MACROECONOMIC RECOVERY WITHOUT STRUCTURAL CHANGE:

IS THE ASIAN FINANCIAL CRISIS OVER AND THE RECOVERY SUSTAINABLE?

(Working first draft, prepared Jan. 25, 2000)

Steve Parker

Asian Development Bank Institute

Tokyo, Japan

E-mail: sparker@adbi.org

These comments represent my own personal views and do not necessarily represent the views of the ADBI. This paper is in first, working draft form, with several unfinished sections to be completed before the presentation; please do not quote without permission of the author. Comments are welcome.

Prepared for the 6^th Meeting of the Trilateral Forum on "US-China-Japan Cooperation in Promoting Trade and Investment Liberalization in the Asia-Pacific Region," January 28-29, 2000, hosted by the University of California Berkeley Roundtable on the International Economy, Berkeley, California

After a deeper and more prolonged economic decline than anyone expected during the first year of the Asian currency, the Asian crisis economies have rebounded much more strongly than expected since the last quarter of 1998. Even as the regional recovery surges ahead, however, many of the structural problems that contributed to cause the crisis initially and then which added to the severity of the domestic economic declines over the first year and a half of the crisis remain. Although impressive frameworks for rationalizing the huge amounts of non-performing loans (NPLs) and recapitalizing banking and corporate sectors have advanced impressively, actual implementation has been slow. Most NPLs remain parked in Asset Management Corporations; most banks remain nationalized or undercapitalized; most corporates remain highly leveraged and in many cases technically insolvent; and, few improvements in corporate governance, accounting/transparency and legal systems have gone beyond the planning stage.

This presents the following questions:

1. Can the macroeconomic recovery be sustained without further structural reforms?
2. Will "reform fatigue" set in? Can governments continue to implement politically sensitive structural reforms as the hardship from the crisis ebbs and the "good times" of economic growth return?
3. Given the strong recovery even though serious structural problems remain, was the importance of structural problems in the Asian economies exaggerated?
4. Is it best to focus on maintaining economic growth while more gradually enacting structural reforms in ways that lessen short-to-medium-term political and social tension?

Although we ask these questions for the Asian crisis economies, the debate particularly over how quickly structural reforms must be done in an increasingly global economic environment certainly reminds us of the on-going and now more than a decade-long debate between the United States and Japan on the speed of structural reform in the Japanese economy, and the more recent but increasingly intense debate (centered primarily on the terms of Chinese accession to the WTO) between the United States and China on how quickly to implement politically sensitive structural reforms even though China’s economy continues to grow strongly.

To provide a range of perspectives on these questions, I would like to lay out the rest of the presentation in the following way:

A. Evaluating the Current Economic Recovery in the Asian Crisis Economies

1. Summarizing Current Macroeconomic Conditions and Future Prospects
2. Evaluating the Causes of the Economic Recovery
3. Highlighting Remaining Structural Constraints to Sustained Growth
4. Additional Considerations
5. Risks to Sustaining Recovery

B. Reviewing the Lessons Learned from the First Year and a Half of Economic Collapse

1. What Caused the Crisis? – the Double Mismatch!
2. Why Was the Economic Collapse So Deep and Widespread? – The Twin Crisis!

C. A Short Digression on the Malaysian Capital Controls

D. Some Tentative Conclusions

 

A. EVALUATING THE CURRENT ECONOMIC RECOVERY IN THE ASIAN CRISIS ECONOMIES

Current Macroeconomic Conditions. The current prognosis for East Asia is increasingly optimistic (see Table 1). Growth levels have recovered to positive levels for all the crisis economies (albeit from a quite low 1998 base year), with Korea registering a spectacular 10 percent rate of growth for 1999. Even Indonesia, which is struggling through a fundamental political transformation, registered slightly positive growth in 1999. Equally impressive, inflation and interest rates are quite low in all the crisis economies, in many cases lower than before the crisis; exchange rates have stabilized in terms of the US dollar, yielding a 20-30 percent real devaluation compared to pre-crisis currency levels (with little impact on domestic inflation!). Export growth in nominal US dollar terms has gained with imports growing even more quickly as domestic economies recover, causing "excessive" current account surpluses to fall to more healthy levels; foreign exchange reserves have been rebuilt in all economies, again with Korea standing out with a tripling in reserves over the last two years; and, stock markets have recovered from post-crisis lows, surpassing pre-crisis levels in several economies in the region. One is struck by how similar the collapse and recovery has been for the crisis economies, given the many differences in the particularities of each country’s situation.

