnerability was quite naked. This line of reasoning leads Wade & Veneroso to endorse Jagdish Bhagwati's recent (1998) call for a halt to capital liberalization, at least in Asia. Notably, his prescription for India, which remains relatively closed at least to portfolio capital inflows and outflows, is to keep it closed. Similar reasoning, as well as the simple observation that China has thus far weathered the storm that has engulfed its neighbors, is persuading other Western observers to endorse China's longstanding policy of restricting capital flows and currency conversion. Bhagwati's position is startling as he is a highly respected mainstream economist, who endorses free trade. His argument, as well as that of another eminent international economist, Dani Rodrick (1998), is that the logic for free trade in goods and services does not carry over to free flows of capital. The logic for free trade rests on the gains that ensue from specialization in lines of production coincident with comparative advantages. The logic for free capital flows rests on gains that ensue from moving capital to projects and regions with higher than average rates of return. Although neither Bhagwati nor Rodrick spell it out, the argument against free capital flows in light of Krugman's story is presumably that ex p o s t these returns may turn out to be lower than expected because of the misallocation and over-investment biases introduced by asymmetric information. Ex ante, domestic borrowers and lenders expect higher rates of return than are actually realized because they expect private 'Panglossian' returns rather than the true returns that net out either the costs of publicly-funded bailouts for as long as they continue, or the costs of higher interest rates or bankruptcy once they cease. Foreign lenders expect rates of return that are higher ex ante than ex post because they too expect bailouts, whether from the governments that they presume will stand behind domestic borrowers, or from international institutions like the IME It may also be that foreign lenders are less well informed about the creditworthiness of domestic borrowers than are domestic lenders. To this view may be added the Krugman argument that unrestricted access to foreign capital greatly compounded the Asian financial system's potential for moral hazard, and led to Panglossian over-investment in reproducible capital

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and over-valuation of fixed assets. But this does not necessarily lead to the Bhagwati/Rodrick/Wade conclusion that capital inflows should be restricted; rather, it leads more readily to the conclusion that cozy, comfortable relationships between government, financial intermediaries and industrial conglomerates should be ruptured. To do so strikes~ at the heart of Asian capitalism, since the extraordinary debt-equity ratjo~ would be unsustainable were government quasi-guarantees to be withdrawn. In fact whether or not to restrict capital flows into countries where liberalization is a done deal may well be moot, since capital liberalization may be irreversible. Once the river of foreign funds has begun to flow, those with an interest in keeping it flowing - not least, those who have borrowed heavily and contracted high debt loads - will strongly resist re-regulation. Moreover, capital inflows are likely ultimately to force the dismantling of non-arms-length financial relationships. If capital liberalization so severely exacerbates adverse selection and moral hazard that financial crisis ensues, reform is almost inevitable. Cold-eyed capitalism will prevail. Hence the Asian economies that did enthusiastically liberalize portfolio flows in the 1990s - Indonesia, Thailand and, to some extent South Korea - are those most likely to continue the course, both because they are now reliant on continued inflows, and because the damage to their financial intermediaries, and to the government fiscal accounts dedicated to supporting them, has been so profound that reversion to the ancien regime is unthinkable. Should the idea even be mooted, it is probable that IMF, World Bank and other official emergency lending would be cut off; more importantly, so would private capital inflows. Malaysia, which has thus far avoided (or at least postponed) submission to an IMF program as well as bank and corporate restructuring, is also likely to retain its liberalized regime in the long run, despite its imposition of short-term capital controls in September 1998. In contrast to the crisis economies, Japan postponed full liberalization until the late 1990s, with its 'big bang' (which will, inter alia, allow unrestricted access to foreign financial institutions) just now underway. Yet Japan pioneered the Asian financial crisis with its- asset bubble that burst in 1989. Throughout the period both before and after the bubble burst, Japan was a capital exporter, not importer; hence it was not the free availability of foreign capital that exacerbated moral hazard and led to the bubble and burst. This suggests that capital account liberalization was not the root cause of Asia's crisis, but rather that it was cozy 'crony' capitalism. Capital from domestic saving was available in sufficient abundance to swamp the system with misallocated capital without help from abroad. Non-performing loans at Japanese banks are of the same order of magnitude as those in the crisis economies. That Japan avoided

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banking and currency crises for nine years after its asset bubble burst was due to its prolonged ability as an extremely affluent nation to subsidize bleeding banks and the like, as well as its decision (at least de facto) to let the yen float and thus fall gradually. Indeed, the yen has depreciated by over 40% since 1995, more than the net depreciation of all but Indonesia of the 'crisis' economies since July 1997; but 40% over four years rather than a few months does not constitute a currency crisis or precipitate a banking crisis. Although it is unlikely that the Asian economies which liberalized will revert to closed capital accounts, those which did not are equally unlikely to liberalize in the near future. Neither India nor China has yet moved to fully convertible currencies or to unrestricted capital accounts, nor, in practice, has Taiwan. While China, dramatically for some decades now, and India more tentatively and more recently, have welcomed and received foreign direct investment, they have not opened themselves to the volatility of unrestricted portfolio flows. It is likely that the lesson they will learn from the Asian crisis is to postpone liberalization for the foreseeable future. Whereas the IMF, as part of its efforts to promote capital account liberalization under its newly amended Articles of Agreement, might have pressured them in the recent past, its official stance is now, in the words of its First Deputy Managing Director, Stanley Fischer at the September, 1997 annual IMF/World Bankd meetings, " . . . t o phase capital account liberalization appropriately - which means retaining some capital controls in the process." It should be apparent from this discussion of capital liberalization that the pure and polar visions which divide economists on a priori ideological grounds - government failure versus market failure - become much less pure, polar and divisive in the afortiori world of practice. Indeed, in offering practical advice about what should have been done then, and, especially, what should be done now, economists on both sides of the ideological divide have proved uncharacteristically confused. They seem to see through a glass darkly, with their previous ideological clarity badly blurred. 5. I F N O T A V I S I O N

ON THE ROAD TO DAMASCAS,

HAS A N Y C O N S E N S U S E M E R G E D ? WHAT S H O U L D HAVE BEEN D O N E B E F O R E D I S A S T E R STRUCK Hindsight is cheap wisdom; nevertheless the Asian crisis has probably clarified the minds of many analysts about what should have been done well before

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disaster struck. Although there is no complete consensus, more economists than before agree that far better domestic financial disclosure, supervision and regulation should have been put in place in the borrowing countries. The reasons this did not happen had much to do with interest group obstacles in the context of win/win high-growth economies. But it also had to do with the prevailing ideology of de-regulation, an ideology that overarched itself when it came to the banking sector. One might suppose also that consensus has moved further toward the merits of flexible exchange rates for borrowing countries that, like the Asian crisis economies, had their inflation rates well under control and therefore had no need for the monetary discipline that fixed rates provide. After all, since an exchange rate crisis is, almost by definition, the involuntary relinquishment of a fixed exchange rate, flexible rates should preclude such crises. However, the extreme volatility in the baht, won, rupiah and ringhit since they were floated amounting in the case of the rupiah to a virtual free-fall throughout the second half of 1997 and first half of 1998 - has led some to call for a return to fixed rates, hardened, perhaps, by currency boards. Dornbusch (1998) calls for currency boards in Indonesia and Russia, and more recently in Brazil; but others (see Roubini, 1998) warn of the "myths" surrounding such an arrangement. If there is any consensus, it is that "automaticity" - pure flexibility or a strict currency board - is preferably to a managed-rate or even fixed-rate system that is prone to government intervention. It is probably safe to say that economists have become more sensitive to safe sequencing of deregulation: cautious phasing out of capital controls seems to be the order of the day, even at the IME implying that liberalization may have been too rapid or too wholesale in the past. In fact economists who never did so before have begun to talk about taxes on international capital flows: the debate about foreign exchange turnover taxes like the Tobin tax has revived, and attention has turned to Chile's reserve requirement on short-term foreign deposits. Nevertheless throwing sand into the wheels of international finance remains intensely controversial; undoubtedly, there is much less consensus surrounding this measure than the other three. -

What Was Done Wrong When the Crisis Broke There is less consensus about how the crisis was managed. Criticism has focused on the IMF. At least two eminent economists have called for its abolition (Schultz, 1998; Schwartz, 1998), primarily on the grounds that it generates moral hazard among both developing-country borrowers and developed-country lenders. Less extreme judgments are that the IMF acts well

Was Capitalism or Cronyism the Cause of Asia's Economic Crisis?

39

beyond its mandate by imposing surrogate government on independent countries (Feldstein, 1998), or that it relies too readily in crisis on restrictive monetary and fiscal measures, in particular high interest rates, to arrest currency decline (Sachs, 1997; Stiglitz, 1998). Others, notably representatives of the IMF itself, defend its past and present roles and call urgently for renewed funding from its shareholders (Fischer, 1998). These disparate views of the IMF's role are manifestation of the disparate lenses through which equally eminent economists view international financial markets. What Should Be Done Now

If the emerging consensus about what went wrong and what was done wrong is fragile, any consensus about what should be done now is even more so. To be sure, most policy-makers at both domestic and international levels agree that financial disclosure, supervision and regulation should be enhanced - indeed, standing committees of the BIS, IMF and G-10 have been studying such measures since the Halifax G-7 summit of 1995, and in June, 1998, Canada took a proposal for international 'peer supervision' to the G-22 meetings - but both the political and practical impediments to achieving financial reforms remain profound. As for exchange regimes, the 'Washington consensus' that developing countries should adhere to fixed rates had about run its course at the IMF well before the crisis broke, but it remains to be seen what new conventional wisdom will emerge should inflation pose a problem in Asian countries where currencies have depreciated sharply. Jeffrey Sachs, perhaps the world's the most prominent critic of the IMF's part in this (and previous) crises, advocates fully flexible rates (Sachs, 1998b). At the other extreme, Rudiger Dornbusch, equally eminent and Sach's former mentor, one high profile economist advocates currency boards for Indonesia, Russia and Brazil. However, it was abundantly clear that the IMF would not condone a currency board for Indonesia when President Suharto flirted with the idea in early 1998, shortly before his political demise; as of early 1999, Russia is out of the question, given its lack of reserves, pariah status with both private and official lenders, and de-capitalized banks; Brazil is perhaps a better candidate, but it currently lacks sufficient reserves to back its monetary base. Moreover, none of the other crisis countries seem remotely interested in, or indeed positioned, even to peg their exchange rates given continued turbulence in exchange markets as well as their depleted reserves. On the other hand the economies that have held their pegs - Hong Kong, China and Taiwan, - are well aware that to be forced to

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devalue would invite loss of control - currency crises - that could infect the banking and then real sectors and escalate into full-blown financial and economic crises. And so far, these three economies have avoided crisis. What about capital controls, or at least 'sand in the gears of international finance'? Prominent economists such as Dani Rodrick and Jagdesh Bhagwati have questioned the merits of free capital flows. It is likely that skepticism from them and other reputable quarters will lend moral support to countries that have yet to liberalize their capital accounts and are not so inclined- notably India and China. It is also likely that such skepticism in professional quarters will slow down the IMF's campaign to liberalize capital flows under an extension of its Articles of Agreement. Countries that have already liberalized are studying techniques for throwing sand in the wheels, and Malaysia has already implemented such measures. On balance, it is unlikely that any country will eschew capital inflows on a blanket basis. Distinctions will be drawn between direct and portfolio investment, and between long term and short-term flows. China, for example, has thrived for two decades on massive inflows of direct investment (mostly as joint ventures, and more recently as 'Build Operate Transfer' and similar arrangements), despite severe restrictions on both the inflow and outflow of portfolio capital and without even a convertible currency. Similarly, no country in its right mind would advocate restrictions on short-term trade capital.

6. CONCLUSION In short, there is a consensus about Motherhood measures, but no consensus about most measures. Economists still see Asia's convulsions through a glass darkly, and no divine revelation has descended upon them. What follows is a summary of prevailing opinion, in declining order of broad consensus. All agree on better international disclosure and supervision but the practical obstacles are formidable. Few advocate re-regulating capital flows to the crisis economies but many now advocate slowing down de-regulation of non-crisis economies. Some now toy with the idea of slowing down the turnover of short-term capital flows via taxes or other means of 'throwing sand in the gears'. Many now argue that the role of the IMF should be re-examined, although opinions run the spectrum from those who would see it abolished to those who advocate both increased funding and increased powers. Among the increased powers that are being mooted are authority to disclose unfavorable information about member countries without their permission, and increased authority to mobilize private lenders to restructure debt and debt payments.

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On exchange rates there is no consensus whatsoever. W h i l e some maintain that the crisis economies should keep the flexible exchange rates regimes circumstances have chosen for them, others argue for the opposite, credibly fixed-rate regimes underpinned by currency boards. Between the two extremes, proposals are now afoot to create a 'snake in the lake' for East Asia, m o d e l e d on the 'snake in the tunnel' that Western European economies engineered after the collapse o f the Bretton Woods fixed-rate regime in 1971. Most observers do agree that the non-crisis Asian economies should stick to their fixed rate regimes, if only because the potential for precipitating more regional instability, were China and/or Hong Kong to relinquish their pegs, is too horrible to contemplate.

NOTES 1. In 1 Corinthians 13, verse 12, St. Paul writes, "For now we see through a glass darkly, but then face to face . . . . " 2. For an argument that East Asia's crisis was primarily a 'liquidity' or capital market failure, see Dean (1998a, b and 1999). For a related argument applied to China, see Dean (2000). 3. The first half of this section draws on Dean (1997). 4. See Dean (1992) and Dean & Bowe (1997) for extensive reviews of the 1980s debt crisis and its resolution. 5. See Dean (1996). 6. Parts of this section draw on Crockett (1997). 7. The best articulation of this view is Krugman (1998b). 8. See for example Diamond & Dybvig's (1983) analysis of bank values subject to multiple equilibria. The combination of illiquid assets, short-term liabilities and free rider behavior that they model would be useful to analyze the Asian crisis if it were extended to an international context with countries taking the place of banks. 9. The parallel to the U.S. economy in mid- to late-1998 is hard to ignore. See The Economist magazine of May 8, 1998, as well as the three previous issues. 10. Several years ago, the New York Times these epithets to distinguish the noninterventionist, pure market economists, who mostly seem to hail from institutions located on fresh water, like the University of Chicago, from their less-than-pure brethren who preach and practice at places like Harvard, MIT and Stanford, on the salt water East and West coasts. 11. In addition to Wade (1998) and Wade & Veneroso (1998a) see the succint summary of their view in Wade & Veneroso (1998b). 12. The direction of cause and effect is not clear here. The absence of alternatives to bank deposits could be because (Asian) household savers are risk averse and value liquidity, or it could be that Asian savers are forced to rely on bank deposits because equity and bond markets are underdeveloped and thus excessively risky and illiquid.

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REFERENCES Bhagwati, Jagdish (1998) The Capital Myth, Foreign Affairs, May/June, Vol. 77, No. 3, pp. 7-13. Bowe, M., & Dean, J. W. (1997). Has the Market Solved the Sovereign Debt Crisis? Princeton Studies in International Finance No. 83, August, 66 pages. Cline, W. (1995). International Debt Reexamined, Institute for International Economics, Washington, D.C. Corbo, V., & de Melo, J. (1985) Liberalization with Stabilization in the Southern Cone of Latin America: Overview and Summary. World Development, 13, 836-866. Crockett, A. (1997). The Theory and Practice of Financial Stability. Essays in International Finance, International Finance Section, Princeton University, No. 203, April. Dean, J. W. (1992). The Debt Confessional. World Competition, 15, March. Dean, J. W. (1993). Will Financial Deregulation be Good for Malta? Bank of Valletta Review, 8 (Autumn), 1-12. Dean, J. W. (1996) Recent Capital Flows to Asia Pacific Countries: Trade-offs and Dilemmas. Journal of the Asia Pacific Economy, 1(3), 287-317. Dean, J. W. (1997) Can Financial Liberalization Come Too Soon? Jamaica in the 1990s. Social and Economic Studies, 47(4), 47-59. Dean, J. W. (1998a). Why Fiscal Conservatives and Left Wing Academics are Wrong About Asia. Challenge, 41 (March/April). Dean, J. W. (1998b). Asia's Crisis in Historical Perspective. Journal of the Asia Pacific Economy, 3(3), 267-283. Dean, J. W. (1999). Is East Asia Illiquid or Insolvent? Multinational Business Review, Fall. Dean, J. W. (2000). Why Financial Crisis May Come to China but not Taiwan. In: A. Chowdhury & I. Islam (Eds), Beyond the East Asian Crisis: The Path to Innovation and Economic Growth. Cheltenham, UK: Edward Elgar. Diamond, D. W. (1984) Financial Intermediation and Delegated Monitoring. Review of Economic Studies, 51,393-414. Diamond, D. W., & Dybvig, P. (1983). Bank Runs, Deposit Insurance and Liquidity. Journal of Political Economy, 91,401-419. Edwards, S., & van Wijnbergen, S. (1986). The Welfare Effects of Trade and Capital Market Liberalization. International Economic Review, 27(1), 141-148. Donald K. E. (1998) Americanizing Asia? Foreign Affairs, May/June. Feldstein, M. (1998). Reforming the International Monetary Fund. Wall Street Journal, Oct. 6. Grosse, R. (1994). Jamaica's Foreign Exchange Black Market. Journal of Development Studies, 31(1), 17-27. Haggard, S., & Maxfield, S. (1996). The Political Economy of Financial Internationalization in the Developing World. International Organization, 50(1), 35~8. Irvine, S. (1997). Asian research: worth the paper it's printed on? Euromoney, December. Krugman, E (1994). The Myth of Asia's Miracle. Foreign Affairs, Nov/Dec, 62-78. Krugman, E (1997). The Currency Crisis, prepared for NBER conference, October, http:/ /web.mit.edu/krngman/www/crises.html. Krugman, P. (1998a). What Happened to Asia? for a conference in Japan, January, http:/ /www.mit.edu/people/krugman/index.html. Krugman, P. (1998b). Bubble, boom, crash: theoretical notes on Asia's crisis, http://web.mit.edu/ krugman/www.html.

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McKinnon, R. (1991). The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy. Baltimore, Md.: Johns Hopkins University Press. Naisbitt, J. (1996). Megatrends Asia: eight Asian megatrends that are reshaping our worm New York: Simon & Schuster. Roubini, N. (1998). The Case Against Currency Boards: Debunking 10 Myths about the Benefits of Currency Boards, http://www.stern.nyu.edu/~nroubini/asia/CurrencyBoardsRoubini.html Rodrick, D. (1998). Should the IMF Pursue Capital-Account Convertibility? In: S. Fischer, R. N. Cooper, R. Dornbusch, P. N. Garber, P. B. Kenen, C. Massad, J. J. Polack, D. Rodrick, & S. S. Tarapore (Eds), Essays in International Finance. International Finance Section, Princeton University, No. 207, May. Sachs, J. D. (1996). Financial Crises in Emerging Markets: The Lessons from 1995. In: A. Tornell & A. Velasco (Eds), Brookings Papers on Economic Activity (pp. 147 - 215). Sachs, J. D. (1997). IMF is a power unto itself, Financial Times, Dec 11. Sachs, J. D. (1998). The Economist, October. Schwartz, A. J. (1998) International Financial Crises: Myths and Realities. The Cato Journal, 17(3), http://www.cato.org/pubs/journal/cj 17n3-3.html. Stiglitz, G., & Weiss, A. (1981 ). Credit Rationing with Imperfect Information. American Economic Review, 71,393-410. Wade, R. (1998). The Asian Debt-And-Development Crisis of 1997: Causes and Consequences. World Development, August. Wade, R., & Veneroso, E (1998a). The Asian Crisis: The High Debt Model vs. The Wall StreetTreasury-IMF Complex. New Left Review, March-April. Wade, R., & Veneroso, E (1998b). The resources lie within. The Economist, Nov 7. Young, A. (1992). A Tale of Two Cities: Factor Accumulation and Technical Change in Hong Kong and Singapore. NBER Macroeconomics Annual, MIT Press. Young, A. (1994a). The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience. NBER Working Paper No. 4680, March. Young, A. (1994b). Lessons from the East Asian NICS: A Contrarian View. European Economic Review Papers and Proceedings, May.

ORIGINS AND POLICY IMPLICATIONS OF THE ASIAN FINANCIAL CRISIS Phil Sang Lee and Kyung Suh Park 1. INTRODUCTION The financial and currency crisis that has rocked the Asian countries during 1997 and 1998 is going to be another history as the subject economies are more or less recovering from the worst states of the crisis. However, not many people had expected the currency crisis, which started in a small Asian country, would have so much impact on other countries. An immediate concern was whether China could remain stubborn with regard to its foreign exchange policy despite rising unemployment, high inflationary pressure, and failing financial and real sectors. The collapse of the Russian economy also portended a possible worldwide depression. During the turmoil, the asset prices in the crisis countries experienced huge drops, roughly ranging from 40 to 60%, and helped worsen the financial status of local firms and financial institutions, leading to liquidity crunch and a series of corporate failures. The financial crisis also turned into a social crisis with rising unemployment and mounting social instability, and threatened the political regimes in the region. This article overviews the contents of the individual crises these Asian countries have gone through, analyses their similarities and differences, and provides policy implications. It focuses on why the Asian crisis had happened and evaluates the properness of the international assistance programs including those of the IME Then, it proposes policy remedies to prevent the occurrence

Asian Financial Crisis, Volume 1, pages 45-78. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

45

46

PHIL SANG LEE & KYUNG SUH PARK

of another crisis. Since the crisis is not totally yet over, suggested policy remedies should be interpreted with limited applicability.

2. ORIGINS OF THE CRISIS 2.1. Overview

The Asian crisis originated from multiple sources of problems that were of course closely interrelated, and showed several different features from the previous ones. 1 Originally, the crisis started from the currency crisis in Thailand in April 1997, which spread to neighboring countries of Indonesia, Malaysia, and to South Korea with the lags of a few months. However, in the background of the currency crisis lie a basketful of other factors that stem from micro- to macroeconomic problems of the region. Interestingly enough, these economic factors that caused the crisis are quite similar among the crisis countries with minor diversity. The dominating common feature of the Asian crisis, partly differentiating itself from other ones, is the extreme form of moral hazard on the part of the interested parties whether they being the government, firms, financial institutions, investors, or depositors. Accordingly, the market discipline that usually forces any economy to maintain efficiency through competition was non-existent in critical ways in these economies, z The moral hazard problem led to overinvestment in real sectors that relied on highly leveraged financial structure, and to reckless credit extension to those finns by financial sector. Other factors that helped to exacerbate the problems by camouflaging and postponing their early exposure include huge influx of global liquidity, outrageously insufficient financial regulatory system, and political and social cultures that set the stage for the moral hazard problem. Increasing interconnection among global economies and the flux of short-term capital also expedited the vicious contagion that started from Thailand and spread to other economies in the area. In the following, we diagnosis the origins of the crisis in more detail, trying to derive the similarities and differences among the groups. 2.2. Real Sector Problems 2.2.1. Overinvestment It would not be an easy task to define a certain level of investments by an economy as excessive or not. In the case of the Asian countries that had achieved high growth over the past decades or so, highly leveraged investment

Origins and Policy Implications of the Asian Financial Crisis

47

strategy was viewed as a necessity to exploit the growth potentials of those economies. However, in retrospect, too much of their investment was channeled to the areas with the worries of over-competition, or to speculative activities, and these investments produced returns that could not justify their financing costs. In the case of Korea, the average annual returns on assets of manufacturing firms were below 1% during the 1990s, and the average return on equity were just over 5%. Their average debt to equity ratio deteriorated from 302.5% in 1994 to 397.3% in 1997, and EBIT-to-Sales ratio was --0.3%, which showed a stark contrast with 8.3% of the U.S., 5.1% of Taiwan, and even with 3.4% of Japan. In terms of industrial productivity, the growth rates of value added per employee had decreased from 18.1% of 1994 to 4.7% in 1997. Macroeconomic variables also support the over-investment hypothesis. During the 1990s, investments as a proportion of GDP in the crisis countries showed rising trends, and remained much higher than those in the 1980s. Except Indonesia, the investment over GDP in those countries used to be less than 30% during the 1980s, but approached or exceeded 40% level during the first half of the 1990s. The countries that showed highest growth in investment were Malaysia and Thailand as their governments followed expansionary growth policies. On the other hand, Indonesia and Philippines followed a more conservative macroeconomic policy and their investment growth rates remained pretty much same as in the 1980s. Higher investment rates would not be a problem as long as domestic savings can support such level of investment. However, the savings as a proportion of GDP of those countries remained 2 to 6% below the investment rates, and the gap widened during the 1990s. 3 The countries that showed the biggest investments-savings gap were Malaysia and Thailand again, whose gaps approached 10% level on average during the last decade. In both of Malaysia

Table 1.

Korea Indonesia Malaysia Philippines Thailand

Investment over GDP (%)

1987

1990

1991

1992

1993

1994

1995

1996

29.8 31.4 23.2 -27.9

36.9 36.1 31.3 24.2 41.1

38.9 35.5 35.8 20.2 42.2

36.6 35.9 33.6 21.3 40.0

35.1 29.5 37.8 24.0 41.9

36.1 31.1 40.4 24.1 43.4

37.1 31.9 43.2 22.2 46.6

38.2 32.1 43,0 24.2 42.8

Sources: IMF, International Financial Statistics, various issues; DRI, World Markets Executive Overview, fourth quarter 1996.

48

PHIL SANG LEE & KYUNG SUH PARK

and Thailand, it was mainly the sharp increase in investments that drove the widening gap despite the stable or increasing savings rates, while it was decreasing savings in case of Indonesia. Stiglitz (1998) argued that the marginal productiveness of an economy at this rate of investments cannot be so high as to justify the foreign debts they incurred to fill the investments-savings gap. Not only the quantity and contents of the investment in the region mattered, but also how the investment was funded was another factor that affected the course of the crisis. Most private sector investments relied on debt-form financing either from domestic or foreign sources. Korean Chaebols, for example, maintained debt ratios over 400% and their interest payment costs out of sales exceeded 6% as compared with 2 to 3 % of competing firms of other countries. The high debt service burden rendered these companies vulnerable to minor changes in the market conditions, and as the international competitiveness of Korea wanes, it fell as a heavy burden on the economy. The huge non-performing loans provide another evidence of the inefficient investments in those countries. As of June 1998, the Non-performing Loan (NPL) ratio for Thailand was 30%, and was expected to increase to 35% by the end of the year, while other crisis countries showed a similar level of financial deterioration, which implied a possible collapse of the industrial bases of those economies. In Indonesia and Thailand, domestic and external credits were channeled to non-traded goods sectors which usually contained high risk but do 1 0 a, - -

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-15 1987

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Fig. 1. Savings-Investments Gap of the Crisis Countries. Sources: IMF, International

Financial Statistics, various issues; DRI, World Markets Executive Overview, fourth quarter 1996.

Origins and Policy Implications of the Asian Financial Crisis Table 2.

Korea Indonesia Malaysia Thailand

49

Non-performing Loans of the Crisis Countries (Loans overdue by 3 months)

End of 1997

June 1998

End of 1998 (estimates)

9% 15% 7% 18%

13% 25% 10.6%~ 30%

21% 35% -35%

Note: ~As of April 1998. Sources: Bank of Indonesia, Financial Statistics, various issues; Bank of Korea, Monthly Bulletin, various issues; Bank Negara Malaysia,Annual Report 1996; Bank of Thailand, Annual Economic Report 1996.

not contribute to improving external debt problems. In Korea, large portions of loans by non-bank financial institutions were extended to failing conglomerates. 4 The high leverages and non-performing loans of the crisis countries were also closely related to their financial systems and government's economic policy. Their capital markets are still underdeveloped and private sector firms had relied on loan credits from financial institutions as their main source of funds. With the government's interest rates control and high inflation rates during the growth periods, bank credit was a cheap source of funds and ensuing financial distress cost of debt was not so high since the governments protected large conglomerates or firms with connection to political power.

2.2.2. Corporate Governance and Managerial Transparency We need to point out the crippled corporate governance structure in those countries as the critical source of mismanagement. Basically, the majority of shareholders could not monitor or influence the management of large corporations in those countries as their management was controlled by a few monopolistic owners who were usually connected to political powers. Investment decisions were made not based on economic feasibility, but based on private interest of the owners whose main objective was to expand their kingdoms. The management of a large conglomerate was monopolized by a dominant shareholder (so called 'owner-manager') who solely appointed the members of the board of directors. Minority shareholders were generally silent and ignored partly due to their lack of concern on long-term performance of their firms, and due to prohibiting

50

PHIL SANG LEE & KYUNG SUH PARK

legal procedures against mismanagement. Externally, the market for corporate control was still at the burgeoning stage of development due to the government's policy to protect the existing management, low labor market flexibility, and the traditional corporate culture of identifying firms with their founding fathers. In addition to the extreme forms of the conflict of interests between ownermanagers and minority shareholders, flimsy accounting standard and auditing system lowered the level of management transparency, and hindered the sound development of capital markets. The underdevelopment of capital market increased firms' dependency on banking credits as the major source of funds, and raised the instability of the economies.

2.3. Financial Sector Problems 2.3.1. Runaway Credit Expansion The overinvestment problem of the real sector would not have occurred if the financial sector had shown some discretion in their credit allocation. The driving power that supported the overinvestment of affected countries was the credit expansion either through domestic financial institutions or through foreign sources. During the 1990s, the growth rates of bank and non-bank credits to private sector well exceeded the growth of real sector in the Asian economies. Table 3 shows that banking credit as a proportion of GDP had increased sharply in the crisis countries. Korea recorded 65% increase and Thailand 92.9% over the 3 year period from 1993 to 1996, while Singapore and

Table 3.

Korea Indonesia Malaysia Philippines Singapore Thailand Hongkong

Bank Credit over GDP (%)

1993

1994

1995

1996

13.6 23.5 25.0 12.2 400.2 27.8 356.2

16.0 23.5 20.0 10.2 349.1 38.0 377.6

18.2 24.2 21.5 10.9 330.2 55.0 366.1

22.4 24.9 26.3 15.9 305.1 53.6 301.3

Sources: DRI, World Markets Executive Overview, fourth quarter 1996; Bank of Indonesia, Financial Statistics, various issues; Bank of Korea, Monthly Bulletin, various issues; Bank Negara Malaysia, Annual Report 1996; Bank of Thailand, Annual Economic Report 1996.

Origins and Policy Implications of the Asian Financial Crisis

51

Hongkong showed decreasing proportions. Unfortunately, these credit increases were directed to risky assets such as real estate investment and to financially shaky firms with no economic prospects. 2.3.2. Regulatory and Supervisory Blunder The lack of discretion on the part of financial institutions as resource allocators was partly attributed to government's involvement in the management of financial institutions and the implicit safety nets. Governments usually involved in allocating financial resources and maintained strong control both on the financial and real sector until the crisis fell upon them. They controlled interest rates, specified the business scopes of financial institutions, and even specified their manpower levels, branch networks and capitals, naming a few. Even after going through extensive financial reform process in the 1990s, those governments still maintained their influence on financial institutions through implicit guidance channels. Worried about the destabilizing effect of financial deterioration, supervisory authorities of those countries had applied lax loan classification and loss provision requirements on non-performing loans, which delayed but amplified the financial crisis of the region. There was also an incentive problem of the government officials dealing with financial institutions. They benefited from the controls and red tapes during their incumbency and even after retirement, since they could safely landed on the management jobs of the financial institutions they used to control. To perpetuate the benefit, the control on financial institutions tended to persist and financial reform measures were superficial in contents. Therefore, it is not surprising that the extensive financial reforms implemented during the 1990s turned out to be failures, leading to the financial crisis. Not only these reform measures were perfunctory, but also they critically underestimated the importance of supervisory functions and prudential regulations that should have accompanied any financial deregulation. Whatever prudential regulations existed usually aimed at restricting specific behavior of financial institutions, but did not add up to maintaining a sound level of capital adequacy that would protect the institutions. Furthermore, these prudential regulations were mostly based on ex-post approaches so that authorities intervened in problematic institutions only after their financial conditions became out of control. The results of the paternalistic policy of the governments were the mounting non-performing loans of financial institutions including commercial banks as shown earlier. On the other hand, under the governments' safety umbrella, financial institutions pursued high-risk-highreturn strategies, and did not worry much about the credit conditions of their corporate customers.

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53

The excessive intervention by the regulatory authorities basically hurt the governance of financial institutions. Political connections usually played an important role in the appointment of the management of financial institutions, and managers were obliged to offer favored loans to the firms that were connected to those proteges. Such misconduct was closely related with the government's exclusion of shareholders in the governance of commercial banks. The government played the role of the de facto owner of commercial banks, and shareholders were excluded from exercising their ownership rights. In Korea, it was only in 1997 that the outside directors representing shareholders could sit on the Board of Directors of commercial banks and large shareholders could influence the appointment of the members. In the absence of shareholder monitoring, management of banks was generally ready to provide 'policy-directed' or 'politically favored lending' to corporate customers. Depositors also never worried about their savings since there existed general belief that financial institutions would never fail. They even shifted their funds to failing financial institutions which offered high interest rates to avoid liquidity problems after the financial crisis broke out. Such lack of market discipline also worked to bolster the moral hazard of the management of financial institutions to pursue high risks.

2.3.3. Misguided Financial Deregulation In the 1990s, financial reforms were undertaken for the purpose of increasing the efficiency in financial sectors in those countries. They commonly included interest rates deregulation, new entries of financial institutions, increased degree of managerial discretion, expanded business scopes of each financial institution, and so on. Without exception, external opening was implemented on a relative short period of time partly due to the urge of foreign investors. One critical phenomenon that accompanied the financial deregulation process in those countries was the growth of non-bank financial institutions such as savings and loans, merchant banks, finance companies, and investment trust companies, etc. They grew under the less stringent regulatory controls than those on commercial banks. Their business lines included loans to private sectors and their shares in the loan market grew rapidly through aggressive credit policy. On the other hand, the prudential requirements were almost nonexistent for nonbank financial institutions. For example, in Thailand, while the regulatory authority tightened its control on the banking sector, it allowed the establishment of finance companies during the 1990s that were not subject to the strict loan control applied to commercial banks. Most of their funds were flowed into the real estate and development sector, but as their mortgage value

54

PHIL SANG LEE & KYUNG SUH PARK

dropped, these finance companies went bankrupt causing credit crunch in the market. 5 Later on, these NBFIs contributed to the onset of the financial crisis through their shaky financial conditions. It was finance companies in Thailand and merchant banks in Korea that started the credit crunch and triggered foreign investors' run on those economies. The Thai government's effort to reshape Bangkok as the financial center in East-Asian area, which led to the establishment of 'Bangkok International Banking Facilities(BIBF)' in 1993, is evaluated as another policy blunder. The institution worked as a main intermediary for foreign capital inflows that were channeled to real estate and property sector. One notable feature of any financial crisis observed during the past decades is that they were usually preceded by a series of financial deregulations. 6 Experience shows that financial reforms were mainly directed at a larger degree of managerial freedom, but did not properly dealt with the incentives of the management or owners of financial institutions, which were critical to the stability of financial systems. Regulatory authorities which implemented financial deregulation were not usually ready for a new set of rules they imposed on the market. Prudential regulations did not catch up with the new paradigm, and the implicit safety net of old regimes persisted in the minds of regulators and other economic agents. People usually changed only after they faced a financial crisis.

2.4. External Sector Problems 2.4.1. Inflexible Foreign Exchange Control System Those countries in crisis had adopted fixed exchange rate system, or a floating system with a band. Maintaining stable foreign exchange rates, usually pegged to U.S. dollars, was an important policy imperative to those countries to attract foreign capital, and was more or less successful. During the 1990s, the Korean won depreciated only 2.2% per annum, and the Thailand's Baht slightly appreciated. Such movements in the exchange rates of the crisis countries were surprising considering the differences in interest rates between domestic and foreign money markets of those countries, and reflected the monetary authorities' sticky exchange rate policies. Korea had maintained a floating rate system with a band ever since 1990. Under its Market Average Exchange Rate (MAR) system, the Korean won has supposedly been allowed to move freely against the U.S. dollar according to market forces, with the maximum movements of plus minus 2.25% against the previous day's closing price during the most of the period. 7 However, the economic policy that put the first priority on the competitiveness of its export

Origins and Policy Implications of the Asian Financial Crisb~ Table 4.

