International capital is now rushing into emerging economies like Indonesia, Korea and Thailand.  Interest rates are much higher than in the still crisis-battered American and European economies.  And “quantitative easing” by the US Federal Reserve is feeding the capital rush.

Somehow this is strangely reminiscent of the lead-up to the 1997 Asian financial crisis which was also preceded by massive capital inflows into the region.  Could Asia be headed for another financial crisis?  Or did it really learn the lessons and make the necessary reforms?

East Asia’s miracle

The starting point for exploring these issues is the Asian economic miracle.  Although people will still argue the point, East Asia really did enjoy miraculous economic growth following World War 2 and leading up to the 1997 Asian financial crisis.  It was a miracle in many ways.  First, after the War, no-one ever imagined that Asia could develop in such a way.  And consensus bets on the prospective stars of Asia were placed on Burma and the Philippines, both of which are today’s basket cases.  Second, never in the history of the world had such rapid economic growth been seen before.  The Industrial Revolution was a dawdle by comparison.

In North East Asia, especially Japan and Korea, government played a major role in the policies that generated the miracle.  Rapid development was driven by exports, but not free trade.  Imports were greatly restricted, as was access to foreign exchange.  Government basically created export machines, and the role of imports and foreign exchange was to feed this export machine.  Driving this export machine was high investment, financed by domestic savings.  Well educated work forces, prudent macroeconomic policies and good infrastructure were also important elements – as was a demographic transition as the share of the working population rose relative to the total.  But producing exports for international markets meant that local enterprises were riding up a steep learning and innovation curve which kept productivity growing strongly and promoted catching up towards global best practices. 

Foreign direct investment was virtually non-existent.  Foreign technology was sometimes licensed.  Imports were copied by reverse engineering.  Industrial espionage was probably rife.  Sure governments were corrupt.  Mistakes were made.  But overall it worked, as these economies quickly rose to global standards.  But the key was the domestic learning process thanks to the nexus between capital accumulation, human capital formation, and assimilation of foreign technologies.

In South East Asian countries, like Malaysia, Indonesia, Singapore and Thailand, governments also had an iron grip on power.  But foreign direct investment and tourism played important roles, and actors as vectors for knowledge transfer.  Again, prudent macroeconomic policies, political stability, good infrastructure and in some cases good education systems were also key ingredients.

Financial sectors remained underdeveloped.  Some banks were owned by enterprises (often family-owned).  Moreover, governments used banking systems as mere instruments to finance their development plans.  Finance was allocated to enterprises, mainly big ones, which were key to development strategies.  Other elements of a mature financial system, notably stock and bond markets, were never really allowed to develop.

Exchange rates were basically kept fixed to the US dollar.  This provided price stability for exporters.  And with access to international financial markets virtually closed, a fixed exchange rate could be maintained.

Unfolding of the Asian Financial Crisis

In the 1990s, a number of East Asian countries started opening up access to international capital markets without however setting the necessary regulatory and prudential framework to manage the new risks of liberalized financial markets.  Local banks and residents could now borrow internationally.  They were not just restricted to borrowing locally.  International banks could chase clients in East Asia.

These were the heady days of the “East Asian Miracle” which had captured everyone’s attention.  The World Bank even wrote a book with this title.  International investors thought that the region could do no wrong.  And locals in the region also believed the hype.

So even though the region barely needed to borrow external savings, there was a frenzy of capital flows.  Interest rates were lower overseas.  Sure, banks and enterprises were taking out short term loans to finance longer term investments.  But these could be rolled over (?), the party would go on.  Sure, the loans were foreign currency denominated.  But with exchange rates fixed, there was no risk on that front. 

Then asset bubbles started popping up in real estate and stock markets, and over capacity developed in some sectors.  Many realized that investment projects financed by foreign capital were not always sound.  And then like all herds, these foreign investors got cold feet and exited the region as quickly as they entered it.  We were into a boom-bust cycle.

This is a pattern that has become only too familiar.  International investors go from one excess to another.  Hot money only too quickly becomes cold money.  Those Asian borrowers who had taken out short term loans were left with nothing, as loans stopped being rolled over.  And because they still had fixed exchange rates, East Asian governments saw their foreign exchange reserves rapidly depleted, as they financed the repayment of all of these loans.

The IMF then bumbles into the picture

The high priests from the Washington-based International Monetary Fund then moved into the picture.  Their job is maintain global financial stability.  In its own words, “The IMF provides loans to countries that have trouble meeting their international payments and cannot otherwise find sufficient financing on affordable terms. This financial assistance is designed to help countries restore macroeconomic stability by rebuilding their international reserves, stabilizing their currencies, and paying for imports—all necessary conditions for relaunching growth.”