Consensus Forecast. Most forecasters, including the IMF, now expect the recovery to deepen and stabilize in 2000 and 2001, as shown in the forecast years in Table 1 (forecast by Lehman Brothers). Economic growth is expected to stabilize around 5-7 percent growth for all East Asian developing economies over the next two years, with inflation continuing to fall in 2000 and then picking up a bit in 2001. Current account deficits are expected to move back into deficit by 2001, with exchange rates expected to gain moderate strength in the East Asian developing economies.

In fact, as capacity utilization rates increase rapidly throughout much of the region (capacity utilization in Korea currently already exceeds pre-crisis levels), much of the worry among forecasters now is that the East Asian economies may grow too fast, with calls for tightened macro policy and higher interest rates to cut off looming increases in inflation. The expected rise in US interest rates should also contribute to higher interest rates in East Asia. The Lehman Brothers forecast presented in Table 1 assume these policy responses.

Interestingly, the recent doubling of oil prices to around $30 a barrel, which would have had a serious impact on the region just ten years ago, is now expected to have a relatively minor impact on inflation, exchange rates and real sector activity, partly reflecting new production processes and products that are much less energy intensive than in the past.

A.2. Key Factors Underpinning the Recovery Starting in Late 1998

Economic conditions began to stabilize in the crisis economies in mid-1998, and in general the East Asian economies survived relatively unaffected the subsequent emerging market crises in Russia and Brazil (and the related Long-term Credit Management hedge fund collapse) in August/September 1998. Economic growth bottomed out in all the developing Asian economies in the 3^rd quarter 1998 and began a steady and strong recovery in the 4^th quarter of 1998.

Three key factors have underpinned economic recovery and the re-emergence of business confidence in the East Asian economies:

1. The shift in IMF-sanctioned policy toward expansionary domestic macroeconomic policy;
2. The reasonably effective formulation of government programs to manage the huge levels of non-performing loans, the recapitalization of the financial sector and the resuscitation of the corporate sector; and,
3. Major improvements in international economic conditions.

The Shift Toward Expansionary Macroeconomic Policy. Around the 2^nd quarter of 1998, almost a year after the crisis had begun, the IMF reversed its high interest rate, tight macroeconomic policy conditionality, which many feel contributed importantly to lengthening and deepening the economic downturn by more than was needed to cope with the initial crisis (as explained below). Korea, Thailand, the Philippines and Indonesia shifted toward more expansionary policies during this period. Malaysia held back due to the speculative overhang from the large offshore Ringgit market in Singapore, which Malaysia remedied in its September 1 imposition of stringent controls on capital outflows, and then quickly moved to an expansionary macro policy as well (as explained below).

Historically large government deficits and loose monetary policy (lower interest rates) served relatively quickly to inject demand into the economy. The expansionary policy reinforced inherent business cycle tendencies for companies to begin to rebuild depleted inventories and for consumers to reduce high levels of crisis-related precautionary savings and satisfy pent-up demand as prospects for growth improved. Even though interest rates declined, investment responded more slowly given the substantial excess supply in these economies. As growth ensued well into 1999, however, investment has picked up in the crisis economies, especially in Korea although much less so in Indonesia.

The Reasonably Effective Formulation of Government Programs to Rationalize the Huge Levels of Non-Performing Loans, Recapitalize Banking Systems and Resuscitate the Corporate Sector. An important part of the process of regaining confidence in the economic management of the East Asian economies was the reasonably effective formulation of government policies to rationalize the huge levels of non-performing debt and to regain the solvency of banking and corporate sectors. In this process, governments set up centralized Asset Management Corporations to take over NPLs from the banking system, effectively nationalizing insolvent commercial banking systems and socializing much of the costs in the process. (Thailand used de-centralized, private AMCs, and is relying on private capital infusions to recapatilize their banks.) The crisis countries have also set up government mediation agencies to encourage the private workouts of foreign debt (for all crises economies except Indonesia, this largely involves negotiations among banks and financial institutions, while the majority of Indonesia’s debt is made up of foreign borrowing by hundreds of corporates from hundreds of creditors, creating a more difficult negotiating environment).

Governments under pressure from the IMF also have worked to improve bank supervision and enhance capabilities for managing business risk, to improve the legal and market institutions for resolving bad debts (like bankruptcy courts), and to improve corporate governance (increased transparency, better accounting, protection of minority shareholders, better monitoring processes for owners and management – note that in Asian-prevalent family businesses, management and owners are often one in the same).

