The Growth Period
The economic growth of the Southeast Asian economies in recent years has been the envy of the world. During the decade from the mid-80’s to the mid-90’s the average real GDP growth in Thailand, Malaysia, and Indonesia averaged more than eight percent. Even the Philippines, considered to be the sick man of Asia, was showing positive growth. Per capita income was steadily growing in each of these countries as well. The rates of inflation were generally holding steady or falling slightly. Unemployment was low. The level of poverty was dropping while literacy was rising. The savings rate was high and the work ethic strong.[1] These countries seemed to have all of the right ingredients for investment.
Global Liquidity
Following the 1990-91 recession in the United States, the US Federal Reserve kept the federal funds rate at an artificially low level, a policy which enabled US banks to repair their balance sheets. The owners of capital moved their resources to the economies of Southeast Asia for higher rate of return. In addition, weak domestic demand in Japan and in Europe made their banks all too willing to lend to the tiger economies as well. This led to a steady inflow of capital into the region.
Growth Without Development
The growth in these emerging markets was thus increasingly funded by foreign short-term credit and portfolio investment. The foreign borrowing was used primarily to increase investment rather than consumption. However, much of the investment was in speculative ventures, especially real estate and equities. With their currencies pegged to the US dollar, financial and corporate borrowers did not bother to hedge their short-term dollar-denominated debts, even given their exposed position, assuming that the currency peg would hold and that expansion would continue.
Financial Sector Weaknesses
The developing crisis exposed the “underdeveloped” state of the capital markets, especially among the young cubs of Southeast Asia. Market capitalization there is largely dominated by banks. Since institutional underpinnings are barely existent, there are weak controls over the banking sector. Capital reserve requirements are inadequate for the risk level of the investments, and lending is often done without rigorous credit scrutiny. Requirements for public disclosure and transparency in financial statements are not up to the international standards. Given this type of situation, it is easy to ignore due diligence requirements.
Crony Capitalism
In addition, there is the issue of ‘moral hazard’ in many of these countries. That is, traditionally those making the loans are not really at risk should the loans turn bad. In part this relates to the close political and personal connections that have existed between the government and the financial sector. The fact is that government officials have often pressured banks to make loans based on political or personal considerations rather than business decisions. The other side of the implicit agreement is that the government will bail out the banks if the borrowers default. Thus those making the loans have little personal risk and consequently little reason to worry about the soundness of their loans.
The Fall
The credit boom made these economies vulnerable to a shift in the market conditions. The need to raise interest rates to control the overheating of the economy and to defend the exchange rates caused a fall in property values and a corresponding increase in non-performing loans. The low quality of these bank assets led foreign investors to move out of the Southeast Asian markets, causing further depreciation of their currencies. The bubble burst in the second half of 1997, beginning with the forced devaluation of Thailand’s baht in July, then the attacks on Malaysia’s ringit, followed by the pressure on the Indonesian rupiah, Philippine peso and even the Singapore dollar.
These devaluation’s reflect a very fundamental fact of international economics: central banks can either intervene in the foreign exchange markets to defend their currencies. or in the domestic market to try to affect interest rates and domestic growth. In the long term, they cannot successfully do both.
What Needs to Happen Now
The crisis in Southeast Asia is not uniquely a regional issue. There are implications for the rest of the world as well, given the increased global interdependence among nations. Their problems cannot be solely solved internally, although reforms must begin with these economies.
- First, there must be structural reforms in the financial sectors of the countries whose currencies have come under attack. Their governments need to clean up the banking mess by closing the insolvent banks, setting up sophisticated regulatory systems and deposit insurance plans, and better supervising their banks. They need to adopt tough financial standards that are comparable to the international standards in order to gain the market’s confidence. This crisis differs from many previous ones because it is not government debt that is the issue here. The problem is more a matter of overextension of private lending, albeit lending which is closely tied to government activities and pressure. The banking systems must increase the transparency of their actions so that investors can judge the credit-worthiness of their loans. The owners or shareholders must b held liable for their lending decisions by having their own capital at risk. Specifically, capital cronyism must give way to decision-making based on the merits of the project and the financial stability of the borrower. This would squeeze out speculative investments. In addition, the governments must learn not to interfere unduly. The government should put in place sound economic policies, while central banks must be careful not to establish conflicting policies in the domestic money market and the foreign exchange market which could send distorted signals to the market.
- As the region’s largest economy, Japan must be part of the solution. The Japanese government needs to boost its domestic demand to help absorb the exports which these tiger economies must depend upon to get their economies moving again. Whereas Japan has traditionally tried to stimulate its economy by increasing exports, this time it must work to increase demand internally.
- China is also a pivotal actor in the region. It is important for China to maintain its exchange rate. This will require a level of sacrifice since it is likely to result in slower growth and higher unemployment. If China chooses to devalue the yuan to compete in the export markets, it will only exacerbate the problems.
- The industrialized world, including US and Europe, must provide an open market and help these economies get back on track. This will mean an increase in the trade deficit for a time, and pressure on prices and profits for some domestic producers.
- Finally, the International Monetary Fund must keep its focus on providing liquidity, and not rely on bailing out these economies. The IMF must insist that these countries face up to the fundamental structural reforms which are required in their financial sectors as a condition of receiving IMF assistance.
Some believe that the we are only at the beginning of the Asian crisis and that the real effects are just beginning to take place. Among the big concerns is the fact the most Asian companies are facing their fiscal year-end. Deadlines for many major debt extensions and outstanding financial contracts are tied to these dates. This may force banks and other lenders to revisit their financial positions. Tight fiscal and monetary policies, some mandated by the IMF, make it harder for companies to meet their debt obligations. This, in turn, can potentially lead to more bankruptcies which would further strain the banking sector and destabilize the financial markets. A severe market disruption could have a dampening effect on the entire world.
Yet, the ASEAN countries have to learn the ruthless reality of globalization and be willing to work on the political and economic reforms. Southeast Asian economies still have many strengths. The fact remains that their economic macrofundamentals are still strong. There is evidence that some countries are showing the political courage to take the necessary steps. Others may be less certain at this time. Overall, these tigers could bounce back, better and stronger. The question is “When?”
While events continue to unfold, it is difficult to identify when and where to invest in Southeast Asia. In making such decisions, one must be very aware of the degrees to which countries are making the necessary political and structural reforms. Since the current crisis is structural in nature, structural reforms are needed. Whether or not the time is ripe for investing in an ASEAN country depends on the seriousness of economic and financial reforms taking place.
With every crisis comes opportunity. Investors must focus on long-term fundamentals. Economic success in this region depends on governments, as well as investors, making and keeping their long-term commitments.
Endnote
[1] State Department, US Government. 1996 Country Reports on Economic Policy and Trade Practices.
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