Exchange Rates against the U.S. dollar (annual average) 1990

Korea Indonesia Malaysia Philippines Thailand

55

707.8 1842.8 2.7 24.3 25.6

1991

1992

1993

733.3 780.7 802.7 1950.3 2029.9 2087.1 2.8 2.6 2.6 27.5 25.5 27.1 25.5 25.4 25.3

1994

1995

803.5 771.3 2160.8 2248.6 2.6 2.5 26.4 25.7 25.2 24.9

1996 804.5 2342.3 2.5 26.2 25.3

Sources: IMF, InternationalFinancial Statistics, various issues.

sector forced the monetary authority to frequently intervene in the market and to maintain stable exchange rates. During the first of half of the 1990s, the real effective exchange rate of the Korean won had depreciated unlike the other crisis countries, partly due to the appreciation of the Japanese yen during the period and mainly due to the government's policy to support the export sector. However, the sticky exchange rate policy of the Korean government needed to be complemented by higher volatility in domestic money markets. The mounting balance of payments surplus due to the increasing exports and the inflow of capital forced the monetary authority to involve in a massive sterilization operation by issuing Monetary Stabilization Bonds (MSBs) in large scale, leading to a circle of higher interest rates and larger inflow of foreign capital. The overflow of liquidity helped to cause asset bubbles in the economy and increased its overall risk with rising debt dependency. Thailand had maintained a multiple currency basket system, mainly pegged to the U.S. dollar, from mid 1984, and relatively large interest rate differentials to induce foreign capital inflows needed for its economic growth. However, as the U.S. dollar appreciated during the period, the Thailand Baht got overvalued, exposing it to a potential currency attack. The high domestic interest rates helped to control the overgrowth of domestic credit, but the credit expansion in external sector was inevitable. The critical blow to the Thailand's economy was the emergence of China as its main competitor in the export sector since mid 1990s. As a result, its export in 1996 recorded 0% growth rate and the amount of foreign debt increased sharply. Unlike Thailand, Indonesian monetary authority had maintained more flexible foreign exchange policy by adjusting its currency according to its current account deficit levels. Its 'crawling peg' system allowed the Indonesian Rupiah to depreciate 3 to 4% every year. Anyway, the currency adjustment was not enough to correct the productivity gap between Indonesia and other

56

PHIL SANG LEE & KYUNG SUH PARK

competing countries. Its real effective exchange rates appreciated despite the nominal depreciation, and its export markets depending on imported raw materials and cheap domestic labor was eroded by the emergence of China and Vietnam as its main competitors ever since the early 1990s. With the Thailand's currency crisis and the limited foreign reserves, the Indonesian government had to convert to a floating rate exchange system in August 1997 facing currency attack by currency speculators. Malaysia provides an interesting case among the crisis countries in that it had tried to contain the possible adverse effect of foreign capital inflows well before the financial crisis broke out in Asia. The reaction of the Malaysian government to the inflows of foreign capital prior to the crisis showed some difference from those of Thailand or Indonesia. Worried about the increasing portion of short-term inflows during the early 1990s, the Malaysian government adopted a floating exchange rate against U.S. dollar in 1993, and later used a currency basket weighted to the currencies of its major trade partners. In 1993 and 1994, the Malaysian monetary authority engaged in massive sterilization operations to prevent a rapid increase in money supply due to the increase in foreign reserves, by issuing 'Bank Negara Bills'. It also reduced domestic credit expansion by transferring government deposits from commercial banks to the central bank, raised reserve requirements including those on foreign capital inflows, limited net open foreign currency positions and prohibited any non-trade related swaps and forward transactions, among others. As the result of the active external policy, the Malaysian economy showed a better shape in this area; lower foreign debt to GDP ratio, lower short-term debt proportion and short-term debt to reserve ratio, However, it could not avoid the financial crisis. In general, the interest rate differentials between domestic and foreign assets remained high due to its high expected growth rates and probably due to imperfect financial market conditions. This was despite the stabilizing inflation rates in the 1990s, low government deficits and the stable exchange rates that were pegged to major currencies. When these governments partly liberalized capital account flows, it was usually large sized corporations of international recognition that were allowed to tap the foreign capital and credit markets. The resulting deterioration in average credit rating of the pool of corporate borrowers, who mainly resorted to domestic credit, left upward pressure on domestic interest rates, in addition to the credit squeeze by the sterilization operations. One group of victims of external opening of an economy was the small-sized firms that could not benefit from the low cost foreign sources of funds, and suffered from domestic credit squeeze due to sterilization policy. An important lesson from the Asian experience is that, unless the differential in

Origins and Policy Implications of the Asian Financial Crisis

57

economic growth rates disappears, inflows of foreign capital do not help to lower domestic interest rates. Other way to dissipate the interest rate differential is to let its domestic currency appreciate, which would undermine the competitive edge of its exporters. There seem to be no free lunch again. 2.4.2. Increase in Current Account Deficit The most conspicuous commonality among the affected countries was the increasing level of current-account deficits in recent years. The current-account deficits in those countries, ranging 3.41 percent of GDP in Indonesia to 9.18 percent in Thailand, were viewed as benign since they were used to fill their investment-savings gap, rather than consumed. As long as those countries with rising trade gap maintain sound fundamentals such as manageable budget deficit, low inflationary pressure, and competitive export sectors, no immediate shift of foreign capital out of the economy was expected and currency attacks did not occur. However, the situation during the mid 1990s attracted some worries since the deficit widened further with the sudden decrease in export growth rates, which is supposedly interpreted as the waning competitiveness of those countries after a decade of rapid growth. 8 One of the driving forces behind the export slowdown was the rising costs of production. Wage growth, above all, exceeded productivity growth in general. Above all, relatively higher inflation rates under sticky foreign exchange forced their real effective exchange rates to rise. The ASEAN 4 countries generally experienced appreciation in real effective exchange rates, which hurt the competitiveness of their exporters. Korea, unlike the other countries of the region, showed depreciating real effective exchange rates and modest inflation rates during the 1990s, but in retrospect, the improbable is interpreted as having reflected the undermining fundamentals of the economy. Behind the scenes lies the Chinese factor, which had worked to disturb the competitive balance in the region. The late starter China, armed with its cheap labor, caught up fast with the ASEAN 4 economies. Korea, nutcracked between these developing countries and Japan, struggled to establish competitive positions in autos, semiconductors, petrochemicals, etc., only to find overcompetition in the world markets. 2.4.3. Massive Inflows of Foreign Capitals On the other hand, the protracted current account deficits in those countries needed to be supplemented somehow, and maintaining commensurate capital account surplus was a natural choice. Capital inflows in credit forms rendered the countries to accumulate stocks of foreign debts, which more than doubled

58

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after t h e o n s e t o f the crisis. T h e p r e c i p i t a t e d a s s e t p r i c e s m a d e it h a r d e r f o r the private s e c t o r s to r e s t r u c t u r e t h e m s e l v e s t h r o u g h the s a l e s o f t h e i r b u s i n e s s lines. A s the e c o n o m i e s o b s e r v e d a s e r i e s o f b a n k r u p t c i e s , i n c r e a s i n g s o c i a l i n s t a b i l i t y d u e to i n c r e a s i n g u n e m p l o y m e n t also t h r e a t e n e d t h e p o l i t i c a l

Table 10.

Macroeconomic targets

Financial Sector Reforms

Real Sector Reforms

T h e I M F C o n d i t i o n a l i t y f o r the Crisis C o u n t r i e s Indonesia

Korea

Thailand

-reduced public subsidies and tax privileges ~tivestiture of state enterprises -cancellation of some infrastructure projects -macroeconomic targets for 1998 • inflation 20% • GDP growth 0% • budgetary deficit of 1% of GDP • current a/c deficit of 2.2% of GDP • official reserves of 5.2 months of imports -comprehensive financial restructuring including closure of troubled banks -strengthening regulatory framework ~teposit guarantees for small depositors

-selective increase in income and corporate taxes -broadening of VAT base -macroeconomic targets for 1998 • inflation 5.2% • GDP growth 2.5% • budgetary surplus of 0.2% of GDP • current account deficit of 2.3% of GDP

-VAT increase -reduced subsidies ~tivestiture of state enterprises -flexible exchange rates -macroeconomic targets for 1998 • inflation 5.0% • GDP growth 3.5% • budgetary surplus of 1% of GDP • current a/c deficit of 3.0% of GDP • official reserves of 4 months of imports

--comprehensive financial restructuring including closure of troubled financial institution -improving accounting and disclosure rules -consolidated supervisory function -elimination of traderelated subsidies -removal of restrictive import licensing and FDI rules -promotion of labor market flexibility

-restructuring of financial institutions -improving accounting and disclosure rules -removal of unconditional financial support to insolvent institutions

-removal of state regulated monopolies and cartels -abolition of restrictions on marketing arrangements

Sources: IMF Press Releases Nos. 97/37, 97/50 and 97/55.

-enhancing export sector competitiveness through emphasis on education and training

70

Table 11.

PHIL SANG LEE & KYUNG SUH PARK Changes in Economic Environment after the IMF Rescue Program

Agreement Date Total IMF support ($ billion) GDP growth rates CPIs Unemploymentrates Foreign Reserves ($ billion) Total foreigndebt ($ billion) Interest Rates

Korea

Thailand

Indonesia

12/3/97 57.0 -7.7%p + 3.9%p + 4.1%p + 28.7 -6.6 Stabilized after a hike

8/20/97 17.2 -5.4%p + 1.8%p + 2.7%p + 0.9 -2.1 minorincrease

11/5/97 40.0 -14.6%p + 48.0%p + 9.6%p -3.1 + 25.9 Sharpincrease

system, further delaying the implementation of any determined reform plans by the govemments. Another criticism on the IMF program was its fairness in cost sharing. The rescue programs were mostly focused on domestic issues such as enhanced transparency of the overall economy including corporate sectors, removal of public subsidies to private sectors, further financial deregulation including external opening, etc. However, there was less concern or lack of action to deal with the external factors that triggered the financial crisis. The funds provided by the IMF were used to pay back the foreign debts or to guarantee future debt payments, thereby protecting foreign creditors despite de facto bankruptcy of the subject economies or financial institutions. While asking for fairness in cost sharing among the involved parties of the crisis countries for an incentive reason, the IMF was neglectful in dealing with the moral hazard of foreign creditors. 15. Many observers had pointed out the short-term capital that sloshed around the world as the major culprit of the crisis. Negative role of the short-term capital was emphasized by scholars and journalists, who even doubted the role of the market capitalism as the best way to govern the world economy. The criticism of the biased approach to the Asian problems takes more ground since other countries with much less transparency, more political corruption and regulatory intervention, and less external opening avoided the crisis. Finally, and probably the most critical aspect of the IMF's approach to a financial crisis including this one was its ex-post concept of intervention. Any international support programs in the past including those of the IMF had been implemented only after the situation got pretty much out of control in a subject country. This was partly due to the lack of authority and information on the part of rescuers to intervene in local economic issues including debt control. Such

Origins and Policy Implications of the Asian Financial Crisis

71

ex-post intervention tends to create moral hazard of related parties and costs a lot more resources of international society.

5. POLICY IMPLICATIONS OF THE CRISIS 5.1. Management of International Capitals Flows Debates on whether to control the movement of short-term money abound. The key to understanding the nature of short-term money in terms of setting international regulation is to understand the difference between financial assets and real assets, especially the higher barrier to movements of real assets in an international context. Financial assets show much faster mobility by definition, and affect asset prices that cannot be matched fast enough by real sectors. In a world of debt financing, bankruptcy mainly due to the lack of liquidity are not rare, which hurt the financial institutions and worsen the credit crunch problem in real sector in a vicious circle. Informational asymmetry aggravates the problem further in financial markets. Depending on the movements of major players with certain information or economic purpose, markets jolt from one state to another, resulting in extreme instability in an economy. The situation gets worse in an international market that includes cross-border capital flows since the positive boomerang effect of capital shifts and their influence on other sectors of a market takes more time to happen or would never occur. Good examples are currency markets that connect the domestic economy with external economies. With the value of a currency swings so fast with capital shifts, no economy can possibly reallocate their resources instantly and adjust to the changing environment while it takes time before lower interest rates, for example, in other countries where capital shifted into have positive effects o n your economy. In the meantime, the domestic economy goes through serious credit crunch, and economy wide corporate failures follow. As the world's financial markets gets integrated further, and the mobility of funds gets faster, there is a mounting need for an architecture that can deal with international financial issues. Understanding that cross-border capital flows have severe externalities on the world economy, monetary authorities need to strengthen the measures to monitor and control these flows. First, on an international level, an improved reporting system on the size, maturity structure, repayment schedule, currency composition, creditor and debtor information, external debts and foreign reserves of debtor countries should be in place. The establishment of an international organization or a function in existing institutions to monitor and control capital flows should be considered.

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Not only it has the authority to monitor international capital flows, it should be able to set and implement an international rule, like the BIS rule, that controls the external debt levels of member countries. Such idea reflects the negative externality a credit extension by private creditors to member countries has. Second, they need to see to it that capitals are properly allocated to private sectors. Excessive investment in risky assets such as real estate needs to be controlled. Rising asset price would be an indicator to evaluate the impact of capital inflows. Third, they need to monitor the financial soundness of intermediaries in foreign exchange dealings including their currency net positions, maturity gap, short-term dependency, overall credit conditions, etc. Even the financial soundness of institutional investors including hedge funds need to be under the control of an international monitoring and regulatory agency. Fourth, there is an urgent need for strengthening the role and capability of the IMF as a lender of last resort. The capital base of the IMF should be expanded and possibly additional funds can be obtained from the international investors, who are criticized more or less for their imprudent investment behaviors. Worries about increasing moral hazard on the part of the crisis countries are not substantive considering the severe pains these countries have gone through. The Asian crisis needs to be tackled through an international cooperation that spans not only major countries and international organizations, but also private financial institutions. One immediate concern is the need for a more aggressive approach to the underlying problems of debts of the crisis countries. It is not too late to impose proper costs on those private creditors considering that the existing program failed to correct the moral hazard problem of the private creditors. Understanding that the Asian crisis occurred due to the mistaken judgements of both the subject countries and the international creditors, the share of the latter in the costs of the restructuring needs to be increased. Such adjustment would also be appropriate to prevent the occurrence of a similar crisis in the future by heightening the awareness of the international financial society. Capital that looks for high returns in the international financial markets are more or less free riding on the global safety nets such as the IMF and other international mechanism that work to support the stability of the markets. 16As in the case of domestic depositors and creditors who share in the implicit and explicit costs for deposit insurance mechanism, these international investors also need to share in the costs of maintaining system stability. Certain portions of the international investment funds that move across borders should be earmarked as an insurance fund whether it being called

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Tobin's tax or whatever, to be used as a rescue fund for both investors and subject countries. In the short run, one way to solve the external debt problems of the crisis countries without incurring too much cost on the creditors would be debt-equity swaps. As long as a debtor has a positive equity basis, such a scheme could work with some technical difficulties in valuation.

5.2. Need for Market Discipline Since the integral part of the financial crisis in Asia originated from the moral hazard on the part of corporations, financial institutions, the government, reform measures to bolster competition among the economic agents should be strengthened. During the restructuring process, those related parties, whether they being the management, employees, shareholders, depositors or the government should be accountable for their lack of prudence in the past. One critical area that needs restructuring but has the power to resist is the government sector. An overall review of government's role in an economy is in order since the origin of the moral hazard lies in the paternalistic government and its control of markets. The corrective program should be aimed at, above all, downsizing government organizations and privatizing state owned corporations. To correct the tendency to delay any substantive financial reforms, a legislation to prohibit government officials from obtaining jobs in the financial institutions under their control needs to be seriously considered. On a more fundamental level, the corruptive social structure should be reformed too. Without abolishing the cronyism that connects politicians, regulators, corporate firms and financial institutions, the current effort of the crisis countries would lead to another round of crisis. Measures to increase the transparency and the accountability of each sector including public as well as private sectors should be implemented. Legal measures such as minority shareholder rights and class action suits to support the working of market discipline also need to be complemented. Industrial reforms that would remedy over-capacity and over-debt problems of firms also need to be implemented.

5.3. Overhaul of Financial Supervisory Structure Removing moral hazard problems in the real and financial sector through introduction of stronger market discipline needs to be accompanied by the restructuring of financial supervisory functions too. As noted earlier, the crisis could have been avoided if an early warning system in financial sectors had worked to prevent the reckless loan practices of financial institutions. This calls for an improved monitoring of financial institutions. Risk adjusted capital

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requirement system of the BIS type should be introduced and strictly implemented in developing countries. Actually, the need for stricter regulatory and supervisory requirements is stronger in those countries due to the overall opaqueness of the economies from corporations to financial institutions. Understanding the limits of the BIS rule, the supervisory authorities also need to complement it with the CAMEL (Capital, Assets, Management, Earnings and Liquidity) approach of the U.S. federal reserve system. In this regard, the crisis countries need to accept the Basle Core Principles of Effective Banking Supervision, which has been recently agreed among the key member countries. One important area that needs increasing attention of supervisory authorities is the non-bank financial sector. In the crisis, it was the NBFIs that mainly channeled capital inflows into risky investments and contributed to losing confidence of foreign creditors with their credit crisis. With increasingly blurred business lines between banks and non-bank financial institutions, and the latter's increasing role in the financial market, a capital requirement rule similar to that of banking sector needs also to be applied to NBFIs. In addition to the regulatory requirements on financial soundness, a workable internal risk management system should be in place in financial institutions, partly enforced by regulatory authorities as a part of the restructuring process. Whether it being an ALM system or VaR (Value at Risk) system, the internal organization for risk management should be revamped and a risk-based management system should be introduced. More importantly, abreast with the strengthened prudential regulations, additional degree of freedom in the area of the governance of financial institutions should be allowed. Regulators should abstain from their desire to intervene in and affect the management of financial institutions. 5.4. Lessons on Financial Deregulation and Market Opening

The financial deregulation and capital account liberalization in the crisis countries helped to expand the quality and availability of financial services to domestic customers, but at the same time they entailed significant costs by exposing domestic markets and participants to external risks without proper readiness. Many researchers report positive correlation between financial deregulation and ensuing financial instability. ~7Their experience suggests that sound macroeconomic conditions such as low current account deficits, fiscal austerity, and low inflation rates need to precede major financial liberalization. A prolonged capital account surplus cannot be maintained unless strong

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economic fundamentals and proper measures to manage external accounts accompany this. In the crisis countries except Korea, large capital inflows resulted in currency appreciation in real terms and high inflation led by asset and factor price bubbles, which tended to hurt the competitiveness of their export sectors. Their experience also shows that sterilization of capital inflows to contain nominal exchange rate and inflationary pressure has adverse pressure on domestic interest rates, which tends to bring in more foreign capital, and imposes additional fiscal burden on the government and private firms. In conclusion, an attempt to control both the exchange rate and the inflation rates is successful only in the short run, and is almost impossible to be maintained in the longer run.

Another prerequisite for external liberalization is the sound financial status of domestic financial institutions, which would operate as the intermediaries of capital account flows. It is usually financial institutions, not real sector firms, that provide the initial trigger for the adverse movements of short-term capital. Once in a crisis, they tend to shrink their credit supplies for their own survival and worsen the situation. In the same vein, a well developed domestic financial market prior to the external opening would help. The crisis countries in general had weak government bond markets among others, which narrowed the monetary authorities' span for open market operations prior to the crisis, and limited the government's financing capability for restructuring the economies.

6. CONCLUDING REMARKS If economic history tells us anything, it would be that arguing for a system against another could be a very risky bet. The Asian crisis, as its another byproduct, set the stage for disputes over the superiority of economic systems. Such disputes are of course heavily affected by recent performances of the economies that adopted a certain form of an economic system. It has been only a decade that the Japanese system based on its closely intertwined relationship among firms, banks, and the government had been applauded as a model case for western economies that were going through economic slowdowns. Other Asian countries also emerged as world competitors out of dire poverty only in a couple of decades based on their government driven economic development programs. Considering that the western countries took more than a century to achieve the current success, such performances and the values lying behind them do not seem to deserve such a barrage of criticism as observed these days.

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After diagnosing the common features of these crisis countries, we may have to be careful in our definition of the Asian crisis. We usually call it a financial or currency crisis, mainly because it started from the currency attacks on the countries with increasing current account deficits, large inflows of short-term foreign capital, shaky foreign reserves and weak financial institutions which were unable to service their foreign debts. However, it is our understanding that behind these financial deficiencies existed the real problems of an old history. Many papers had pointed out the weak financial system as a main culprit for the crisis, especially the role it played during the development of the crisis. It is true that a healthier financial system would have helped the economies avoiding the difficult situation they are going through now. However, such arguments are sometimes confused about the causality of the events. The main reason for the shaky financial system at the time of the crisis in these countries was the collapsing real sector, which had started well before the crisis. Mounting non-performing loans and loan losses had weakened the financial system, and eventually led to the financial and currency crisis. A sound financial system, by definition, does not coexist with failing real sector, and the hypothesis that a healthier financial system could have saved those economies loses its logical basis. Overinvestment based on high leverage has pervaded the economies, but the quality of the investment and the leverage worsened over time. The fundamental reason for rising domestic and external debt was the decreasing competitiveness of those countries; private sectors in those countries could not produce enough returns to sustain the level of debt. However, we may still call it a financial crisis because the allocational role of financial institutions failed to work to tell good investments from bad investments. Finally, we need another caveat in interpreting the result of analysis in this chapter. Individual items listed above as the causes for the financial crisis do not necessarily qualify for necessary or sufficient conditions for the crisis. Countries with much less corporate transparency still avoid a crisis, while countries such as Sweden and Finland with much more transparency and stronger market discipline plunged into a financial crisis. The amount of external debts is not a major factor either, since Korea, e.g. used to have much higher external debt to GDP ratios in the early 1980s. Only the combination of the local problems seems to add up to a financial crisis, but we do not know the exact combination since otherwise we would be in a much better position to predict and to take actions well before any crisis realizes. Finally and most importantly, there remains the important issue of controlling international investment capital such as hedge funds that played a

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key role in triggering the crisis. In this sense, the term 'the financial crisis' fits the case. They have grown up to sizes that are big enough to j o l t any economy, let alone those o f Asian countries. Unlike in a real sector, we m a y now have to define the concept o f monopolistic power in international financial markets in a different way. For example, the size o f capital an investor can mobilize within a certain period o f time relative to the size o f the existing market should be a new criteria for monopolistic power. Understanding that financial markets are very different from other markets is the key to the solution o f the issues.

NOTES 1. The Asian crisis is the third major currency crisis of the 1990s after the crisis in the European Monetary System in 1992-93 and the Mexican peso crisis of 1994-95. 2. Several authors rightfully pointed out the moral hazard issues as the core of the Asian crisis. 3. On the other hand, Asian countries that avoided the financial crisis generally recorded positive savings-investment gaps. 4. Even before the financial crisis, 5 conglomerates out of the 30 largest went bankrupt creating $2 billion of bad loans that amounts to almost two thirds of the total capitals of commercial banks in Korea. 5. See Bhanupong(1998). The finance companies' lending exhibited higher degree of concentration compared with that of commercial banks. 6. See Johnson et. al. (1997) for a detailed analysis. 7. With the onset of the crisis, the band has been expanded to plus minus 10%. 8. Coupled with the increasing trade deficits, increased remittance of earnings by foreign capital also contributed to the widening current account deficits over the periods. 9. The short-term dependency also limits the monetary authorities' room for maneuver facing speculative attacks. Precarious capital movement forces the central bank to maintain higher reserves than is normally required. 10. Economic and Social Survey of Asia and the Pacific 1998, ESCAP, United Nations. 11. See Park (1998) for more details. 12. Thailand shows the highest investment-savings gap, Malaysia and Philippines following next. 13. See Kaminsky & Reinhart(1996), and Stocker(1995) for a detailed explanation. 14. The amount of the local currency foreigners could mobilize was pretty much limited to their investments in Korean stocks that was barely over 13 billion U.S. dollars at the maximum at the time the currency crisis started. 15. See Camdessus (1998) for an argument. 16. The recent episode of rescuing the Long Term Capital Management provides a good example of how hedge funds are free riding on the institutional safety net. 17. See Johnston et. al. (1997) for example.

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REFERENCES Bank of Indonesia, Financial Statistics, various issues. Bank of Korea, Monthly Bulletin, various issues. Bank Negara Malaysia (1996). Annual Report. Bank of Thailand (1996). Annual Economic Report. Bhanupong, N. (1998), Improved Management of the Financial Sector: A Case Study of Thailand. Presented at the Seminar on Improved Management of the Financial Sector held at ESCAP, 20-22 May 1998. Camdessus, M. (1998). Reflections on the IMF and the International Monetary System. Address to the Economic Club of Washington, March 12, 1998, Washington, D.C. DRI (1996). World Markets Executive Overview, fourth quarter 1996. Howell, M. (1998). Asia's ~ctorianfinancial crisis. Paper presented at the conference on the East Asian Economic Crisis, Institute for Development Studies at the University of Sussex, 13-14 July 1998. IMF, International Financial Statistics, various issues. 1MF (1997). Press Releases Nos. 97/37, 97/50 and 97/55. Johnston, R. B., Darbar, S. M., & Echeverria, C. (1997). Sequencing Capital Account Liberalization: Lessons from the Experience in Chile. Indonesia, Korea, and Thailand, IMF WP/97/157, November 1997. Kaminsky, G. L., & Reinhart, C. M. (1996). The twin crises: The causes of banking and balanceof-payments problems. International Finance Discussion Paper, Board of Governors, 1996. Park, Y. C. (1998). Financial Liberalization and Opening in East Asia: Issues and Policy Challenges. Korea Institute of Finance. Stiglitz, J. (1998). The role of international financial institutions in the current global economy. Address to the Chicago Council on Foreign Relations, February 27, 1998, Chicago, Illinois, U.S.A. Stoker, J. (1994). lntermediation and the business cycle under a specie standard: the role of the gold standard in English financial crises, 1790--1850. University of Chicago, Chicago, U.S.A.

KOREAN FINANCIAL CRISIS AND REFORM: AN OVERVIEW Daesik Kim and Jaeha Park 1. INTRODUCTION A s more and more dismal economic figures 1 come in, it becomes clearer that the Korean economy is in turmoil. The jobless rate hit 7.6% in July 1998, the highest level in 31 years, leaving 1.65 million 2 people out of work. The GDP shrunk 5.3% during the first half of 1998, the largest drop in Korean history. 3 The inflation rate was 7.3% year-on-year in July. These numbers are expected to worsen as the IMF's bailout program continues. Currently, Korea is pushing hard to restructure the economic system, while simultaneously analyzing the causes of the current crisis. This chapter first summarizes the causes of the current crisis on which diverse opinions has been expressed, and then describes financial reform measures taken so far. Since a huge body of literature on the causes of crisis already exists, our focus is on the financial sector reform in Korea. 4 We also present our own interim evaluation and expectations. Many economists have tried to evaluate the causes of the recent currency and financial crisis in Asia. Although no consensus has been reached, there are two competing views in the literature: the 'weak fundamentals hypothesis', which emphasizes weak macroeconomic conditions and policy inconsistencies, and the 'financial panic hypothesis', which emphasizes rapid shifts in market sentiment and expectations. We examine these hypotheses in light of the precrisis situation in Korea. Our tentative explanation emphasizes the lack of

Asian Financial Crisis, Volume 1, pages 79-122. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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proper policy responses to external shocks as well as instability inherent in the international financial markets as a triggering event for the Korean crisis. Next we describe the ongoing resolution process of the crisis. In this section, three main challenges faced by policy makers are described. The first problem is resolving the liquidity crisis by slowing down massive capital outflows. Another is reforming the institutional framework, including the financial regulatory structure for the soundness and safety of the financial system. The last is restructuring the whole financial industry by closing, merging, or recapitalizing institutions to improve the financial efficiency. As of the end of September 1998, the Korean government has finished the first round financial restructuring and provided a fiscal support of 37.7 trillion won out of the planned 64 trillion won that amounts to 15.2% of the 1997 GDP of 421 trillion won. The second round is being completed by June 1999, aiming at clean financial institutions. The structure of our analysis is as follows: Section 2 addresses the first and second issues, Section 3 describes the financial sector reform process in brief and Section 4 includes concluding remarks. The Appendix II summarizes the restructuring progress in corporate, labor and public sector.

2. CAUSES OF THE KOREAN FINANCIAL CRISIS 1. Theoretical Models of Crisis Quite a few studies have tried to examine the causes of financial crises. They include Krugman (1979), Obstfeld (1994), Radelet & Sachs (1998), Corsetti, Pesenti & Roubini (1998), Esquivel & Larrain (1998), among others. The literature, however, is separated into two groups: the traditional theory (weak fundamentals hypothesis), and the self-fulfilling model (financial panic hypothesis). The traditional theory asserts that currency crises are caused by weak economic fundamentals, while the self-fulfilling model argues that crises can occur independently of any fundamental economic failings, but are strongly correlated with the expectations of market participants. Krugman (1979) represents supporters of the former theory, and Obstfeld (1994) champions the financial panic model. A brief summary of these two views is stated below.

Weak Fundamental Hypothesis This theory of balance-of-payment crises was put forward by Krugman (1979), who argued that crises occur when a continuous deterioration in economic

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fundamentals becomes inconsistent with the exchange rate system. This inconsistency would induce gradual capital outflows and loss of foreign exchange reserves. Once reserves reach a certain threshold level, speculators' attack the currency to avoid capital losses, exhausting the reaming reserves within a short period of time. Supporters of this view are consequently close observers of macroeconomic indicators such as the exchange rate. Krugman (1979) cites two approaches to this conventional theory based on the method of prediction used to forecast the crisis. The first approach is a 'Model Diagnosis Hypothesis', which forecasts crises by estimating the probability of investor's speculative attacks based on the deterioration of the current account balance and stock of reserves. Econometric models for this analysis are the Probit or Logit models, used by Frankel & Rose (1996) and Agenor, McDermott & Ucer (1997) respectively. The second approach is the so-called 'Indicator Hypothesis', which estimates whether the indicator variables are overheated beyond the critical point or not. Goldstein (1998) and Kaminsky & Reinhart (1996) set this critical point at 10%, whether it be current account deficit or budget deficit. The more indicator variables beyond this critical point, the greater the likelihood of a crisis. Indicators often used are the real exchange rate, the current account balance, stock prices, M2/foreign reserve, real production, money multipliers, number of banking crises, real interest rates, foreign reserve levels, terms of trade, demand for M l, domestic credit/GDP and so on. Financial Panic Hypothesis

According to this theory, a currency crisis can break out with a sudden shift of market expectations and investor confidence. For example, a country receives a shock when its neighbor devaluates. Market observers expect the home government to depreciate its currency to soften or avoid the shock. This expectation alone can cause investors to attack the currency, even if the economic fundamentals are perfectly sound. According to this view, crises are generated by a panic of the market, that can be triggered by an event as trivial as a bad rumor about the level of reserves. Such a rumor could prove to be selffulfilling. Obstfeld (1986,1994), Calvo & Mendoza (1996), Sachs, Tornelt & Velasco (1996), and Sachs & Radelet (1998) support this idea of panic. There are two approaches to the financial panic theory. The first states that expectations will only translate into a full-blown currency crisis if economic fundamentals were already weak. The second approach says that expectations can cause a crisis even if fundamentals are perfectly sound.

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The main points of the financial panic theory are the following: (1) a currency crisis can only occur if there are external shocks, and no currency crisis occurs without external shocks, (2) a currency crisis can be avoided even in the presence of external shocks if the initial symptoms of a crisis are controlled by the proper policies, and (3) the exact time when external shocks break out cannot be estimated with any accuracy. In essence, the difference between the two models is that deterioration of economic fundamentals is a necessary but not a sufficient condition for a currency crisis in the financial panic hypothesis, while it is both a necessary and sufficient condition in the fundamental hypothesis.

2. Symptoms of Crisis 2.1. Current Account and Exchange Rate during the 1990s Until 1995, the ratio of current account balance to GDP in Korea was at a reasonably low level, between 0.3% surplus in 1993 and 2.8% deficit in 1991. Since 1996, however, current account deficits have grown significantly, and the ratio reached 4.9% in 1996. The widening of current account deficits was mainly due to the drastic fall in the international prices of Korea's major exporting products, such as semi-conductors, automobiles, steel, and petrochemical products. The price of the 16 Megabyte DRAM memory chip, for example, had plummeted from fifty dollars in January 1996 to less than two dollars by October 1997. Prices of petrochemical products have also declined, though less dramatically. This fall in w o r d prices, as can be seen in Table 1, caused the terms of trade 5 and current account balance to degenerate rapidly. The terms of trade fell from 103.7 in 1994 to 87.7 in 1996, and the ratio of current account deficit to GDP

Table 1.

Current Account and Terms of Trade

(%)

Current Account/GDP Terms of Trade Real ExchangeRate (Won/Dollar)

1991

1992

1993

1994

1995

1996

-2.8 97.7 98.4

-1.5 98.2 100.5

0.3 102.5 100.0

-1.0 103.7 95.0

-1.9 100.0 91.3

4.9 87.7 98.3

Source: The Bank of Korea, National Income, Balance of Payment, various issues Park & Rhee (1998)

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soared from 1.0 to 4.8% during the same period. The cumulative trade deficit from 1994 to the third quarter of 1997 totaled a tremendous 49.7 billion dollars. In contrast to the current account deterioration, the won/dollar exchange rate appreciated significantly in real terms during the 1990s. If the real exchange rate index 6 is set at 100 in December 1993, it fell to 95 in December 1994, and 91.3 in December 1995, but increased to 98.3 in December 1996. The degree of appreciation in Korea, however, was relatively mild compared to other Southeast Asian nations. 2.2. Growth of External Debts and its Structure Since the early 1990s, the Korean government has accelerated financial market deregulation and market opening. With the financial liberalization, financial institutions were allowed greater freedom in managing their assets and liabilities, especially in borrowing foreign capital. As can be seen in Table 2, capital inflows increased continuously throughout the 1990s, jumping drastically after 1994. Thus capital inflows far exceeded the current account imbalances, leading to the accumulation of gross external liabilities in excess of financing needs for current account deficits. Total external liabilities, measured according to a new definition agreed upon by the Korean government and the IMF, 7 reached 157.5 billion dollars at the end of 1996, which grew by 250% compared to the volume of 1992. As can be seen in Table 3, the debt to GDP ratio reached 34.9% in December 1997 from 20.4% in 1992. Not only the size of the external liabilities, but also the maturity structure showed dramatic change. That is, the bulk of capital inflows were made up of short-term external financing with maturity of less than one year. Table 3 shows that 63.5% of total liabilities had maturity of less than one year in 1996. The

Table 2.

Capital Inflows and Current Account (US$100 million) 1990 1991 1992 1993 1994 1995 1996 1997.1-10

Capital Inflows (A) Capital Outflows (B) Net Capital Inflows(A-B) Current Account Source: Bank of Korea

51.5 101.0 97.1 83.0 201.9 14.2 32.2 28.4 48.6 85.8 37.3 68.8 68.7 34.4 116.1 -21.8 -87.3 -45.3 3.8 -45.3

309.6 135.4 174.2 -89.5

387.3 155.1 232.2 -273.2

235.2 92.2 143.0 -132.0

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Table 3.

Long-term (A) (A/C: %) Financial Institutions Domestic Firms Public Short-term (B) (B/C: %) Financial Institutions Domestic Firms Total Liabilities (C = A + B) DebffGDP (%) Short-Term Liabilities Usable FX Reserves (%)

Korea's Foreign Liabilities and Assets (US$ billion) 1992

1993

1994

1995

1996

1997

26.0 (41.2) 13.9 6.5 5.6 37.0 (58.8) 29.8 7.2 63.0 20.4 216

26.7 (39.9) 15.0 7.8 3.8 40.3 (60.1) 32.5 7.8 67.0 20.2 199

30.3 (34.2) 17.7 9.0 3.6 58.4 (65.8) 47.4 11.0 88.7 23.3 228

41.0 (34.3) 27.5 10.5 3.0 78.7 (65.7) 63.1 15.7 119.7 26.3 268

57.5 (36.5) 41.5 13.6 2.4 100.0 (63.5) 78.0 22.0 157.5 32.5 340

86.0 (55.7) 50.3 17.6 18.1 68.4 (44.3) 43.8 24.6 154.4 34.9 769

Source: The Bank of Korea, Foreign Currency Statistics Yearbook, 1998

ratio of short-term liabilities to usable reserves was 216% in 1992, and the figure climbed to 340% in 1996 and 769% in December 1997. The increase of short-term capital was brought about by several factors: the rapid growth in imports and export-related credits; the lower cost of short-term borrowing compared to long-term borrowing; and lifting the ban on short-term foreign borrowing but not easing bans on medium and long-term borrowing in 1994. In particular, regulations on medium and long-term borrowing, intended to control total domestic liquidity, inevitably forced financial institutions to raise short-term credit to finance domestic foreign-currency denominated lending. Domestic banks borrowed heavily from foreign banks and lent mostly to domestic investors. Since banks can usually roll-over foreign liabilities, in normal times the high ratio of short-term debt may not be a concern, yet when combined with a rapid currency depreciation, such an imbalance may lead to severe financial vulnerability. In such a situation, a panic could cause serious liquidity problems. To make the situation worse, financial institutions, especially merchant banking corporations, were investing recklessly in foreign securities, offshore funds, and derivatives, without any international experience. As a result, these institutions have lost heavily in Malaysia, Ireland, and France in recent years. Eighty-nine offshore funds were leveraged by two to five times their capital

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base. Altogether, disguised as foreign institutional investors, these domestic financial institutions invested heavily in Korean stocks and high-risk securities throughout Southeast Asia. By the end of October 1997, merchant banking corporations had borrowed US$ 20 billion in short-term capital, 5% of which was sunk into non-performing assets. The Korean government, unfortunately, had never supervised these financial institutions' behavior properly in spite of liberalization.

