Note: Remarks as prepared for delivery
Foremost a Financial Crisis
When asked why he robbed banks, Willy Sutton replied, “That’s where the money is.” In a sense, Sutton was a global philosopher who would have understood Asia today. The Asia crisis is first and foremost a financial crisis. Asian financial sectors—with the notable exception of Singapore and Hong Kong being—are hampered by crony-influenced loans, undercapitalized banks, poor supervision, and worse accounting. As a result, bad bank loans now range between 10 and 20 percent of gross domestic product (GDP). A properly functioning financial sector must be considered a fundamental feature of a strong economy, right along with fiscal prudence, low inflation, high personal savings, and good education.
Ancillary to collapsing Asian financial sectors were interventionist policies, most obviously in the use of policy-direct lending to choose winners—first textiles, steel, chemicals, and other heavy industries and later autos, electronics, and pharmaceuticals. Some of the policy-directed loans made good economic sense, especially in the 1960s and 1970s, when Asia was getting started on its path of sustained rapid growth. But over time, more and more bank loans were directed into doubtful projects on the basis of personal relationships. By 1997, the outcome was bankrupt banks and heavily leveraged corporations throughout much of Asia.
Financial crises are an old phenomenon, stretching back to the tulip bubble and the South Sea craze. Charles Kindelberger writes that financial crises have recurred about once a decade for the past several hundred years. In the United States, we all remember the stock frauds and bank failures in the 1930s, the savings and loan collapse in the 1980s, and the machinations of Michael Milken. We should also recall the step-by-step construction of safeguards against financial excess and pure greed. The Glass-Steagall Act, the Securities Exchange Act, stepped-up surveillance by the Comptroller of the Currency and the Federal Reserve, and standards set by the Bank of International Settlements were all devised to limit risk and prevent outright fraud. But it takes a long time, and continuing trial and error, to strike the right balance between free-wheeling, highly-productive capital markets and appropriate regulation. The task in fact is never done; at most, top-flight regulators can catch up with the financial practices of today, but they must remain alert to the innovative and perhaps risky practices of tomorrow. What happened in Asia was a generation of lax regulation before the crisis struck.
Stable Exchange Rate Systems
Barry Eichengreen has argued that only two polar exchange-rate systems can be regarded as stable: one is a single currency (like the dollar or euro) and, by extension, a disciplined currency board (like Hong Kong); the other is a virtually free floating arrangement (like the dollar versus the deutch mark). Intermediate systems, like the erstwhile semi-pegged currencies of East Asia and the still pegged systems of Brazil and China, invite currency overvaluation, excess unhedged dollar borrowing, and devastating shifts in confidence. Korea illustrates the dilemma. Overvaluation showed up in a growing current account deficit. But no one—not the central bank, not the chaebol, not S&P—knew the extent of Korean public and private dollar debt before the crisis. Before the crisis, the accepted figure was about $70 billion. Today, the widely published number is $170 billion. Some observers think that offshore corporate borrowing could push the number as high as $250 billion. When contagion reached Korea from Southeast Asia, the Bank of Korea tried to defend the won. But Korean corporate borrowers attempted to hedge their dollar liabilities, and the result was a second and devastating round of pressure on the won. Ultimately, currency collapse was compounded by political paralysis and revelations of extensive corruption.
The combination of weak banking systems and semi-pegged currencies recalls Oklahoma City and the combination of diesel oil and fertilizer. All it needed was a detonator to explode.
The Cart and the Horse
The Asian debacle surely calls into question the International Monetary Fund’s (IMF’s) goal of quick-step capital account convertibility for all member countries. The lead horses should instead be financial services liberalization, competition, and prudential regulation; the cart should be free international movement of capital. The IMF should push for well-ordered financial systems, ones that welcome a major foreign presence, before pressing governments to allow their domestic corporations and banks to borrow freely in dollars, deutsch marks, or yen. To be concrete, the IMF should press Malaysian Prime Minister Mahatir Mohammed to welcome soundly-based foreign financial firms, and to embrace Anglo-Saxon style financial regulation and accounting standards, even as he rants against speculative capital flows.
End of the Asian Miracle?