The IMF is however like an old grandmother which puts all sorts of tough conditions on its loans.  The IMF was however most used to the wild-spending crisis cases of Latin America.  And so the IMF told the Asian crisis countries to take some Latin American medicine – cut government expenditure, increase interest rates, hold the exchange rate up, and so on.  These are the sorts of things you should do when a financial crisis has been caused by a reckless irresponsible government.  In East Asia’s case, this was not the case.  It was a reckless and irresponsible private sector that caused the crisis.

The IMF’s bitter medicine made things only worse.  The crisis-affected countries stumbled from recession to depression.  In Korea, IMF became known as “I’M Fired”.  The IMF could see that it had made a big mistake.  It quickly adapted its policy approach.  Pressure to cut public expenditure was reduced.  Exchange rates were allowed to float and depreciate.

Lots of things were to happen, but East Asia recovered very quickly as strong exports led the way.

Some lessons of the East Asian crisis

(i)               Exchange rates.  Apart from China, all East Asian countries now have floating exchange rates.  Everyone understands that exchange rates can be volatile.  If people borrow internationally, there is an exchange rate risk that must be managed.

(ii)              Foreign exchange reserves.  The crisis-affected countries saw their foreign exchange reserves cleaned out in no time at all.  So they all then built up massive reserves to protect themselves against future crises.  With a floating exchange rate, reserves are of course not really necessary.  But if a government wants to intervene to influence the value of its exchange rate, it needs to be able to buy and sell reserves.      

(iii)             Balanced opening of the capital account.  Korea was very notable for having very closed policies to foreign direct investment, while it opened up to other capital flows, like short term financing.  One way to reduce vulnerabilities to crisis to try to attract more foreign direct investment which is usually a more stable form of finance.  Korea has done this, and is now receiving increasing amounts of FDI.

(iv)             Develop local stock and bond markets (capital markets).  This is a means of reducing reliance on international capital markets, and is particularly relevant because so much Asian capital is in fact invested outside the region.  Many efforts have been launched in this direction.  Progress is being achieved, but it has been slow.  Capital flows into the region following the global financial crisis could provide a boost.   

(v)              Capital controls.  Malaysia implemented some controls on capital flows at the time.  At the time, it was highly criticized.  Now there is a growing consensus that “hot money” can be a major problem, and that some capital controls can be useful.  The main problem is that beyond the short term, the golden boys of Wall Street can always find a way around such capital controls. 

(iv)             An Asian IMF?  At the time of the Asian financial crisis, Japan proposed creating an Asian IMF which could deal with regional financial stability issues.  The US government quickly killed the idea, which was also not supported by the Chinese government.  In its place, the so-called Chang Mai Initiative was launched.  It is still far from clear how useful this will become.  At the same time, the IMF has learnt many lessons from the Asian financial crisis and has fundamentally changed.  The IMF still has a deep “Stigma” in the region, and very few governments would be willing to accept finance from the IMF.  Pressure is mounting on the IMF to have an Asian as its next Managing Director, not a European as is usually the case.

(v)              Economic strength.  It seems clear that financial volatility and crises are one of the Achilles heels of globalization.  To some extent, the only way to cope with capital volatility is by being strong.  The crisis-affected countries have been performing quite well over the past decade or so.  But political instability is a major problem in Thailand and the governability of Indonesia is always questionable.

Today’s hot money

East Asian governments, and the IMF are all very alert to the potential risks of the hot money flowing around the world today.  Some countries are undertaking measures like exchange rate intervention, and capital controls.  This can be helpful.  But above all, it is important to be aware, and certainly not surprised, that all this money might flow out over the next year or two as the US economic situation improves.

Another Asian financial crisis?

It is hard to see a remake of the Asian financial crisis, even if today's hot money is creating massive instability.

The place to look for a crisis is always where things seem too good.  And that place is China.  But China has such massive foreign exchange reserves that it is capable holding its financial system intact. 

The next Asian crisis could well be a social and political crisis in China.  It is splashing lots of money around everywhere in the world with its financial diplomacy while half of its population live on under $2.50 a day.  The gap between rich Chinese Communist Party members and the poor peasants gets wider and wider.  And the tensions between the hardliners and the moderates seem difficult for anyone to manage.

Any system needs the capacity to let off steam.  This is perhaps the greatest strong point of democracy.  In China, the steam is building up, but it is difficult to let any out of the system.  Something has gotta give.       

References:

Post-Crisis Development Paradigms in Asia, Masaru Yoshitomi and ADBI Staff, Asian Development Bank Institute

http://www.adbi.org/book/2003/03/01/392.development.paradigms/  

The East Asian Miracle: Economic Growth and Public Policy (World Bank Policy Research Reports)

http://www.amazon.co.jp/East-Asian-Miracle-Economic-Research/dp/0195209931  

International Monetary Fund

www.imf.org