2.3. Over-Investment and Deterioration of Balance Sheets of Corporations From early 1997, large conglomerates in Korea began to go bankrupt, largely due to high debt-equity ratios and low profitability, a necessary result of overinvestment. Among other reasons, political intervention gave firms easy access to the financial market, and encouraged over-investment regardless of low profitability. Large conglomerates thus had an advantageous position in a secured loan market. The low profitability problem was concentrated, especially, in the manufacturing sector of traded goods. To some extent, excessive borrowing from domestic banks and financial intermediaries in international capital markets facilitated and fueled the over-investment. When, in 1997, large losses and outright defaults emerging in the corporate sector signaled a profitability problem, the firms, banks, and investors that had relied heavily on external borrowing were left with a large amount of short-term foreign debt that could not be easily repaid. The currency crisis that ensued exacerbated the problem, since the currency depreciation dramatically increased the real burden of dollar denominated debt and led to further financial woes. Several indicators show over-investment and highly risky investment by Korean corporations. First, efficiency of investment as measured by the incremental capital output ratio was decreasing. Second, the number of nonperforming loans before the crisis was above 15% of the total. Third, by mid- 1997, eight of the thirty large conglomerates were either de facto or de jure bankrupt. Fourth, in 1996, 20 of the largest 30 conglomerates showed a rate of return on invested capital below the cost of capital. Fifth, the debt-equity ratio for Korea's top 30 conglomerates averaged over 900% at the end of 1996. 2.4. Moral Hazard of Governmental Implicit Guarantees As is widely known, commercial and merchant banks in Korea have long operated under an implicit governmental guarantee, though it is not legally codified. Few believed that the government would allow these institutions to go bankrupt. The implicit government guarantee encouraged domestic financial institutions to borrow larger amounts of funds abroad and invest in riskier

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projects than they otherwise would, believing that the government would bail them out if they incurred serious losses. As the process of financial market liberalization proceeded in the 1990s, the severe deficiency of domestic financial markets increased the risk of financial crises in Korea. By international standards, many financial sector features were inadequate, including the transparency of public and private financial institutions, bank capital requirements, banking supervision, and bankruptcy procedures. The presence of financial insurance without proper prudential supervision created a clear moral hazard problem, reducing the incentive to carry out a proper risk assessment of potential projects. The economy as a whole ended up investing too much, and taking on excessive risk. Even before the onset of the currency crisis, the financial system was in dire straits because of excessive lending to large trading-sector conglomerates, many of that went bankrupt even before the currency crisis hit the economy in late 1997. It should be noted that often private banks in Korea were effectively controlled by a chaebol, and thus often gave such conglomerates privileged access to credit, exacerbating the moral hazard problem. This moral hazard problem appears to have affected the behavior of foreign financial institutions lending to Korean banks as well as other financial institutions and corporations. Since foreign banks were aware of the government guarantee, they did not feel the need to conduct careful credit analyses of Korean financial institutions and finns to which they were lending vast sums of money. When the crisis began to surface, however, foreign banks and investors abruptly withdrew their investments, making no serious efforts to reschedule their loans to troubled Korean banks.

3. Triggering Events 3.1. Asian Crises and the Contagion Effect There are several channels of contagion: the stock market: the foreign exchange market; other trade spillovers; and investment and real links that transmit the real shocks of one country to the asset values (stocks, exchange rate) of other countries. Late on October 23, 1997, the Hong Kong stock market crashed and sparked the exodus of foreign capital out of Asia, including Korea. The stock market crash was also transmitted to Korea via the foreign exchange market. In Asia, as the currencies of countries competing in the same world markets came under attack and depreciated sharply, the fundamental value of other currencies that

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had not yet depreciated started to deteriorate. These competitive devaluations explain part of the contagion and are called 'beggar-thy-neighbor' policies. By the end of October 1997 in Korea, the effective real appreciation of the won caused by the collapse of several other currencies was quite large. The Korean won had depreciated by only 14%, relative to December 1996, implying that the won had appreciated in nominal terms by 37, 36, 20 and 15% relative to the currencies of Thailand, Indonesia, Malaysia and the Philippines respectively. Since Singapore and Taiwan competed directly with Korea in a wide range of export products, the fact that they had allowed their currencies to depreciate put Korea at a more serious competitive loss. By November, the Korean won was falling rapidly (by 25% during the month and 39% over the year). The financial turmoil in the Hong Kong stock market in late October, in particular, created a sharp depreciation of the Korean won, exacerbating Korea's credit crunch problem in the international capital market. This crunch in turn caused a currency crash and liquidity crisis in an economy with unhedged and short-term foreign liabilities. Since the Korean economy was the largest economy in Asia besides Japan, the fall of the won implied a real depreciation that negatively affected the competitive position of the other countries in Asia. Thus the fall of the won resulted in further competitive devaluation throughout East Asia. 3.2. A Series of Corporate Bankruptcies and Financial Distress of the Financial Institutions In 1997, the crisis was triggered by a series of bankruptcies of large conglomerates, or chaebols, that had borrowed heavily to finance their investment projects. Eight of the thirty conglomerates failed, sending shocks throughout the real and financial markets. These bankruptcies were mainly a result of overly aggressive diversification, excessive investment in certain industries such as steel, autos, and retail, and the decline in corporate profits brought about by the prolonged economic downturn. The recent and rapid deterioration in the terms of trade especially hurt corporate profits, since many Korean export firms imported raw materials. Table 4 shows the major bankruptcies in 1997. The series of bankruptcies started in December 1996 when 'Hanbo' was unable to meet the payments of the principal and interest on its loans, and was placed under court receivership. Then, in March, 'Sammi Steel' also sought court receivership, followed by the 'Jinro' Group in April, the 'Daenong' group in May, the 'Kia' group in July, the New Core Group in November, and so on. Among these, the bankruptcy of 'Kia' in July was the most injurious shock to the Korean

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Date Jan. 23 Mar.19 Apr. 21 May 19 July 17 Nov. 1 Nov. 4 Dec. 8

Table 4.

Eight Bankruptcies of Conglomerates in 1997 (in billion won)

Group

Major Business

Hanbo Steel Sammi Steel Jinro Retail Daenong Retail&Textile Kia Autos Haitai Food &Electronics NewCore Retail Halla Heavy Industry Total

Rank Debt/Equity Loansby Ratio (%) Banks 14 26 19 34 8 24 25 12

3,245 8,598 523 658 1,224 2,067

4,627 811 1,340 699 4,440 1,310 938 3,036 17,201

Loansby Non-banks 968 36 895 603 5,035 1,971 377 3,440 13,325

Note: (1) The national ranking figures indicate firm size in terms of assets in 1997. (2) Debt-EquityRatio as of the end of 1996 Source: Press release of Financial SupervisoryCommission(FSC)

economy. By the end of the 1997, 72 corporations listed on the Korean Stock Exchange had failed. After this, more high-profile bankruptcies followed. After this string of bankruptcies, the non-performing loans of financial institutions amounted to 28.5 trillion won as of September 1997, which was equivalent to 6.3% of all outstanding loans. Merchant banks held an additional 3.9 trillion won of bad loans as of October 1997, equivalent to 2.9% of all outstanding loans. These corporate bankruptcies which occurred in 1997 saddled the nation's commercial banks with an extremely heavy burden of non-performing loans, or a ratio of 14.9% of non-performing loans to total loans by December 1997, compared with 3.9% in December 1996. By the end of 1997, commercial banks held 82.5% of all non-performing loans among banks, and about 78% among financial institutions. With these unfavorable ratios, banks were highly vulnerable to financial crisis. At the end of 1997, only 12 of 26 commercial banks satisfied the required 8% capital adequacy ratio.

3.3. Korean Government's Policy Mismanagement Just before the onset of the currency crisis, Korean policymakers made a series of erratic judgements and policy errors. First, policymakers judged that Korea's strong economic fundamentals would sustain the economy and safeguard it from the Southeast Asian currency crisis. Therefore, they did not take any

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strong measures to deal with the extemal financial situation. This arrogance and secrecy on the part of the government was pivotal in allowing the economy to slide into crisis. Second, on August 25, 1997, the government issued a statement that the Korean government would ensure the payment of foreign debts by Korean financial institutions. And on October 23, 1997, the Korean government decided to save the Kia group from bankruptcy with a Korea Development Bank contribution. These guarantee announcements increased moral hazard problems and made the bankruptcies of private financial institutions a national concern. Third, confidence was eroded further when it became apparent that monetary authorities had lied about foreign exchange reserve levels. The government insisted that the Bank of Korea held about US$ 30 billion in reserves in November. However, simple calculations revealed that this claim could not be true, and only about US$15 billion remained. Thus foreign investors deduced that the Korean government could not effectively manage currency problems. The fourth critical mistake was inherent in the government guarantee. As noted above, the underlying source of moral hazard was the implicit government guarantee on external borrowing by financial institutions and corporations. However, this guarantee was not legally authorized, only traditional and implicit. The ratio of short-term foreign liabilities to total domestic loans was 13.3% at the end of December 1996. Foreign creditors assumed that these loans had governmental protection, even though this guarantee was only implicit. The failure of the Financial Reform Act, diminished usable reserves and rising non-performing loans made the implicit guarantee no longer credible. When the crisis erupted, abrupt speculative outflows occurred, exacerbating the currency crisis. The fifth and the most serious policy mistake by the Korean government was poor management of foreign reserves. Already in July 1997, foreign capital inflows began to diminish due to the South East Asian crisis. From August, central bank reserves began to fall rapidly as private capital inflows virtually vanished. Under these circumstances, the optimal policy was to allow the Korean won to depreciate, reflecting market forces. Instead, the Bank of Korea continuously intervened in the foreign exchange market, rapidly depleting foreign reserves. Finally, although market fears were rising and Korea's external financial situation had become markedly worse in late October, it was not until November 21 that the government finally approached the IMF for assistance. This move clearly should have been made at least several weeks earlier, since

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Table 5.

1997.8 1997.9 1997.10 1997.11 1997.12

Movements of Foreign Stock Investments (US$ million) Inflow

Outflow

Net Flow

788.2 757.9 760.8 1,530.9 1,045.0

835.5 1,146.2 1,547.1 1,807.5 707.2

-47.3 -388.3 -786.3 -276.6 337.8

Source: Press release of Korea StockExchange(KSE) by then market sentiment had become overwhelmingly negative that aid could not be organized fast enough to avert a crisis.

3.4. Degradation of Sovereign Credit Rating and Herding Behavior Just after the Hong Kong stock market crash, on October 24, 1997, S&P downgraded Korea's short-term rating from A + to AA-, and long-term grade was changed to 'negative'. Because of this development, the exodus of foreign capital from Korea as well as Asia was certain. As we see in Table 5, at least US$1.1 billion was removed from the country in October and November alone, while US$ 76 million exited the stock market in October. Prices of bonds issued by the Korea Development Bank fell to that of junk bonds, and the spread was widened from 128bp to 269bp only 10 days later. Altogether, the roll-over rates of Korean banks' external debt with foreign debtor were merely 58.8% in November and 32.2% in December. Considering all the circumstances, the 1997 crisis does not seem to have been caused by failing economic fundamentals alone. Rather it seems to have been triggered by a combination of domestic and foreign factors such as a heavy chain of corporate bankruptcies, distress of financial institutions, policy mismanagement by the Korean government, the South East Asian crisis, degradation of Korea's sovereign credit rating and so on. On the other hand, an overridden corporate debt ratio, weak financial institutions, and the bureaucratic financial market were not recent phenomena, rather they were unfortunate by-products of a high growth economy and features well-known by both resident and non-resident investors for years. Yet these background problems made the Korean economy particularly susceptible to the crisis sweeping across East Asia. A series of policy mismanagement and downgrading of Korea's sovereign credit rating, combined with other destabilizing factors, made the eventual crisis inevitable.

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3. RESOLUTION OF KOREAN FINANCIAL CRISIS Although the Korean financial crisis was apparently caused mainly by foreign exchange liquidity problems, it is deeply rooted in the inefficient and distorted financial system. The government-led development strategy of the past 30 years has involved routine government intervention in financial sector, preventing the development of market disciplines. Selective credit allocations and prolonged interest control, which were used as primary tools of economic development in Korea, have resulted in an inefficient and distorted financial system. Strict segmentation with the financial industry and high entrance barriers have limited the initiative and innovation of financial institutions. Extensive government involvement in the internal management of financial institutions has undermined the autonomy and accountability of the management. On the other hand, a lack of effective supervisory system failed to prevent the excessive risk taking and moral hazard problems plaguing the industry. Over the years, the negative effects of government-led economy have accumulated to the point of explosion. In recognition of the structural problems, there have been intermittent attempts 8 to overhaul the outmoded financial system toward a market-oriented one. However, those government-initiated reform efforts were often faced with political barriers and the scope was too limited to eradicate the distortions deeply rooted in the financial sector. According to the Letters of Intent submitted to the IMF, the Korean government's strategy for overcoming the financial crisis can be classified into two parts: first, aggressive measures to facilitate the ease of imminent liquidity problem as well as financial market liberalization for relatively long-term purpose. Second, measures for an extensive restructuring of the financial and corporate sectors toward a market-oriented system, including reforms of the financial regulatory structure and the labor market. These issues are not new, but have been discussed for a long time before the crisis with little implementations. The only true remedy for the crisis is to establish a new economic order ruled by market principles. This new order, in turn, will necessarily require painful structural reforms across the board. Due to the IMF program and the government's aggressive efforts to facilitate external financing, the initial foreign exchange problems have been ameliorated to some extent. However, the Korean economy suffers from the most painful economic contraction since the Korean War. Nearly 3,000 firms have filed for bankruptcy every month during the first half of 1998, which led to a mounting non-performing loans and a rapid erosion of the capital base of banking sector. The capital base erosion and a highly uncertain real sector situation has led to

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a credit crunch in the financial market, which again aggravating the real sector and the financial sector. Without prompt resolution of insolvent financial institutions, credit crunch can not be ameliorated. Further delays in financial sector restructuring would undermine the soundness of the whole financial system and the core economic base of the nation could be seriously damaged. Although the Korean government has just finished the first round of financial sector restructuring to ultimately break off the vicious cycle, the on-going restructuring needs to be further accelerated. In this section, the process of resolving the imminent foreign exchange liquidity problems and the recent financial sector reform efforts in Korea are reviewed, including the description of the government policy directions and progress up to date.

1. Resolving Foreign Exchange Liquidity Problem 1.1. Facilitating the External Financing At the onset of the currency crisis in November 1997, the most urgent national task to resolve was the foreign exchange liquidity problem to stabilize the market. The primary goal of the government therefore has been how to stop capital outflows and to facilitate external financing. The major factors easing the liquidity problems include: (1) The bailout fund from the international organizations has greatly eased Korea's short-term liquidity problems at the early stage of the crisis. As of the end of August 1998, a combined total financial assistance from the IMF, IBRD and ADB has reached around US$ 26 billion9 out of a total package of US$ 58.4 billion. (2) The short-term debt problems of Korean financial institutions were eased by the conversion of US$ 21.8 billion short-term external debt into longerterm government-guaranteed loans in April 1998.1° The Korean government was able to get access to the international financial market by issuing inaugural global bonds 11 totaling US$ 3.9 billion. Reflecting an overall improved investors' confidence in Korea, the roUover rate of maturing external debt rose from 32.2% in December 1997 to 92.7% in May 1998, followed by 100.2% and 86% in June and August respectively. (3) The current account surplus after the crisis has substantially improved although it is mainly due to a drastic decline in the import demand. Over the period of January to August, 1998, the current account surplus reached a historical record of around US$ 27.5 billion, 12 drastic change from a deficit of US$ 23 billion in 1996 and a deficit of US$ 8.6 billion in 1997. The foreigner's net security investment of around US$ 3.2 billion over the same period was another important factor.

Korean Financial Crisis and Reform Table 6.

93

Official Foreign Exchange Reserves (in US$ billion)

1998 Dec. Dec. 1996 1997 Jan. Feb. Mar. Apr. May June July Aug. Sept Foreign Reserves(~ 33.2 20.4 23.5 26.7 29.8 35.5 Overseas Deposits ® 3.8 11.3 10.9 8.0 5.4 4.6 Others ® --0.2 0.2 0.2 0.2 Usable Reserves 29.4 8.9 12.4 18.5 24.2 30.8 (®-®-®) Won/US$ 839 1,484 1,706 1,623 1,505 1,391

38.8 40.9 43.0 45.1 46.9 4.2 3.7 3.6 3.5 3.4 0.2 0.2 0.2 0.2 0.2 34.4 37.0 39.2 41.4 43.4 1,394 1,397 1,227 1,351 1,391

Note: Reserves at the end of each month and Won/US$rate at the monthlyaverage Source: Press release, The Bank of Korea

The emergency fund from the international organizations, followed by gradual improvement in investor's confidence and a record level of current account surplus, has successfully halted the capital outflows and substantially increased the usable foreign exchange reserves as shown in Table 6. The usable foreign exchange reserve has increased from a record low level of US$ 8.9 billion in December 1997 to US$ 43.4 billion in September 1998 and the foreign exchange rate has stabilized around 1,350 to 1,400 won per dollar in spite of the recent turbulent international market situations. Improvement of external financing environment and stabilized foreign exchange market have enabled the government to turn to the economic restructuring issues in Korea.

1.2. Capital Market Liberalization Since foreign capital inflows are of crucial importance to the Korean economy, the previous schedule for capital market opening has been drastically accelerated. The newly introduced market-opening measures toward liberalizing capital flows include the adoption of the fully floating exchange rate system well in advance than scheduled,13 and a complete removal of restrictions on foreign ownership of listed stocks and bonds with minor exceptions 14 The short-term money market instruments of CPs, RPs and trade bills were also opened to foreigners with no restrictions. Facilitating foreign exchange transactions, a new law was legislated and will be put into effect in two stages starting on April 1, 1999. One of the most significant changes is the adoption of the negative list system, which will

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completely deregulate the foreign exchange market and capital flows. In addition, to promote the foreign direct investment, the government has fully liberalized foreign hostile M&A of domestic firms in May 1998, and allowed both foreign residents and non-residents to purchase land in Korea without any restriction through the amendment of 'Foreigner's Land Acquisition and Management Act' in April 1998. New FDI Promotion Act opened 9 additional industries for FDI in May. As a whole, Korea becomes literally a free open economy. The market-opening deregulation measures undertaken so far are quite drastic in their scope and scale. However, thus far, sufficient inflows of foreign capital have yet to materialize in Korea. The amount of foreign direct investment recorded only US$ 4.1 billion ~5 and the financial investment US$ 3.16 billion over the first 8-month period of 1998. Given the level of the current capital market liberalization, it could have been larger and is expected to grow as the uncertainty arising from the on-going economic restructuring process decreases.

2. Reshaping the Institutional Framework Financial sector restructuring is crucial for economic recovery, and thus has been at the center of reform efforts. Swift and prudent reform has necessitated the establishment of an institutional framework to coordinate and monitor the reform process. To this end, major financial reform bills were legislated to provide a legal basis for required institutional reforms. On December 29, 1997, the National Assembly passed a package of the long-awaited 13 financial reform bills designed to facilitate financial restructuring, improve prudential regulation, and accelerate capital market liberalization. The package contained bills to correct the built-in inefficiency of financial market by enhancing the independence of the central bank, establishing a neutral consolidated Financial Supervisory Commission (FSC), and liberalizing foreign ownership of Korean securities. Enhanced independence of the central bank for monetary policy and establishment of the FSC for a neutral supervision implies a shift from a MOFE-monopolized financial policy making structure to a decentralized one with a check and balance system working. The passage of the package signaled the end of government-controlled financial resource allocation and has provided the legal basis for financial reforms.

The Central Banking. According to the new Bank of Korea Act, the independence of the central bank has been substantially enhanced. The Governor of the Bank of Korea (BOK), previously appointed by the Ministry of Finance and Economy (MOFE), is now appointed by the President on the

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deliberation of the State Council. The Governor of BOK, instead of the Minister of MOFE, now chairs the Monetary Board that is the supreme policy making body of the BOK. In addition, the previous dual objectives of the central bank, maintaining the stability of currency value and the soundness of the banking and credit system, are replaced by maintaining price stability. Escaping from the direct influence of the MOFE, the Monetary Board is expected to carry out more advanced central banking for the unified goal of price stability. Instead, its responsibility for supervising banking industry is transferred to the newly established FSC. A Consolidated Supervisory Body: The FSC. Inefficiency and ill-use 16 of financial supervisory system of Korea has been a target of criticism since the early 1980s. Ending the controversy over the right structure, the Financial Supervisory Commission (FSC) has been newly established in April 1998 under the Office of the Prime Minister to function as a neutral and independent agency. It replaced the MOFE which had previously the de facto supervisory power through four legally independent agencies. For efficient financial supervision with a well-defined goal, the four existing supervisory bodies ~7will be merged into a new Financial Supervisory Board by the end of 1998, and the Board will be directly superintended by the FSC. In addition, the FSC established a sub-committee, the Securities & Futures Commission (SFC), which is responsible for orderly functioning financial market. The FSC currently plays a key role in restructuring the financial and corporate sectors, which will be described in the next section. Under the new structure, the Bank of Korea no longer has its supervisory power over the banking sector although it has a limited bank inspection power. The rationale for consolidating supervisory powers was basically two: (1) separating the supervisory power from the MOFE is a necessary condition for neutral and independent supervisory function (established under the Prime Minister's Office), and (2) a reality that distinguishing financial institutions is increasingly meaningless due to accelerating financial deregulation will necessitate a consolidated supervisory body for effective supervision. Although its effectiveness needs to be tested, it is a reality in Korea. This means the end of a de facto concentration of power to the MOFE. A potential check and balance among MOFE, FSC, and BOK is expected to help the industry be more competitive and viable. A Consolidated Deposit Insurance: The KDIC. Another important change is strengthening the deposit insurance function. The Korea Deposit Insurance Corporation (KDIC), the consolidated deposit insurance body, is established under the MOFE according to the financial reform bill in December 1997. The

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KDIC, which was originally set up for commercial banks in 1996, was expanded to serve all the financial institutions by absorbing the other five existing separate insurance funds. 18They do not have a supervisory power over the institutions although it has a limited joint inspection power with the FSB. Due to its short history, the KDIC does not have enough reserve and issues its own bonds to finance the need, which was authorized by the Assembly. The amount of authorized bond is currently 31.5 trillion won, which is being used for capital injection and deposit loss coverage of ailing financial institutions. In November 1997, the MOFE announced, to prevent a collapse of banking system in the middle of currency crisis, that he government would guarantee the principal and interest of all deposits fully until the end of year 2000. After the announcement, a serious moral hazard problem has emerged such that the government scaled down the protection level to 20 million won for the deposits made after August 1, 1998. This change is a right step toward a market-driven restructuring of the financial system.

The Korea Asset Management Corporation (KAMCO). The KAMCO was first established in 1962 to manage bad loans of the state-run Korea Development Bank. On November 24, 1997, KAMCO has completed a major reorganization to carry out the main objectives of acquisitions and dispositions of the nonperforming Loans in a more efficient manner, under the control of the MOFE. For this purpose, KAMCO, as a Bad Bank, is adopting the divisional structure based on the organizational structure of the Resolution Trust Corp. When KAMC was reorganized, the size of NPLs was 38 trillion won and the size of the Non-Performing Asset Management Fund was 10 trillion won, that increased to 32.5 trillion won now. The bailout fund is used to buy nonperforming loans of financial institutions and the assets of ailing business firms. The KMACO resources are financed by issuing its own bonds of 32.5 trillion won and by disposing purchased assets through direct sale or asset-backed securities. The KAMCO bailout funds, ~9 along with the KDIC, constitute the fiscal support needed to facilitate the financial sector restructuring process. Improvement in Standards in Prudential Regulation and Supervision. Along with institutional framework changes, a new system of prudential regulation and supervision has been established. In accordance with the 5th agreement with IMF last May, FSC announced a plan to strengthen the regulatory standard so as to conform to an internationally acceptable level. Some of the measures undertaken include marking-to market for securities (June 1998), more bank information to be disclosed to meet the international accounting standard (April 1998) and more conservative loan classification and loan provisions (July 1998). Under the new loan classification scheme, effective July 1, the

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Precautionary classification is applied to loans whose interest payments are 1 month to 3 months in arrears, while the old standard was 3-6 months in arrears. The Substandard includes loans with longer than 3 months of interest payments in arrears instead of the old standard of 6 months. And Loan loss provision for precautionary loans is increased from 1% to 2. In addition, to improve BIS capital ratio calculation, of all provisions except those with respect to assets classified as normal and precautionary will be deducted from Tier 2 Capital to be implemented in January 1999. Measures are also being taken for improving bank management's accountability. In the absence of well-functioning monitoring system, the existence of major shareholders is needed to discipline the management. 2° The government is working on the revision of the bank law within this year, including a reform in banks' ownership structure. To improve the accountability of bank managers, the law suggests a removal of the individual equity ownership ceiling of the current 4% for national banks and 15% for provincial banks starting in January 1999. Thus, so-called 'reverse discrimination' against localities that only foreigners may go over 4% is expected to disappear. At the same time, a recent rise in minority shareholder's activism21 will play a key role in enforcing bank management's accountability. 3. Restructuring the Financial Sector

Despite the seemingly successful currency crisis management, Korea's economy has yet to emerge from the current recession, and there are fears that the economy may slide further into a vicious circle of a vulnerable financial system ridden with accumulated bad loans, a credit crunch problem, and a realsector recession. Against this backdrop of ailing financial and corporate sectors, widespread moral hazard phenomenon and economic uncertainties, a quick-fix solution of liquidity injection and partial restructuring is insufficient. Recognizing the gravity of the problem we face, the government has been actively implementing comprehensive reforms in the corporate and financial sectors. This reform, begun in April 1998, reflects the government's serious commitment to bold reform. Since the main body of restructuring must be the Korean government, it will be necessary to review the government actions to understand the restructuring process. 3.1. Basic Framework of Financial Sector Restructuring The ultimate goal of financial restructuring lies in achieving a sound and stable financial system. The government, on April 14, 1998, announced the basic f r a m e w o r k o f 22 financial sector restructuring. Before this date, the Korean

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government didn't have a blueprint for financial restructuring. Occupied by currency crisis management, the government has taken quick-fix and partial measures against ailing institutions such as merchant banks or Korea First Bank and Seoul Bank. It was too busy to design a consistent and extensive restructuring plan conforming to the ultimate goal. In April, a complete plan was suggested for the first time. The basic principles, announced by the government, to facilitate the financial sector restructuring can be summarized as follows: • • • •

Stabilize financial markets through swift and extensive reform. Provide timely and sufficient fiscal support. Set transparent principles for accountability among parties concerned. Confirm internationally accepted standard.

The first and second principles aim at normalizing the financial system as soon as possible through swift and extensive reform with extensive fiscal support. It is based on other countries' experiences that delayed actions increase the costs of restructuring and decrease the success probability. Specifically, non-viable financial institutions must be distinguished from viable ones. Once this is done, the government will act swiftly to bolster viable institutions through equity participation and the purchase of non-performing loans. To qualify for this assistance, banks are required to downsize their branch network and layoff employees such that fiscal support will be linked to their self-rehabilitation efforts to minimize the taxpayers' burden and eliminate the moral hazard problem. Equally swift action will be applied to those institutions judged as 'non-viable'. The government is creating a firm exit strategy to close these institutions, thereby stabilizing the financial market and protecting depositors and creditors from potential defaults. The third one indicates transparent burden sharing rules in the resolution process of insolvent institutions. The fourth asserts that the structural reforms will be made in accordance with market principles and international standards and practices. Under those principles, the government decided that the financial sector restructuring would be pursued in two phases. • In Phase 1, normalization of the banking sector has been given a top priority before non-bank financial institutions. • In Phase 2, the reform measures for non-bank financial institutions will be carried out in line with the financial market situations. Reflecting the priority, the FSC announced the time schedule of financial sector restructuring on April 14 and a revised one on June 19, 1998. According to the schedule, the first round of financial restructuring is scheduled to be completed

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for c o m m e r c i a l banks by the end o f A u g u s t 1998 and for m o s t n o n - b a n k institutions b y the e n d o f S e p t e m b e r 1998, w h e r e a s restructuring o f financial institutions that w e r e not i n c l u d e d in the first r o u n d will be dealt after October, 1998.

3.2. The First-round Financial Sector Restructuring A s o f S e p t e m b e r 30, 1998, the g o v e r n m e n t finished the first r o u n d restructuring f o c u s e d on banks and i n s u r a n c e c o m p a n i e s as planned. T h e p r o g r e s s up to date is first s u m m a r i z e d in Table 7. M o s t o f the financial institutions w e n t t h r o u g h r e v i e w process a c c o r d i n g to the s c h e d u l e and are subject to c o r r e c t i v e actions taken by the g o v e r n m e n t . T h e detailed procedures, c o m m o n to all, are d e s c r i b e d in the next section for c o m m e r c i a l banks. E v e n t h o u g h all the institutions shared the s a m e appraisal process, the actions for a c o n d i t i o n a l l y a p p r o v e d institution w e r e different d e p e n d i n g on

Table 7.

S u m m a r y o f the F i r s t - r o u n d R e s t r u c t u r i n g (as o f S e p t e m b e r 30, 1998)

Institutions

Major Actions

Banks (26)

• Equity write-offs of 2 banks put into sale • Announce 12 undercapitalized Banks -P&A of 5 disapproved banks ~Conditional approval of 7 banks • Three pair-mergers announced (6 banks) • Revoke license of 16 banks under resolution • 14 under rehabilitation plan 1 merger with a bank • 2 licenses revoked • 4 operation suspended • 2 conditional approval • close 4 life insurance companies • 16 under management improvement measures • 2 surety ins. to be merged • 1 license revoked • l suspended operation • 10 liquidated or acquired • 15 under rehabilitation plans • 1 suspended • 20 under management control • 11 under management guidance • 12 to be liquidated • 27 under management guidance

Merchant Banks (30) Securities Companies (34)

Insurance Companies (50)

Investment Trust (8) Leasing Companies (25) Mutual Savings & Finance Co. (230)

Credit Unions (1,653)

The number within parentheses is the total number of institutions

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whether it is a bank or a non-bank. For banks, fiscal support were selectively provided only when rehabilitation plans were approved by FSC and implemented. And voluntary merger between banks and the inducement of foreign investment were encouraged through support measures such as the KAMCO's purchase of NPLs or through recapitalization provided by KDIC for the purposes of covering the deterioration of BIS ratio upon acquisition of a troubled bank. For non-banks, as they have majority shareholders, self-driven rehabilitation through recapitalization was encouraged under the responsibility of major shareholders. In the first round, targeted non-banks were merchant banks, securities companies and insurance companies. However, when a recovery was deemed unrealistic, those institutions were closed and their business was transferred to other institutions with fiscal support covering the difference between assets and liabilities. No immediate industry-wide actions against institutions like investment trusts, leasing, mutual savings and credit unions are scheduled yet although individual rehabilitation efforts or mergers are encouraged. 3.2.1. Commercial Banks The general restructuring strategy described in the previous section was strictly applied to 26 commercial banks, 16 nationwide banks and 10 provincial banks. The detailed procedure is worth reviewing to understand how the restructuring process has been. (1) The government recapitalized two banks, Korea First and Seoul, which proved insolvent last year before the blueprint was ready last April. The government and the KDIC invested 1.5 trillion won in each bank on January 30, 1998 after reducing their paid-in capital from 820 billion won to 100 billion won each. The two banks will be sold in an open auction at the earliest possible date. (2) For the rest of banks, the Financial Supervisory Commission (FSC) examined the capital adequacy as of December 1997. Twelve banks that fell short of BIS capital adequacy ratio of 8% were required, on February 5, 1998, to submit self-rehabilitation plans until April 30, 1998. For the other 12 banks that satisfy the BIS ratio, upon completion of due diligence reviews by the end of August, troubled banks are subject to forceful corrective actions. (3) Accounting firms conducted due diligence review of the banks during May 1-June 8, 1998, in accordance to the internationally accepted criteria 23 agreed upon with the IBRD. The review results turned out to be much

Korean Financial Crisis and Reform Table 8,

101

Due Diligence Results o f 12 Undercapitalized Banks (Billion Won %) Assessment Results (As of March 1998)

Banks

Adjusted Assets

BIS Ratio

ChoHeung Commercial Hanil KoreaExchange ChungCheong KyungKi DongWha DongNam DaeDong Peace KangWon ChungBuk Total

44,280 1.49 6,926 19.2 38,004 1.81 7 , 2 4 9 24.3 43,508 4.53 6 , 7 7 2 20.2 47,174 2.13 10,792 28.6 3,770 -5.97 1,619 36.3 7,239 -9.61 2 , 8 6 2 49.0 9,556 -3.72 2 , 2 5 4 28.5 7,115 -5.81 1,118 20.9 5,563 -6.75 1,735 34.1 6,517 -1.57 602 12.9 2,969 -16.0 1,034 45.8 2,487 -5.52 801 28.5 218,182 43,764

NPL

NPL Ratio

Rating C C C C D D D D D C C-~9 C

As of Dec. 1997

Asset

NPL

55,600 2,623 48,552 1,451 53,853 1,324 62,319 2,518 4,829 425 8,894 590 12,968 602 10,055 293 7,715 487 8,359 228 3,869 443 3,139 249 280,152 11,233

NPL Ratio 7.0 4.8 3.6 5.7 12.5 9.7 7.9 5.7 9.6 4.5 18.3 11.3

Note: 1. Assessment is based on new criteria applied to numbers as of March 1998, while the number as of Dec. 1997 on the old BSB criteria 2. NPL: Precautionary and lower 3. Ratings (C: Conditionally Approved, D: Disapproved) assigned by FSC Source: Press Release of FSC (July 1, 1998) & Bank Statistics (1998)

worse than expected as shown in Table 8. Comparing the self-reported N P L ratios as o f D e c e m b e r 1997 with the ratios from due diligence review, utilizing the numbers as o f March 1998, indicates how distant the officially announced bank data is from the reality. Even after considering the fact that a stricter standard in evaluating loans and other assets was applied and 3-month time difference between the measurements existed, it shows how seriously distorted the bank data have been so far. (4) The 12-member Bank Appraisal Committee evaluated the plans during June 20-27, 1998, and submitted the suggestions 24 to the F S C on June 28th. The reviewed items were capital adequacy, recapitalization plan, asset quality classification, reduction plan for risky assets, cost reduction scheme, management improvement plan etc. (5) With the input from the Bank Appraisal Committee, the F S C evaluated the prospects for viability and arrived at either an ' a p p r o v a l ' , 'conditional approval 'or 'disapproval' classification 25 for each bank on June 29, 1998.

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DAESIK KIM & JAEHA PARK The FSC's final decision was: (1) None of the 12 banks received 'Approval', (2) 7 banks received 'Conditional Approval', and 5 banks received 'Disapproval'.

The 7 conditionally approved banks were ordered to submit revised implementation plans containing forceful management reform and recapitalization plan through outside funds inducement or merger by the end of July, and are being reviewed on a quarterly basis. In the event of disapproval of the implementation plans, a mandatory merger or transfer of business order is to be imposed. So far, while two of these banks, Commercial Bank and Hanil Bank, decided to merge with each other, others are under self-rehabilitation process. The 5 disapproved banks are ordered to be liquidated and to have their good assets and liabilities transferred to relatively stronger banks under a P&A arrangement. 26This P&A order was a historical event in Korea since a bank had never been closed before, and gave a clear signal that unconditional protection of financial institutions was no longer valid. However, a few conditionally approved banks were too big to fail. While the Korea First Bank and the Seoul Bank were allowed to continue their operations, the 5 closed banks' assets constituted only 7.3% of the 12 undercapitalized banks Three bank mergers were announced so far, which was encouraged by the FSC's promise of purchasing NPLs or supporting recapitalization. They include a Commercial Bank of Koera and Hanil Bank merger, which were conditionally approved, a Hana and Boram bank merger, and a Kookmin and Korea Long-term Credit bank merger. Given the incentives, more merger attempts are expected. 3.2.2. Non-Bank Financial Institutions Merchant Banks. The increasing bankruptcies of business firms and foreign currency crisis led to the suspension of operations of 9 merchant banks on December 2, 1997 and another 5 banks on December 10, 1997 until the end of January 1998. They were ordered to submit the rehabilitation plans until the end of 1997. After due diligence review 27 during December 19-27 and Appraisal Committee's review 28 for a month starting December 29,1997, the MOFE ordered 10 banks to transfer business to a newly set-up bridge bank on January 30, 1998. After several rounds of the similar process, for now, out of total 30 merchant banks, 16 troubled merchant banks 29 had their licenses revoked and are currently undergoing closure procedures. In the process, the funds to pay depositors are expected around 1.27 trillion won to be financed by

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the KDIC bond issuance. 3° The remaining 14 merchant banks are monitored to insure that they implement their rehabilitation plans and achieve a BIS ratio of 8% by June 1999. Insurance companies. Out of total 50 companies, 22 domestic insurance companies, which didn't meet the solvency margin ratio or had assets lower than liabilities as of March 1998, were singled out and ordered, on May 11, to submit the rehabilitation plans by June 20. A due diligence review was completed over June 20 to July 20, and revised plans were submitted on July 28. The Appraisal Committee reviewed the assessment reports during August 6-11. The FSC announced the final results on August 11. Four life insurance companies (Kukje, BYC, Taeyang, Korea) ordered to close on August 21, 1998 will have their assets and liabilities transferred to relatively stronger insurance companies after a due-diligence review in late October. Among these assets and liabilities, 4 billion won is required to purchase the non-performing assets, and 1.2 trillion won is needed to compensate for the gap between liabilities and assets. Sixteen insurance companies currently subject to management improvement measures are being monitored to insure compliance on quarterly basis. Two surety insurance companies (Daehan and Hankuk), 31 vital to small business financing, are scheduled to merge by November 1998. The purchase of non-performing assets at these companies, totaling 5 trillion won, requires KAMCO 1 trillion to purchase face value of 3 trillion won and was completed in late September. Securities companies. Out of total 34 securities companies, two securities companies (DongSuh, Korea) had their licenses revoked on May 22, 1998 after five extensions of suspension period. Four companies with operational net capital ratios of less than 100% were ordered to submit management improvement plans. After diagnostic reviews by evaluation committee during September 20-23, 1998, two (Dongbang Peregrine and KLB) were suspended in addition to already two suspended companies (HanNam, KDB in July). Other two (Sangyong, SK) was conditionally approved of their rehabilitation plans on September 25, 1998, and ordered to submit a revised rescue plan until October 24, 1998. Other Non-Banks. Ten of 25 leasing companies will be either liquidated or acquired, by decision of their major shareholders. Those not undergoing liquidation are having their assets and liabilities transferred to other institutions

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by means of a bridge leasing company. The remaining 15 leasing companies will be monitored to insure implementation of rehabilitation plans. Although a concrete restructuring plan is not yet set, for the six existing investment trust companies, the government is continually inducing management improvement and monitoring the implementation of rehabilitation plans. Sinseki Investment Trust had its license revoked, and Hannam Investment Trust, currently under suspension, will transfer its business to Kookmin Investment Trust by the end of September and undergo liquidation procedures. One Investment Trust Management Company (Dongbang-Peregrine) has dissolved of its own accord, and five companies are seeking dissolution. The restructuring process will begin as the capital market stabilizes. Out of 230 companies, the Non-Bank Supervisory Authority is imposing management control on 20 companies, and management guidance on 11 companies, with the goal of inducing rehabilitation. Companies deemed incapable of recovery will be closed either through a business transfer, sale or liquidation. One business transfer order was issued so far. A bridge company created on September 16, 1998 specifically for mutual savings and finance companies will manage the closure process. Twelve credit unions were determined to be liquidated, and 27 subject to management guidance measures. Troubled unions will be required to pursue individual efforts or undergo mergers to induce rehabilitation. The MSFC and CU industries were not given a priority during the first round financial restructuring. 4. F I N A N C I N G T H E F I N A N C I A L R E S T R U C T U R I N G Two critical questions in the process of economic restructuring are how to share the costs among the parties concerned, and how to mobilize the necessary resources. The government made it clear that the cost of economic restructuring must be met primarily by the financial institutions so as to minimize both the burden on taxpayers and the risk of moral hazard. The government's fiscal support will only be provided as a supplementary measure to these institutions' own restructuring and financing plans. The fiscal support is provided for the purchase of non-performing loans, recapitalization of viable institutions, and possible deposit payoffs in the event of closure only when the self-rescue plans of ailing institutions are successfully implemented. The needed resources are raised mainly by the bonds of the Korea Asset Management Corporation (KAMCO) and the Korea Deposit Insurance Corporation (KDIC), whose interest payments are absorbed by the budget.