Major Improvements in International Conditions. Probably more than any other indicator, the East Asian currency markets and productive sectors gained confidence when the Japanese Yen appreciated abruptly by almost 20 percent in October, 1998 and then continued to gain in total almost 40 percent in value by the end of 1999. Around this same time, US interest rates lowered, basic commodity prices (and prices for many East Asian exports more generally) began to increase for the first time in almost three years, and the electronics sector reversed a multi-year depression toward a strong and what appears to be a persistent recovery in terms of both prices and volumes.

The appreciation of the Yen and stronger global market conditions yielded a rejuvenation in nominal export growth in 1999, particularly through higher export prices. Lower international interest rates accommodated the decline in domestic interest rates due to more expansionary macroeconomic policy and encouraged the renewal of some foreign capital inflows back into the crisis economies, especially into equity markets.

Over the course of 1999 as the recovery gained steam and the high Yen took hold, Asian imports (except for Indonesia) began to increase substantially, including importantly Japan. Since except for the Philippines and China, the largest market for East Asian developing economy exports is other East Asian economies, the rapid increase in East Asian imports contributed importantly to spur East Asian exports -- a kind of reverse trade contagion may have begun to take hold.

Looking more closely at the relative roles of the Japanese, Chinese and US economies, all three contributed positively in 1999 to creating a positive regional and international environment for recovery by the crisis economies. Over this period, the strong U.S. economy served as a bastion of economic stability and strength, generating demand during a time of economic downturn throughout much of the rest of the world. US macroeconomic management also is credited with maintaining international liquidity and moderating interest rates during the periods of most intense global financial instability. The appreciation of the Yen was critical, but my understanding was that the Yen was pushed up by market forces --the post-Russia/LTCM-crisis unraveling of hedge fund positions in September/October 1998 and the increased confidence in prospects for Japanese growth in late 1999 -- and not by official Japanese policy. Despite the large appreciation of the Yen, the Japanese economy bottomed out in 1998 and began to move toward positive growth, generating a substantial increase in Japanese imports in 1999. Low interest rates in Japan also helped the Japanese banks rationalize their large exposure to bad debts in East Asia.

China’s contribution was less direct, but still quite important. China’s maintenance of a fixed exchange rate during 1997 and 1998 when confidence levels in the region were particular fragile was critical. It is well recognized that China resisted triggering a possible debilitating round of competitive exchange rate devaluations in the region even though domestic economic conditions were troublesome – China’s export growth had fallen significantly, domestic unemployment was rising, domestic prices were falling and economic growth was propped up by expansionary fiscal policy. As well, the loss in competitiveness of Chinese exports due to the high RMB almost surely benefited the other East Asian exporters.

Additional Considerations. It is important to mention four additional positive factors supporting the recovery. First, for the Southeast Asian economies, the severe draught that augmented the economic damage to the region in 1997 and into 1998 came to an end, with good weather in late1998 into 1999 producing healthy agricultural yields.1 Secondly, Asians in the crisis economies proved much more resilient than expected, responding to the hardships of the crisis by liquidating savings, increasing sharing among families and groups, expanding NGO support activities, migrating from cities to more prosperous rural areas, quickly developing new government social safety net policies, and so on. In general, the social implication of the crisis proved much less severe than initially predicted.

Third, Asian political processes responded positively to the many tensions and conflicts related to the crisis, electing reform-minded governments in Korea, Thailand and Indonesia and supporting in large part serious policy reforms and economic/institutional restructuring.

Fourth, foreign direct investment inflows into the crisis economies remained relatively strong even as short-term capital outflows were massive. Record levels of FDI were achieved in Korea and Thailand in 1998, while FDI remained solid in every other economy except Indonesia (where FDI actually became negative). Although FDI inflows remained strong during the crisis, even while almost all other private capital inflows dried up, the composition of FDI shifted dramatically toward FDI in the form of mergers and acquisitions (estimated to be about 2/3s of all FDI into the five crisis economies in 1998). This implies, on the other hand, that foreign direct investment into greenfield and capacity expansion projects dropped precipitously, which may mean that East Asia is falling behind its catch up path in terms of adopting the new technologies needed to enhance productive efficiency. Much of the new M&A investment (M&A was essentially non-existent in the crisis economies before the crisis) most likely reflects repressed demand for foreign investment in economies such as Korea and Thailand where policy reforms opened up new sectors to FDI, and to policy reforms throughout the region that made 100% foreign ownership much easier. As well, much of the Japanese FDI (which did decline substantially to East Asia) consisted of capital enhancements to financially strapped subsidiaries.

