>> MIM Speaks
LESSONS FROM THE ECONOMIC CRISIS
JULY 19, 1998 -
THE STAR
LET me start by narrating an incident that took place at pa
bar in New York on the 10th anniversary of the end of the
Vietnam War. A Jewish veteran of the war, seeing an Asian
across the bar, opened a bottle of beer, went to the Asian and
poured the beer on the Asian.
The Asian was shocked and asked the Jewish veteran why he did
this. The war veteran said: "For all the suffering I had
during the war."
The Asian said: "But I am Korean and not Vietnamese."
The veteran replied: "Vietnamese, Korean, Chinese, Japanese
...
I can't tell the difference; you are all alike."
Half an hour later, the Korean took a bottle of beer and
poured it on the Jew. Asked why he did this the Korean
replied: "For sinking the Titanic."
The veteran said: "Man, you are crazy, that was an iceberg."
The Korean replied: "Iceberg, Rosenberg, Steinberg ... I
cannot tell the difference."
The inability to "tell the difference" by young money-centred
decision-makers may be one of the reasons why we have a
crisis!
July marks the first year since the start of the East Asian
currency crisis that began unravelling with the decision of
the Thai Government to freely float the baht. With- in days,
currencies around the South-East Asian region came under
similar attack from hedge fund managers and speculators.
Benpres Holdings, a leading Philippine conglomerate, describes
the situation appropriately: "Before July 1997, the exchange
rate of the baht was a distant figment in the local business
imagination. Over the next six months the now proverbial
Asian flu deflated economic asset values and decimated growth
expectations region-wide."
The small South-East Asian currency and share markets,
dominated by buyers or sellers from London and New York, soon
found that the advantages of a free capital market have
disadvantages that were not foreseen.
Hedge fund managers and speculators, with a short-term outlook
on events in a region, may cause the local currency to
collapse through the rapid movement of large amounts of
capital thus causing serious destabilization of the economy.
Drops in share prices may affect the company and shareholders
who are mostly from the upper-income group. But raids on the
currency and sudden transfers of funds abroad cause sharp
drops in exchange rates.
This has an immediate impact on prices of necessities, which
disproportionately affects lower income groups.
What was initially perceived as a currency crisis soon
developed into a financial markets crisis as stock markets-in
the region rapidly lost value, then into a financial sector
crisis that exposed the vulnerabilities of financial
institutions and banks in the region, and, lastly, an economic
crisis in the real sector.
Barely six months before the crisis, however, Indonesia was
being singled out by multilateral agencies as the latest of
the East Asia success stories with then President Suharto
receiving an award for successfully reducing poverty rates.
Today, its economy, its financial institutions and industries
are in a shambles and daily questions are being raised about
economic survival for the poor and political survival for the
current government.
The East Asia crisis is much more complex than any situation
ever experienced in recent economic history.
The severity of the crisis was not foreseen nor were the
spiralling or contagion effects that both drove the crisis and
were consequences thereof. Fundamental to our understanding of
this and future crises will be our own understanding of
regionalisation and globalization the new forces unleashed by
such a phenomenon, and the impact it has on countries and the
lives of citizens within those countries.
And here we are talking about relatively small countries that
had opened their financial markets and where the volume of
foreign directed transactions in the markets are more than
half of the daily transactions.
Exchange rate misalignment (as in the Mexico case) turns out
to be only the "tip of the iceberg" in the East Asian case. On
the surface, such misalignment together with an erosion in the
terms of trade results in current account deficits that lead
to a currency crisis for which the usual IMF programme is an
appropriate instrument for recovery.
Mexico's liquidity crisis of 1994 was ripe for such a rescue
package.
The East Asian crisis, however, has turned out to be a
different animal altogether. The consensus among experts is
that the East Asian crisis is more accurately a financial
crisis first exposed by the exchange rate misalignment.
As a financial crisis, it is characterised by:
1. A rise in bad loans extended by banks and non-bank
financial institutions to the private sector
2. Poor regulation in allocating capital and savings to
lenders;
3. A liquidity crunch, and
4. Difficulties of corporates (and countries) to roll over
debt due to eroded credit standing.
As financial institutions request early payment from clients
or raise interest rates to protect asset quality, the crisis
has spilled over to the real sector.
Heavy interest burden, coupled with foreign exchange losses,
higher operating costs, the drop in sales and the
deterioration of profitability are leading to an increase in
business failures. Worse, assets already deflated by the
crisis, remain idle when their income stream was expected to
service debt.