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Table 9. Non-Performing Loans of all Financial Institutions (in trillion won, as of the end of March and June 1998)

Banks Non-Banks Total End of June %of total loan

Bad Loans ~

Precautionary Loans ~2~

NPLs

40 28 68 63.5 10.1%

46 4 50 72.5 11.6%

86 32 118 136 21.7%

Disposal Target

100

~t~Sum of Estimated Loss, Doubtful, and Substandard ~z~Collateralized loans with 3 to 6 month interest payments in arrears 4° Source: MOFE Press Release (May 20, 1998)

4.1. The Estimated Amount of Non-Performing Loans (NPLs) The main task in financial sector restructuring is the disposal of nonperforming loans. According to the government estimate 32 on May 20, the total of non-performing loans (NPLs) of all financial institutions was 118 trillion won as of the end of March 1998, as shown in Table 9. It consists of 86 billion won from banks and 32 billion won from non-banks and became the basis for the financial restructuring plan. This figure includes loans of 50 trillion won which are classified as 'precautionary'. The Korean government targeted 100 trillion won worth of NPLs for immediate disposal as of March 1998, including the core NPLs, bad loans, of 68 trillion won. The rest of 32 trillion won reflects the fact that a portion of the precautionary loans can become sour, on one hand, and the NPLs can be reduced due to business firms' rehabilitation efforts, on the other hand, as corporate restructuring continues. The government estimated that the total market value of these NPLs averages out at only 50% of their book value. Therefore, the realized loss borne by financial institutions will be approximately 50 trillion won, which will eventually result in the erosion of their capital base. The rest is filled with fiscal support. The targeted 100 trillion NPLs would be disposed through two channels. First, financial institutions will dispose on their own accord half of their respective total of NPLs by either selling off collateral or calling in loans. Second, KAMCO will purchase the remaining half from the financial institutions at an estimated market price of 50% of the book value. In accordance with the agreement with the IMF, any disposal of NPLs by KAMC

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is made only for those financial institutions whose rehabilitation plans are approved by the FSC. According to the subsequent estimate as of June 1998, the total NPLs have increased from 118 to 136 trillion won (21.8% of total loan), with bad loans from 68 to 63.5 trillion won (10.9% of total loan) and precautionary loans with from 50 to 72.5 trillion w o n . 33 The government asserts that the new numbers are within a reasonable range and that it is not necessary to change the restructuring plan set previously. Nonetheless, due to the tightened loan classification standards effective July 1, 1998, a substantial portion of precautionary loans will migrate to the 'substandard' category before the end of this year. Furthermore, the quality of some of the precautionary loans may deteriorate over the course of on-going corporate restructuring process. In light of this, the bad loans are expected to peak at 100 - 120 trillion won by the end of this year. On the other hand, the ongoing corporate workouts will significantly reduce the amount of precautionary loans. Moreover, the FSC's strict supervision will diminish the likelihood of new NPLs from developing.

4.2. Fiscal Support up to September 30,1998 The first round of its financial sector restructuring ended on September 30, 1998 aimed at revitalizing the troubled banks. As noted before, the government's basic principles of fiscal support are: (1) it will not financially support the financial institutions unless appropriate self-rehabilitation efforts and fair loss sharing among concerned parties 34 are undertaken, and (2) fiscal support should be sufficient enough to return solvency of the troubled financial institutions. Under these principles, the Korean government, 35 on May 20, has announced to spend a total of 64 trillion won to facilitate financial restructuring until June 1999. This total public fund is approximately 15.2% of 1997 GDP of 421 trillion w o n , 36 which is rather burdensome compared to other c o u n t r i e s 37 that have experienced similar financial crisis. Among this, 32.5 trillion won would be used to finance the purchase of non-performing loans while 31.5 trillion won for recapitalization and deposit payment of ailing institutions. Among the total 64 trillion won, 37.7 trillion won has been injected by the end of September 1998, of which, interestingly enough, 21 trillion won was spent in September only, particularly, on the last three days of September. Presumably, this is done to meet the tight schedule announced on April 14, which signals the government's strong will to meet the original schedule. As shown in Table 10, 39 trillion won worth of bad loans has been purchased from banks, merchant banks, and surety insurance companies with the

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Korean Financial Crisis and Reform Table 10. Schedule o f Fiscal Support (In trillion won, as o f September 30, 1998) September 1998

NPLs~l)

Book Purchase Capital Injection Loss Coverage Total

Total up to Oct-Dec. Sept. 1998~5~

Nov.97Aug. 98

Bank

Insurance

1st half 1999~6~

16.0 8.612~ 1.5~3~ 6.614)

20.0 8.1 4.9 5.8

3.0 1.0 0 1.2

39.0 17.7 6.4 13.6

25-30 9.8 1.9

12-17 5 6.5

16.7

18.8

2.2

37.7

11.7

11.5

Total 76-86 32.5 28 "417~ (31.5) 60.9 (64.0)

m NPLs: substandard or lower loans ~2)Purchases from 30 commercial and specialized banks, 30 merchant banks and 2 surety insurance ~3)Capital Injection to Seoul and Korea First banks ~4)Deposit payment for suspended merchant banks, MSFC, and credit unions ~5~For the 2nd round restructuring of special banks, a few sound banks, merchant banks, security companies and trust companies ~6)Set aside for newly realized NPLs in the 1st half of 1999 ~7~Do not include the expected loss from sale of Seoul & Korea First Banks and from put-back option exercises on assumed loans of 5 acquiring banks: ( ) is available amount Source: MOFE press release (Sept. 20, 1998), 'Progress in Financial Restructuring and Future Tasks'

K M A C O bond o f 17.7 trillion won by the end o f September 1998, which amounts to approximately 45% o f the book value. A n d 25 to 30 trillion won worth o f NPLs will be purchased from specialized banks, sound banks, merchant banks, securities companies, mutual savings & finance companies with 10 trillion won, starting from October 1998 until the end o f 1998. Additional non-performing loans realized in the future will also be purchased by the K A M C O to make a cleaner banking system Support for recapitalization and loss compensation has been provided to banks acquiring ailing banks and merging banks. The K A M C O purchases the NPLs o f 5 acquired and acquiring banks, and capital was injected so as to prevent the deterioration o f acquiring banks' BIS ratio. New banks created by the merger o f a sound bank and troubled bank is given enough fresh capital to bring their BIS ratio up to standards o f sound banks. New banks resulting from a merger between two troubled banks were given a capital injection sufficient to bring their BIS ratio up to 10%, reflecting the potential bad loans before the

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end of 1998. The total support for recapitalization and loss coverage up to September 1988 amounts to 6.4 trillion won and 13.6 trillion won respectively, totaling 20 trillion won. The government uses the public bonds to finance the projected fiscal support. The Korea Asset Management Corporation (KAMCO) would issue the bonds of total 32.5 trillion won to purchase the NPLs of 50 trillion won or more. And the Korea Deposit Insurance Corporation (KDIC) would issue the bonds of total 31.5 trillion won for equity participation and for compensation of the differential between liabilities and assets to have a margin of 3.1 trillion above the expected 28.4 trillion won. All the issued public bonds are provided 'in kind' to the ailing institutions rather than sold in the market to minimize the possible crowing out effect. Considering that banks have enough liquidity now and the BIS risk weight of public bond is 0%, not much of bonds is expected to cash in. The government provides a guarantee on these bond issues and will bear interest costs. These interest costs are estimated to be 3.6 trillion won for 1998, and 8 to 9 trillion won for 1999. Most of the fiscal support is expected to be recouped over time by the sales of collateralized assets, the divestment of acquired equity shares of financial institutions, and by the liquidation of insolvent financial institutions. Thus, the burden on taxpayers will be minimized to the interest costs related to public bond issues, which will correspondingly decline over time. In addition, assetbacked securities 38 will be issued against collateral to render KAMCO greater flexibility in its financing for the disposal of NPLs. Reviewing the resources allocated in September 1998 in Table 11 may help better understand the fiscal support plan. As noted before, the fiscal support provided in September only amounted to 21 trillion won, resolving the problems of 23 banks and 2 surety insurance companies. 21 trillion won financed by KAMCO and KDIC bonds consists of the NPL purchase of 9.1 trillion won, the capital injection of 4.9 trillion won, and the loss coverage of 7 trillion won. According to the announced principle, the institutions eligible for NPL purchase are limited to those planning a merger or those whose rehabilitation plans have been approved by the Financial Supervisory Commission (FSC). They are to date the resolved and acquiring banks (5 each), 4 merged banks, 9 banks under self-rehabilitation plan, and 2 surety insurance companies under merge. And the eligible bad loans are those classified as 'Substandard Loans' with interest payments longer than 3 months in arrears. The bad loans are exchanged for the KAMCO bonds at an average price-to-book ratio of 24%. Banks with the BIS ratios exceeding 8% as of December 1997 are being under review completed August 31. Banks which deemed to be in danger will

Korean Financial Crisis and Reform Table 11.

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Contents of Fiscal Support in September 1998 (in trillion won) Purchase of NPLs Total NPLm

Institutions 5 Resolved banks 5 Acquiring Banks 4 Merged Banks 9 Self-rescue Banks 23 Bank total 2 Surety Insurance Total (25) Financing

7.3 6.7 7.4 11.5 32.9 5.0 37.9

Size of Price of Capital Loss Purchase Purchase Injection Coverage

4.6 1.0 2.7 1.2 5.0 2.4 7.8 3.5 20.0 8.1 3.0 1.0 23.0 9.1 KAMC Bonds (9.1)

0 -1.3 5.8 3.6 0 0 0 4.9 5.8 0 1.2 4.9 7.0 KDIC Bonds(11.9)

BIS Ratio after Support -11-13% 10-13.3% ---

Total NPLs equal to substandard or lower on the new standard, as of June 1998 Source: MOFE press release (Sept. 29, 1998)

be subjected to a management appraisal during September. And at the end of this appraisal, targeted banks are required to comply with management improvement recommendations. There is no concrete actions taken against them yet. The next stage in the restructuring process will address non-performing loans at specialized banks and non-bank financial institutions. The government will commence purchasing these non-performing loans starting October 1998. Depending on the progress of financial restructuring, the government will complete implementation of the corporate work-out plan, an important element of the corporate restructuring plan, by the end of 1998.

4.3. Recapitalization by Financial Institutions In addition to the government's fiscal support, financial institutions are called on to recapitalize on their own accord by means of issuing equities and subordinated debt instruments, as well as by inducing foreign capital. In domestic market, despite extremely sluggish stock market conditions, 4 banks raised equity capital of more than 0.8 trillion won as of the end of June. Also, banks and securities companies raised 5.4 trillion won in capital by issuing subordinated debt instruments in the first quarter o f 1998. As for foreign capital inducement, capital inflows for joint ventures with domestic financial institutions increased during the first half of 1998. By the end of July,

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approximately US$1.75 billion was invested or committed by foreign investors in Korean financial institutions, including 0.67 billion to 5 banks and 1.08 billion to 8 non-bank institutions. Although the amount, so far, is minimal, it is expected to grow as the economic uncertainty decreases.

5. CONCLUDING REMARKS We have examined the causes of Korean financial crisis and described the financial sector restructuring process. As to the causes, we reviewed the fundamental weaknesses in Korean economy that might have resulted in loss of foreign investors' confidence in Korea. We agree with those asserting that the weaknesses could be necessary but not sufficient conditions for the Korean crisis. Without question, such flaws of Korea have been known for years to international markets. In transforming such factors to crisis, the contagious effects from other Asian countries and a series of policy missteps were critical. However, it doesn't mean that Korea has no need for correcting structural flaws. In fact, there is nothing new in the contents of the current restructuring efforts requested by the IME They have been discussed for years with little implementation in Korea, mainly due to selfish internal politics among various interest groups. Although the current situation is painful, it will be a good opportunity for Korea to build a sound economy without major resistance. From the financial crisis, we have learned how important an efficient and sound financial system is to maintain a healthy economy. Korean financial sector has had absolutely no ability of and no incentive for monitoring the real sector and preventing misallocation of resources, which made the economy vulnerable to external shocks. The most urgent task in Korea is to build a system for a competitive and resilient financial sector. And Korean crisis41 suggests that a small open economy should pay attention to possible contagious effects by adopting stricter policy measures than its fundamentals require. Such policy measures may include bank supervisory standards stricter than usual, defined rules to correct possible problems swiftly and maintenance of adequate level of foreign currency reserves. However, unless the current international financial order changes, a small economy, no matter how hard it tries, is being forced to pay more than due costs, by either experiencing crisis or putting too much resources to prevent it, to be a member of the global economy. Inventing measures to correct the inherent problem emerges as an urgent task of international society. As to the financial sector restructuring, we tried to describe the process. As of today, it must be too early to evaluate the reform process and predict the

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results with confidence. However, a few concerns remaining after the first round financial sector restructuring and future challenges can be presented. • The essence of the first round restructuring is the disposal of NPLs, where an accurate estimation of NPLs as well as securing fiscal support is crucial. The amount of NPLs could become much larger than the government's estimate, depending on both future economic conditions and the applied classification criteria. As the corporate restructuring gain momentum under mounting international market uncertainties, bad loans may be much more than expected. And the government's estimate is based on loan classification scheme such that an application of new rule, effective July 1, would make the NPLs much larger. In addition, even after the KMACO purchase, the nonperforming loan ratio still remains at 3.52%, based on the figures as of June 1998, which is higher than the goal of 1% set by the government. It seems necessary to secure more fiscal resources enough to restore the domestic and international market confidence in the government's willingness and ability to resolve ailing institutions' problems. • The government plan for recapitalization assumes a half of 39 trillion won to be raised by financial institutions through new stock issuance, foreign capital inducement and subordinated debt. Considering the sluggish domestic financial markets, only feasible alternative is foreign capital. If the foreign capital inflow is slower than expected, the restructuring process may take longer and the current credit crunch may continue. • Disposal of bad loans to meet the BIS ratio is not the fundamental solution to the financial crisis. The deep-rooted problem in Korea is a long history of government intervention in private sector. With the current fiscal support, the government became the largest shareholder of almost all the banks. In addition to disposal of bad loans, supplementary measures for autonomous and accountable management are necessary for laying ground for a competitive financial industry. • The government aims at swift and extensive restructuring and is so far in control. However, it is possible that the policy makers may lose their decisiveness and enthusiasm toward reforming the financial sector for political or economic reasons. 42 Maintaining the current policy stance of accelerating the restructuring process is a challenging issue in Korea.

NOTES 1. Refer to the trend of Korean macro economic variables in the Appendix I. 2. The rate was 4.5% in January 1998 (0.93 million). As restructuring continues, it is expected to reach 8.2% by the year-end and 10% in early 1999. 3. The IMF's bailout program settled in December 1997 required a 2% GDP growth and 5% inflation rate in 1998, which proved to be too optimistic.

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4. For corporate sector, refer to Appendix lI. 5. Terms of Trade are calculated by dividing the export price index by the import price index and multiplying the result by 100. 6. Real exchange rate is calculated as the multiple of the nominal exchange rate and the CPI of the foreign country, divided by the CPI of Korea. It is normalized so that the real exchange rate in December 1993 is equal to 100. 7. A new definition of total external liabilities agreed by the Korean government and the IMF adds the offshore borrowing of Korean banks and their overseas branches and subsidiaries to the external debt as defined by the World Bank. 8. The most recent attempt was the proposal made by the Presidential Commission for Financial Reform (PCFR). Recognizing the urgency of the financial reform, the government established the 31-member PCFR in January 1997 to prepare a comprehensive set of reform measures to overhaul the financial system. Most of the Commission's recommendations were enacted into the 13 financial reform bills only on December 29, 1997, after the IMF Letter of Intent required it, which was too late to prevent the financial crisis. 9. So far, the IMF only has provided a total of US$18 billion out of the promised US$ 21 billion after the 7th reimbursement of US$1 billion on Sept.2. If we look at the period of Jan.-Aug. 1988, a total of US$ 8.2 billion has been rendered: US$ 6.2 billion from IME 0.99 billion from IBRD and 1 billion from ADB. 10. A total of 134 banks of 32 countries accepted terms agreed in the New York negotiations in January 1998. The Korean National Assembly approved a government guarantee of $27.7 billion for this purpose, effective April 8. The roll-over ratio of maturing loans of $22.6 billion was 96.5%. 17.2% of the maturing loans were converted into 1-year maturity, 45% into 2 years, and 37.9% into 3 years. 11. The global bonds consist of US$1 billion of 5-year maturity and US$ 3 billion of 10-year maturity. The issuing rates were US TB rate + 345 b.p and US TB rate + 355 b.p. respectively. As of the end of September, the premium rate was 710 basis points. 12. This figure includes the US$ 1.99 billion export of gold collected through the unprecedented nationwide gold collection campaign. 13. In fact, the market situation in December 1997 left the government no choice but adopting it. 14. The ceilings on foreigner's stock ownership have changed from 26% to 50% on December 11, 1997, to 55% at the end of the same month, and is abolished completely in June 1998. The only exception is for public company stocks with aggregate ceiling of 30% and individual ceiling of 3%. On December 23, 1997, the aggregate foreign bond holding limit of 30% and the 10% limit on individual holdings were abolished. 15. This figure represents an actual decline in FDI flows by 18.7%, compared to the same period of 1997. 16. The regulatory and supervisory tools have been frequently used for governmentcontrolled resource allocations or even for corruptive and political reasons, rather than for the soundness of financial industry. 17. They include the Banking Supervisory Authority, the Securities Supervisory Board, Insurance Supervisory Board, and Non-bank Supervisory Board. 18. The Fund is composed of 6 accounts: Bank Account, Securities Company Account, Insurance Company Account (Insurance Company Account is divided into life and non-life insurance), Merchant Banks Account, Mutual Savings and Finance Company Account, and Credit Union Account.

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19. On November 26, 1998, the KAMC started its operation by purchasing the combined face total of 4.39 trillion won in non-performing loans at Korea First Bank and Seoul Bank at the discounted price of 2.91 trillion won. The average discount rate was set at 66.3%. Refer to the next section for details. 20. For non-bank institutions, there is a major shareholder who is typically one of

Chaebols. 21. Minority shareholders of Korea First Bank that went belly up last year successfully filed a derivative suit against two ex-presidents and two ex-directors of the bank for their misdeed, and the court fined them 40 billion won. 22. Press release of the MOFE on the 4th National Economic Council Meetings (04/14/1998). 23. Precautionary & Substandard are based on new standard. In addition, the asset size was adjusted by evaluating bond holdings on market value rather than book value and loans by subtracting the estimated loss (20% of Substandard+75% of Doubtful + 100% of Estimated Loss) from the book value. 24. The Committee's suggestion was 4 Approval, 2 Conditional Approval and 6 Disapproval. 25. According to the FSC, an 'Approval' rating leads to submission of detailed quarterly implementation plans, which will be monitored on an ongoing basis. A 'Conditional approval' requires a submission of implementation plans within one month. In the event of disapproval of an implementation plan a mandatory merger order or transfer of business order will be imposed. A 'Disapproval' leads to mandatory merger or transfer of business under a purchase & assumption arrangement. Banks identified as being conditionally approved or disapproved that on a voluntary basis pursue mergers with sound banks is exempt from mandatory exit. 26. To ensure the soundness of acquiring banks, only high-grade assets of the liquidated banks were transferred. Non-performing assets classified as 'substandard' or lower were excluded. Additional safeguard measures were taken to prevent inherent risks involved in P&As: • KDIC has covered for any shortfalls in net worth of transferred assets and liabilities; ° KAMC and KDIC are supporting the disposal of NPLs by the acquiring banks, and their recapitalization; • within a certain period after P&A transactions, the acquiring banks can exercise a put-back option by requesting KAMCO to purchase acquired assets if these are later found to be non-performing. 27. As of October 31, 1997, the outstanding non-performing loans of 30 merchant banks amounted to 3,898 billion won and the ratio of non-performing loans to total loans was 2.90%. The BIS ratios of suspended 10 banks were all negative. 28. The MOFE announced that the top priority was given the feasibility of achieving the BIS ratio of 4% by March 1998, 6% by June 1998, and 8% by June 1999. 29. 10 banks in Feb. 1998, 2 banks in April 1998, and 2 banks in July 1998. 30. Refer to Press release of the MOFE (02/26/1998). 31. The cumulative losses of Daehan and Hankuk, as of May 1998, were 1.6 and 0.9 trillion won respectively. A due diligence review was carried out during June 20 to July 15. 32. Refer to the press release of MOFE on the 6th national Economic Council Meetings(05/20/1998). 33. In the new announcement, the numbers as of March 1998 are different from those in Table III.4. Bad loans are 59.6 trillion won instead 68 and precautionary loans are 57.7 instead of 50. No explanation for the differences was however provided.

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34. Examples of the rehabilitation efforts include cost reduction such as layoffs and branch network downsizing and recapitalization efforts through major shareholder or foreign investment. Those of loss sharing include writing down existing equity and forcing management to take responsibility for their misdeeds. In the process, the depositors took little loss. 35. Refer to Press release of MOFE(05/20/1998). 36. At an exchange rate of 1,350 won/US$, 1997 GDP is US$ 211.8 billion. 37. It is known that the ratios of restructuring cost w.r.t. GDP are 6% of U.S.A. (1991-1995), 4.7% of Sweden (91-93), 8.3% of Finland (91-93), 4.3% of Japan (estimated after 98). 38. In fact, in early September, KAMC sold to Goldman Sachs approximately 255 billion won (in book value terms) of acquired NPLs, most of which were uncollateralized. The sale of these NPLs was made in the form of asset-backedsecurities (ABS). 39. Despite the highest NPL ratio, KangWon Bank got a Conditional Approval since a merger was announced with Hyundai Merchant Bank. Both are affiliated companies of Hyundai Group. 40. The loan classification standard has changed on July l, 1998: 'Substandard or lower' from longer than 6 month interest payments in arrears to longer than 3 months, and 'Precautionary' from 3-6 months to 1-3 months interest in arrears. 41. Refer to Shin & Hahm (1998) for this argument. 42. Facing worsening macro economic situation and credit crunch, the government announced an economic stimulus package on September 2, which aims at boosting consumption through money increase and interest rate reduction. The package can be understood as a policy priority shift from a painful fundamental reform to real sector revitalization by announcing recapitalization of all banks up to a BIS ratio of 10% with fiscal resources. It implies no more bank closures.

REFERENCES Agenor, E, McDermott, J., & Ucer, M. (1997). Fiscal Imbalance, Capital Inflows, and the Real Exchange Rate: The Case of Turkey. European Economic Review, 41,819-825. Bank of Korea (1998). Foreign Currency Statistics Yearbook. Bank of Korea. National Income, Balance of Payment, various issues. Bank of Korea. Bank Statistic. Bank of Korea. National Income, Balance of Payment, various issues. Bank of Korea. Various press releases (www.bok.or.kr). Calvo, G., & Mendoza, E. (1996). Mexico's Balance-of-PaymentsCrisis: A Chronicle of a Death Foretold. Journal of International Economics, 41,235-264. Corsetti, G. Pesenti, E, & Roubini, N. (1998). What Caused the Asian Currency and Financial Crisis?. NYU Stern School Internet Site, (March). Eaquivel, G., & Larrain, E (1998). Explaining Currency Crises. NYU Stern School Internet Site, (June). Financial SupervisoryCommission(FSC) of Korea. Various press releases (www.fsb.or.kr). Frankel, J., & Rose, A. (1996). Curency Crashes in Emerging Markets: An Empirical Treatment. Journal of International Economics, 41,351-366.

Goldstein, M. (1998). Early WarningIndicators and the Asian Financial Crisis, mimeo.

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Im, J. (1998). Management of Financial Crisis in the Post-Crisis Period, mimeo. Korea Institute of Finance. Kaminsky, G., & Reinhart, C. (1997). The Twin Crises: The Causes of Banking and Balance-ofPayments. Problems. International Finance Discussion Paper, NO.544, Board of Governors of the Federal Reserve System. Korea Institute of Finance (1998). Current Developments in the Korean Financial and Labor Markets, May 20. Korea Stock Exchange (1998). Equity Bulletin. Krugman, P. (1979). A Model of Balance of Payments Crises. Journal of Money, Credit and Banking, 11, 311-325. Krugman, E (1998). What Happened to Asia? NYU (Stern School) lnternet Site, January. Lee, J. (1998). Korean Currency Crisis. Crisis in Asia: Differences and Similarities, The SJE-KIF International Symposium, Seoul, Korea, August 21. Lee, S. (1997). The Financial Crisis in Korea, mimeo. Yale University, December 1997. Ministry of Finance and Economy (MOFE) of Korea. Various press releases (www.mofe.or.kr). Obstfeld, M. (1986). Rational and Self-fulfilling Balance-of-Payments Crises. American Economic Review, 76, 72-81. Obstfeld, M. (1994). The Logic of Currency Crises. Journal of Evolutiona~ Economics, 43, 115-213. Park, W. (1998). The Causes and Predictability of Currency Crisis in Korea, mimeo. Korea Institute of Finance, April 1998 (in Korean). Park, D., & Rhee, C. (1998). Currency Crisis in Korea: Could B Have Been Avoided?. Park, Y. (1998). Financial Crisis and Macroeconomic Adjustments in Korea, 1997-1998, Financial Liberalization and Opening in East Asia, Korea Institute of Finance, March. Radelet, S., & Sachs, J. (1998). The Onset of the East Asian Financial Crisis. NYU Stern School Internet Site, March. Rhee, Y., & Lee, J. (1998). Was the Currency Crisis in Korea Predictable?, mimeo, February (in Korean). Sachs, J., Tornell, A., & Velasco, A. (1996). The Collapse of the Mexican Peso: Sudden Death or Death Foretold. Journal of International Economics, 41,265-283. Shin, I., & Hahm, J. (1998). The Korean Crisis: Causes and Resolution, Korea Development Institute. Presented at the East-West Center/KDI Conference on Korean Crisis, July 28.

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APPENDIX I T R E N D IN E C O N O M I C INDICATORS IN K O R E A 1996 GDP (trillion won) G D P Growth (%) Consumption (%)

Investment(%) Unemployment Rate (%) Current Account (US$b) Foreign Debt (US$b) FX Usable Res. (US$b) M2 Growth (%)

CPI (%) 3-yr Corp.Bond Rate (%) KOSPI(1980=100) Won/US$

Defaulted Bill Rate (%)

1997

Jan. 98

389.8 420.9 -7.1 5.5 -6.9 3.5 -7.1 -3.5 -2.0 2.6 4,5 -23.1 -8.2 3.1 157.5 154.4 151,3 29.4 8.9 12,4 15.8 14.1 15.4 4.9 4.5 8.3 12.6 24.3 23.4 833.4 654.5 475.2 839 1,484 1,706 0.17 0.52 0.72

Feb

Mar

Apr

May

-62.6 ----3.9 ----9.7 ----23.0 --5.9 6.5 6.7 6.9 4.1 3.6 3.6 4.1 150.3 151.3 155.2 155.0 18.5 24.2 30.8 34.4 14.6 12.1 12.9 18.3 9.5 9.0 8.8 8.2 20.0 18.7 18.0 17.0 525.2 523.0 444.0 356.3 1,623 1,505 1,391 1,394 0.83 0.62 0.57 0.62

June

July

Aug

66.0 -6.6 ---12.2 ---29.8 --7.0 7.6 7.4 3.2 3.7 2.3 153.8 152.3 150.8 37.0 39.2 41.4 16.3 21.1 20.9 7.5 7.3 6.9 16.1 13.2 11.9 313.3 327.8 312.8 1,397 1,227 1,351 0.58 0.69 0.55

A P P E N D I X II PROGRESS IN CORPORATE, LABOR, PUBLIC SECTOR RESTRUCTURING [ 1 ] Corporate Sector Restructuring 1. Basic Principles Restructuring of the corporate sector was launched following the January 13 agreement between then-president-elect Kim and heads of Chaebol, which set forth five key goals: • Enhancement of transparency of corporate management. • Dismantling of cross guarantees among corporations. • Significant improvement of capital structure. • Singling out core businesses and strengthening cooperative relationship with SME. • Enhancement of accountability of controlling shareholders and management. To effectively pursue the goals, implementation principles were developed; Corporate restructuring will be driven by creditor financial institutions; The work

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out concept will be at the center of the overall process; Non-viable firms will be subject to exit; Develop a scheme to provide full support to sound SMEs

2. Progress to date 1. Capital Structure Improvement and Business Restructuring Creditor banks have been assessing the viability of their client firms, and are taking necessary actions to apply workout programs or to force the exit of insolvent firms. Exit of Non-Viable Firms In May, creditor banks established a formal review committee to assess the viability of 313 client firms showing signs of financial weakness. Upon the completion of their evaluation, creditor banks classified 55 corporations as nonviable. Out of those classified as non-viable, 52 corporations are affiliated with Korea's top 64 business groups. Specifically, 20 of the 52 are affiliated with the 5 largest business groups. The remaining 3 corporations do not have any affiliation with business groups. The outstanding loan amount of the 55 nonviable corporations totaled approximately 5 trillion won. To facilitate the exit of those non-viable corporations, no new credit has been extended by their banks, and financial assistance across affiliate companies for the purpose of bailout has been disallowed.

Corporate Workout Programs Workouts are a more effective means for corporate restructuring than legal proceedings, such as court receivership or composition proceedings, in that historically, these practices have not met with much success in Korea due to lack of expertise and a proper institutional framework. In February, legal procedures pertaining to corporate rehabilitation and bankruptcy filing were simplified so as to facilitate rulings on the exit of nonviable firms and to ensure better representation of creditor banks in the resolution process. In effect, the improved procedures reduced what had previously been legalistic exit barriers. Workout programs will be applied only to those viable firms that have voluntarily entered into negotiations with creditor banks. It is expected that the process of negotiation and the actual make-up of the plans will be completed by the end of this year. The FSC will monitor the proceedings from a prudential regulation standpoint. A portion of the Technical Assistance Loan (TAL) of US$ 33 million, provided by the IBRD, will be used to employ outside experts as advisors not only for the design of corporate workout programs but their implementation as well.

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Workout Programs for Large Corporations. At present, more than 200 financial institutions have signed the 'Corporate Restructuring Agreement' to carry out corporate workouts with the top 6-64 business conglomerates, known as chaebols. Also, workouts are being applied to non-chaebol corporations, identified as financially weak but viable by their creditors. Currently, creditor banks are evaluating the financial status of 35 subsidiaries of 13 chaebols, and 16 non-chaebol corporations that have been selected as possible workout candidates . Upon the completion of the evaluation, creditor banks and the corporations will devise detailed workout programs, including debt-equity swaps and debt rescheduling, based on the rehabilitation plans submitted by corporations. Workout Programs for Small and Medium Enterprises (SME). The scope of corporate workout programs is being expanded to include SMEs. Creditor banks have evaluated the financial status of approximately 22,000 SMEs with outstanding loans of 1 billion won or more, and classified about 13,000 of these as viable. These viable SMEs were selected as candidate firms for workout programs. A special task force unit within each bank is reviewing the feasibility of rehabilitation plans and will soon devise specific measures and schedules for workout programs. Business Restructuring of Chaebols Most important in Korea's corporate sector restructuring is the large-scale reform of the five largest chaebols, given the preponderance of their market share and economic influence. Their restructuring should involve not only capital structure improvement but also business restructuring. The five largest chaebols and their creditor banks have already reached an agreement on debt reduction and other restructuring measures based on the agenda for chaebol reform announced early this year. Recently, the government and the top five chaebol leaders announced a framework for mergers and business swaps, referred to as 'big deals'. The big deals represent an expedient way for corporations to focus on their core competencies,, reduce over-capacity in key industries, reduce overlapping investments, and create management efficiencies. To date, 10 industries have been identified as having the highest levels of over-capacity in terms of excess or duplicate investments. Current discussions on the big deals are focusing on seven of these industries: semi-conductors, petrochemicals, automobiles, aerospace, train car manufacturing, power plant equipment/vessel engines, and oil refining. The discussion stage will be followed up with a concrete outlining of particulars related to actual

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Big Deal Plan among the Top Five Chaebol (as of September 1998) Contents

Details & Pending Problems

• Hyundai & LG

° Joint venture with ownership Structure under discussion • Consortium with foreign partner • Samsung + Hyundai, Petrochemicals • To be discussed • SK+LG • Hyundai + Daewoo + Samsung • To be discussed after Kia auction Automobiles • Samsung + Daewoo + Hyundai • Consortium with equal share Aircraft • Consortium with foreign partner • Hyundai + Daewoo + Hanjin Railroad Cars • Under discussion Power Plant Facilities • Hyundai+ Samsung + -Consortium of Hyundai & Korea • Korea Heavy & Ship Engines -Korea to take over Samsung • Hyundai to take over Hanwha Oil Refinery • Hyundai + Hanwha

implementation, which is expected to take place by the end o f this year, if not earlier. The chaebols involved in big deal discussions have requested extensive tax benefits and financial support, such as debt-to-equity swaps, debt restructuring and lower interest rates. The government has already prepared a revised tax bill, which will eliminate major tax-related hurdles. Discussions with respect to financial support have yet to conclude, but it is certain that creditor banks will only provide support conditional upon strong rehabilitation measures taken in line with market principles and international standards. Just as is the case with the workout programs for other firms, any financial support for business restructuring o f the 5 largest chaebols will be devoid o f moral hazard. The F S C will monitor all proceedings from the prudential regulation standpoint. One remaining concern with the big deals is the potential that they m a y result in concentrations of power and subsequent unfair business practices, such as monopolies, or other similar price-fixing vehicles, etc. For this reason, the Fair Trade C o m m i s s i o n will strengthen its market monitoring and investigation o f any potential unfair trade practices.

2. Improving Standards in Corporate Governance Transparency and accountability in corporate governance are being facilitated by the following measures.

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Table 13. Tasks Transparency

• • • • • Cross Debt • Guarantee • Capital Structure • • Business Activities • • • • Accountability • • •

A g e n d a for Reform Measures

Adoption of Combined Financial Statements International Accounting Principles Strengthening Voting Rights of minority shareholders Appointment of outside directors for listed companies External auditors committee No new cross debt guarantee between subsidiaries Resolution of existing cross guarantee Agreement with creditor banks to reduce debt ratio Exclusion of tax shield on excessive borrowings Adoption of corporate-split system Liberalizing foreign ownership of real estate Full liberalization of M&A Streamlining bankruptcy procedures Strengthening legal liability of controlling owners Introduction of cumulative voting system Allowing voting rights of institutional investors

Time Schedule To be in 1999 Oct. 1998 May 1998 Feb 1998 Feb 1998 April 1998 April 1998 April 1998 In 2000 June 1998 June 1998 May 1998 Feb 1998 June 1998 Oct 1998 June 1998

These new standards are and will continue to be strictly enforced. A recent case in point is the penalty i m p o s e d by the Fair Trade C o m m i s s i o n on chaebol subsidiaries found to be involved in insider trading. Indeed, measures for improving standards in corporate governance are already inducing greater transparency in business practices and a generally more open corporate culture. Recently, a court ruling was handed down in favor o f minority shareholders in a suit against the m a n a g e m e n t o f the Korea First Bank. The executives were held responsible for lending money in defiance o f the shareholders' objections. This unprecedented ruling is expected to open the door for other small shareholders of corporations under financial difficulties to follow suit. [2] Labor Market Reform Enforcement o f New L a b o r Standards: L a b o r market flexibility was legally instituted with the revised L a b o r Standard Act passed in February, which allowed layoffs due to managerial difficulties. The resolution of the Hyundai M o t o r strike in September represents a test case with respect to the new Labor Standard Act, in that it was the first application o f the law at a large industrial plant.