Identifying Risks to Sustaining the Recovery. Lastly and quite briefly, it is important to note the main risks to the recovery. The region is quite vulnerable to further international shocks. Most importantly, any substantial decline in US economic growth would prove quite serious, as would a major downward correction to the buoyant US stock markets or a major increase in US interest rates. A substantial depreciation in the Yen could also significantly dampen the recovery, as would a fall back into recession by the Japanese economy. It is not clear how important at this stage a moderate depreciation of the Chinese currency would be, nor whether East Asian economies would be seriously affected by another emerging market crisis in Russia or Latin America. The recent doubling of oil prices does not seem to be a major risk, although it will serve as a minor drag on economic growth and as a contributor to inflationary pressure.

The most serious risks inside the Asian crisis economies appear to be largely political economic in nature. At one extreme, Indonesia is struggling for its life as it attempts to transit to a democratic political system, given serious economic, religious and ethnic tensions. Upcoming elections in Thailand and Korea offer the chance to derail momentum for continued policy reform. There is a region-wide concern that as the recovery takes hold, "reform fatigue" may set in that will reduce the "political will" to continue to implement tough and politically sensitive structural and institutional reforms, which could leave the region more vulnerable to a reoccurrence of the conditions that led to the previous crisis. We will review the remaining structural problems in the crisis economies in the next section.

A.3. Highlighting the Remaining Structural Constraints to Sustained Growth

Although substantial progress has been made in developing the frameworks for resolving NPLs and recapitalizing the banking and corporate sectors, actual implementation has been slow. There has been a tendency for AMCs to delay the disposal of assets until market conditions improve, creating an asset market overhang that limits recovery in asset prices. 2  Few banks in East Asia have actually been recapitalized, with almost all banks in Korea and Indonesia now government owned. Few corporates have paid off their bad debts (either to domestic or international creditors). And, the many initiatives to improve corporate governance, bank regulations and supervision, competition policy, accounting standards and legal systems, have either just been implemented or are still at the planning stage.

When the recovery began, banking systems in all the crisis economies were barely functioning (and have improved only marginally since then), burdened with requirements to off-load NPLs and recapitalize, with strong capital adequacy requirements providing incentives to limit loans and expand purchases of low-risk government financial assets. This generated what has been widely noted as a credit crunch. But the situation was even further aggravated because many of the corporates were not able to pay off their previous debt (and had assigned much of their available collateral), making them unlikely candidates for loans anyway. Firms were still highly leveraged, and in general had the same management as before the crisis. And yet, with these serious and continuing structural constraints, economic recovery has ensued steadily since late 1998.

Strong macroeconomic incentives for growth are working to pull the East Asian economies out of an abyss, and in this case these incentives appear strong enough to overcome these serious structural weaknesses remaining throughout the region. But such benevolent incentives cannot be maintained – fiscal deficits will be tightened and international economic conditions will turn less benign. It appears to most that restructuring and institutional strengthening must advance more rapidly into effective implementation as a precondition for sustained growth in the region.

B. REVIEWING THE LESSONS LEARNED FROM ECONOMIC COLLAPSE OF THE FIRST YEAR AND A HALF OF THE CRISIS

As we look back to the initial year of the crisis, a common view is emerging on many of the key characteristics that caused the economic impact of the crisis to be so deep. In my view, we still don’t understand well exactly why the crisis itself started and then spread so quickly among East Asian economies that by most accounts had strong macroeconomic fundamentals.

B.1. What Caused the Crisis? – The Double Mismatch!

The now obvious direct cause of the crisis is clearly understood to have been the build up of what we understand ex post to be "excessive" short-term international capital inflows, largely in the form of unhedged foreign currency loans to Asian banks that were on-lent to Asian companies, often for medium- to long-term use to support domestic currency generating activities – the "double mismatch." The rapid reversal to large capital outflows that occurred in mid-1997 caused the collapse in currency values first in Southeast Asia, and then at the end of 1997 in Korea.

Why this huge capital inflow with double mismatch characteristics occurred in the mid-1990s is not well understood. In our last meeting in Shanghai, I offered the explanation that macroeconomic policies in Asia in the mid-1990s had attempted to follow the US-FEDs lead in 1994 to raise interest rates to fight inflation and achieve a "soft landing" from the rapid investment-led growth in the region during this period. In this process, two things happened. Differentials between domestic and international interest rates, which had always been relatively large, remained large, especially when US interest rate began to fall in 1995 and 1996. Probably most importantly, however, a major shift in exchange rate expectations occurred throughout the region – toward expectations favoring strong exchange rates. This created self-reinforcing problems, which was not well understand by monetary authorities. Large exchange-risk adjusted interest rate differentials encouraged Asians to borrow from abroad in foreign currencies. The resulting increase in capital inflows reinforced strong exchange rates, which maintained the risk-adjusted differential. These arbitrage incentives most likely explain the build up in foreign borrowing.