To understand how we are to navigate through this crisis means
that we need to understand what caused it and what is at
stake.
Economist Paul Krugman perhaps has it right. "The Crisis," he
writes, "is not about the fall in the value of the currencies,
it is about real problems in the financial and real sectors,
especially-structural ones. It is about financial excess. The
excessive risky lending of (financial) institutions that
created inflation - not of goods, but of asset prices.
"The overpricing of assets was sustained in part by a sort of
circular process, in which the proliferation of risky lending
drove up the prices of risky assets, making the financial
condition of the intermediaries seem sounder than it was."
High growth created the bubble that eventually burst under the
weight of the system. What we are faced with today and which
managers and policy-makers have to contend with are issues of
moral hazard, together with the weaknesses of the local
financial system, the problems of business failures, and most
important and critical, new problems of social dislocation and
social unrest.
What have we learned?
As we survey the landscape, we ask ourselves: What
fundamentals matter?
In East Asia, the traditional macroeconomics fundamentals do
not appear to have been grossly out of focus. There were large
current account deficits, but with low inflation, fiscal
balance and with high savings in almost all East Asian
countries.
What was seriously out-of-line, particularly in Thailand,
Indonesia, and South Korea, were the micro-fundamentals.
1. Large private sector foreign debts, much of it unhedged and
without forex earnings to service debt, were not uncommon. In
Thailand, 12 years of an extremely stable foreign exchange
rate, with a large interest differential between
baht-denominated and dollar-denominated loans, made it
attractive to borrow short-term off-shore for long-term
property projects, in spite of an obvious oversupply.
In Indonesia, the crawling peg provided a high degree of
predictability in foreign exchange risk. Over time the over
reliance on dollar-denominated debt made the situation risky
in the face of excess capacity and currency devaluation.
2. Increased percentage of short-term debt over total debt. In
a period of eight years, Thailand's ratio of long-term to
short-term debts fell from a ratio of 6 to a ratio of 2.
3. Slow rising productivity where various measures reveal that
returns on total factor productivity may have been as low as
one-fifth the increases in capital over the past decade.
With relatively low domestic interest rates, Malaysia had no
short- term debt while the lessons learned from past
devaluations in the Philippines discouraged businessmen from
borrowing abroad.
Critical to the problem has been the risky lending by banking
and financial institutions now resulting in rising
non-performing loans. Over capacities of industry were
overlooked as banks lent to corporates on the basis of their
reputations and track records rather than on the basis of
industry capacity or market demand.
The large share of debt invested in speculative sectors (for
example, real estate) and the low or negative return on
capital subsidised by conglomerate structures are also at the
core of the problem.
The East Asian crisis is, therefore, a private sector debt
crisis rather than the traditional public sector liquidity
crisis. The extent of private sector debt in Korea Indonesia
and Thailand was badly understated.
Poor regulatory regimes linked to structures of political
connections and/or politically-driven governance have led to
lack of transparency in terms of process and information.
But with all our faults and defects, was such a severe and
sudden adjustment needed? Could the necessary changes be
brought about more quickly with less pain and suffering to
those who are already disadvantaged?
The contagion effects of the crisis are likewise unparalleled
in history. Within South-East Asia, Malaysia and the
Philippines suffered by identification, by their association
within Asean and their proximity as neighbouring countries.
Such an effect points to a new paradigm that suggests that
globalisation as a phenomenon has arrived and must be
addressed squarely.
International capital, with the mobility of electronic media,
can have great impact - both positive and negative - on local
economies that have liberalised, precisely to make themselves
attractive to such capital flows.
Today we have to ask the questions how free should the free
flow of capital be and what limits should be considered to
protect small economies?
To quote Moeen Qureshi, formerly a senior officer of the World
Bank and now chairman of Emerging Markets Corporation:
"Capital markets in the emerging economies are in no position
to deal with the massive flows of funds that are typical of
today's free global financial markets. These capital flows can
cause serious volatility in large markets - in the tiny
markets of Asia, they can be devastating."
Thus far, analysis has shown that the currency crisis goes
beyond the liquidity crisis first perceived and exploited by
hedge fund managers and speculators. Is there not in fact
something structural at the core of the East Asian crisis that
allowed excesses to have built up over time?
NEXT WEEK: The issue of corporate and political governance
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