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Although the employment adjustment at Hyundai did not proceed as smoothly as hoped, for Korea it represents a significant first step away from the conventional practice of providing life-time employment. Despite the prolonged strikes and the difficulty the two sides had in reaching an agreement, Hyundai was able to achieve its targeted employment adjustment by layoffs, unpaid leave, and early retirement. Yet there is still room for further improvement in business-labor relations and corporate culture. For this reason, the Tripartite Commission is drawing lessons from the recent settlement of the Hyundai strike, and will devise measures for enhancing a new business-labor culture. Any layoffs in Korea are critical at this time given that the government has only recently begun work on its plan to expand the social safety net for displaced workers. Once unemployment benefits are more commensurate with the recent increase in need, labor management conflicts are likely to ease. [3] Public Sector Reform Public sector reform is urgent for two related reasons. First, productivity in the public sector, including state owned enterprises (SOEs), has been far from exemplary, and hence, mandates immediate betterment. Second, the public sector must show itself to be a leading model of efficiency, given that it is the government that is both coordinating and promoting reform in the private sector.

Government Reform. In order to build a small but efficient government, the central government streamlined and reoriented its organizational structure in February with strategic employment cuts. It plans to further reduce its employment by 11% (approximately 17,600 employees) by the end of the year 2000. Local governments will also consolidate their organizations and labor force. At present, related rules and regulations are being revised in order to achieve a targeted employment cut of 12-13% (approximately 35,000 local government employees in total). In conjunction with government reform, the quasi-government sector, including public institutions and various associations, will be streamlined. Reform of State Owned Enterprises (SOEs). The Korean government has decided to overhaul SOEs by either privatizing them or enforcing drastic management reform, depending on their business orientation. The more commercially-oriented SOEs will be privatized. Out of 24 non-financial SOEs (mother companies), 5 SOEs will be privatized immediately within this year, and 6 SOEs gradually by the year 2002, while the

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remaining SOEs are targeted for managerial reform and consolidation. The 82 subsidiaries of these 24 mother companies will also be subject to privatization or management reform: The future status of 27 subsidiaries of those SOEs to be immediately privatized will be determined by the new private management; Among the remaining 55 subsidiaries, 40 will be privatized immediately or gradually, while 15 will undergo restructuring or be consolidated.

THE ASIAN FIVE: FROM FINANCIAL CRISIS TO ECONOMIC RECOVERY M. Faizul Islam ABSTRACT The financial crisis erupted when Thailand delinked its baht to the dollar on July 2, 1997. The contagion affected Malaysia, South Korea, Thailand and the Philippines subsequently. These countries slid into recession in 1998. The crisis also exposed the weaknesses that were inherent in their economies. The International Monetary Fund rushed to rescue them financially in exchange for reforms. Thanks to the reforms that were taking place, all countries except Indonesia pulled out of recession by 1999.

1. INTRODUCTION The financial crisis in the Asian Five (Indonesia, Malaysia, Philippines, South Korea and Thailand) was triggered on July 2, 1997 when the government of Thailand announced that it was abandoning the baht's peg to the U.S. dollar. Instantaneously, the baht fell 15% against the dollar. This unprecedented action ignited the regional financial crisis. The currencies and stock markets of the Asian Five tumbled in tandem. Immediately preceding the crisis, economic conditions apparently appeared to be strong. All of a sudden, the financial meltdown took place. According to the Washington-based Institute of International Finance April 1998 Report, investors lost $80 to $100 billion in equities in the second half of 1997. The Asian Five slid into recession in 1998. A year later, the Asian Five excluding Asian Financial Crisis, Volume 1, pages 123-146. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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Indonesia had been experiencing a positive economic growth. This unexpected U-turn had caught even the optimists by surprise. Increased attention had been drawn by policy-makers, investors, academia, international agencies and others to examine the causes of the financial crisis, the road to economic recovery and the lessons learnt from erstwhile 'Asian Tigers'. The objective of this chapter is to analyze the causes of the financial crisis and assess their march towards recovery. The rest of the chapter is as follows. Section 2 analyzes the causes of the crisis. Country analysis is presented in Section 3. Section 4 concludes the chapter.

2. THE BACKGROUND OF THE CRISIS 1. Mismanaged Exchange Rate Policy Over the past decade, Thailand, the Philippines, Indonesia and Malaysia linked their currencies to the U.S. dollar for currency stability. Their choice or decision to link their currencies to the dollar was not irrational. However, once the choice was made, they failed to follow the consistent rules and policies. They intervened to tamper with the inherent adjustment process. We know from exchange rate economics that a currency can have either a fixed or flexible exchange rate. Each system has its merits and demerits. Under a flexible system, the money supply is exogenous whereas in the fixed, it is not. That is, if a country chooses a flexible exchange rate, any balance of payments adjustment takes place through changes in the exchange rate. In this case, the central bank retains control over the monetary policy. With a fixed exchange rate, money supply automatically adjusts to changes in international reserves. In other words, money supply becomes endogenous. Its monetary policy works like an auto-pilot, emasculating the central bank or politicians of any authority. As such, at times the central bank may be tempted to intervene in the market to thwart the effects of external imbalances through sterilization. Such an interventionist policy does more harm than good. This is exactly what their central banks did. As a result of their dollardenominated currencies, there had been an increased capital inflows freed of exchange-rate risk. In turn, they ran balance-of-payments surpluses. This created too much liquidity and credit resulting in an equity and real estate bubble, higher growth and fear of inflation. The central banks intervened and started issuing debt to sterilize the excess liquidity. This futile sterilization pursuit was finally abandoned with the delinking of the baht in early July 1997. The contagion affected the rest of the Asian Five.

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2. Lax Banking Rules

The banking crisis has been aggravated by the failure of regulators to supervise lenders properly and safeguarding the integrity of the financial system. The regulatory environment under which the financial institutions operated was weak. Poor banking standards resulted in overinvestment in some industries (ex. real-estate in Thailand, physical infrastructure in Malaysia, tradeables in South Korea). Some of the banking irregularities were as follows: (I) Money was lent on the basis of collateral whose value plummeted instead of cash-flow basis generated by projects they financed. (2) Loans were made at a slight premium over what U.S. government bonds paid. (3) The standard capitalreserve was not maintained. The Basel-based Bank for International Settlements prescribes under a risk-weighted capital structure, an adequacy ratio of at least 8%. (4) Long-term projects were financed out of short-term debt. Bankruptcy laws were either obsolete (ex. Indonesia), non-existent (Thailand) or unforceable (ex. Philippines). Whatever bankruptcy law existed, it was totally different from that of other countries. For example, when an American company is unable to pay its debt, its creditors force it into bankruptcy. The bankruptcy judge draws a payment plan or liquidates the firm and divides the assets. On the contrary, the creditors in these troubled economies were the losers. In Indonesia, it was almost impossible to force a debtor into bankruptcy. In South Korea, filing bankruptcy papers was easy. The decision-making was time consuming. Although the commercial banks in South Korea were privatized in the 1980s, the management were selected by the government who were driven by political pressure and not shareholders' interests. 3. Globalization of Financial Markets

The financial markets were getting highly integrated in the 1990s. Realizing that the returns in the mature economies had already peaked, foreign investors went on a buying frenzy in search of higher returns in the Asian Five. They disregarded the concomitant potential risks. As long as it was an Asian company, the stock was bought. Eventually, their investment went bust. As soon as they became disappointed with the returns, they exited the market. Any economy is certainly impacted through financial integration. It multiplies the benefits of good policies and institutions on the economy or inflicts huge costs because of bad policies and weak institutions.

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4. Corruption Corruption was rampant too. The level of corruption is directly related to the degree of government size and intervention. As long as government continued to enjoy discretionary powers in the economy and the liberalization process, bribery was prevalent. When a bribe was given, it increased the transaction cost and subsequently raised the price of a good. The problem arose when the bribe became unpredictable. In the end, prices became distorted which could not be relied to serve as a signaling mechanism in the economy. Berlin-based Transparency International (TI) in its annual publication ranks several countries on the basis of corruption. In its 1997 report, it ranked Indonesia 7th, Philippines 13th, Thailand 14th, South Korea 19th and Malaysia 21st as most corrupt out of 52 countries surveyed. It is the conviction of TI that corruption stops development in countries where it is present. In South Korea, two former presidents and several business tycoons were jailed or fined for graft. Beginning in 1997, the Korean government was embroiled in a bribe-for-loans scandal. Former Philippines President Ramos came under severe attack in 1997 when his critics claimed that his party and government officials received kickbacks from a $2.3 billion Manila Bay landdevelopment project. In Malaysia and Indonesia free press did not exist. Political parties UMNO and GOLKAR have ruled Malaysia and Indonesia respectively for many years. Few high-level corruption cases reached courts or ever get convictions in these two countries. In the Asian Five, the politicians and bureaucrats used state-controlled banks to channel money to friends, families and entrepreneurs who had close ties with them. The beneficiaries reciprocated by campaign contributions and personal gratuities. Capital was allocated not to those who deserved it, rather who were in a position to demand it. Markets did not play a major role in allocating resources. For instance, it was widely believed that Hanko, South Korea's 14th largest conglomerate got special treatment for assisting to bankroll the 1992 election campaign of then President Kim Young Sam. Hanko received special favors from the government to build a massive new steel mill. Hanko's founder Chung Soo allegedly bribed legislators and bankers to fund the project. He borrowed a hefty $6 billion which ultimately pushed the company into bankruptcy. Politicians used tax money to finance mega public projects and physical infrastructures. Businesses speculated in real estate investment and built enormous overcapacity in automobiles, computers, steel, textiles and electronics. The infusion of billions of dollars into a corrupt crony-capitalist system was partly responsible for the economic turmoil.

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5. Regulated Economies

Given their colonial past, the Asian Five economies still remain insulated and regulated - of command and control. The Heritage Foundation and the Wall Street Journal publish annually an Index of Economic Freedom. They rank each nation on the basis of 10 key areas: trade policy, taxation, government intervention, monetary policy, capital flows and foreign investment, banking policy, wage and price controls, property rights, regulation and black market activity. In its 1998 index, South Korea ranked 24th, Thailand and Malaysia 28th, Philippines 44th and Indonesia 62nd out of 154 countries. Not that there were walls between nations, but walls existed within. In South Korea, a handful of companies or chaebol control 50% of Gross Domestic Product (GDP). They operate under a centralized and bureaucratic leadership. Businessmen in South Korea complained that they are required to get as many as 2000 government seals of approval before starting a new business enterprise. For more than three decades, the Indonesian economy has been largely controlled by then-President Suharto's family, close associates and political party. Despite IMF's request to diminish the dominant influence of friends and families in the economy, President Suharto following his (short-term) victory as the head of state for the seventh term, appointed his family members and close acquaintances to key positions in the new cabinet.~ He vowed to back a controversial national car project owned by his son and a state-owned jet company. In Thailand, there was a very close relationship between the Bank of Thailand and the powerful cartel formed by the big five commercial banks. Many senior officials at the central bank and commercial banks switched positions back and forth. The Asian Five has shown aversion to foreign investment, ownership or participation. For example, South Korea companies have invested roughly twice ($13.4 billion) abroad as foreigners in South Korea ($6.9 billion) in 1996. 2 Given their monopoly-type economies, the businesses in the Asian Five operate within the fortress erected by tariff walls. The combination of protected home markets, state enterprises, government-directed financing and subsidies resulted in a glut from computers to ships. The Asian Five economies had not only failed to reap the maximum benefits of a fully unrestricted market system but faced the enormous costs of avoiding it. The regulated economies which had been rigid in structure remained indifferent in adjusting to the rapidly changing global environment.

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3. COUNTRY ANALYSIS This section examines the pre-crisis economic conditions in each of the Asian Five. It also traces the reforms and economic developments taking place in each individual country since the crisis erupted.

Thailand Thailand was the first country where the financial crisis surfaced. On July 2, 1997 the Bank of Thailand allowed the baht to float freely. The baht fell 15% against the dollar within days. Thailand pegged its currency to the dollar at a time when its current account deficits were increasing. Pegging the currency resulted in a huge influx of foreign money. People borrowed cheap U.S. dollars in exchange for the expensive baht. Money was cheap and plentiful. During the heyday of 1993, Thai firms issued convertible bonds. Investors seized the opportunity of buying shares at bargain prices. Due to the easy availability of credit, political patronage and fledgling financial sector, money was used to build commercial and residential real estates (luxurious condominiums) instead of investing in physical and human capital. The speculative increase in the property and equity values precipitated the financial sector meltdown. The government ran down reserves unsuccessfully to defend the value of the baht.

IMF Rescue Package On August 21, 1997, the IMF and other Asian donors approved $17.2 billion for Thailand to pay for the financial sector debt, shore up reserves and stabilize the baht. The IMF stipulated that the government: • Raise excise taxes in order to create a budget surplus of 1% of GDP. • Declare bad loans as non-performing after 6 months instead of 12. • Allow foreigners to own majority shares in financial institutions for at least 10 years. • Set up New Financial Sector Restructuring Agency (FRA) by royal decree. • Increase capital requirements from 8.5% to 12% for all financial institutions. • Audit standards as a condition for reopening. • Set up asset-management company to dispose of non-performing assets. • Bank of Thailand (BoT) suspend infusion of liquidity to the ailing financial institutions and disclose the size of the reserves every two weeks. BoT was further denied of easy monetary policy.

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Short-term corporate foreign debt was $67.3 billion at the end of December 1997. Since the crisis, it was clear that increased foreign participation, bank recapitalization and effective corporate restructuring were essential to an economic recovery. To begin with, the government set up the FRA modeled on the U.S. Resolution Trust Corporation to liquidate the assets (cars, property, furniture) of 58 insolvent finance companies. The government eased regulations allowing foreign control in banking, financial, real estate ownership and manufacturing sectors. In response to IMF's requirements, Thailand began to formulate a legal procedure for bankruptcy. A year later after the crisis occurred, the government formulated a reform package to revitalize financial institutions and inject money into the cashstarved economy. Instead of nationalizing big banks that have failed to raise new capital, the plan would recapitalize them through an exchange of securities. Thus, the government issued as much as 300 million baht ($7.18 billion) in government bonds in exchange for preferred shares or subordinated bonds issued by the banks. The banks had to issue payments for their shares and bonds in excess of 1% than the interest on government bonds. This plan called for a reduction in the number of commercial banks from 15 to 12, closure of five more insolvent companies and protection of depositors and creditors. Out of 91 ailing finance companies, FRA closed 58 of them in 1998. Following the passage of bankruptcy and foreclosure laws in early 1999, the FRA liquidated the remaining 58 bust companies. Six banks have been nationalized for merger and sale. Four state banks are to be sold by the end of 1999 to the highest bidders. The new law is expected to streamline the bankruptcy procedures, facilitating creditors to dispose of bad loans. Responding to critics about the nature and the impact of its rescue packages, the IMF toned down some of its prescriptions for Asia's troubled economies) In 1999, Thailand was allowed a budget deficit equal to 6% of GDP and a relaxed tax policy. The Thai government expects that its 1999 stimulus package of 130 billion baht ($3.5 billion) would further boost the economy. Following the crisis, interest rates had to be raised to fight inflation and prop the value of the baht. Short-term interest rate was around 17% before the crisis. It peaked above 20% and has fallen to 3% in September 1999. Inflation which rose after the crisis has receded too. Thailand has built up a sizeable trade surplus with the world. This was the result of a reduction in imports and an increase in exports. A surplus in Thai's trade balance has also boosted reserves. At the depth of the crisis, reserves fell to nearly zero from $25 billion. In August 1999, Thailand had a $32 billion in foreign reserves. With trade balance

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- -

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.

50

.

40

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2O 0

1994

1995

1996

1997

1998

60

1999

Source: IMF

Fig. 1. International Trade.

in surplus (Fig. 1), soaring reserves and subdued inflation, the baht has appreciated about 31% vis-a-vis the U.S. dollar (in nominal terms) since bottoming out in early 1998, (Fig. 2). Improvements in economic fundamentals have lifted the Thai's stock market from its trough. However, the market was still below its pre-crisis level by 20%

(U.S. D o l l a r p e r Baht, N o m i n a l ) 0.045

0.04 0.035 0.03 0.025 0.02 0.015 . . . . . . . . . . . . ~,, J 1994 1995

i

1996

1997

Source: IMF

Fig. 2. Thai Baht.

1998

1

I

1999

The Asian Five: From Financial Crisis to Economic Recovery

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in September 1999. The Standard & Poor Ratings services has revised its ratings of Thai securities from negative to stable in July 1999. The economy is expected to grow 4% in 1999 after shrinking 9.4% in 1998. In sum, the national elections in late 1997 provided the new reform-minded Premier Leepkai an excellent opportunity to take bold, necessary and unpleasant measures to revive the country's economy and restructure the financial industry. Many foreign investors are making their presence in Thailand's financial, retail, automobile and cement industry. The economy which is now out of recession, so far has been driven by domestic demand and renewed growth in exports. It appears that the government is relying on a relatively weak baht to boost exports. Non-performing loans still account for 46% of the total lending in the financial system. Continued efforts are required to restructure thousands of struggling companies and the debt overhang. Few completed deals have mostly involved deferred payments rather than debt-for-equity swaps. Business recovery hinges on renewed access to traditional sources of capital. Malaysia

Pressured by the Thai baht, Malaysia delinked their dollar-denominated currency on July 14, 1997. The ringgit fell 2% to 2.55 against the dollar. For several days earlier, Malaysia's central bank, Bank Negara bought $1 billion in vain to defend its currency. There was a surge in real estate values and investment in mega-projects diverting money away from manufacturing. Malaysia was also having currentaccount deficits problems. Sensing opportunities to make profits, currency traders 'sold short' on the ringgit. Prime Minister Mahathir Mohamad accused currency traders of undermining the ringgit. On August 2, 1997 Bank Negara banned 'short selling'. His constant barrage against the currency speculators simply made the matter worse. He later on lifted the ban on short-selling. His policy gyrations confused foreign investors even more. An expansionary budget was presented in October 1997. It was possible because she had a budget surplus. During the 1990s, the economy was domestic demand-driven. She spent billions of dollars in physical infrastructures. Immediately after the crisis, investments on mega-projects were put on hold. Because of dwindling reserves, Bank Negara was not in a position to defend the currency through buy backs, rather allowed interest rates to rise to do the job.

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M. FAIZUL ISLAM

Recognizing that the economy was slowing down from 8% in 1997, the central bank eased monetary policy by lowering the reserve requirement from 13% to 10% thereby injecting 14 billion ringgit into the banking system in early 1998. Because of relatively little foreign debt, Malaysia tried to remedy the problem without external assistance. Since the crisis began, Primier Mahathir opposed IMF-style reforms because he believed, it would make the situation even worse. Malaysia's financial problems were not as severe as Thailand, because the former had a reasonably efficient regulatory system and a relatively independent central bank. The Bank Negara had an early warning system to identify any potential problem. Once detected, it tried to assist the potentially troubled institution. Despite deregulation and liberalization of the financial sector, its expansion remained relatively conservative. No new bank license has been issued since 1980s, The capital ratio was well above 8% - the highest in Southeast Asia. In a very unusual move in March 1998, the government took over the management of Halim Securities-a troubled stock brokerage, and gave eight others to act up. This action reflected the government's determination of restructuring the battered brokerage industry. On September 1, 1998, to stem excessive capital outflow, Malaysia imposed currency controls - outlawing trade in the ringgit and imposing onerous curbs on foreign stock investors. The ringgit was also pegged to the U.S. dollar: 3.8 ringgit per U.S.$, (Fig. 3). The Mahathir government unveiled another expansionary budget in October 1998 to stimulate the economy. Monetary policy was also loosened by slashing interest rates and lowering the statutory reserve requirements. The default period for non-performing loans was extended from 3 to 6 months. Banks were directed to resume lending to stock and property markets. Two agencies Danamodal and Danaharta - were set up to shore up the banking industry. After contracting 7% in 1998, the Malaysian economy is expected to grow 2.4% in 1999. Malaysia's long-term openness to trade has made it easier to boost exports. She accumulated a surplus in trade by higher exports and reduced imports, (Fig. 4). Reserves have increased to $32 billion by July 1999. Inflation and interest rates are below their pre-crisis levels. The Kuala Lumpur Stock Exchange Index has risen from 350 in September 1998 to over 700 a year later. The stock market is still below the pre-crisis level of 1100. In August 1999, the stock market rallied when Morgan Stanley Capital International decided to reinstate in February 2000, the Malaysian market in its international index in response

133

The Asian Five: From Financial Crisis to Economic Recovery

(U.S. Dollar per Ringgit, Nominal) 0.45

0.35 0.3

0.25 0.2 .l,,i..i..,. ,t. 1994 1995

,J..l.,=,.i..I,.i,.l..J..L..i,.I..l..I..J..I,,I..J.

1996

1997

1998

1999

IMF

Source:

Fig. 3. Malaysian Ringgit.

to the government's decision to ease currency controls imposed in September 1998. With the help of the investment bank Solomon Smith Barney, the Malaysian government was able to raise $1 billion in the international bond market in May 1999.

(Merchandise,Billions of Ringgit) 28

24 20 16

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-

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12

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1994 Source:

1995 IMF

1996

1997

1998

Fig. 4. International Trade.

1999

134

M. FAIZUL ISLAM

Capital controls controversy A controversy has surfaced whether the controls on capital helped the economic recovery. The rationale for the government's imposition of capital controls was to stern the capital outflow, despite efforts at checking its flight through higher interest rates. Premier Mahathir believed that such selective exchange controls were undertaken to stop currency and stock market speculators from causing financial turmoil which had disrupted the Malaysian economy.4 Eminent economists like Robert Barro, Paul Krugman, Jeffrey Sachs and World Bank economist Joseph Stiglitz criticized IMF's policies in addressing the financial crisis. Economists Krugman, Barro and Jagwadish Bhagwati even supported some limited form of capital controls, from the devastating impact of investor stampedes when the country is under a financial siege. They believe that the IMF's policy of sterilized intervention coupled with high interest rates is worse than (temporary) capital controls. When the controls were placed in September 1998, the critics thought Malaysian defiance of economic orthodoxy would prove to be a blunder. The government was using it as a ploy to delay restructuring the financial sector. Controls would drive away foreign investors. A year later, given the economy's spectacular turnaround, the IMF conceded in its (September 1999) Annual Review of Malaysian economy that controls over capital have produced positive results. A consensus is building that imposing controls may be justified when there is a potential for risk. At least for now, the government has minimized the control's adverse impact on investors. Some observers think that good macroeconomic policies and significant progress in restructuring the financial sector were largely responsible in terms of economic recovery. If the controls remain in place for too long, the greater will be the likelihood of distorted exchange-rate and interest-rate levels resulting in an inefficient use of capital.

South Korea South Korea, the world's tenth largest economy, became the twenty-ninth member of the Organization for Economic Cooperation and Development in 1996. Several months later, the financial crisis erupted in South Korea. About half a dozen conglomerates (including Hanbo, Sammi) had collapsed. The merchant banks lent money to the already highly leveraged conglomerates. They also made huge, leveraged bets on risky bonds at times from short-term borrowing from abroad. The average South Korean company was leveraged four times its equity. The debt-to-equity ratio rose from 330% in 1996 to 450%

The Asian Five: From Financial Crisis to Economic Recovery

135

in 1997. Lack of market forces to determine efficient allocation of resources led to the creation of some conglomerates. South Korea experienced current-account deficits since 1990 (with a minor surplus of $1013 million in 1993). The deficit hit a record of $23.7 billion in 1996. Bad bank loans were estimated to be over $300 billion because of Korean's banks heavy exposure to troubled conglomerates. Problems of banking regulations existed which were similar to Thailand. Corporate debt stood at $470 billion in 1997. The culmination of all these financial troubles resulted in the won's depreciation. The long-term factors responsible for the crisis were that the South Korean economy remained protected and regulated and the governments were corrupt. IMF Rescue Package

In December 1997, the IMF agreed to provide South Korea with $55 billion to address the crisis. In return, South Korea had to: • Slash growth to 3% (down from the 1997's 6% growth rate) • Cap inflation at 5% (through raising interest rate) • Reduce current-account deficit to be equal to 1% of GDP (down from 1997's 3% level) • Produce a balanced budget by raising taxes and reducing spending The following measures had been undertaken since the crisis. • The amendment of the General Banking Law and the Financial Industry Act of 1997 raised foreign ownership to 100%. This amendment had: (1) made it easier for the acquisition of, and greater ownership in, domestic companies by foreigners, and (2) completely opened financial markets where even hostile takeovers are permitted. • The government had lowered the capital requirements for financial institutions setting up brokerage houses in South Korea from 300 billion won to 200 billion won. This was an effort to attract foreigners to invest in Korea. • To make business firms more transparent, the government required conglomerates to publish consolidated statements and reduce crosssubsidiary grantees. • In response to economic slump, chaebol reduced its workforce to make it more efficient. When IMF's help was sought in December 1997, many market observers thought the country would not recover. It was assumed that the government did

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M. FAIZULISLAM

(Merchandise, Billions of Dollars)

t5 (RHS) 14 .................................. 13~ 2H LS )(1 m ~ P ° ~ 12 11 10 9 8 7 ...................... 6 Balance

Source:

4 031 -1 -2 -3 -4 -5

IMF Fig. 5. internationalTrade.

not have the political will to introduce the necessary reforms. To utter surprise, South Korea's impressive economic turnaround took place by December 1998. Two years after the crisis, inflation and interest rates have fallen below precrisis levels. Foreign investment and trade surpluses are up (Fig. 5). Reserves have soared from its bottom of $20 billion in December 1997 to $65 billion in July 1999. Improvements in economic fundamentals and bargain hunting by (foreign) investors have pushed the stock market to rise above the pre-crisis level. By August 1999, the won has appreciated nearly 30% against the U.S. dollar (in nominal terms) since bottoming out in January 1998. In January 1999, two credit-rating agencies - Standard & Poor and Fitch IBCA - have raised South Korea's sovereign-debt rating to investment grade from the junk-bond category. The credit agencies pushed Korean debt into the junk-debt status when the debt crisis swept the country. South Korea began to pay off the IMF beginning in December 1998, and since mid-1999, the government has stopped borrowing the remainder of the funds. After a negative growth rate of 6% in 1998, the Korean economy is expected to grow 6.5% in 1999. How did the South Korean economy recover so quickly? It was due primarily to the newly elected President Kim Dae Jung in December 1997 who introduced and implemented the reforms from the outset. Chaebol and the labor unions who vehemently opposed those changes are surely but slowly yielding to President Jung's reform plans. As mentioned earlier, the

137

The Asian Five." From Financial Crisis to Economic Recovery

(UoS. Dollar per Won, Nominal) 0.0014

0.0012

0.001

0.0008

0.0006

0.0004

............... 1995 1994 Source:IMF

1996

1997

1998

1999

Fig. 6. Korean Won.

government took very bold and timely steps in restructuring the economy based on market principles and IMF-mandated prescriptions. 5 The economic growth has been partly fueled by deficit-financing which is expected to be about 5% to 6% of GDP in 1999. Record levels of foreign investment in 1998 and 1999, and higher exports have also aided in the economic recovery. Philippines

Philippines delinked peso from the U.S. dollar on July 11, 1997. As soon as this switch was announced, the peso fell 9.8% from 26.4 to the dollar to 29 per dollar. The earlier strength in the peso was the result of capital inflows - equity and physical investment and foreign remittances. The central bank, however, failed to recognize that the strong or at times overvalued peso was hurting exports. Oil accounted for 95% of overall imports. With earlier deregulation of the oil business, a weak peso and dollar-denominated oil price, the prices skyrocketed at the gas pumps. This had resulted in street protests. Also, the 'E1-Nino' phenomenon had hampered agricultural output in 1997. Unlike Thailand, the Philippines banking sector remained strong. Like Malaysia, the Philippines did not seek IMF's assistance. Had it not been for the natural calamities, the economy could have avoided a recession in 1998. Following the crisis, both inflation and interest rates shot up. Two years after the crisis, these economic variables have fallen to pre-crisis levels. As a result of lower imports and higher exports, the Philippines is having a trade surplus since mid-1998, (Fig. 7).

138

M. FAIZUL ISLAM (Merchandise, Billions of Dollars) 2 1.5

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1994

1995

1996

1997

1998

1999

-2

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Fig. 7. International Trade.

The economy continued to benefit from more than $6 billion in annual remittances from Philippinos abroad. Foreign reserves rose to $14 billion in August 1999, an all-time high. The peso has merely increased 8% against the U.S. dollar (in nominal terms) since bottoming out in early 1998, (Fig. 8). Because exports play an important role in the economy, a weak peso is good because it is likely to make Philippino goods more competitive. The economy is expected to grow 2.2% in 1999. (U.S. Dollar per Peso, N o m i n a l ) 0.045

0.04 0.035 0.03 0.025 0.02

1994

1995

1996

1997

Source: IMF

Fig. 8. Philippines Peso.

1998

1999

The Asian Five: From Financial Crisis to Economic Recovery

139

The Philippino economy has held up relatively well in the face of the regional economic crisis. The economic recovery is dependent on weather, exports and remittances from Philippinos working overseas. Indonesia

On July 8, 1997 the Jakarta stock index was at an all-time high of 740 reflecting Indonesia's sound economic fundamentals. The Thai's financial problem started to affect the Indonesia's rupiah. The central bank responded by raising the interest rate. The overnight loan rate was 20% and 49% for small banks. There was a flight out of equities. The stock market dropped and so did the value of rupiah precipitously. The rupiah was allowed to float on August 14, 1997. The central bank governor Djiwandono pursued 'moral suasion'. He invited and asked foreign and local bankers not to listen to rumors. When currency traders were 'short-selling', the central bank spent U.S.$500 million to defend the rupiah in vain. On September 3, 1997 the government announced a plan to respond to the crisis. It called for revising the budget, postponing spending on some capital projects, raising taxes on luxury import items, liquidate insolvent banks and increase foreign ownership. These announcements had a mild but temporary effect on the stock market. The rupiah declined continually. The fall in the value of the rupiah had made many unhedged loans much too expensive to repay. Lack of transparency in corporate financial affairs was compounding the problem. Corporate debt was estimated to be $70 billion in 1997. Bad loans were estimated to be over 70% of total loans. On October 8, 1997 Indonesia approached IMF for assistance. A $43 billion rescue plan was prepared for Indonesia. Indonesia rejected IMF's austerity measures of raising taxes and reducing expenditures (including slashing subsidies on staples). The people lost confidence in then President Suharto's ability to handle the crisis and the economy. The lack of action pushed the rupiah to fall to as low as 11000 to the dollar. Investors were selling rupiah to buy U.S. dollars at any price. Suharto's dismissal of key high-ranking central banks officials did not help in restoring confidence among the investors. A 50-point second letter of agreement was signed with the IMF in January 1998. It did not even restore the confidence on the rupiah. Prices of essentials were rising and the poor were the hardest hit. Social unrest became widespread. The pace of reform bogged down because of pending presidential election and Suharto's toying with the idea of currency-board. 6

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As expected, Suharto was elected president for a five seventh-year term on March 11, 1998. As before and much to IMF's chagrin, he appointed his friends and family members in the government. The government finally abandoned plans for a currency board in March 1998. In accordance with the IMF's plan, the government had agreed to divest 12 state-owned enterprises. The plywood cartel would be dismantled. Then cartel chairperson Bob Hasan stepped down. Fees levied on plywood exports had been removed. With foreign exchange reserves nearly depleted, some Indonesian traders have resorted to barter trade. For example, Australian beef were exchanged for Indonesian beer and cement. On April 4, 1998 the newly created Indonesian Bank Restructuring Agency (IBRA) shut down seven small banks and took control of seven big ones. Some of these institutions were partly owned by friends and relatives of Suharto. This unprecedented move was applauded by observers who were led to believe that it may assist in restoring confidence that Indonesia is serious about banking reforms. The third pact between the IMF and the Indonesian government was signed on April 8, 1998. Both sides tried to narrow their differences. The IMF had agreed to ease its requirements. For example, Indonesia would be able to have a budget deficit of more than 1% in the light of worse-than-expected economic conditions. (Earlier, the IMF mandated that the limit not exceed 1%). Subsidies for food and energy would be allowed if suffering among the poor continues. The $43 billion rescue package called for the termination of government funding for an airport development project, dismantling of plywood monopoly benefitting the President Suharto's associates, ending subsidies for a national car project owned by his son Tommy. The continued economic turmoil, social unrest and political chaos led to the resignation of ex-President Suharto on May 21, 1998. President B. J. Habibe who became the new interim head was faced with a colossal task of rebuilding a devastated economy. At the outset, he urged the IMF to renegotiate a suspended $43 billion bailout, and foreigners to invest in Indonesia. Recognizing that its strict fiscal, monetary and restructuring policies have partly led to the social fallout, the IMF began to waver on its policies. The policy allowed the continuity of subsidy on food, eased interest-rate and exchange-rate targets. The IMF also resumed disbursements of funds. In early 1999, Indonesia also passed an antimonopoly law stamping out monopolies, cartels and other practices. Under IMF pressure, cartels in the paper, cement and plywood industries as well as the monopoly that controlled imports of basic foodstuffs were dismantled.

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Progress on the banking sector reform and corporate debt restructuring

In the first half of 1998, as many as 23 failed banks were shut down, and the Indonesian Bank Restructuring Agency had 54 institutions under its care. As part of the IMF bailout package, the government moved to nationalize much of its ravaged banking system in August 1998. After initial reluctance and delay, the government closed thirty eight banks, took over seven, and agreed to bailout more than nine in March 1999. The banking sector had been hard hit by high interest rates, huge non-performing loans and a big drop in the value of its currency. The mixed signals and inconsistency in its implementation were driven by politics rather than economics. The IMF and WB which had publicly criticized the delay earlier, released additional funds earmarked under the bailout package. Under the terms of the bailout, the government would lend 80% of the money needed to raise capital to at least 4% of its bank's risk-adjusted assets, provided the bank owners come up with the rest in cash. According to Standard & Poors Rating Services, the bank bailout program is expected to cost $87 billion or 82% of the country's annual GDP, making it among the world's costliest banking crises in the last three decades. More than 170 Indonesian companies with a total debt of $22 billion, have entered into debt negotiations under the Jakarta Initiative, sponsored by the World Bank in May 1999. Western bankers have recognized the need to compromise after nearly two years of political and economic crisis. Many lenders fear that the country has fallen in a debt trap. Like other heavily indebted developing countries, a concern has surfaced whether Indonesia will be able to revitalize the economy without debt relief. In this context, the IMF and WB have ruled out any debt forgiveness for Indonesia. Due to a collapse in economic activity, political uncertainty and social unrest, the Indonesian economy contracted 15% in 1998. Following the crisis, inflation and interest rates shot up significantly which have fallen to nearly precrisis levels two years later. The trade surpluses have grown, largely due to a reduction in imports, (Fig. 9). Foreign reserves have risen from as low as $12 billion in February 1998 to $16 billion in August 1999. Two years after the crisis, the stock market was 25% below its pre-crisis level. Before the crisis, 2439 Indonesian rupiah was exchanged for US$1.00. The rupiah depreciated steeply and then recovered. In September 1999, a U.S. dollar could buy 7692 rupiah. In other words, the rupiah-dollar exchange rate was still 96% below its pre-crisis level, (Fig. 10). The economy is expected to be in recession for the second consecutive year in 1999.

142

M. FAIZUL ISLAM (Merchandise, Billions of U.S. Dollars)

~

5 4.5 4

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Bahmce(RHS) .

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Fig. 9. International Trade.

To sum up, Indonesia's financial crisis has been the worst in the region. The problem has been compounded by the government's reluctance to introduce and implement the much-needed reforms expeditiously. Social unrest and political uncertainty - the fall of Suharto regime, the subsequent formation of President Habibe's new interim government, the June 1999 parliamentary

(Rupiah per U.S. Dollar, Nominal) 0.0005 0.0004 0.0003 0.0002 0.0001

1994

1995

1996

1997

1998

SourCe: IMF

Fig. 10. Indonesian Rupiah.

1999

The Asian Five: From Financial Crisis to Economic Recovery

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elections, referendum for East Timor's independence, and the election of the new President Abdurrahman Wahid - have certainly slowed the recovery process. Due to lack of commitment in implementing IMF policies, the disbursement of aid was sporadic. Corruption continued to flourish even under the interim government which sapped the vitality of the economy. 7 The road to future recovery will depend whether the new President Abdulrahman Wahid will have the mandate, and the boldness to expedite the implementation of the stipulated reforms. The banking sector needs to be revitalized. The government and corporate debts have to be rescheduled or restructured and consolidated with greater supervision. Corruption should be checked by downsizing government and by making the economy more market-based. Transparency and accountability have to be introduced.