Alwyn Young and Paul Krugman were right in predicting the demise of the Asian miracle—but right for the wrong reason. Young and Krugman both said that 7 to 10 percent Asian growth could not go on forever. That much was obvious: the most optimistic projection for China was another twenty years of above 8 percent growth; and before the crisis nearly everyone expected growth in Southeast Asia, Korea and Taiwan to taper off. However, the Young-Krugman argument was novel in that they claimed Asian growth was based on sheer capital accumulation (machines and degrees), not on productivity gains (total factor productivity or TFP). Contrary to this argument, recent research by Chang-Tai Hseih shows that TFP has accounted for one-half to two-thirds of gains in output-per-worker in the “four tigers.” In other words, productivity gains have made a major contribution to rising standards of living in Asia. Michael Sarel reaches similar conclusions. The implication is that, if the current crisis leads to serious financial reform, the golden era of Asian growth could be prolonged, since nothing is fundamentally amiss in productivity performance.
Evolving Institutions and Stray Asteroids
Though the International Monetary Fund has shown a remarkable ability to change with changing times, the Asian crisis presents a grave new threat. The IMF has a record of adapting to meet new challenges: from custodian of fixed exchange rates in the Bretton Woods era; to monitor of floating rates in the Smithsonian era; to debt workout professor for Latin America and other emerging markets in the 1980s; to reconstructor of Eastern Europe and the former Soviet Union after the fall of the Berlin Wall. To avoid a fatal asteroid from Asia, however, the IMF must now evolve further, from an emergency room surgeon to a preventive care physician. Consider these limitations on current IMF operations:
- It cannot disclose adverse information on its “client” countries prior to a crisis.
- But sick countries do not come for help until they need emergency room treatment.
- When country W crashes, the IMF has neither the mandate nor the money to arrest contagion in countries X, Y and Z.
- It also lacks the mandate and expertise to regulate domestic financial systems and enforce proper accounting standards.
With these constraints, the IMF can only perform emergency surgery when a crisis strikes, insisting on drastic reforms and protecting the money center banks to avoid further contagion. This is no way to run a hospital and it is no way to handle financial oversight.
Based on his study of postwar Europe, the late Mancur Olson taught us that severe crises are required to rout out vested interests, retire the old leaders, and usher in true reform. In Asia, here is my scorecard to date:
- In Taiwan, Singapore, Hong Kong, drastic reforms are unnecessary.
- In Thailand, drastic reforms were necessary and are happening.
- In Korea, drastic reforms are necessary and may happen, but so far it is “mostly talk, little action.”
- In Malaysia, drastic reforms are necessary and are unlikely to happen.
- In Indonesia, drastic reforms are acutely necessary and will probably not happen.
Where Are the Big Boys?
What about the biggest actors, Japan, the United States, and China? Even though it has made $19 billion in bilateral contributions to the bailout, Japan’s economic woes have left it missing in action. After years of stagnation and a weak yen, in 1998 the Japanese economy will probably grow less than 1percent, the yen will probably stay at Yen120 to Yen140 per dollar, and Japan’s current account surplus will still exceed $100 billion (though the decrease attributable to the crisis in Asia will be about $20 billion). Three major policy questions face Japanese leaders. Can Japan recapitalize its weak banks, an operation which requires about $400 billion? Can Japan implement major structural reforms? Will Japan stimulate its economy with fiscal action? At this writing the answers are no, no, and no.
The position of the United States—whose bilateral financial contribution to the bailout is $8 billion so far—has yet to be tested. In 1998, the U.S. economy should experience nearly 3 percent growth and a current account deficit of about $200 billion, a $30 billion increase over 1997 attributable to the Asian crisis. There are two major policy issues for Washington. Will the U.S. Congress pass the IMF funding package, both the New Arrangements to Borrow (NAB, $3.5 billion) and the quota increase ($14.5 billion), in a timely fashion without crippling amendments? Can the United States resist placing restrictive trade measures on imports of steel, autos, machine tools, semiconductors, and other Asian products? The answer to the first question could be part of the loaf—NAB but not the quota increase. The answer to the second question could depend on how Clinton reads import pressures in the context of the mid-term congressional elections.
China has to date played a stabilizing role, basically by standing fast. The Chinese economy is expected to grow by 6 percent or so in 1998, and its current account position should be roughly balanced (representing a decrease attributable to the crisis of about $20 billion). Three policy issues face Beijing. Can China hold its current exchange rate (about 8.6 yuan = $1.00)? Can China reform its trade system, especially non-tariff barriers that protect state-owned enterprises? Can China recapitalize its very weak banking system ($30 billion has so far been committed to a $100 billion-plus problem)? If China answers “yes” to all three questions, it could become a leader in today’s Asian drama.
Edward Fogarty, Research Associate at the Council on Foreign Relations, helped draft this essay.