Until mid-1997, the rapid growth of the East Asian economies was widely regarded as a miracle. This growth had propelled Asia to such heightened importance in the world economy that the next millennium was already anointed “The Pacific Century” by some. Then, in 1997 many of the Asian tigers and “tiger cubs” were suddenly tamed. They went from being an economic miracle to needing one.
The impact reverberated around the world. Because of the global nature of the economy, the cost of supplies, of labor, and the prices of competitive products were affected for many businesses throughout the world. The deflation in East Asia helped keep inflation low in the US. Now, with the East Asian recovery apparently underway, the dynamics will change. Interest rates, prices, and competition all may be different. Business people everywhere need to keep informed about these changes and plan accordingly.
The Tigers Tamed
When the Thai government was forced to abandon the peg of the baht to the dollar on July 2, 1997, it sounded an alarm throughout the region. Investor sentiment changed overnight. Within days, speculators attacked the currencies of Malaysia, Indonesia, and the Philippines. Not even the “grown-up” East Asian economic tigers, Hong Kong and Korea, were spared from the attack. The currency crisis spread rapidly throughout the region and beyond and finally grew to include much of the emerging market arena.
While the countries most impacted by the crisis differed in important respects, they also shared some important characteristics. They generally had policies fostering low levels of inflation and fiscal discipline by the government, and all had experienced rapid economic growth in the previous years. The openness of their economies, and high savings rates, combined with the low cost of production, encouraged foreign investment. In the early 1990’s, what had been a reasonably modest inflow of capital increased more than six-fold.
In the early 1990’s, the Federal Reserve set the US interest rate artificially low to stimulate the American economy. Given that the exchange rate of the tigers was tied to the dollar, and the growth rate of their economies was strong, they looked very attractive. More money flowed in than could be profitably used at modest risk. Much of the investment moved into ill-conceived real estate projects. These projects, in turn, became the collateral for a great deal of debt.
When the dollar began to recover in mid-1995, the exports of the tigers became less competitive. Pressures on their currencies grew because their underlying economies were not growing in tandem with the dollar’s rise. The pace of capital inflows slowed and investors had difficulty obtaining credit. Local exporters, who might have increased their sales abroad in a period of devaluation, faced fierce competition from the same region in which they had tried to export their way out of the crisis. Furthermore, with the entire region under pressure, exporters from several countries were competing with each other to try to export their way out of the crisis. The shift in perceived future investment risk impacted the stock markets of these countries, and pressure mounted even further, especially on countries with large current account deficits. Then the real estate bubbles burst, and the drop in real estate values left banks holding huge portfolios of bad property loans. The risk of default sparked a wider financial crisis.
There were, however, some key domestic factors that also contributed significantly to East Asia’s financial crisis. These included inherent weaknesses in the financial systems of these countries: little regulation and lax supervision, little reporting of financial data that would allow outsiders to evaluate a business, poor management of risk, and continuous lending to politically well-connected firms, sometimes at the government’s direct behest. There was often little due diligence regarding the creditworthiness of the borrower or the economic merit of the project for politically-favored enterprises.
Particularly in Korea, domestic enterprises were dominated by poorly-managed, but politically well connected, conglomerates, or chaebols, that were highly financed by debt. These conglomerates soaked up most of the available credit, leaving little left for small businesses, thus creating an unbalanced industrial structure that found itself in competition with both the low-wage economies in the region and with Japan.
The Tigers Lick Their Wounds
In the early phase of the East Asian crisis, the immediate issue was recapitalization. This was accomplished with external financing from rich nations and international agencies. This capital injection was designed to cushion the effects of the credit crunch and provide trade financing to small and medium-sized firms. Funding also was required for the hemorrhaging financial institutions. They were, and in many cases still are, buried under piles of non-performing loans.
In Japan, South Korea, Thailand, Indonesia, and Malaysia the governments set up their own versions of the US Resolution Trust Corporation (RTC) to close down or merge failed institutions into stronger ones and dispose of the non-performing loan portfolios.
In Indonesia the banking sector eventually is to be reduced through closures and nationalization from the more than 200 to 40 – 50 banks. Revised banking laws will open up banks to 100% foreign ownership, require an audit for all banks, and make the central bank independent in November. All of this is dependent, of course, on the nascent democracy being able to survive and the new political leaders being able to withstand pressure from the previously powerful.
Thailand has begun to recover. Consumer spending and exports, led by cars and electronics, are on the rise. The Thai government has not required further IMF funds and has even begun to make payment earlier than expected. The biggest stumbling block to recovery in Thailand is the slow pace in its restructuring reforms, especially the sale of troubled banks. The heavy public debt could eventually handcuff fiscal policy. Private-sector debt is under better control.
In Korea, the state-run Korea Asset Management Corporation (Kamco) has been entrusted with the task of buying non-performing loans from the financial sectors and resolving them or reselling them to foreign investors. In an effort to reform the undercapitalized banks, the Korean government plans to nationalize the moribund banking industry. As part of the negotiations with the government, the Korean chaebols have agreed that overlapping subsidiaries in the seven chaebols will be consolidated through mergers, acquisitions, and joint ventures.