4. CONCLUSION Before the crisis, the Asian Five had a hard-working, well-educated and welltrained labor force, entrepreneurial spirit, small public debt and enjoyed robust economic growth. However, crony capitalism, poor governance, corruption, mismanaged exchange rate policy, regulated economy, laxed banking rules, weak domestic institutions in a globalized financial market, and lack of competition, or in broad terms, deviation from market-principles, led to the financial crisis. Clearly, the solutions in resolving the crisis lie in addressing the causes of the crisis. These former Asian tigers are now on the path to economic recovery. The speed and extent of recovery have taken even optimists by surprise. Except Indonesia, the other four countries will be out of recession in 1999. The rate of economic recovery among the Asian Five has been uneven. Between 1998 and 1999, foreign direct investment has been increasing in South Korea, Thailand and the Philippines but falling in Malaysia and remaining negative in Indonesia. The South Korean economy has shown a spectacular recovery because the new head of state was very bold in implementing the IMFmandated and market reforms as quickly as possible. The task is not over as yet. Much depends on whether the chaebol and labor unions will allow the market forces to prevail in the economy. Thailand, under the leadership of Premier Chuan Leekpai, had also made a reasonable progress. Banking sector reform and corporate debt restructuring remain incomplete. A healthy banking system is essential before these institutions can start pumping money to finance economic activities. 8 The Indonesian economy appears to have bottomed out. The IMF-mandated reforms are being implemented very slowly. The delay in

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M. FAIZUL ISLAM

implementing the reforms has increased the economic and social costs. The course of the Indonesian economy in future will largely depend whether President Abdurrahman Wahid will proceed with these IMF-mandated and market-reforms boldly and expeditiously. The Malaysian economy has also rebounded very well. Apparently, Premier Mahathir's self-devised policies including capital controls are producing positive results. However, the longer these controls remain in place, the greater the likelihood of distorted exchangerate and interest-rate levels leading to an inefficient use of capital. The Asian Development Bank, IMF, WB and other donor countries had been playing an important role in the economic recovery process. Recognizing the mistakes, the IMF and WB have adjusted their policies accordingly at different times, to ensure that their policies do not become too painful. To avoid such contagion in future, the IMF has established the Contingent Credit Line for qualified member countries in 1999. It is essential for the international community to evolve some safeguards to ensure that investors do not stampede out of emerging economies on rumors of a crisis.9 The institutions are either not developed or sophisticated in emerging markets when compared to the developed countries to deal with the instantaneous (out)flow of huge amounts of (short-term) capital. Where reforms come slowly, crisis can help. It is true in several of these crisis countries. The sooner the market and IMF-mandated reforms are being implemented, the faster has been the economic growth.

NOTES 1. The Wall Street Journal, March 16, 1998, p. A18. 2. Far Eastern Economic Review, March 26, 1998, p. 12.

3. When IMF's initial stringent budget constraints were implemented, it created social unrest. With taxes raised and subsidies withdrawn, the poorest had been hard hit. Unemployment shot up. (In 1998, the World Bank stepped in with $300 million to assist those hardest hit). 4. The controls which were narrow in scope, were imposed a year after the crisis took place. The objective was to discourage short-term portfolio investors to gain from its trading, and for offshore hedge funds to exert downward pressure on the ringgit. The ban on remitting the proceeds of share sales imposed in September 1998 was replaced by a graduated exit tax later in February 1999. After September 1, 1999, money that was in the country for at least a year could be repatriated tax free. Critics argue that because the controls were imposed belatedly, it had minor effects on the economy. 5. Daewoo - the second largest chaebol deserves illustration. It epitomized the best and worst of the Korean economy. Because of their close ties to government and access to capital, the conglomerates had a clear incentive to expand imprudently causing moral hazard. Daewoo piled up a corporate debt of $47 billion, more than the national foreign debt of Poland or Malaysia. On August 16, 1999 creditors of Daewoo group approved

The Asian Five: From Financial Crisis to Economic Recovery

145

a restructuring plan that shrinks the failing conglomerate from 25 affiliated companies down to six automobile-related units. In sum, the Kim government has made it clear that there would be no more state-directed financing to help chaebol expand into strategic industries. Also, the government would not provide guarantees to support their illconceived and over-ambitious expansion plans. Under his tenure, he is allowing market forces alone to allocate resources, deregulate and open the Korean economy fully to outside participation. 6. In order to put a quick fix to the rupiah, then President Suharto on February 9, 1998 expressed interest in favor of a 'currency board' (pegging the rupiah between 5500 to 6000 to one U.S. dollar). IMF disapproved of it. Critics argued that by having a currency board, he was not serious about addressing the economic fundamentals of the economy. That is, critics viewed that by adopting a currency board, then President Suharto would forgo the much-needed structural, banking, legal and monetary reforms in future. President Clinton even telephoned him to accept IMF's plan. 7. The IMF suspended disbursements early in 1999 after a company linked to Mr. Habibe's Golkar party siphoned $70.5 million out of recently nationalized PT Bank Bali. 8. The economic recovery in the Asian Five has been partly driven by increases in budget-deficits. In the event, government's stimulus spending slows, the consumers and businesses will face difficulty in obtaining credit from a weak banking sector. 9. In an article written by Premier Mahathir and published in the February 11, 1999 issue of the Far Eastern Economic Review (p. 31 ), he has indicated that capital controls will not be lifted until the global community devises a new financial regime that stops speculative activities of currency trader's.

REFERENCES Duca, J. et.al. (1998). What does the Asian crisis mean for the U.S. economy? Federal Reserve Bank of Dallas, (March-April), 1-6. Far Eastern Economic Review, various issues. Goldstein, M. (1998). The Asian financial crisis: causes, cures, and systematic implications, Policy Analyses in International EconomicsNo. 55 Washington:Institute for International Economics. Greenwood, J. (1997). The lessons of Asia's currency crisis. The Wall Street Journal, October 7, A22. Hunter, W. C, et.al. (Eds) (1999). The Asian Financial Crisis: Origins, Implications and Solutions. Boston: Kluwer Academic Publishers. International Monetary Fund (1997). World Economic Outlook: Interim Assessment, December, Washington,D.C. Krugman, P. (1994). The myth of Asia's miracle. Foreign Affairs, November/December,62-78. Lane, T. (1999). The Asian financial crisis: What have we learned? Finance and Development, IMF, September, 44-47. Mahathir, M. (1999). Malaysia: Bouncingback. Far Eastern Economic Review, February 11, 31.

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Malpass, D. (1998). The road back from devaluation. The Wall Street Journal, January 14, A I8. Malpass, D. (1997). Floating into monetary trouble. The Wall Street Journal, July 23, A 18. Ranson, D. (1998). Inflation steals the benefits of devaluation. The Wall Street Journal, April 28, A18. The Economist, various issues.

EAST ASIAN CRISES AND GLOBAL CAPITAL FLOWS: CAUSE OR EFFECT... ? Christopher Lingle and Reuben Mondejar EXPLORING THE CAUSE AND NATURE OF THE CRISES looking for culprits to blame for the economic crises that swept through much of Southeast and East Asia beginning in July 1997, one of the usual suspects is the putative instability of capital markets. An alternative interpretation is that capital flows were only the messenger of bad tidings about the unsustainable nature of the growth experienced by emerging economies in the region. Acceptance of this latter view would mean that the growing demands for capital controls are misguided and perhaps counter-productive in restoring long-term stability to the region. The proposition explored here is that crises that afflict East Asian economies are rooted in the nature of political and corporate governance in the region. While this proposition points to a simple truth, resolution of the problems requires fundamental changes that will difficult to implement. This is because the financial and currency crises are an outcome of deeply-rooted institutions that reflect cultural conditions peculiar to each country. In turn, there can be little hope for speedy implementation of the fundamental changes. Indeed, the choice may be made not to effect change that would be too threatening to the political status quo. Consequently, restoration of stability to the region's economies will not come quickly while recovery may be many years off and In

Asian Financial Crisis, Volume 1, pages 149-173. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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will result in a much lower growth trajectory than experienced during their 'miracle' phases. In essence, the recent turbulence in regional markets sharply contradicts the World Bank's 1993 report on East Asia's 'miracle' economies suggesting that their governments "got the basics right." If economic and political fundamentals had indeed been sound in the region, it is unlikely that the discussion of the region would be focusing upon crises. What began as a currency crisis in Thailand spread to other countries where financial crises have sparked recessionary economic conditions (Goldstein, 1998). The thesis offered here is based upon developments in what is known as New Institutional Economics (North, 1990; Alston, et al., 1996) as a means to understand growth and change as well as economic and social interactions. Institutions are systems of rules, conventions, laws or customs that serve as enabling mechanisms discovered through the process of human interaction. Such arrangements emerge and endure inasmuch as they reinforce stability within a community or facilitate change by reducing uncertainty. The rule structure of institutions provides an aspect of predictability in the course of social interplay. This predictability arises from the incentive structures embodied in the institutions that guide individual choices and shape the social impacts of these decisions. This all relates to economics since markets both depend upon and set the stage for the emergence of a contract culture and commercial morality. In turn, institutional frameworks will evolve to reinforce and reward or punish actions in reference to the agreements and the legal institutions that support them. Cultural change and economic growth reflect the speed of learning expressed through the learning process. Entrepreneurial action is the search and application of new knowledge that occurs when there are adequate payoffs from the expense of their quests. As such, institutional arrangements based upon openness and that encourage competition will offer greater opportunities for entrepreneurial innovation. In contrast, the presence and enforcement of monopoly imposed by government mandate will retard learning and put a brake on economic growth. Consequently, a strong case can be made for the linkage between economic liberty, as seen in institutional arrangements that promote free markets, and high growth. Informal institutions of shared beliefs, social norms, moral codes or cultural conditioning may reflect ethnicity or some other common characteristic. An informal arrangement that drives market development as well as being the outcome of market interactions is trust. At the micro level, the development of markets is limited by extent to which trust becomes ingrained in commercial relations. While elements of trust must become implicit at the macro and global

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level, large projects involving a more complex set of parties will require an institutional framework for the non-arbitrary settlement of contract disputes. As market exchange expands, group or ethnic identity becomes less important as the basis for reliable terms of exchange. For most, it will be counter-intuitive that the impersonal nature of markets actually encourages a higher level of trust to emerge. By contrast, institutional arrangements that encourage collective identity will weaken the sense of trust, especially among outsiders. In the end, individualist-based institutions will encourage more equitable treatment of strangers in order to allow for expansion of market exchange. Most governments in East Asia neglected the necessary infrastructural development for their modernization. While there were some steps to provide some elements of physical infrastructure (transportation, communications, educational facilities), intangible infrastructure expenditures and human capital investments were too often neglected. What is lacking is the institutional infrastructure where these countries could more readily mesh into a global market that demands increasing transparency as well as the harmonization of policies, laws and business practices (Lingle, 1998). The presumed successes of an 'Asian model' provided cover for the dysfunctional democracy of one-party or one-family regimes where electoral success was seldom a function of true endorsement by the masses. Too often, political longevity reflected a grip on power based upon either the carrot of cronyism or wielding the stick of fear and repression. More benign methods involved co-opting key elements of civil society through trade unions dominated by supporters of the regime or filling key university posts with sycophants or concocting laws designed to tame the media. Authoritarianism and Economic Growth: A Riddle Unraveled

One casualty of these crises is likely to be the myth that interventionist or authoritarian governments can effectively shepherd economic development. Until recently, advocates of 'Asian values' insisted that the rapid growth in the region was evidence of a superior political system that was responsible for their undisputed economic successes (Mahbubani, 1995). Another related notion was fatally damaged by the regional turmoil that began with the devaluation of the Thai baht in 1997. In the future, suggestions that political connections can inoculate investments against the vagaries of the market will have little credibility. Anyone wishing to stake claims for the salubrious effect of authoritarianism for economic growth will find it difficult to explain

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Indonesia's economic collapse. Likewise, it should be clear that efficient markets eventually punish despotism. It is contestable whether one can speak about a single 'Asian model' behind the earlier meteoric rise of East Asia's economies. Nonetheless, a common thread in the political culture in these diverse countries can be identified that offers insights into their recent precipitous demise. More specifically, the economic and political institutions apparent throughout the region are ill suited for the effective responses required by the demanding climate of the global economy. While the dominant political culture that guided economic and political structures suited the specific agenda of a given ruling party or regime, they also reflected an underlying conservatism inherent to local traditions and culture. It is difficult to offer a simple categorization about East Asia given the wide differences in the national cultures, languages, and historical circumstances. While admittedly this task requires generalizing the ungeneralizable, there is a commonality in the political arrangements in most of East Asia. This is that politics reflect a deeply rooted collectivist approach to governance. As such, the interests of the greater community, mostly as interpreted by some elite, are placed above individual rights and freedoms. In turn, expressions of individualism are deterred by such admonitions as "the exposed nail is hammered down." The sense of the dominance of collective is seen in assertions that Asian governments and regional institutions operate on a principle of consensus building and their strong desire to seek harmony. At the same time, success in life or commerce depended upon personal and political connections. These political and economic arrangements actually have a venerable history and may have served noble purposes in the past. Like institutions in other parts of the world, they emerged from the process of human interaction resulting from local conditions that were appropriate for their times. The institutions that allowed communities to survive and then thrive were kept while others would eventually be discarded. Unfortunately, the current institutional arrangements are in conflict with the requirements of global markets that function best in presence of individualistbased institutions operating within conditions of greater corporate and political openness. In an advanced market context, reliance upon personal relationships tends to limit the extent of economic exchange and opportunities. As complexities in economic conditions grow, it also becomes more difficult for government policy makers to pick 'winners' or choose the 'right' policies. In a modern political context, dependence upon governmental connections invites endemic corruption and may allow for extensive nepotism. At the same

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time, authoritarian regimes attempt to justify repression on the basis of enforcing cultural traditions of harmony and respect for authority. While East Asia has no monopoly on corruption, surveys of business leaders involved in global commerce by Transparency International indicate that their impressions are that some of the most corrupt regimes are in the region. While these institutional arrangements might have worked in the past, they are likely to fail to serve well in the future. This is because the most demanding component of the ongoing process of globalizing markets is the free and generally unfettered international capital flows. Unfortunately, the political culture in most of East Asia has militated against the development of domestic capital markets that might have allowed their economies to weather competitive storms that have washed over the region. Most governments purposely sought to control credit allocation. In tum, there were restraints on the emergence of free and open capital markets because it suited the domestic political agenda. Financial markets in most of the region were underdeveloped, inefficient and weak in that the visible hand of government replaced the invisible hand of market forces. Consequently, there was little disclosure and almost no scrutiny of institutions that were under the protection of the ruling governments. In turn, the real cost of non-economic transactions or unsound loans could be more readily concealed. There were several operational consequences of East Asia's underdeveloped domestic financial markets. First, much of the internal financing of commercial and development project was channeled through the domestic banking system. Second, there was greater dependency upon foreign capital to provide liquidity to the domestic banking system. Government-directed investment sent illusory signals to domestic financial institutions that the projects involved low-risk or no-risk commitments of capital since they would bear the imprimatur of ranking officials. A heavy reliance upon bank lending instead of capital markets is problematic since bank managers or directors can be more easily swayed by political pressure. In contrast, large numbers of independent private investors in capital markets demand greater access to information and require greater accountability before offering up funds. In essence, financial markets in most of East Asia were politicized so that commercial risks were ignored on the basis of promised protection from political connections. This may have worked while growth rates were high over past decades, but it is now painfully clear that political connections cannot protect investors from downside risk. At the same time, countries like Japan, Korea and Taiwan continued to apply outdated restrictions on foreign direct investment. (Others like Singapore welcomed manufacturing finns but limited the activities of foreign banks.)

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Borrowing from abroad supplanted the participation of foreign companies with greater international experience that could offer balance sheets that made sense to the rest of the world. These outsiders could also have injected a bit of competitiveness lacking in their coddled domestic economies. It could be argued that cause and effect is blurred here. Perhaps capital markets in these economies were underdeveloped because of the low levels of their overall development. Yet it can hardly be claimed that neither Japan nor Korea were unable to open up and modernize their markets. As it is Taiwan's total market capitalization, the largest in Asia, is only about $178 billion compared to America's (presumably overstated?) market capitalization of $12 trillion. Most other countries in Asia can barely match the value of a largish company listed on the NYSE. Liberalizing East Asia's Financial Markets: Too Much Too S o o n . . . ?

In the aftermath of the financial deluge sweeping across East Asia and other emerging or transition economies, the search for villains and victims has ignored much of this evidence. Indeed, a variety of longstanding critics of globalization insist that liberalization went too far, too fast (Greider, 1998; Rodrik, 1998). A refrain that has gained momentum is that limits on capital flows be implemented and overseen by international watchdogs. It is unlikely that the end of the Asian 'miracle' was the result of overzealous economic liberalization and deregulation (Rodrik, 1997). Unfortunately, this interpretation has a wide following that may lead to abatement in the process of financial deregulation. Where this message is heeded, markets can be expected to slow down eventually, inviting deepening recession. Following the anti-foreigner rhetoric of Prime Minister Mahathir, Malaysia was first out of the blocks. This decision was apparently spurred on by suggestions of the advantages of capital controls offered by Paul Krngman who later issued an apologetic plea that his proposal should only be implemented under extreme limitations (Krugman, 1998). Limitations that are unlikely to be imposed in an autocratic, single-party state like Malaysia. Many leaders of emerging economies have no wish to shake up the status quo, and there will be an increasing clamor for more regulation of capital markets, especially to restrain short term flows. However, further liberalization of capital markets can yield benefits for them if they take steps to strengthen their banking systems by enhancing transparency and competitiveness. These reforms would make capital flows less erratic. By encouraging more efficient use of capital, growth prospects would likely improve.

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It is true that the currency and financial crises in Thailand, South Korea and Indonesia resulted from a sharp reversal in capital flows that poured in during the early 1990s. But the stampede was not the result of rapid financial liberalization. Nor was it the fault of short-term capital flows, per se. Shortterm commitments of capital are compatible with long-term growth as long as there is a balance between inflows and outflows. Problems arise only when there is a mass exodus and that usually occurs only when there is a loss of confidence in the overall system. Apparently, East Asia's economies suffered from just such a crisis of confidence arising from government policies obstructing market adjustments and limiting competition while banks with nonand under-performing loans were kept in business. Economic And Political Risks In East Asian Emerging Markets

Conventional wisdom often declares that emerging markets, especially those in East and Southeast Asia prior to the emergence of the crises, are an investment play that should not to be missed. This view is not surprising in light of the reported high rates of economic growth in East Asia. The five fastest growing nations in the world in 1996 were in East Asian (Vietnam, China, Malaysia, Singapore and Thailand). From 1990, China grew over 135%, Indonesia 124%, and Singapore experienced 99.8% growth. In the same period Japan grew only 26.8%, its worst period since the early 1950s. Eight of the top ten nations in growth since 1990 were in East Asia (World Bank, 1994). Singapore moved from 18th to 4th in per capita GDP since 1990. That meant it overtook its former colonial master (Great Britain) and the U.S. in this crude measure of standard of living. If it were able to continue on its present course, it would have overtaken Switzerland and Japan by around 2003 to become the world's wealthiest nation. In early 1997, South Korea was awarded membership in the exclusive industrialized club of the OECD. Unfortunately, many of these statistics now look quite hollow. However, the turmoil in East Asian currency and stock markets during 1998 indicate that considerably more caution should have been exercised before international funds were directed there. In all emerging economy plays, prudent investors should look closely into combined economic and political risks in order to avoid being involved in what might turn out to be a crapshoot. Interestingly, even with the recent well-publicized setbacks, it appears that the greatest fear among many potential investors and business interests was missing out on important opportunities in East Asia. This fear seems to be pushing up many of the region's stock market despite few signs of

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improvements in the real side of the local economies and little change in their supporting institutions of governance. It is not surprising that emerging markets exhibit relatively high political risks. This type of risk of the disruption of commercial activity arises out of internal conflict like civil wars or power struggles. However, there are also relatively high risks stemming from actions or policies taken by governments that somehow disrupt or destabilize economic activity. These include policies leading to inflation or hyperinflation, increasing budget deficits, or increasing the likelihood of fraud or default on international loans by sovereign governments. Then there are the run-of-the-mill risks that any business venture may simply fail due to lack of commercial viability. Costs and Benefits of Authoritarianism and Asian Values The authoritarian nature of regimes both raises and lowers political risks. There is a misleading impression of the contribution of authoritarianism to stability since the various one-party or one-family regimes have been in power long enough to perfect political repression. Such stability is likely to be illusory and can only be counted on for the short run. If despots are too severe, they invite coup d'etats or assassination. If they are not strong enough, then the political opposition may sweep them out of office. In all events, the mortality of despots (benevolent or otherwise) ensures that political risks will eventually rise due to uncertainty over the transition of power as evident in China, Indonesia, and Singapore. Dynastic succession or one-party regimes are not an uncommon feature in East Asian politics that is often mistakenly associated with stability. Like other forms of nepotism, intra-family political succession is consistent with the culturally-imbedded commitment to family that is said to define social relations in much of Asia. Of course the most painful example of this is in Indonesia. In terms of the concerns of international investors, both reflect forms of corruption that arise from leadership whose authority is seldom challenged. Where nepotism is prevalent, there are also a variety of costs to the community that should be considered. Political costs arise in the form of losses of political rights. Nepotism also invites economic inefficiency from the diversion of resources towards a single family or cronies in a dominant political party. By interfering with market transactions, nepotism imposes costs upon the greater community and upon potential investors by reducing returns on gross investment. Before acquiring political power, the offspring of rulers often develop their own power base, perhaps as grants of national monopolies over certain

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economic sectors. According to a rating by Transparency International in 1995, Indonesia was considered to then have the world's most corrupt regime. Indeed, 6 of the 10 worst rating were Asian countries. A similar rating for 1996 revealed that Pakistan and Nigeria replaced Indonesia and China as the countries most affected by corruption while 5 of the 10 countries with the worst rating were in Asia (in order, Pakistan, Bangladesh, China, India, and Indonesia). Nepotism and special privileges will distort these markets for insiders as well as for outsiders. Many Asian countries have leaders who seek to impose secular dynasties upon their citizens. Unilateral transfer of political control to family members is often found where there were anti-colonial movements are led by charismatic autocrats. An ill-educated citizenry often faces repression of dissent so Asian autocrats can decide in the best interest of their family regardless of the impact on the country or foreign investments. Another problem with authoritarian regimes in the region is that they interfere with the level of transparency in economic dealings demanded by responsible international investors. For example, in addition to tight controls on domestic news reporting, China recently announced its intention to restrict the flow of financial and commercial information from international news services. While the limits placed upon political debate in Singapore are well known, the ruling party has gone to great lengths to punish individuals for leaking economic data. In 1994, several journalists, a private investment adviser, and a civil servant were prosecuted for publishing quarterly GDP estimates before their official release. This sort of obsessive control of data thwarts the independent corroboration required by long-term investors. Similarly, repression of a free press chokes off an independent source of information about events in these countries that might be relevant to foreign investors.

East Asian Infrastructural Development Requires Long Term International Capital There will be numerous opportunities to invest in East Asia over the next decade. In order to facilitate expanding markets, the countries in the region must undertake massive infrastructural development. A World Bank study suggests a need for a total of $1.5 trillion in expenditures with $600 billion for improving port facilities, roads and other transportation systems. About $500 billion will be spent for expanded power capacity, $250 billion on telecommunication, and about $150 billion for water and sanitation facilities. Prior to the crisis, this would constitute on average expenditures of about 7% of

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average GDP for the region's economies. It would require a substantial increase from 4% that was spent in 1994. Unfortunately, the underdeveloped capital markets of the emerging economies of East Asia are likely to impose limits upon their capacity to grow due to a shortage of long-term capital lending. Despite high rates of household savings, the region's capital markets remain inefficient and far more underdeveloped than their trading systems. Emerging Asia-Pacific economies must develop a more efficient means to channel domestic savings and to attract international capital to provide funding for infrastructural investments in telecommunications as well as power and transport systems. Several problems loom large in the provision of domestic or even regional funds for development projects in East Asia. On one hand, family-owned companies that tend to be narrowly concentrated on trade or property development hold a large proportion of the business assets in the region. On the other hand, widespread government ownership requires that a substantial amount of funding for business expansion will involve the issuance of public debt. Eventually, widespread privatization will allow capital to be raised through the sale of stocks and equities. However, firms based in East Asia will have to shed their preference for secrecy. Potential investors from outside the region will demand greater transparency before lending. Similarly, international investors who wish to participate in East Asia will require increased clarity of risk/return assessments as international transactions extend beyond the range of friends or family contacts. In sum, despite having domestic saving rates of 30% and higher, East Asian economies do not mobilize their capital efficiently. Historical mistrust of financial institutions leads to high demands for liquidity by savers. In turn, the high stock of savings has not been transformed effectively into long-term investment. There are some estimates that the Chinese government has squandered as much as 40% of domestic savings by making 'loans' to the stateowned enterprises. Governments and private borrowers in East Asia must develop more transparent and legally reliable investment frameworks. These include improved corporate governance, better clearing and payment systems, acceptable accounting standards, and modernized credit-rating systems. Risks in Equity Purchases in East Asian Emerging Markets

Problems associated with commitments of long-term capital investment also stem from the volatility of East Asia's emerging markets. This volatility undermines the security of international equity investment. Not unlike the experience of other emerging markets, the stock exchanges in East Asia

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represent a high-risk investment due to their high price volatility. The collapse of the Mexican peso in 1994 led to a simultaneous downturns of most emerging markets, with Latin American markets affected the most. Now, deep currency devaluations in Thailand, the Philippines, Indonesia, Malaysia, and South Korea have been matched by local stock market declines of as much as 50% over the first 18 months of the crises. Despite so many fingers being burned in similar high-risk emerging-market plays in the past, some of the same players found another bitter pill in Southeast Asian markets. In this instance, it was precipitated by the Thai government's refusal to take steps to ease the financial trauma induced by an abrupt abandonment of the baht's peg with the U.S. dollar in July 1997. As early as June 1996, the International Monetary Fund (IMF) advised Thailand to shift to a flexible exchange rate regime to avoid imminent economic problems. The Thai government blithely ignored this advice and risked further damage to its economy by defending the baht in the forward exchange market. This attempted defense failed, and Thailand's foreign exchange reserves fell dramatically as the baht lost about 40% of its value. Much of the rest of Southeast Asia experienced similar problems as ASEANs leaders proved themselves incapable of effective crisis management, both jointly and individually. Thailand and Malaysia imposed a variety of capital controls aimed at halting short selling by foreigners. Unfortunately, these measures irreparably harmed investor confidence and were soon scrapped. Nonetheless, many investment advisers continue to promote portfolio holdings in emerging markets since the stock markets in most of them have outperformed the stock markets in the more developed economies. This is all true, but it means that timing and composition of investments under highly volatile market conditions make for a very risky game. A given portfolio of stocks in emerging economies might fall by 20-50% and not recover for several years. There are numerous reasons behind the volatility of stock markets in East Asia's emerging economies. With their low capitalization, they are susceptible to quick shifts of 'hot capital'. These flows might be movements away from bad news (coup d'etats, drought, strikes, doubts about succession of leaders, inflation, or structural fiscal deficits) or towards good news (deregulation, privatization, reduction of trade barriers, or structural reforms). Most of these countries provide little reassurance in terms of minimizing political risk, the constancy of real interest rate or stable prices. There are also concerns about the imposition of controls over capital movements as well as the maintenance of overall economic freedoms. What can be expected is a vicious cycle where market volatility leads to a greater concentration of 'hot capital' that in turn induces greater volatility that frightens off more long-term investment.

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In light of these problems, it is almost certain that economic growth in the region will be slow to recover. On the one hand, successful financing of necessary public infrastructure may 'crowd out' other domestic investments by forcing up market rates of interest. On the other hand, if the infrastructural projects are not completed then the capacity of these economies to return to positive rates of growth will be severely limited.

Global Capital and Forces of Economic and Political Modernization Successful economic development in the future will depend upon a number of conditions that shape and define the so-called global economy. Perhaps the most important momentum behind the internationalization of economic activities arises from the high degree of capital mobility. The capacity of capital to migrate and reside more or less at will insures that the search for the gains from trade arising from comparative advantage is temporary, elusive, and increasingly contested. It will be increasingly important that countries develop greater flexibility and responsiveness in their economic and political institutions. Otherwise the automatic adjustment mechanisms that contribute to stability and aid growth will be obstructed. Countries wishing to become players in the global marketplace will have to face up to the implications of this simple observation. These observations might be heeded by countries in early stages of development that might wish more to pursue development through the promotion of export-oriented production or more advanced economies that seek to ease higher rates of growth to keep living standards high and unemployment low. Aspirants in the global marketplace that wish to remain competitive and enjoy success will be guided toward policy mixes and institutional arrangements that are flexible and responsive. Otherwise, commercial aspirants will find their market shares lost to competitors and national economies will experience an exodus of capital. In the future of a truly global economy, the institutions of every country will be affected by external shocks generated by repetitive waves of competition. Those that are not flexible will simply break down in face of these challenges. From the micro side, small and medium sized enterprises will be well placed with nimble responses to exploit niche opportunities. This will imply that this will work best in situations where there is extensive domestic competition among firms, including allowing foreign producers in to contest local markets. From the macroeconomic side, policies that are capital friendly combined with liberal trade regime will increase and enhance linkages with international markets that facilitate trade and capital flows.

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There are risks and challenges associated with such arrangements. Not least of these is the upsetting of traditional relationships that may lead to some political instability. However, the political stability associated with the cozy relationships between many Asian governments or politicians and commercial interests has proved to be a recipe for disaster. China: Asia's Next And Biggest B u b b l e . . . ?

After speculative bubbles burst in erstwhile economic powerhouses in Southeast Asia, the damage spread quickly to North Asia. This should not be surprising since many of the East Asian 'miracle' economies pursued similar paths for development. As suggested above, the systems of governance once acclaimed as the basis for rapid growth in East Asia can be seen as the source of their own economic undoing. Now that South Korea and Japan find themselves rattled by the chilling winds of economic reality, China's most recent growth spurt is also stumbling. Economic performance is trailing off and export growth is falling just as nearby Tiger economies with weakened currencies are hoping to export their way back to prosperity. Ironically, China may have contributed to its own misery and that of its neighbors. Following its competitive devaluation of the yuan by about one-third in 1994, the bitter truth is that China may have contributed to the devaluations that now plague much of East Asia. Unfortunately, economic advisers and many enterprise managers in China are too ill acquainted with markets to understand that competitive advantage is a moving target. Consequently, China's manufacturers are beginning to confront the realities of growing mountains of unsold inventory. Township and village enterprises (TVEs), a Chinese hybrid of collective ownership where operations follow limited market principles once served as an important contributor to economic growth. Now they are struggling under excess capacity and increasingly contested markets while they are starved of access to capital that continues to flow from state-run banks to state-owned enterprises (SOEs). Clearing the growing inventories may require another devaluation of the quasi-floating Chinese currency. However, it will be resisted since it will certainly put strains on the ability of Hong Kong to hold its peg against the U.S. dollar and add to the problems of repayment of China's debt burden. Perhaps the weakest link in China's continued economic progress is caused by the lack of transparency within its financial institutions. In keeping with the development approach in much of the rest of East Asia and its own authoritarian legacy, tight controls over capital markets result in a heavy reliance upon bank lending for industrial and commercial developments.

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Avoiding the openness demanded by private investors in bond markets, banks can be obliged to grant loans to meet political ends and so neglect appropriate risk assessment in their lending decisions. Like elsewhere in the region, banks provide a more supple and predictable source of funds. These funds may be for subsidies to support industry policy or to reward political cronies. Additionally, the Bank of China suffers from a complete lack of independence, and it has never carried out the oversight role of a modern central bank. Despite announcements of an intent to reduce subsidies or low interest loans to SOEs and to force them to sink or swim, there is no clear plan of action. In light of the regime's gradualist attitude towards economic transition, change will not come soon. Meanwhile, any attempt to clear up the non-performing loans held by the SOEs hangs like the sword of Damocles over the regime's head. At the beginning of Zhu Rongji's reform program of nearly 300,000 SOEs, roughly 75% were effectively bankrupt and kept going by 'loans' that were essentially grants from state banks. By their own admission, the ratio of bad loans to assets in China's banking is about 20-30% and growing. This figure is likely to mushroom dramatically once property prices and rentals begin to fall in response to the overbuilding in many of China's largest cities. Like in Southeast Asia, a property bubble is looming while infrastructural investments in South China, especially in the Pearl River Delta and Shanghai, provide enormous excess capacity. In turn, the cascading effect on Chinese stock markets and the rest of the economy has already been outlined in stark relief in the experiences of neighboring Southeast Asian economies. There is no easy way out to sort out the ongoing financial crisis. It would be bad enough if banks only had to find a way to unburden themselves from losses arising from lending to property developers and slumping sales by TVEs. However, suggestions to sever the financial lifelines to the SOEs are likely to fall on deaf ears due to the expected social and political costs. All of the solutions require substantial economic pain in the short run. If SOEs are forced to repay their debts they must privatize, restructure or liquidate. Each option requires massive cost cutting which unavoidably translates into drastic cuts in employment as well as reducing workers' benefits that often include cradle-to-grave services. Estimates of job losses range from 20-50 million workers that will be made redundant through downsizing. China's hybrid foreign exchange system will not protect it from the pressures of the economic forces that are disciplining countries with more solid fundamentals. Its growing current account deficit will require changes in the real economy or changes in the exchange rate. Governments around the world have suffered from believing that they can defeat market logic.

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As a first step, it should be made clear that international support for China and other emerging economies will depend upon consistent provision of transparent data in a timely manner. This would allow for more intensive evaluation of their economies and avoid the sort of underestimates of the rot found by the IMF in South Korea's banking sector. As outlined in the new accords, greater foreign competition in the banking systems and formation of an active, aggressive bond market would also provide more external scrutiny. In comparing China's current economic balance sheet to those in Southeast Asia prior to July, it looks like deja vu all over again. However, the result may be worse since China's bubble will burst in the face of over 1 billion people. Zhu Rongji: Helmsman of the Chinese Titanic... ?

As a rising star whose credentials and declarations indicate clear thinking on economic matter, Zhu Rongji's 'election' as China's prime minister is to be applauded. There is a clear consensus that he is a tough taskmaster who can restore discipline among the party faithful and act as an able helmsman for the economy. However, it should be remembered that even exceptional cult figures make little real difference when the tide flows against them. Many of Mao's positive achievements were tarnished by the failure to move the economy forward. Similarly, it is likely that Deng's worthy contributions may be seen as too little, too late. Indeed, Chinese authorities must undertake deep reform that goes far beyond fine-tuning or tinkering with economic policy. It remains to be seen whether Zhu will have the authority or the will to direct the necessary thoroughgoing economic restructuring. Pragmatism, the guiding principal for Chinese modernization, is headed straight into a minefield of immense proportions. Privatization is doomed to failure because the state-owned enterprises cannot be made profitable without shedding millions of workers. Meanwhile, the drying up of foreign capital will put a damper on growth. In all events, official growth rates are misleading that they do not match with other vital economic data such as energy consumption. In sum, the obstacles that Zhu will face are a set of realities defined by a highly competitive global capital market. As such, some basic contradictions of China's 'market socialism' may soon become fatal afflictions. After all, history shows that communist economies cannot reform, they eventually collapse. The bottom line for China's modernization is the privatization of the large number of loss-making SOEs. Political decisions to this end have already been taken. The plan is to scrap those that are loss making - more than h a l f - and

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reorganize the rest into large, highly diversified and profitable corporations along the lines of the Korean chaebol. In the process, the banking system will be transformed so that they are no longer merely agents for distributing government subsidies to cover SOE losses. After reform, the banks are to become profit-making financial institutions to stimulate Chinese growth with an efficient and modem banking system. At least this was the idea when the chaebol looked like something other than the industrial dinosaurs that they are proving to be. But which conditions must be met to make this a policy with any prospect for success? The Chinese capital market is effectively illiquid due to the massive subsidies offered to SOEs. Funding for the privatization program will have to rely on a variety of sources other than domestic savings. The main techniques are incoming foreign investment, a continuing and substantial trade surplus and international loans. These sources are drying up. Even the trade surplus policy does not look convincing after the rounds of devaluation in other export-oriented Asian economies. Every reasonable conclusion from these observations is then that the privatization program can not succeed, for lack of funds. Chinese economic policies will, in a worst case, face a large number of subsidy-demanding firms and half-reformed new corporations that do not generate the expected level of profits. To go on, it will require some more fundamental policy change in China than we have seen so far - or an aggressive devaluation of the renminbi that looks increasingly likely despite continuing claims to the contrary. If the economics of the project looks bad, the political outcomes might be worse. In many Chinese towns a sole SOE is the principal employer. Closing a number of these companies or moving parts of them to a regional center will result in a number of industrial 'unemployment islands'. Political unrest is likely to follow the surge of local unemployment. This is especially so, since China has no social insurance safety net in place to avoid such political reactions to policy changes outside of the employment-linked benefits from SOEs. Unlike peasant unrest, industrial unrest does not tend to stay local. It has always a capacity to be transformed into a national political issue. With 20-25% of the Chinese population affected by the planned privatization project, it difficult to see how deep political consequences can be avoided.

China and The Globalization of the Asian Economies Under Deng Xiaoping, China staked its future on its participation in a new international market order. The forces of the global economy can act as a tidal wave that can easily erase the remarkable gains achieved since the late 1970s.