The other side of the double mismatch – borrowing short-term to finance longer-term activities – can be explained more by institutional traditions. Most Asian banks dominated by ethnic-Chinese traditions (particularly those in Southeast Asia) traditionally borrowed and lent funds in terms less than a year, expecting to roll-over debt each year after the books have been cleared and new "relational" situations determined. Thus, most loans in these countries had always been short-term, even when used for longer-term activities. For Korea, whose banking system has long been dominated by government influence and which has traditionally been used to finance longer-term projects, direct government policy actually encouraged a shift toward short-term borrowing. That is, the Korean government liberalized short-term capital inflows before they liberalized longer-term capital inflows.

The third component to the short-term debt build up is the foreign lender. Foreign banks, largely "new entry" banks from Europe with limited experience in Asia and anxious to get into the game and Japanese banks financing on-going capacity expansion by Japanese firms, continued to pour money into East Asia right up to mid-1997. Asian financial intermediation systems did not properly evaluate the risk factors for individual projects, and certainly did not account for the ramifications of systematic collapse. Many foreign lenders did not adequately monitor their clients.3  This problem was exaggerated because of traditional banking practice in Asia – where the justification for loans are often made based on relational information and past experience with the loans then backed by collateral. Strong due diligence for estimating the expected returns of a project were not common among most Asian banks, and obviously the pro-cyclical nature of collateral just adds fuel to the fire (asset bubbles raise collateral levels which in turn supports increased lending).

These issues raise key questions as East Asia and the international community (governments, donors and businesses) think about how to develop more effective early-warning monitoring processes. East Asia had an impressive reputation for prudently managing official debt levels over the course of decades of economic development, but to a large extent East Asia viewed private capital flows as self-enforcing and of limited threat to macroeconomic stability. Given the largely private-sector characteristics of this crisis, East Asian economies will more closely monitor international capital flows and will improve their indicators to determine when capital inflows become excessive and raise issues of systematic vulnerability – when too much of a good thing can be your worse enemy. I should note that others blame the too rapid opening of capital account controls and too rapid liberalization of financial markets without appropriate domestic regulatory and institutional capabilities.

B.2. Why Was the Economic Collapse So Deep and Widespread? – The Twin Crisis!

Why did crisis caused such a deep economic decline in East Asia? Part of what made the Asian crisis so difficult to understand was that it affected a group of countries that by consensus had reasonably strong macroeconomic fundamentals, as commonly applied before the crisis. Unlike Latin America and other developing countries that had faced currency crises in the past largely due to profligate governments, East Asian governments had a strong track-record of responsible macroeconomic management – fiscal policy tending toward balanced budgets, monetary growth at moderate levels, exchange rates rarely overvalued by significant amounts, and an impressive record of official debt management. The East Asian crisis, alternatively, was caused largely by the excessive build up in private short-term capital inflows – an excessively profligate private sector operating in economies with immature financial intermediation systems and relatively weak private market and government regulatory and legal institutions, and thus with limited self-monitoring and self-correcting processes. As well, these were economies where domestic private and public institutional capacities had been built on managing success, placing little consideration on the dispute settlement processes designed to handle losses, non-performing loans, bankruptcy, and the restructuring of management during severe downturns.

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C. A Digression on the Malaysian Capital Controls

The seemingly successful implementation of capital controls by Malaysia has been held up as a major attack on economic and IMF orthodoxy, adding on to the apparent successful implementation of controls on capital inflows by Chile in the mid-1990s. As we purview the landscape of economic policy orthodoxy, there is now a much greater recognition that developing countries may need to use various forms of policies to manage/control international capital flows. In this context, it is important to ask: Why were the Malaysian capital controls done, and what did they accomplish?

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D. Some Tentative Conclusions

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Endnotes:

1. Note, for example, that many analysts estimated that the Philippines was affected more seriously by the draught than the combined impact of the financial crisis.

3. By most accounts the "old guard" U.S., European and Japanese banks that had been operating in Asia for many years did not significantly increase lending to Asia during the several years before the crisis. Several of the big U.S. banks actually cut back their lending to Southeast Asia because profitable projects were becoming scarce.