Malaysia reacted to the crisis by adopting radical measures, including currency controls and debt write-offs. This was done, at least in part, to avoid taking money from the International Monetary Fund. The IMF requires tough economic reforms that demand austerity on the part of the people and government alike for some time to deal with excesses in the economy. The doomsday scenarios predicted by many have not materialized in Malaysia thus far. Economic growth for 1999 should be better than 4%, driven by export and government spending. The ringgit’s fixed rate of 3.80 to the US dollar makes it undervalued relative to its regional neighbors and that has helped to boost exports.
The government is pursuing expansionary fiscal and monetary policies to reflate the economy, but at the same time has created a budget deficit of more than six percent of GDP. While not alarming, this is not sustainable. Capital controls may have saved Malaysia from the severe social and financial upheavals that its neighbors suffered, but its disengagement from the global financial system may still cause some long-term problems.
The Philippines is also beginning to move forward. Manufacturing output has not yet begun to grow, but the import of raw materials has increased, suggesting that factories are beginning to revive their production.
Singapore was able to basically sidestep Asia’s economic crisis. The city-state had swallowed its own economic medicine earlier, when the dose was smaller. Beginning in mid-1996, the government introduced measures to deflate a swelling property bubble, including high property taxes, a restriction on early real estate sales to avoid speculation, and an increased housing supply.
Japan is a unique case for several reasons. There is not space to discuss it here, but without recovery in Japan, it will be difficult for the rest of the region to truly recover.
In one sense it could be easy to renew one’s faith in Asian miracles when observing the rate of economic recovery in these economies over the past year. Factories are scrambling to keep up with soaring export orders and increasing domestic demand. Stores are jammed and corporate earnings are surging. The Institute of Developing Economies forecast in mid-December of 1999 that, excluding Japan, East Asia’s ten biggest economies would expand 6.5% in 2000, up from 1% in 1998, when six of the economies actually contracted. Table I provides an overview of past and predicted GDP growth for the original group of ASEAN nations.
ASEAN GDP GROWTH RATES 1995 – 2000
Source: Asian Development Bank
Yet, while the worst of the crisis seems to be over, the risk of setbacks cannot be excluded. Some fundamental problems remain. The region is still suffering from the collapse in asset prices. While the smaller companies are recovering, the large conglomerates still have excess capacity. There is an escalation of corporate bankruptcies, and even the overall rate of growth has slowed down from its peak in mid-summer, 1999.
Much will depend on the global picture. The young tigers cannot grow themselves out of recession domestically. They do not have sufficient aggregate demand. The credit crunch will hamper their attempts to export themselves out of recession, but the key issue is whether there will be a slowdown in the US economy and, if so, whether the economies of Japan and Europe can sustain enough growth to compensate. The rise in global oil prices could also make inflation a major concern.
The massive debt overhang from the last two years of financial crisis will continue to impact the region. Overextended firms must start to sell off their assets or shut down operations. Even though there are cheap bargains available, many prospective buyers have been unwilling to take over the mounting debts of these companies, and the creditors still refuse to write off these debts as bad loans. On the other hand, American automobile companies are bidding for some of the prize Korean assets.
What began as a currency crisis became a credit crisis, and this led to a crisis of confidence. Investors are no longer motivated by the expected rate of return that once led them to invest in these countries. For many of them, there is a fear of being burned again. But some major players are beginning to return including the Soros Quantum Fund and the American International Group.
In the longer term, the key issue is whether these countries are willing to make the difficult, but crucial, reforms in their financial and political systems. There is widespread agreement that there must be much more transparency in their banking systems. Adopting generally accepted accounting standards is part of that. Crony capitalism, where loans are made on the basis of political connections rather than on the merits of project, will have to give way to much better risk management. New regulations are needed along with a legal infrastructure that will enforce them. Finally, there must be an openness to competition in the banking industry. Foreign banks can bring new technology and people experienced in data management, risk control, internal oversight, and external supervision. Prior to the crisis, most of the countries in the region restricted the entry of foreign-owned banks. That has begun to change.
South Korea is now actively promoting small and medium-sized businesses. The newly-elected government in Indonesia is redirecting economic resources from capital-intensive industries such as aerospace and automobiles to labor-intensive manufacturing and agribusiness. At the same time it is investing more in education. And Thailand has been lowering barriers to foreign investment in retail and consumer finance.
Structural reforms are painful. They involve loss to people who have benefited under the prior system, especially the politically well-connected. On the other end of the economic scale, they often translate into unemployment and social pain that may cause social upheaval and rioting. Yet, unless progress is made on structural reforms, foreign capital will not flow into the region. It will require political resources and courage to stick with these reforms.
One of the real problems of a quick partial recovery is that the impetus for structural reform could be sidetracked. For those countries willing to make the changes – or which are forced by events they cannot control to make such changes – the prospects are positive. Some important macroeconomic fundamentals are in place. The region has a high savings rate. The labor force is young, well-educated, hard working, and disciplined. Real estate prices have dropped to realistic level. Asia is a cheap export base still, as well as home turf to a burgeoning consumer class. Most of the governments are pursuing free market policies, and democratic movements are getting stronger.
The question is whether the tigers will decide to stay in the arena and compete in the free market or will be tempted to crawl back into their dens and hope for a different kind of miracle. The answer to that question will affect not only businesses in those countries, but those around the world.
“Fixing Asia’s Bad-Debt Mess” provides an updated look at one aspect of the problem.