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Evidence confirming this contention can be found in the financial crises affecting much of East and Southeast Asia beginning in the late 1990s. The institutional demands that shadow the new global investment patterns are not often observed or well understood. China is not in a strong position to accommodate these demands. China's economic growth depends upon foreign capital to carry out ambitious infrastructural development or to gain technical expertise. These activities require transparency in commercial operations and accountability for political choices that do not exist in the economic and governmental institutions in China, or elsewhere in the East Asian region. While the modern globalized capital market builds on centuries of historical development, some recent events have brought about fundamental and perhaps irrevocable changes in its operation. Competitive pressures for investment funds helped stimulate a market for footloose capital. These pressures prompted and were also aided by financial and technical innovations to facilitate movement. At the same time there were policy initiatives, like the deregulation of London's financial markets in 1985. Out of this sequence of events and circumstances, capital markets became both more liquid and more efficient. The efficiency is evident in an everwidening set of financial institutions and innovations in the offering of financial instruments like derivatives and other futures markets instruments. Risk-averse financial actors seek to compensate the inherent risks in the activity of lending money, by being well informed. Whatever the state of evolution of capital markets, they depend, in extremis, upon access to reliable and massive amounts of business-related information. With capital having global reach, efficient new information technologies have followed, making the continuing internationalization of capital markets possible. The endeavor to maximize international information flows had several important political effects. The most visible among these has been the stronger drive towards democratization as more countries turned democratic since the 1980s. A democratic community that reflects the influence of individualistbased institutions puts no (or few) restrictions on generation or spreading of information. Authoritarian or 'corporatist' regimes tend to impose greater restrictions as justified by some specified political concern such as social harmony or consensus. A conflict and competition among institutional arrangements will surface in the latter cases, indicating that democratic pressure can easily build up in countries taking active part in the process of globalization. In an increasingly globalized economy, comparative advantage will be based upon favorable institutional arrangements as much as input costs or resource availability.

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There are various problems with China's political development being put in line with these wider requirements for institutional change. The Tiananmen massacre in 1989 indicated that Chinese politics, under communist supervision, fails to meet the standards of the global community or can contribute to the constantly ongoing institutional development demanded by globalization. Yet, China is basing decisive parts of its long-term financial policy on attracting large commitments of future foreign investments into its economy. This marks a deep conflict in its own internal policy, as well as an unresolved conflict between its rigid and slow-changing economy institutions that contrast sharply with the demands of advanced information markets arising out of the globalization process. China's institutional contradictions also arise from requirements of international investors for greater accountability and transparency and who also require a mechanism for settling contract disputes. All these conditions are influenced by the policy settings among economies throughout the world. Consequently, global capital markets inspire a competition among countries to offer the institutional basis that attracts capital. Countries like China, with a political structure that does not accommodate the demands of borderless capital, will not attract the amount of foreign investment needed for its development plans. Instead, it will suffer a net outflow as capital is attracted to better terms elsewhere. So China will be facing a number of internal contradictions so that changing personalities in leadership positions will be no more effective than rearranging deckchairs on the Titanic. Even if Zhu is able to get the economy right, China will face political pressures that may be overwhelming.

Japan's Big Bang Promises: Rhetoric or Reality... ? Former Prime Minister Ryutaro Hashimoto complained that currency devaluations in Southeast Asia were behind devaluation pressures that were forcing down the value of the yen against the dollar. Soon afterwards, Japan's Ministry of Finance (MOF) officials announced plans to minimize short-selling of the yen, including the screening of market details more closely to seek out 'irregular' transactions which might represent manipulation of market prices. Perhaps the promises to liberalize Japan's financial markets and open its economy to competition deflected the sort of criticism when leaders in Southeast Asian countries tried to blame others for their woes. Nonetheless, the excoriation made by Malaysian Prime Minister Mahathir against George Soros and other speculators was different only in tone, not in substance. With these

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attitudes firmly entrenched among Japan's hierarchy, it shows how difficult it is for its 'Big Bang' financial market deregulation to be fully implemented. Japan's model for modernizing its banking and financial sector was inspired by Margaret Thatcher's reform of the British securities industry in the late 1980s. Beginning in December 1997, Japanese banks and securities firms were able to jointly market investment trust funds. These are essentially mutual funds and are not yet widely used by individual investors. Most Japanese savers hold accounts in low-interest deposits in the postal savings system. While 140 trillion yen goes into securities, only about two percent of total invested assets go into investment trust funds. In April 1998, foreign currency exchange laws were liberalized, allowing any individual or business to make foreign currency transactions without prior approval from the Ministry of Finance. Prior to this change, such transactions could only be made to officially designated banks. Businesses can now negotiate for foreign exchange from Japanese or foreign banks or can make arrangements internally with their own finance departments. Most importantly, individuals are allowed to invest personal assets at higher rates overseas or in foreign currencies through foreign banks in Japan. Other deregulations include securities trades of more than 50 million yen that will allow securities firms to set their own commissions. It is expected that increased competition will lead to an improvement in service and lower trading costs offered by securities firms. If all goes well, it may breathe new life into Japan's sagging equities market. Modernization of corporate structures will allow new holding companies to be formed for the first time in the post-WWII period. New securities firms will not need to apply for government licensing, banks and securities companies will be able to enter each other's businesses without restrictions, and banks and securities firms will be allowed to sell insurance. The crises in the rest of the region require even more urgent action to avert widening problems in Japan. The slide of the Thai baht and subsequent assaults on the currencies of Indonesia and Malaysia prompted Japan's MOF to propose an Asia-based currency fund. This would have replaced the conventional tough austerity measures required by IMF interventions. Most affected countries in Southeast Asia responded favorably to these overtures, but Western governments and their respective banking community were negative. Japanese banks felt the pinch of the crisis affecting South Korea since they were holding about $20 billion of the $100 billion in short-term debt owed by Korean banks in 1998. In total, Japanese banks lent about $123 billion to various enterprises in Southeast Asia. The looming crises with their overseas exposure added to the woes of Japanese banks that were struggling to cope with

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$580 billion (76.7 trillion yen) in domestic loans that were bad or questionable. Despite serious problems threatening Japan's banking system since the beginning of the 1990s, supervisory authorities avoided taking strong remedial actions. Strikingly, the MOF did not require reporting on non-performing loans until 1993. In this regulatory setting, it is no surprise that there were neither requirements to liquidate collateral (property or stocks) held against the bad loans nor were there banks directed to increase their capital to offset losses. Japan's population is rapidly aging due largely to changing demographics and this is also driving reform. Japan has a fertility rate of 1.5 children per woman. That is well below replacement level and considerably lower than in the U.S. (2.1). According to trends, Japan's 'elderly dependency ratio' (proportion of the population aged 65 and over relative to the population aged 15 to 64) will mean that there will a decrease in the number of the work force relative to an increasing number of retirees. Such prospects have focused minds since it directly threatens their social and economic stability. These stark realities require that Japan's capital markets must become more efficient in order to resolve the persistent slump in its domestic economy. In light of the banking crises sweeping through East Asia, it will be important that capital-adequacy ratios be enforced. Banks with operations limited to domestic activities must meet a 4% ratio requirement within a year while banks with international operations must follow the 8% ratio required by the Bank for International Settlements. However, Japanese banks have used different benchmarks for those assets included as capital than their counterparts in other industrialized countries. After April, Japan's banks must reduce the proportion of their capital-adequacy ratio derived from unrealized gains on stock market holdings. There are signs of continued dithering in the enactment of these necessary reforms. However, containment of the crises sweeping East Asia makes Japan the final line of defense. As such, there is an increasing urgency for the rest of the world that Japan implement global financial standards and modernize procedures for corporate accounting and financial reporting.

Japan's Bleak Future Japan's economy accounts for two-thirds of Asia's economy and generates 15% of global economic output. Unfortunately, this powerhouse has experienced a decline in its GDP 0.7% in fiscal 1997 with a further decline of over 2% in 1998. By the end of the first quarter of 1999, the Japanese economy had

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experienced at least five consecutive quarters of economic decline with more bad news likely for the foreseeable future. Japan's role as linchpin in the global economy is in real danger of crumbling under the combined weight of its own looming domestic and foreign crises (Katz, 1998). While various policies have been announced to deal with Japan's long-suffering economy, there is little evidence that there will be the fundamental changes that will be necessary before Japan will experience a restoration of positive growth. A mountain of non-performing loans obstructs Japan's economic recovery. Until these bad loans are disposed of, the economy cannot be stabilized and without stabilization it cannot be revitalized. Along with establishing the political will to accept the bankruptcy of financial institutions, public money will be injected into solvent banks. The extent of Japan's banking problem and the associated numbers is staggering. Estimates of the value of non-performing or under-forming loans are between U.S.$500 billion to U.S.$1 trillion. The latest accord of October 1998 commits a vast amount of public funds, about 60 trillion yen. From this fund, 25 trillion yen will be made available for bank recapitalization, 18 trillion yen will be committed to nationalize weak banks with the remaining 17 trillion yen used for protection of depositors. A shaky alliance was formed when the small Liberal Party and a smaller Buddhist bloc joined with LDP in the upper house to enact a bill forming a 'financial resuscitation committee' that would be empowered to buy bad loans from failed or failing banks. There are three basic options in dealing with problem banks. The first would involve temporary state control through government purchase of common shares while a restructuring plan was implemented for eventual sale to a private buyer. A second option is for liquidation under bankruptcy laws. Finally, struggling institutions could be placed under control of bridge banks. Unfortunately, these proposals contain no silver bullet to solve Japan's problem and have set off a familiar cycle so often observed in response to impending policy announcements from Tokyo. Bullish market sentiment in anticipation of the package can turn rapidly bearish when the details are announced that send world markets soaring skyward one day and to plunge the next day as reality sets in. An important element driving market sentiments is voiced by the Democratic Party whose refusal to support the LDP plan reflects worries about lax controls over cash injections administered by the same old-boy network. Similarly, there is no clear timetable for the process or enough specifics to provide a sense of confidence in the package.

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There is also the question as to how far the liberalization of Japan's financial system will go. In particular, will foreign banks be allowed to take full control over any of the banks that might be temporarily under government control...? If this is not allowed, there will be a continuing lag in services and efficiency for Japan's domestic banks that are unaccustomed to competition. This situation borders on the tragic. Until the banking crisis is resolved, Japan will be doomed to a prolonged recession. No amount of additional Keynesian pump-priming or reflation will induce Japanese consumers to spend their way out of the current slump. The additional tax burden of the current proposal combined with increased job insecurity and shaky pension plans has frightened the Japanese away from being a country with a high propensity to save into a nation of currency hoarders. As policy leaders in Tokyo stumble in seeking their way, advice from foreign friends offers little clarity or consistency. In Washington, the Clinton administration offers advice based upon unreconstructed Keynesian nostrums. Proposals for pump-priming, reflation and temporary tax cuts offer little hope for a recovery in Japan's economic prospects. Japan's domestic problems include a slow-growth or no-growth recession since the late 1980s after the collapse of its 'bubble economy'. During this time, growth had to be supplied by the international sector that cannot continue to keep the rest of the economy afloat. In the early 1990s, while real estate and stock market values plummeted, the yen experienced a sharp appreciation that prompted production and jobs to move offshore. More recently, the imposition of a consumption tax in April 1996 caused a slump in retail sales. Meanwhile, consumer and business confidence is at an all time low over the failure of the government's attempts to revive the economy. In seeking to minimize domestic political resistance, the government is likely to put its hopes on an export-led growth strategy to revive its flagging economy. Unfortunately, regional financial turmoil will make it unlikely that trading partners in Southeast Asia will be able to continue absorbing 40% of Japan's exports. Changing realities of increased competition in the global economy will thwart any significant increase in Western demand. Like other countries that have tied their future to international trade, Japan's future will be molded by the constantly changing nature of the global economy. As waves of competition sweep the globe, they will spark new imperatives for domestic policies to be in synch with free and open market economies. In particular, the return of Japan as an important player in global capital markets will require an extensive deregulation of the banking industry. Japan's financial services sector is burdened by a ceaseless bad debt problem while half-heartedly approaching 'Big Bang' financial deregulation to remove

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anti-competitive practices. After years of being cosseted from foreign competition while serving the government's program of directed development, 'Big Bang' will require Japanese banks to respond to competitive conditions. They will have to measure performance in terms of return on equity instead of concentrating on maximizing asset size. To this end, Japan's banks will have to restructure their balance sheets to reduce non-performing loans through writeoffs or securitization. Japan's banking sector has extensive exposure to the rest of Asia and is enormous as creditor and equity investor. With an estimated loan exposure of about U.S.$300 billion, Japanese banks are the region's largest creditor with about one-third of these loans in Hong Kong and its increasingly precarious property market. Another US$24.3 billion is in Korea, which is an economic domino that fell in the wake of Asia's financial contagion. Compounding Japan's bad debt problem is the drastic fall in the market value of their Asian equity portfolios. Without these 'hidden' reserves to provide the financial cushion needed to absorb loan losses, domestic bank failures will inevitably rise. While some consolidation in Japan's financial sector is overdue, there is a real risk of system-wide implosion owing to government inertia and mismanagement. The Finance Ministry has still not addressed the pressing issue of reforming the mammoth postal-savings system, which accounts for as much as one-third of Japanese individuals' deposits. Regulators still have no legal responsibility to shut down unsalvageable banks as part of their mandate to take 'prompt, corrective action'. Leaving such discretion in the hands of the regulatory bureaucracy insures that resolution of these problems will not be easy or swift. The government's failed attempt to stave off the recent bankruptcy of Sanyo Securities through an arranged merger attests to the tenacity of the government in applying anachronistic remedies in the face of impending deregulation. Despite the conspicuous pattern of problems in the present, the vacillation for Keynesian fine-tuning does not bode well for the future. A demographic Damocles sword is hanging over their head. A misstep today will impose an increasing burden on a shrinking work force that will also find fewer job opportunities. Perhaps the greatest tragedy will be that young Japanese will choose to migrate to countries that offer better opportunities.

CONCLUSION As suggested, inhibitions of domestic capital markets in East Asia were consistent with the political culture of the region. The more interventionist

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governments sought to exercise tight control over the flow of economic information either by dictate or appeal to tradition. Most other countries also followed or enforced traditions of collectivist institutions guided by governance by consensus that often created an illusion of harmony. In these settings, criticisms of economic conditions or policies tend to be suppressed while independent corroboration of government supplied data is unlikely or impossible. Unfortunately, by limiting access by investors and traders to information, markets are prone to greater volatility arising from rumors and misinformation. Faced with deep and perhaps intractable problems in putting their economic and financial houses in order, economies in East Asian face a difficult uphill battle. Most will seek to cut prices to export their way out of their predicament, but other countries both in and outside of the region will increasingly challenge them in their traditional markets. Meanwhile, foreign investors will impose higher standards in assessing commercial and political risk before committing funds to East Asia. With hindsight, the high performance of the economies in the region came more easily than will even lower growth rates in the future. In essence, shared aspects of East Asia's political culture reproduced flaws in the institutional infrastructure of the 'miracle' economies. Consequently, they were ill prepared to sustain external shocks generated by inevitable global capital flows. As such the rigidity of conservative political institutions led to policies that interfered with the self-adjusting mechanisms in their economies. While restoration of stability in East Asian economies will be a difficult road, the slow pace of institutional changes will make recovery an even longer one. Indeed, it may require a generation before some East Asian economies can replicate the required institutional infrastructure for sustainable economic growth that will be required by the increasingly efficient global capital market.

REFERENCES Alston, L. J., Eggertsson, T., & North, D. C. (Eds) (1996). Empirical Studies in Institutional Change. Cambridge: Cambridge University Press. Arogyaswamy, B. (1998). The Asian Miracle, Myth, and Mirage: The Economic Slowdown Is Here to Stay. Greenwood Press. Goldstein, M. (1998). The Asian Financial Crisis: Causes, Cures, and Systemic Implications. Washington, DC: Institute for International Economics. Greider, W. (1998). One World, Ready or not: The Manic Logic of Global Capitalism. Touchstone Books. Henderson, C. (1998). Asia Falling: Making Sense of the Asian Currency Crisis and Its Aftermath. New York: McGraw-Hill.

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Katz, R. (1998). Japan, the System That Soured." The Rise and Fall of the Japanese Economic Miracle. Armonk, NY: M. E. Sharpe. Krugman, P. (1998). Saving Asia: It's Time to Get Radical. Fortune, (September 7). Krugman, P. (1994). The Myth of Asia's Miracle. Foreign Affairs, (November/December), 62-73. Lingle, C. (1998). The Rise and Decline of the Asian Century. Seattle: University of Washington Press. Mahbubani, K. (1998). Can Asians Think? Singapore: Times Editions Books. Mahbubani, K. (1995). The Pacific Way. Foreign Affairs, 74(1), 100-i 11. North, D. C. (1990). Institutions, Institutional Change and Economic Performance. Cambridge: Cambridge University Press. Rodrik, D. (1997). Has Globalization Gone Too Far? Washington, DC: Institute for International Economics. Young, A. (1994). Lessons from the East Asian NIC's: A Contrarian View. European Economic Review, 964-973. Young, A. (1995). The Tyranny of Numbers: confronting the Statistical Realities of the East Asian Growth Experience. Quarterly Journal of Economics, August. Wade, R. (1993) Governing the Market: Economic Theo~ and the Role of Government in East Asian Industrialization. Princeton, NJ: Princeton Univ. Press. World Bank (1993). The Asian Miracle. Oxford University Press.

FINANCIAL LIBERALIZATION, CAPITAL MOBILITY, AND FINANCIAL CRISES Jiawen Yang* Financial liberalization encompasses deregulation of the domestic financial markets and the freedom of capital mobility across economies. While the world has witnessed a long history of foreign direct investment, financial capital flows including portfolio investment and short-term capital movements gained prominence towards the end of the 20th century. Indeed, international financial capital mobility has been at the core of the so called 'international financial liberalization', 'financial globalization', or 'international financial market integration'. The roles of, and the implications for, international investors and the emerging markets have been very different in the liberalization process. Financial liberalization enables international investors move capital swiftly around the world in search of high returns. For most emerging markets, financial liberalization entails relaxation of capital and exchange controls and opening the door to allow for financial capital to flow in and out freely.1 It is often claimed that free capital mobility benefits to the recipients as well as the investors. Like free trade, the free flow of capital across countries can lower the cost of capital and promote economic growth for the recipient countries. While such potential does exist in the long run, the benefits of free capital mobility to many emerging markets have appeared illusionary. Instead, the swirls of large financial flows have brought adverse, and sometimes * School of Business and Public Management, The George Washington University. I thank Huiping Dong and Lili Zhu for their research assistance. Asian Financial Crisis, Volume 1, pages 175-197. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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devastating, effects to the recipients' economies. The world debt crisis in the early 1980s, the 1994 Mexican peso crisis, and the financial crises suffered by many emerging markets throughout the world in the late 1990s provide ample evidence of the damages that free financial capital flows can bring to the emerging markets. 2 There has been an enormous literature on the causes and consequences of these financial crises. Much attention has been given to the stability of international financial systems and to risk assessment and management on the part of international investors. To the extent the roles of the emerging markets have been discussed, they are often blamed for lack of transparency, lack of regulation and supervision, and lack of appropriate management of their economies in general. The role of financial capital flows has been at the center of policy debates among academics, policy makers, and market participants. Those who blame the emerging markets for their financial crises, argue that capital liberalization is a good thing and emerging markets are better off improving their financial systems rather than restricting the inflow of capital. Others who believe that even a well managed but small economy might be overpowered the power of vast international capital flows argue that some limits on such flows, particularly the most volatile and pernicious short-term kind, might therefore be warranted. 3 It seems there is some confusion in the debates and the literature. First, while people have become increasingly aware of the adverse effects of short-term capital flows to emerging markets, the distinction among different types of capital flows and their impacts on emerging markets is not laid bare. One hears too often that people argue for free flow of capital on the benefits of free markets and on the basis of improving economic efficiency. However, direct investment, portfolio investment, commercial loans, and capital flows involving financial derivatives enter emerging markets with different objectives and have drastically different impacts on host economies. Second, the time structure in many policy recommendations is not clearly framed. The seemingly contrasting policy prescriptions may have different timing implications. For many emerging markets, financial liberalization and free capital mobility may work for them over time when the appropriate macroeconomic infrastructures are established, while some restrictions are necessary given the current chaotic economic and financial situation. The purpose of this chapter is to analyze the impacts of financial liberalization and financial capital flows on emerging markets. In doing so, the chapter attempts to clarify three points. First, it distinguishes financial capital flows from real investment. These two types of capital flows differ significantly

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in the association between the sources and uses of funds, investor responsibility, and contribution to the host economy. Second, through analysis of the characteristics of financial capital flows and the immature nature of the financial system in emerging markets, the chapter highlights the damaging effects of financial capital flows on emerging markets financial stability and economic welfare. Third, the chapter emphasizes that many alleged problems with emerging markets are inherent and solving these problems takes time. In the interim, different approaches toward financial liberalization and capital flows should be adopted based on the development of the economy and the macroeconomic infrastructure.

DISTINCTIONS BETWEEN DIRECT INVESTMENT AND FINANCIAL

CAPITAL FLOWS

A country's economic growth derives from two ingredients: accumulation of physical capital and more efficient use of resources (Dornbusch & Reynoso, 1989). In a closed economy, domestic savings are the only source of investment and physical capital accumulation. In an open economy, however, domestic investment can be financed by foreign capital. It is generally known that industrial countries are abundant in capital while emerging markets have a constant shortage of capital for economic development. Standard foreign direct investment theories claim that foreign investment helps bring a more efficient allocation of capital across countries and is assumed to be beneficial to both the investors and the recipients. To the investors, foreign investment provides them with more investment opportunities and higher returns; to the recipients, foreign investment affords them lower cost of capital and higher economic growth. Yet the assumed benefits depend crucially on the efficient use (or allocation) of foreign capital. Efficient use of capital involves the employment of technology and management skills. In fact, many emerging markets do not welcome or encourage foreign investment for the sake of money, but for the efficiency that may not be obtained through domestic investment. However, foreign direct investment is not the only type of capital flows today and the major features of foreign direct investment do not necessarily apply to all kinds of international capital flows. According to the classification in the Balance of Payments Statistics published by the International Monetary Fund (IMF), private international capital flows consist of the following three major categories of investment:4 Direct investment - reflecting the lasting interest of a resident entity in one economy (direct investor) in an entity resident in another economy (direct investment enterprise) - covers all transactions between direct investors and

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direct investment enterprises. [...] Direct investment transactions (abroad and in the reporting economy) are sub classified into equity capital, reinvested earnings, and other capital (intercompany transactions). Portfolio investment covers transactions in equity securities and debt securities; the latter are subsectored into bonds and notes, money market instruments, and financial derivatives (such as options) when the derivatives generate financial claims and liabilities. Other investment covers short- and long-term trade credits; loans; currency and deposits; and other accounts receivable and payable. Foreign direct investment has been around throughout the modern history and has been steadily increasing over time. The surge and whirling flows of portfolio investment and other investment have been a relatively more recent phenomenon. As Table 1 shows, net portfolio investment, bank loans and other investment to emerging markets well surpassed net foreign direct investment in the years preceding the Mexican peso crisis in 1994/1995. In 1991, non-direct investment capital flows to emerging markets were almost three time as much as direct investment flows. It is even more striking to note the overwhelming non-direct investment capital flows to Latin America and to the five Asian countries that have been affected by financial crises. Table 2 shows that the non-direct investment to direct investment ratio reached 4.21 in 1993, immediately before the Mexican peso crisis. Net portfolio capital flow in that year was actually more than five times as much as that of direct investment. For the five Asian markets, as Table 3 presents, the non-direct investment to direct investment ratio ranged between

Table 1.

Private Capital Flows to Emerging Markets (In billions of U.S. dollars) 1990 1991 1 9 9 2 1993 1 9 9 4 1995 1 9 9 6 1 9 9 7

Net foreign direct investment 18.4 3 1 . 3 Net portfolio investment 17.4 36.9 Bankloans and other 11.9 55.6 Total net private capital 47.7 123.8 inflows Non-direct investment to 1.59 2.96 direct investment ratio*

3 5 . 5 56.8 82.6 96.7 115 5 1 . 1 113.6 105.6 41.2 80.8 32.7 11.5 -35.5 55.4 16.3 119.3 181.9 152.7 193.3 212.1 2.36

2.20

0.85

1 . 0 0 0.84

1998

140 131 66.8 36.7 -57.6 -103.5 149.2 64.2 0.07

~3.51

Sources: IME International Capital Markets, September 1999. * The ratio is defined as (Net portfolio investment+Bank loans and other)/Net foreign direct investment

Financial Liberalization, Capital Mobility, and Financial Crises Table 2.

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Private Capital Flows to Emerging Markets in Western Hemisphere (In billions of U.S. dollars) 1990 1991 1992 1993 1994 1995 1996 1997 1998

Net foreign direct investment 6.7 11.3 13.9 12.0 24.9 Net portfolio investment 17.5 14.7 30.3 6 1 . 1 60.8 Bank loans and other -10.5 -2.0 11.7 -10.6 -38.2 Total netprivatecapitalinfiows 13.7 24.0 55.9 6 2 . 5 47.5 Non-direct investmentto 1.04 1.12 3.02 4.21 0.91 direct investmentratio

26.0 39.3 50.6 54.0 1.7 40.0 39.7 33.0 10.6 2.7 -3.1 -18.1 38.3 82.0 87.2 68.9 0.47 1.09 0.72 0.28

Sources and notes: See Table 1.

four to six in the years preceding the so-called Asian financial crisis. There is, however, a sharp contrast in the composition of non-direct investment capital flows to the two groups of countries. Portfolio capital flows dominated the capital flows to Latin American while bank loans and other investment dominated the capital flows to the five Asian countries. Indeed, bank loans and other investment were three or four times as much as direct investment capital flows to the five Asian countries in 1995 and 1996. The surge and the swirls of large non-direct investment capital flows to emerging markets in the 1990s have been unprecedented. This is a result of at least two new developments in the international financial market. First, financial liberalization in many emerging markets paved the way for the free

Table 3.

Private Capital Flows to Five Asian Emerging Markets Affected by Financial Crisis* (In billions of U.S. dollars) 1990 1991 1992 1993 1994 1995 1996 1997 1998

Net foreign direct investment 6.0 6.1 6.3 6.7 6.5 8.7 9.5 12.1 4.9 Net portfolio investment 0.3 3.4 5.3 16.5 8.3 17.0 20.0 12.6 ~i.5 Bank loans and other 17.9 17.3 15.0 8.7 18.4 36.9 32.9 -44.5 -44.5 Total net private capital inflows 24.2 26.8 26.6 31.9 33.2 62.6 62.4 -19.8 -46.1 Non-direct investmentto 3.03 3.39 3.22 3.76 4.11 6.20 5.57 -2.64 -10.41 direct investmentratio Sources and notes: See Table 1. * Indonesia, Korea, Malaysia, the Philippines,and Thailand.

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flow of non-direct investment capital across countries. Second, financial innovation and the development of information technology have made it possible to transfer capital across countries with many more sophisticated financial instruments and at an ever-increasing speed. Because of their nature and for ease of expression, non-direct investment capital flows will be referred to as financial capital flows hereafter in this chapter. While there has been an enormous literature on foreign direct investment and the economic growth in emerging markets, serious studies of the role of financial capital flows in the economic development of emerging markets are still lacking and lagging. Proponents for the free flow of financial capital use more or less the same arguments for free trade and for foreign direct investment. Application of these arguments to financial capital flows is at best being farfetched if not misleading. There are fundamental distinctions between direct investment and financial capital flows. Table 4 attempts to present a summary comparison of the basic features between direct investment and financial capital flows. As financial capital flows are very much diversified, two major categories - equity securities and debt (securities and bank loans) - are singled out for comparison with direct investment. Features for each category of capital flows are related to each other and are therefore not mutually exclusive. One caveat is in order. Due to the complexity of both direct investment and financial capital flows, the summary can only provide some highlights without being able to cater to much details or specifics. As manifested in Table 4, many important features whereby foreign direct investment contributes to the host economies' efficiency and growth do not exist with financial capital flows. The first and natural dimension that sets financial capital flows apart from direct investment is how the foreign capital is allocated. In direct investment, the foreign investor bypasses financial market intermediation and outlays the budgeted capital to selected projects and operations. It is assumed that the investor has done all the necessary studies and investigations of the investment environment and the specific projects before the capital commitment. On the other hand, financial capital flows enter the host country through financial market intermediation. Financial markets, including the banking sector, are very immature in many emerging markets and may not have the capacity to allocate foreign capital to the most productive uses. It is now well known that many emerging markets suffering from financial crisis bear much blame for problems including weak financial sectors and lack of banking regulation and supervision. Misallocation of foreign capital may also due to government intervention or corruption that are prevalent in some emerging markets.

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Another major distinction between direct investment and financial capital flows is in efficient use of capital. To turn good investment opportunities into economic success requires not only capital, but also the appropriate technology and management skills. Direct investment often brings in technology and management skills as well as capital. The host economy benefits (or has the possibility to benefit) from direct investment through technology transfers and other spillover effects. For many emerging markets, the need for better technology and improvement management is more urgent than pure monetary capital. But there is no technology contents or management skills in financial capital flows. Direct investment and financial capital flows also differ in how the investor is linked to the performance of the end use of capital. For direct investment, investors are at both ends of the investment process - from sources of funds to the end uses of funds. They are the owners of capital and end users of capital at the same time. They are also responsible for the success or failure of the invested projects. On the other hand, the sources of funds and uses of funds are separated in the investment chain for financial capital flows. The owners and end users of capital are different parties. Owners of capital have no direct or immediate control over the uses of capital. For investment in equity securities, the investment return does depend on the performance of the end users (invested companies) and the stock market in general. However, it can withdraw from the market very quickly. Therefore, capital flows to emerging markets through equity market have no strong or long-term commitment. For capital flows in the form of debt securities or bank loans, the debtor has the obligation to service the debt irrespective of the performance of the invested capital in its end use. Very often the debt service is guaranteed either explicitly or implicitly by the debtor's government or international institutions. With debt service guarantees, international lenders have no incentive to care about how the funds are eventually used. In this case the sources of funds and uses of funds are basically severed. The owners of funds (the lenders) may not even know who the end users are. The international lenders bear no commitment to or responsibility for the efficient use of their capital. Moreover, official guarantees of debt service may breed moral hazard and promote opportunistic or reckless lending across countries. As mentioned earlier, bank loans were a predominant component of capital flows to the five Asian countries in the years before the financial crisis broke out in 1997. In retrospect, people now realize that these loans were not properly allocated or used efficiently. Financial institutions in these emerging markets borrowed money abroad and re-lent the borrowed funds domestically without scrutinizing the end users or the projects involved. In a well-developed and

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well-regulated financial market, the banking sector should have the ability to efficiently channel the sources of financial capital to the end uses of funds. First, it is equipped with information and the sophistication for project and credit evaluation. Second, its lending decision is based on market conditions. Third, in case of default, the legal infrastructure provides some recourse of the invested funds. The financial and legal infrastructure in many emerging markets is not yet as developed to affect efficient allocation of financial capital or monitor its performance. FINANCIAL

CAPITAL

FLOWS

AND ECONOMIC

GROWTH IN EMERGING MARKETS: A M I S M A T C H Suffice it to say that the basic theories of foreign direct investment do not apply to financial capital flows given their fundamental differences outlined in the previous section. Can financial capital flows contribute to the economic development in emerging markets then? Whether or not foreign capital can contribute to the recipient country's economic growth depends on whether the sources of funds match the uses of funds in at least two aspects: the investment horizon and the investment return. The time horizon for which the funds are committed by the foreign investor can be different from investment horizon needed by the end users of funds. The required rate of return by the foreign investor may also be different from the return generated from the investment project. In case of direct investment, the foreign investor is responsible to match the investment horizons and the returns. For financial capital flows to contribute to the recipient country's economic growth, it has to meet at least two minimum conditions. First, there has to be a steady and constant inflow of funds. This condition is based on the fact that most financial capital flows are short term in nature while the economic development in emerging markets needs long-term capital commitments. If there is a constant inflow of financial capital, short-term investment can be rolled over to finance long-term projects. This is analogous to the short-term borrowing and long-term lending by commercial banks. Liquidity crisis will occur if the short-term capital inflows stop and reverse. Second, the return generated from investment projects financed by the financial capital inflows has to be high enough to service the foreign liability. In direct investment, the foreign investor bears the losses if the return on the investment falls short of the cost of capital. In financial capital flows, particularly in the case of foreign debt, the required interest rate by the foreign lender is either fixed or floating based on a particular reference rate. The stream of cash flows generated from the invested funds may not be able to meet the

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periodical debt service requirements. Default occurs when the borrower is unable to service the debt. Failure to meet the debt service requirement may be due to liquidity problems or to misuse of funds or mismanagement of the investment projects. Prevalence of such defaults or the threat of such defaults can lead to financial crisis and cripple the domestic economy. International financial capital flows can potentially make contributions to the economic growth of emerging markets if these two conditions are met. Unfortunately, they have not been met in the experience of many emerging markets. First, due to the features described in the next section, the supply of financial capital to developing countries is anything but steady. Internal and/or external adverse events can cause financial capital flows to a sudden stop or even a reversal, thus derailing the investment projects. Second, both the internal and external factors have often made debt servicing difficult for emerging markets. Internally, it is believed that financial capital inflows have not been allocated or used efficiently in many emerging markets. Externally, interest rate and foreign exchange rate risks, commodity prices for the exports by many emerging markets, and the general economic situation in the industrial world all have often aggravated the debt-servicing burden. Generally, interest rate risk is a major source of cash flow mismatch of shortterm capital financing for long-term development. In a domestic setting, investors (depositors) put their money into a bank in part because they require the flexibility that short-term deposits provide, while companies borrow from banks because they want the peace of mind that longer-term loans offer (Dufey & Giddy, 1994, p. 223). When rates rise, the bank's profits are squeezed because the cost of funds rises more rapidly than the return on earning assets. The result is negative profits and declining net worth that threaten the bank's solvency. Two problems exist: (1) the funds may not be rolled over because of disintermediation (the 'silent run'), and (2) if they are rolled over, it is usually at a higher rate. The latter combined with the fixed rate mortgage creates the interest-rate risk that leads to a squeeze on profits and eventually on net worth (Sinkey, 1992, p. 373). Similarly, international investors put their financial capital in developing countries on a short-term basis because they want to retain flexibility while taking advantage of higher interest earnings. Floating rate long-term lending is equivalent to short-term capital as interest rates are set periodically based on contemporaneous interest rates. For a recipient country that uses the short-term funds or floating rate long-term debt to finance long-term development, the income stream and interest payment stream may diverge as they are determined by two different sets of factors. When short-term interest rates rise in the international money market and/or income declines, debt servicing becomes

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difficult. This is what happened when the world debt crisis occurred in the early 1980s. Most of the developing countries debt was denominated in U.S. dollars and set at floating interest rates. The debtor countries export earnings declined due to both a reduction in export volume and a deterioration in their terms of trade as a result of the industrial countries' economic recession. At the same time, U.S. interest rates exhibited a series of spikes and the U.S. dollar appreciated persistently. The simultaneous increase in debt service burdens and decrease in export earnings eventually brought the debtors countries to default. The creditors, mainly commercial banks in the international money centers, were unwilling to roll over their loans. Capital inflows to the debtor countries came to an abrupt stop and then a reverse flow of capital ensued in the years that followed. Misallocation and inefficient use of the borrowed capital may also be the major reason for many emerging markets to fail to generate the necessary cash flow to meet the debt-servicing requirement. First, the foreign capital may be used in non-productive sectors. For example, the borrowed funds may not generate any cash flow if they are used to finance government deficit or domestic consumption. Second, the foreign capital may not be allocated to most viable projects either due to incompetence of financial market intermediation or to government policy. Third, the investment may lack the technology and management skills that are often embedded in foreign direct investment. Although other financial capital flows, including investment in equity securities, may not require contractual returns from the recipient countries, they do exert undesirable pressures on the recipient country's financial systems. The capital markets in many emerging economies have a relatively small investor base and market capitalization. Therefore, they may not be able to absorb unduly large capital inflows. While large inflows may fuel the stock prices, large capital outflows can exacerbate the pressure for market crash. CHARACTERISTICS

OF FINANCIAL INFLOWS

CAPITAL

The analysis in the previous section concludes that financial capital flows do not meet the two minimum conditions for contribution to the economic development in emerging markets, and hence there is a mismatch between financial capital flows and the emerging markets' long-term development strategies. To further understand this point, this section examines the characteristics of international financial capital flows.

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Financial Capital Inflows Are Driven by Excess Liquidity in the International Market Kaufman (1996) compares the contemporary financial capital inflows to emerging markets with those in the 1920s and states, "Then as now, the dilemma is that foreign investing in emerging countries is a fair-weather tactic, mainly driven by the industrial world's excess liquidity" The oil shocks in the 1970s generated tremendous surplus funds from the oil exporting countries. As was observed by Killick & Sutton (1982, p. 51), the overriding objective of these countries was to invest their surpluses in a portfolio of fairly liquid assets that would yield a positive real rate of return or would at least avoid any erosion of real asset values. Commercial banks in the international money centers played an important role in the large-scale recycling of petro-dollars. The banks had effectively increased their international financing as a means of increasing profits and the volume of business (O'Brien, 1982, p. 143). In the early 1990s, lower interest rates in a few industrial countries created a supply of money that was "itching to invest overseas" (Wysocki, 1995). The key point here is the exogeneity of the supply of capital flows to the emerging markets. Many discussions of foreign borrowing, indeed, assume that the accumulation of foreign debt is driven entirely by the borrowing nations. Frieden (1991, p. 53) argues that the possibility of foreign financing is not constant. It is generally the international lenders who set the timing, the amount, and the price at which emerging markets can extract financing externally. Therefore, there is no guarantee that there will be a constant or steady flow of capital to finance long-term economic growth.

Financial Capital Inflows are Subject to Sudden Reversal Since financial capital is liquid in nature, while it is provided quickly, it is also withdrawn quickly when the warning signals are seen (O'Brien, 1982, p. 144). Such warning signals may be any major adverse events, or expectations of such events, be they internal or external, political or economic. In these cases, international investors may be quick to withdraw from the emerging markets and cease to provide future funding or credit. Moreover, with capital mobility, domestic residents as well as foreign investors try to move their capital (or savings) out of the country in panic. Indeed, in the Mexican financial crisis in 1994, local residents put the most pressure on the peso as the crisis approached (Whitt, 1996), thereby accelerating the financial problems and accentuating the costs.

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Financial Capital Inflows Can Become Sources of Speculative Attacks on the Domestic Currency A speculative attack on a fixed or managed exchange rate is a sudden and massive restructuring of portfolios in which market participants attempt to reap gains or prevent losses from an expected change in the exchange rate regime (IMF, 1995, p. 70). It is often regarded as a market's rational response to a perceived inconsistency in economic policies. Calvo & Mendoza (1996) and others argue, however, that a speculative attack can topple an exchange rate peg even when economic 'fundamentals' are sound, if investors display a herding behavior and the country is financially vulnerable with large amounts of shortterm debt. Emerging markets are not alone in being vulnerable to the speculative attacks by international financial investors. In response to the 1992 ERM crisis, the Committee of Governors of the Central Banks of the member states of the EEC stated (Temperton, 1993, p. 301): As the crisis developed, it became evident that the liberalization and deregulation of financial markets and their growing integration - which had greatly facilitated the flow of private capital to Communitycountries with financing needs - had also provided scope for capital movementsof an unprecedented size. Within these capital movements,speculative operations proved at times to be a notable destabilizing force giving rise to serious problems also for currencies of countries with sound economic fundamentals, thereby imposing sizeable costs on the countries concerned. Speculativeoperations also imposed a disproportionate burden on currencies of small countries.

Financial Capital Inflows Are Influenced by Interest Rates in Industrial Countries Studies have shown that interest rates in industrial countries, particularly the U.S. dollar interest rates, have profoundly affected the financial capital inflows and outflows in emerging markets. In the early 1990s, with U.S. interest rates so low, investors were unusually willing to consider moving funds to Mexico and other developing countries in hopes of earning higher returns (Whitt, 1996). Calvo, Leiderman & Reinhart (1993) and Dooley, Fernandez-Arias & Kletzer (1994) suggest that while capital inflows to emerging markets during this period can be attributed partly to policy reforms in those countries, they were also a response to the low interest rates in the United States. In a study of U.S. interest rates and portfolio investment in Latin America, Yang (1997) finds a statistically significant negative relationship for Mexico, Brazil and Argentina. The impact of U.S. interest rates may be best described in a Wall Street Journal article (Wysocki, 1995):

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When U.S. rates drop, they encourageAmericaninvestorsto seek higher rates abroad. That happened in 1990 to 1993, when more than $150 billion flooded the securities markets of Latin America,Asia and Eastern Europe. But when U.S. rates rise, the investmentstend to flow back home. That is what occurredin 1994, in the sell-offof stocks and bonds in many emerging countries. In Mexico, the outflow was a fundamental cause of the financial crisis last December.

Loan Guarantees and Bailouts Bred Moral Hazard in InterNational Lending As pointed out in an IMF report, an important issue in understanding the surges in capital flows and financial crises is the extent to which private investors are encouraged to undertake imprudent risks on account of the expectation of official support (IMF, 1998, pp. 6-7). International lenders sometimes have double or triple protection for their lending to emerging markets. First, their loans are often secured or guaranteed by the governments of the borrowing countries. Second, the governments of the lenders themselves may bail them out if debt crisis occurs since they are too big to fail. Third, international organizations like the IMF may bail them out as they worry about the stability of the international monetary system. These institutional arrangements encourage financial institutions to take excessive risk. In fact they are sometimes too eager to lend when there is excess liquidity in the domestic money market. The excess lending (or excess borrowing on the part of emerging markets) is not readily turned into productive capacities in recipient countries due to reasons discussed earlier. When the bubble bursts and the borrowers default, the international investors are bailed out by international organizations and/or the governments of the industrial countries, who are eventually, at least partially, reimbursed by the taxpayers in the affected emerging markets.

LONG-LASTING DAMAGING EFFECTS OF FINANCIAL CRISES Given the characteristics of financial capital flows and their mismatch with the long-term development strategies of emerging markets, the free flow of financial capital may not render benefits to the emerging markets. In fact, financial capital flows have brought crises rather than developments to emerging markets in the last quarter of the 20th century. By their very nature, emerging markets are more prone to capital-flow-related financial crises. Financial capital flows to industrial countries have been far greater by volume than those to emerging market. Yet the capital-flow-related financial crises with

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emerging markets have so far been much more frequent and severe. Although the overall adverse effects of financial crises on developing countries are hard to gauge and few studies have made strenuous efforts to do so, the setbacks for emerging markets have been sporadically observed in the literature and shown by empirical evidence. The long-lasting damages incurred by the crises-ridden countries include painful economic adjustments, income transfer, high costs of returning to the world capital market, and slower economic growth.

Painful Economic Adjustment and Welfare Deterioration Financial crises often force countries involved to make unusually strong efforts toward austerity such as cutting government spending, tightening monetary control, and devaluing the domestic currency. These contractionary adjustment measures lower imports and thus free foreign exchange to service their external liabilities. However necessary these belt-tightening measures may be, they take a painful toll on their income and standard of living. In evaluating the world debt crisis of the early 1980s, Dornbusch (1984, p. 210) observes, "The duration and magnitude of the income decline are frightening in themselves. Adjustment has gone far beyond cutting fiscal extravagance." Between 1981 and 1983, merchandise imports for Latin America fell 45% in dollars; the current account deficit of the region fell from U.S.$38 billion to U.S.$18 million in the same period. Per capita income in 1983 was 15% lower than it was in 1980 (Kuczynski, 1984, p. 86). By 1990 per capita income in Latin America was still below 1975 levels (Frieden, 1991, p. 3). In evaluating the impact of the Asian financial crisis toward the end of the 20th century, Joseph Stiglitz (World Bank, 2000, p. vii) stated: [...] the crisis has increased povertyin the EastAsian crisis countries, in Brazil and Russia. Not only has the increase in poverty been significant, whether measured by levels of income or consumption, but the crisis has engendered large costly movements of populations and sharp declines in standards of living for the middle classes. Urban poverty increased in all countries, particularly the Republic of Korea. Although efforts were made to maintain spending on social services, real public expenditures on health and education fell in the crisis countries, with a particularly severe impact on access to services in Indonesia.

Resource~Income Transfer In the aftermath of a developing country financial crisis, debt service becomes the focal issue while fresh capital inflows slow down or stop, leading to a net resource outflow. This was clearly manifested for the debtor countries in the 1980s. Dornbusch (1984, p. 210), again, observes, "The large debts due to past

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policy mistakes of the debtors and events beyond their control combine with high interest rates due to U.S. policy mistakes today. The result is a vast transfer of income from poor people in poor countries to wealth holders in rich countries." Kuczynski (1984, p. 87) also observes "Latin America is now transferring to the commercial banks systematically more than it receives from them, a sharp reversal of the trend which prevailed until 1980."

High Borrowing Cost Financial crises often stigmatize developing countries as risky borrowers and the international financial markets demand high premia for new lending to these countries. This further aggravates the difficulties of debtor countries. Bolstered by the joint efforts of the United States and the International Monetary Fund, Mexico was able to come back to the world financial markets to borrow after the peso crisis. However, its new debt issue in July 1995 carried a 5.375% spread over LIBOR (London Interbank Offered Rate) or about 11% on the date of the sale, while similar issues by Korean institutions carried spreads that were well below 1% (World Bank, 1996). Yet the borrowing costs for the Asian economies rose significantly after financial crisis befell upon them as well. By early October 1998, spreads for most Asian and Latin American emerging markets had risen to over 800 basis points (BIS 1999, pp. 35-36).

Slow Economic Growth The most obvious effects of financial crises are on the economic growth of the countries involved. The aftermath of the world debt crisis is alarmingly thought provoking. As Table 5 shows, the average annual GDP growth rate of the Latin American countries (indicated as Western Hemisphere in the table) between 1969 and 1980 was about the same as that of the Asian developing countries. But since world debt crisis, a wedge between the two series of growth rates emerged with Asia growing at higher rate throughout the 1980s and much of the 1990s. Gibson & Tsakalotos (1992) observe that the 1980s was a period in many less developed countries of falling living standards, rising unemployment and poverty and slow, if not negative, growth. Till today several debtor countries have not fully emerged from the shadows of the debt crisis. The divergence in growth rates between the two regions at least in part reflects the difference in financing strategies they had followed in the past few decades. Most Asian countries until the 1990s pursued internally oriented financing strategies. That is, much of the capital needed to finance domestic

Financial Liberalization, Capital Mobility, and Financial Crises

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investment had been provided by domestic savings. On the other hand, most Latin American countries adopted a development strategy of externally financed growth under which much of the funding for domestic investment came from foreign lenders and investors. The funds to repay these lenders and investors were expected to come out of the profits derived from the investment projects (Espinosa & Russel, 1996). It seems clear today that the external financing strategies failed to contribute to the economic growth in Latin America. To the extent that developing countries in Asia had also been a major recipient of international capital, the capital inflows to Asia in the past differed from those to Latin America in two aspects. First, it was observed that investments in Latin America were dominated by debt before the world debt crisis and by portfolio and privatization-related financial flows in early 1990s, while those into Asia had mainly taken the form of direct investment capital (BIS, 1994). Second, it was also observed that during the 1982-91 period, capital inflows had grown relatively steadily in Asia, had been poor in Africa, and had fluctuated sharply in Latin America (Culpeper & Griffith-Johns, 1992). The erratic financial capital flows seem to have retarded rather than helped the economic growth in Latin America throughout the 1980s. The impacts of the more recent financial crises on the economic growth in emerging markets are also obvious. During the late 1980s and early 1990s, Mexico had chosen (intentionally or unintentionally) a development strategy of externally financed growth (Espinosa & Russell, 1996). As Table 5 shows, Mexico's economic growth did pick up speed in the three years from 1989 to 1991 (GDP grew more than 4% each year), but crashed heavily following the peso crisis. Mexico's GDP declined by 6.2% in 1995. Some Asian emerging markets made dramatic changes in their policies toward international financial capital in the 1990s. They took fast steps to open up their capital account and to allow currency convertibility) Indonesia lifted capital controls very early on, allowing short-term capital to move in and out of the country with little impediments. Thailand established in 1993 operations similar to those of international banking facilities in industrial countries to help attract foreign financial capital. Malaysia eased controls on short-term (portfolio) movements in 1996. Korea had been under pressure to allow a higher degree of capital mobility in its negotiations to join the OECD. In spite of the reluctance to open the stock market to foreign funds, Korea allowed its banks to borrow heavily and at very short maturities from international banks (Edwards, 1999). The turmoil in the financial markets in Asia towards the end of the 20th century is a direct result of the premature capital account liberalization by the affected countries. The consequences are severe. Gross domestic product declined 0.4%

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for Thailand in 1997, the year Thailand entered into financial crisis, which was followed by a further 10.2% decline in 1998. GDP dropped by 5.8% and 13.7% for Korea and Indonesia respectively in 1998.

THE T R E N D O F G L O B A L I Z A T I O N AND POLICY IMPLICATIONS FOR EMERGING MARKETS Financial liberalization and financial capital mobility across countries can be seen as part of what is fashionably called the globalization trend. In fact, this trend has gone through several stages. Liberalization in international trade has been going on for hundreds of years and the war for free trade has been carried out in all fronts: economic, political, and battle fields. There have been many rounds of multilateral trade negotiations under the General Agreement on Tariffs and Trade, a forum set up after World War II, and more recently under the World Trade Organization. Tariff and non-tariff barriers have been torn down substantially, rules have been promulgated, but the fight between free trade and protection is still going on, particularly among the major economies in the world. Traditional international trade theories assume factors of production capital and labor - are mobile within a country but immobile across countries. Free trade substitutes for the movement of factors of production in efficiently allocating resources. However, capital did gain mobility a long time ago, but basically in the form of direct investment. Direct investment, like merchandise trade, has increased steadily in the past few decades. According to a report by The Wall Street Journal in 1995, foreign direct investment had grown twice as fast as international trade over the past 25 years, while trade in turn had grown twice as fast as world output (Whitman, 1995). It seems that international liberalization has gained both scope and speed toward the end of the 20th century. In scope, free flow of financial capital has been added to free trade and direct investment. In speed, what took many industrial countries several decades to accomplish has been done in a few years in some emerging markets. Many industrial countries did not liberalize their capital account until the decade of 1980s. But by mid-1990s, many emerging markets removed their exchange and capital controls. At the end of the 20th century, the push for liberalization in services in telecommunication, information, banking, and insurance is gaining momentum. What next then? Are we moving in the direction of free movement of human labor across countries? If free capital mobility can promote efficient allocation and use of resources, one can also argue for free mobility of labor along the lines of efficient allocation and use of an equally, if not more, important factor of

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production. In fact, in high levels of economic integration, such as in the Europe Union, labor mobility is allowed. Arguments for free trade in classical international trade theories are based on comparative advantage. It is often believed that industrial countries have a comparative advantage in capital-intensive goods while developing countries have a comparative advantage in labor-intensive goods. So free trade allows each trading nation to specialize in where its comparative advantage is and benefits from trade with other countries. 6 But what roles do emerging markets play in financial liberalization and liberalization in services? What do emerging market gain or have to offer except for granting market access to international investors and service providers? One has to admit that the pressure for liberalization and globalization has imposed unprecedented challenges to many emerging markets. The issue is not whether emerging markets should liberalize and be integrated into the world economy. Globalization as a trend is irresistible. The issue is how and at what pace to liberalize and be integrated into the world economy. It may be stated as a general rule that hasty liberalization may lead to peril and proactive opening may lead to prosperity for emerging markets. Although there is no consensus on the causes and policy implications of the financial crises in emerging markets in the last years of the 20th century, it is widely agreed that financial liberalization and capital mobility are at the core of the debate. One side of the debate is that there is nothing wrong with capital mobility and the cause of crisis is the weak financial sector in the emerging markets. The policy implication is that emerging markets improve their financial sector and the general macroeconomic infrastructure. The other side of the argument is that reckless financial capital flows can topple even a sound but small economy. Therefore, some capital control is necessary. Two clarifications seem in order in the debate. First, the act of improving the financial sector itself may in effect contain the flow of financial capital. For example, improved banking regulation may stop reckless lending by the banking sector and therefore limit the flow of financial capital from abroad. Second, what should emerging markets do with capital mobility in the interim of their problems being solved? Should they allow financial crises to keep pounding at them in the process? Many problems that the emerging markets are criticized for are inherent with the current stages of their economic development and will take a long time to solve. In the interim, some capital control is needed to avoid or limit the adverse effects of financial capital flows. Financial liberalization should be paced to the improvement of financial sector and the overall macroeconomic infrastructure.

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Economic development and welfare improvement are the long-term goals for emerging markets and for any other country in the world, for that matter. Domestic savings are the ultimate sources of investment financing. Reliance on foreign capital to finance domestic investment is not viable for long-term economic growth. Inadequate domestic savings will eventually pull down investment rates, either directly or through constraints on the continued buildup of foreign liabilities, which must eventually be repaid from domestic savings (World Bank, 1993).

CONCLUDING REMARKS With a basic framework to analyze the sources of funds and uses of funds, this chapter argues that financial capital flows are not viable for long-term economic growth in emerging markets. Premature financial liberalization is the major cause of the financial crisis in many emerging markets at the end of the 20th century. While there has been an enormous literature on the financial crisis in emerging markets, a systematic and coherent theoretical framework to analyze the impact of financial capital flows on emerging markets is still missing. It is hoped that this chapter has started an effort in this direction. On the empirical side, more research is still needed. As IMF points out, the empirical literature has, unfortunately, had only limited success in shedding light on the causes of the surges in capital flows and reasons for the sharp changes in the terms and conditions of market access (IMF, 1998, p. 6). Studies on the absorption capacity of foreign capital and the capital allocation mechanism in emerging markets should also prove valuable in policy analysis.

NOTES 1. The term 'emerging markets' includes the IMF's World Economic Outlook classifications of 'developing countries', 'countries in transition', and the advanced economies of Hong Kong Special Administrative Region (SAR) of China, Israel, Korea, Singapore, and the Taiwan Province of China (IMF, 1998. p. 1). 2. The financial crises that started in Thailand in summer 1997 and spread to other countries in Asia have been often called the 'Asian financial crises'. In fact, the crises have expanded well beyond Asia to include countries in Latin America and the transitional economies in Europe. 3. The former view is represented by Lawrence Summers, the U.S. treasury secretary, and latter is led by Joseph Stiglitz, chief economist at the World Bank. See The Economist (1998) for a more detailed description of the debate.

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4. IME Balance of Payments Statistics Yearbook Part 1: Country Tables 1998, p. xxvii. 5. There has been a change in the IMF definition of capital account in the late 1990s. The traditional 'capital account' is now represented by the 'capital and financial account' in current IMF balance of payments presentations. The term used here corresponds to the traditional definition. 6. Of course the real world is much more complicated and there are many new and sophisticated trade theories for and against free trade.

REFERENCES BIS (1994). 64th Annual Report. Bank for International Settlements, Basle. BIS (1999). 69th Annual Report. Bank for International Settlements, Basle. Calvo, G. A., & Mendoza, E. G. (1996). Mexico's balance-of-payments crisis: a chronicle of a death foretold. Journal Of International Economics, 3--4, 235-64 Calvo, G. A., Leiderman, L., & Reinhart, C. M. (1993). Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors, IMF Staff Papers, 40, 108-51.

Culpeper, J., & Griffith-Johns, S. (1992). Rapid Return of Private Flows to Latin America: New Trends and New Policy Issues. Economic Commission for Latin America and the Caribbean (ECLAC), United Nations. Dooley, M. P., Fernandez-Arias, E., & Kletzer, K. M. (1994). Recent Private Capital Inflows to Developing Countries: Is the Debt Crisis History? National Bureau of Economic Research Working Paper, 4792. Dornbusch, R. (1984). Discussion, in Federal Reserve Bank of Boston. In: R. Dornbusch (Ed.), The International Monetary System: Forty Years After Bretton Woods (pp. 208-212). Federal Reserve Bank of Boston. Dornbusch, R., & Reynoso, A. (1989). Financial Factors in Economic Development. American Economic Review, 2, 204-209. Dufey, G., & Giddy, I. (1994). The International Money Market (2nd ed.). Prentice Hall International. The Economist (1998). Of take-offs and tempests. The Economist, (March 14), 88. Edwards, S. (1999). On Crisis Prevention: Lessons from Mexico and East Asia. NBER Working Paper, 7233. Espinosa, M., & Russell, S. (1996). The Mexican Economic Crisis: Alternative Views, Economic Review (Federal Reserve Bank of Atlanta), 1, 21-44. Frieden, J. A. (1991). Debt, Development, and Democracy: Modern Political Economy and Latin America, 1965-1985. Princeton University Press: Princeton, New Jersey. Gibson, H. D., & Tsakalotos, E. (1992). The International Debt Crisis: Causes, Consequences and Solutions. In: T. Hewitt, H. Johnson & D. Wield (Eds), Industrialization and Development (pp. 41-65). Oxford University Press: Oxford. IMF (1995). International Capital Markets, Developments, Prospects, and Policy Issues. August. IMF (1998). International Capital Markets - Developments, Prospects, and Key Policy Issues. September. Kaufman, H. (1996). Today's Financial Euphoria Can't Last. The Wall Street Journal, November 25.

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Killick, T., & Sutton, M. (1982). Disequilibria, Financing, and Adjustment in Developing Countries. In: T. Killick (Ed.), Adjustment and Financing in the Developing World (pp. 4872). International Monetary Fund: Washington, D.C. Kuczynski, P.-P. (1984). International Emergency Lending Facilities - Are They Adequate? In: Federal Reserve Bank of Boston (Ed.), The International Monetary System: Forty Years After Bretton Woods. Federal Reserve Bank of Boston. O'Brien, R. (1982). Roles of the Euromarket and the International Monetary Fund in Financing Developing Countries. In: T. Killick (Ed.), Adjustment and Financing in the Developing World (pp. 136-54). International Monetary Fund: Washington, D.C. Sinkey, J. F. Jr. (1992). Commercial Banks Financial Management (4th ed.). Macmillan Publishing Company. Temperton, P. (1993). Official responses to the ERM crisis. In: Temperton (Ed.), The European Currency Crisis (pp. 299-316). Probus Publishing Company: Cambridge, England. The World Bank (1993). The East Asian Miracle: Economic Growth and Public Policy. Oxford University Press. The World Bank (1996). Worm Debt Tables (lst ed.). The World Bank: Washington, D.C. The World Bank (2000). Global Economic Prospects. The World Bank: Washington, D.C. Whitt, J. A. Jr. (1996). The Mexican Peso Crisis. Economic Review. Federal Reserve Bank of Atlanta, 1, 1-20. Whitman, M. V. (1995). Domestic Myths on Globalization. The Wall Street Journal, (October 27). Wysocki, B. Jr. (1995). Some Painful Lessons On Emerging Markets. The Wall Street Journal, (September 18). Yang, J. (1997). U.S. Interest Rate and Portfolio Investments in Latin America. Global Business and Financial Review, 1, 37-42.

THE IMPACT OF LIBERALIZATION AND REGIONALISM UPON CAPITAL MARKETS IN EMERGING ASIAN ECONOMIES Christopher Bilson, Vince Hooper and Martin Jaugietis ABSTRACT This chapter examines the trend towards regionalism upon stock market returns for a sample of Asian countries. We find that stock markets are becoming regionally integrated at a faster rate than globally. This finding reflects the growing co-operation between Asian countries. This study focuses upon Indonesia, Malaysia, the Philippines, South Korea, Taiwan and Thailand. These markets suffered severe contagion effects in relation to the Asian financial crisis that occurred during 1997. In addition, this study reports on the significant economic and political events that occurred in Asian economies from 1980. This study concludes that increases in liberalization coupled with stronger 'regionalism' in South East Asia contributed to the Asian financial crisis in 1997, in addition to the structural weaknesses in their financial systems. Policy setters may consider reducing the amount of intra-regional dependence in order to reduce the impact of financial crises and improve stability of the financial system.

Asian Financial Crisis, Volume 1, pages 199-235. Copyright © 2000 by Elsevier Science Inc. All rights of reproduction in any form reserved. ISBN: 0-7623-0686-6

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1. INTRODUCTION The purpose of this chapter is to investigate financial liberalization and the trend towards 'regionalism' in Asia upon stock market returns. However, it is not an objective of this study to examine whether the growth in regionalism and liberalization is good or bad from a socio-economic perspective but rather to suggest some policy-relevant questions for the governments in light of the recent financial crisis in Asia. It is argued that 'regionalism' combined with unsustainable levels of liberalization may have contributed to the Asian financial crisis. We conclude that the move towards greater regionalism in Asia may mean greater contagion effects in the future. We endorse the International Monetary Fund's call for increased transparency; good governance and intensification of the fight against corruption; strengthening of financial and banking systems; effective regional surveillance; continued liberalization of international capital flows and the strengthening of multilateral institutions. The ascendancy of stock markets in the rapidly emerging economies of Asia is due to a continual process of liberalization. Many Asian nations realised the virtues of capital markets and their contribution to economic development. Developed nations capitalised upon the opportunities for profit from investments and portfolio diversification in emerging stock markets, and found that they could hedge against potentially damaging domestic equity market shocks. These opportunities arose because of low correlations of emerging stock markets with other markets, caused by market segmentation. The market movements of developing and developed markets have become more closely related in the past decade. The forces driving globalization are faster global communication and transportation infrastructures, and the homogenization and convergence of consumer demands. This process has been reinforced by a reduction in barriers to investment in emerging equity markets. However, within the paradigm of globalization is a more potent driver of economic development - regionalism. Within Asia there has been a shift towards regionalism from the doctrine of multilateralism (Tussie, 1998). There are two major forms of regionalism in existence in Asia. The first is a relatively restrictive grouping of countries known as the ASEAN (Association of South East Asian Nations) bloc and the second is the less restrictive APEC (Asia Pacific Economic Co-operation) affiliation. The rapid industrial expansion of East Asia has been a significant contributor to the strong association and inter-dependence between their economies and the west under the concept of 'open regionalism.' (Elek, 1992). Regional trading agreements began to proliferate during the 1980s. Most countries now belong to a regional trade group. The United States has

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traditionally taken a multilateral stance and was founder of the principles driving the General Agreement on Tariffs and Trade (GATT), is a member of the North American Free Trade Agreement (NAFTA) and also the Asia-Pacific Economic Cooperation (APEC) group. The trend toward regionalism is likely to dominate the trade agenda during the 21st century. The growth in regionalism may be viewed as a progression from highly protected domestic markets towards complete globalization. The process of globalization seems to undermine the nation state as well as liberal democracy. In consequence, the need to establish democratic structures on an international level is widely accepted. However, such institutions are viewed upon with a high degree of scepticism and sometimes as instruments of economic imperialism. It may also be argued that countries that promote multilateralism are those that will benefit most from such a system. Thus regionalism could be viewed as the response to economic imperialism. Game theoretical analysis suggests that it is less costly and more beneficial to negotiate trade on a regional as opposed to a multilateral basis. A potential criticism of regionalism is that free trade areas are especially harmful because associated rules of origin offer a vehicle for increasing protection toward non-members. In addition, there could be a danger that regional trade agreements will distort trading patterns, complicate trade regulation, and hinder rather than promote progress toward multilateral liberalization. In this chapter we argue that regionalism was in part responsible for the Asian financial crisis. Within Asia, other than the Association of South-East Asian Nations, established in 1967 involving Thailand, Malaysia, the Philippines, and Indonesia, no other trading alliances have been created that may explicitly be defined as a trading bloc (Hodder, 1994). Although foreign direct investment had undergone substantial reforms especially through the relaxation of foreign exchange controls, ASEAN's intra-regional trade only constituted 12% of its total exports and imports in 1994 (Hodder, 1994). However, this had risen significantly in the past five years. Intra-regional trade amongst ASEAN countries is stronger than for any other trading bloc (Garnaut, 1998). Portfolio flows of capital also show evidence of regional patterns emerging through intense competition (Langhammer, 1995). We believe that the substantial growth in regional trade harnessed an over dependence upon the fortunes of the region. This growth in regionalism within ASEAN has been due to similar cultures, traditions and geographic proximity to one another. Geographically it is a series of islands and peninsulas that is controlled by national governments each with widely different political orientation (Hodder, 1994).

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Economic development is inherently endowed with a spatial dimension, which derives from the important cumulative effects of synergy and feedback which are activated by spatial proximity...

[Pompili, 1994]

Regional integration has both economic and political connotations. It is not necessarily just an economic union. Rather, regionalism involves the elimination of various forms of disagreement and discrimination between participating countries (Balassa, 1982). Agreements range from the removal of internal tariffs and quotas to the total unification of political and super-national institutions. Nationalistic tendencies may prevent the loosening of trade barriers because of a country's desire to maintain their own political sovereignty. For developing markets, there is a perception that developed countries close off their markets to the exports from developing countries while still wanting to establish their own markets in developing countries. Sociological analysis suggests that developing nations have been lured into a state of dependence upon Western nations (George, 1988). The regionalism trend is so strong that the decline in multilateral world trade may cause the emergence of three distinct and separate trading blocs centred around the European Community, the Americas, and Asia (Kim, 1992). The acceleration of international economic interdependence during the 1970s and 1980s is not a phenomenon solely characteristic of industrialised nations: GIobalization of economic activity is evident not only in industrialised regions but also in less developed countries

[Michalak, 1994]

2. SUMMARY OF ECONOMIC AND POLITICAL EVENTS IN ASIA LEADING UP TO THE CRISIS In the appendices, a chronology of critical economic and political events is reported for Indonesia, Malaysia, the Philippines, South Korea, Taiwan and Thailand. Prior to the early 1980s the laws governing the access to capital markets by foreigners were restrictive. This phenomenon was not only apparent in Indonesia but other countries within ASEAN. Throughout the 1980s there was a change in global political dynamics occurring in developed countries like the U.K. and U.S. which spilled over into other countries. Whereas, many Latin American countries had been severely affected by their inability to repay loans to Western banks, ASEAN countries were embarking upon a relatively stable economic trajectory. Towards the late 1980s marked a period of privatization of

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former inefficient state run industries and the 1990s. The High Performing Asian Countries (HPAE) were successful because of their high levels of private domestic investment, better educated labour force, rapidly growing human capital and rapid growth in output and productivity. In this sense there is little that is 'miraculous" about HPAEs superior record of growth; it is largely due to superior accumulation of physical and human capital • . . productivity growth in the HPAEs exceeds that o f most other developing and industrial economies. The superior productivity performance comes from the combination of unusual success at allocating capital to high-yielding investments and at catching up technologically to the industrial countries.

[World Bank, 1993].

The growth in the HPAEs considered in this chapter came about due to intensive and extensive growth. With intensive growth the economy grows because it uses new technologies and becomes more efficient, creating more output per unit of inputs. Extensive growth of the economy is due to the use of more resources as inputs, such as more factories, buildings and machines, and has higher participation rates in the labour force. It is generally considered that intensive growth is sustainable, however extensive growth can only be attained in the short-run. • . . Asian growth, impressive as it was, could mostly be explained by such bread and butter economic forces as high savings rates, good education, and the movement of underemployed peasants into the modern s e c t o r . . , if you like . . . . Asian growth has so far been mainly a matter of perspiration rather than inspiration - of working harder, not smarter.

[Krugman, 1997]

As Krugman himself says, this conclusion is controversial. In terms of the crisis, the International Monetary Fund (IMF) viewed these important dates: ~ Phase I (January - April 1997): Lead up to Crisis in Thailand. Phase II (May - beginning July 1997): Thai Crisis. Phase III (Beginning July - mid-October 1997): Crisis engulfs ASEAN--4. Phase IV (Mid-October 1997 - Present): Spillovers across global financial markets. The Asian financial crisis was very different from past occurrences in other regions, for example Latin America. All governments were more or less in fiscal balance; there was no irresponsible credit creation, or runaway monetary expansion; also inflation was low. In addition, there was no substantial unemployment when the crisis began. However, there was an over reliance upon financial intermediaries as central players in the economies of many

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South-East Asian nations. Thai finance companies tended to borrow short and lend to speculative investors, largely in real estate. It was these financial intermediaries that contributed to the inflating of a speculative 'bubble'. The following outlines Paul Krugman's 'Bubble Story': The first act was the story of the bubble. It began, we now think, with bad banking. In all of the countries that are currently in crisis, there was a fuzzy line at best between what was public and what was private; the minister's nephew or the president's son could open a bank and raise money both from the domestic populace and from foreign lenders, with everyone believing that their money was safe because official connections stood behind the institution. Government guarantees on bank deposits are standard practice throughout the world, but normally these guarantees come with strings attached. The owners of banks have to meet capital requirements (that is, put a lot of their own money at risk), restrict themselves to prudent investments, and so on. In Asian countries, however, too many people seem to have been granted privilege without responsibility, allowing them to play a game of "heads I win, tails somebody else loses".

Inflating the Bubble The bubble was inflated still further by credulous foreign investors, who were all to put money into faraway countries about which they knew nothing (except that thriving). It was also, f o r a while, self-sustaining: All those irresponsible loans boom in real estate and stock markets, which made the balance sheets of banks clients look much healthier than they were.

too eager they were created a and their

The Bubble Bursts "Soon enough, Asia was set up for the second act, the bursting of the bubble. The bursting had to happen sooner or later. At some point it was going to become clear that the Panglossian values Asian markets had placed on assets weren't realistic in this imperfect world, that Asian conglomerates are no better than their Western counterparts at trying to be in every business in every country. But the collapse came sooner rather than later because speculative bubbles are vulnerable to self-fulfilling pessimism: As soon as a significant number of investors begin to wonder whether the bubble will burst, it does"

Start of Downward Spiral What actually started this downward spiral? Who cares,t Any little thing can set off an avalanche once the conditions are right. Probably the proximate causes were a slump in the semiconductor market and a rise in the dollar-yen exchange rate, but if they hadn't triggered the crisis, something else would have.

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Downward Spiral So Asia went into a downward spiral. As nervous investors began to pull their money out of banks, asset prices plunged. As asset pricesfell, it became increasingly doubO~ul whether governments would really stand behind the deposits and loans that remained, and investors fled all the faster. Foreign investors stampeded for the exits, forcing currency devaluations, which worsened the crisis still more as banks and companies found themselves with assets in devalued baht or rupiah, but with liabilities in lamentably solid dollars.

[Krugman, 1998]

The IMF's view was that structural factors were at the heart of the economic problems. First and foremost, the crisis was a financial sector crisis. There were several weaknesses. The financial sectors in Indonesia, Korea, and Thailand lacked proper prudential standards and supervision. For instance, financial institutions had been allowed to borrow from abroad because of inadequate prudential controls on their foreign exchange exposure. The sizeable capital inflows had given rise to investment in equity and property and the risks associated with price bubbles. In the case of Korea, foreign borrowing, channelled through the bank had financed excessive investment of the conglomerates, the so-called 'chaebol'. These conglomerates suffered from very high debt/equity ratios. In addition, a large trade decline during 1996-97 hurt the profitability of the conglomerates and resulted in a string of bankruptcies in 1997 to the detriment of the financial sector. The authorities had in some instances come to the rescue of insolvent financial institutions and prevented them from being liquidated. In all the Asian economies affected by the crisis, there is a need to review the close relationship among the government, banks and the enterprises and ensure that it reflects market conditions and is subject to greater transparency about the financial relations between the partners. 3. D A T A A N D M E T H O D The monthly total U.S. dollar ($U.S.) 2 returns used in this study are derived from Morgan Stanley Capital International (MSCI) and the International Finance Corporation (IFC) indices maintained on the Datastream International Equities Database. The use of $U.S. may be criticised on the grounds that capital controls and restrictions on foreign investment, well known to exist in emerging markets, may reduce the meaningful explanatory power of $U.S. returns. However, evidence suggests that domestic currency returns are similar to those of real currency returns, and so justifies the use of $U.S. returns. Furthermore, by using $US returns, cross-country comparability of results is ensured (Harvey, 1991). 3

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The MSCI international indices consist of value weighted, dividend inclusive data of a broad representation of stocks in different countries. Non-nationals can readily purchase almost all these stocks. However, much criticism has been levelled at MSCI indices because they are weighted towards larger capitalization stocks. The results are thereby biased towards a somewhat more stable return series, characteristic of 'Blue Chip' stocks. 4 The MSCI World index covers 80% of the world market capitalization (U.S.$12.1 trillion) in both developed and emerging markets, and thus is a reasonably accurate proxy for the true market portfolio. 5 IFC Indices For the returns on Asian stock markets, the data used is provided by the IFC from the Emerging Markets Data Base (EMDB) available on Datastream. It includes information on more than 1,800 stocks in low and middle income nations totalling U.S.$1.2 trillion in market capitalization. This represents approximately 10% of the MSCI world market portfolio. Similar to the MSCI, the IFC uses a subset of stocks in each country based on a target market share of 60% to 75% of total market capitalization. The indices are intended to represent performance measures of the most actively traded stocks across a diversified range of industries. The data is calculated from monthly, value weighted index returns, with dividend reinvestment, and adjusted for stock levels (new shares, rights issues, and splits), and market capitalization. A detailed description of the IFC indices definitions, methodologies, and their construction is contained in 'The IFC Indexes' manual (IFC, 1997). Information on six Asian markets was collected: Indonesia, Malaysia, Philippines, South Korea, Taiwan and Thailand. 6 Regional Indices In this study we construct our own Asian aggregate index. Regional indices could be criticised in testing the relevance of regional returns to the country in question. This is especially the case for countries with a large market capitalization. To measure the true association of returns in a country to its region, this study constructs an equally weighted regional index that removes the returns of the country being analysed, respectively. With this innovation, one may accurately assess the relationship of returns within the region.

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Return Construction The time series data from MSCI and IFC are not provided in a total return form. Thus, the total percentage return (TR%) series is calculated by:

TR% =

( P t - P, ,)

(100)

(1)

et-- 1

where P,=price index value at time t; P,_ ~=price index value one month prior.

Survivorship Bias The early data is problematic because of a survivorship or look-back'. A question that can never be answered is whether the IFC would have chosen the same portfolio of assets throughout the life of the index. Indeed, some of the stocks may have 'dissolved' during the time span of this study. Hence, there may be evidence of survivorship bias. A study has examined the potential for damaging effects of look-back bias by splitting the sample to include and exclude data to test for survivorship bias. These tests showed that look-back' bias did not effect the results enough to damage the significance of outcomes (Harvey, 1995). Another source of bias occurs in both the IFC and MSCI data where the stocks included in the respective indices are chosen on the basis of historical and expected future performance, size, and liquidity. This implicitly reveals information about a firm's past history and is evidence of another form of bias.

Correlation Measures There is evidence in the past literature to suggest that total equity returns in emerging stock markets are less correlated with the world market portfolio than industrial markets (Harvey, 1995). However, there is also evidence to suggest that Asian emerging stock markets are becoming increasingly correlated with the world market portfolio over time] Observing Fig. 1 shown above which reflects the average correlation a regional and world index for the six Asian countries, there is definite evidence that the regional equity market relationship in Asia has become stronger since 1991. Prior to the intense liberalization phase in Asia, equity markets were positively closely correlated with the rest of the world (i.e. the world market portfolio) and simultaneously regional correlations were negative, but of

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