FRBSF Economic Letter
98-33; November 6, 1998
Responding to Asia's Crises
Pacific Basin Notes. This series appears
on an occasional basis. It is prepared under the auspices of the Center for Pacific Basin Monetary
and Economic Studies within the FRBSF's Economic Research Department.
It is now more than a year since the financial crises broke out in East
Asia. Yet the sharp currency depreciations associated with the crises
have not spurred rapid growth in their dollar exports, which would underpin
a rebound in economic activity in the region. What accounts for the sluggish
recovery in East Asia? What are the appropriate policy responses? This
Economic Letter attempts to provide some perspective on these
questions by reviewing the impact of East Asia's crises on their financial
sectors. It argues that difficulties in restoring financial flows are
the main obstacle to recovery in East Asia, and stresses the importance
of adopting policies that will facilitate the participation of private
investors in the recovery.
Crises and effects
For decades, East Asia was widely regarded as a model for other emerging
markets. Fiscal policy was not profligate, monetary policy was not inflationary,
and the region enjoyed high saving and investment rates. What the crises
in East Asia have taught economists and policymakers is that these "fundamentals"
alone are not enough to insulate an economy from a crisis.
Rather, problems in other "fundamentals" made East Asian economies vulnerable.
Starting in the second half of the 1980s, rapid growth was accompanied
by sharp increases in stock and land prices. East Asians borrowed against
their increased wealth, in some cases rapidly increasing short-term borrowing
from abroad. The boom lasted until the mid-1990s, when a series of external
shocks--greater competition from China, the depreciation of the Japanese
yen, and the sharp decline in semiconductor prices--hurt East Asian export
revenues, causing slower economic growth and falling asset prices. In
some Asian economies, these events were accompanied by growing weakness
in the financial sector that ultimately triggered collapsing currencies,
starting with Thailand in July 1997. The events in Thailand prompted investors
to reassess and test the robustness of currency pegs and financial systems
in the region. The result was a wave of currency depreciations (20%-80%)
and stock market declines (50% or higher), first affecting Southeast Asia,
then spreading to the rest of the region (see Moreno 1998 for more detailed
discussion of the causes of the Asian crises).
Other things equal, a currency depreciation would stimulate growth by
lowering the price of exports. But in East Asia, other things have not
been equal, so to speak. The currency devaluations and collapsing asset
prices not only caused steep reductions in wealth and purchasing power,
but they also disrupted the balance sheets of lenders and borrowers in
East Asia. Many East Asian firms borrowed in U.S. dollars without hedging,
and the large increases in their debt burdens when currency pegs collapsed
have rendered them insolvent. The weak balance sheets of borrowers have
in turn impaired the financial position of banks, producing a severe credit
crunch that is a major obstacle to recovery, particularly in the three
economies with the most fragile financial sectors--Indonesia, Korea and
Thailand. Indeed, lack of access to financing is an important reason why
East Asian exporters have been unable to increase their output. Combining
this with the recession in Japan, one of their major export markets, set
the stage for a severe economic contraction.
Policy responses
Observers agree that the key to overcoming East Asia's crises is to restore
voluntary financial flows and investment spending. However, they disagree
on the best way to achieve this. The strategy so far has been to stimulate
investor confidence and spending by (i) stabilizing the external payments
position of East Asian economies and (ii) restoring credit flows.
The external payments situation has been stabilized through large IMF-led
aid programs (totaling $118 billion for the most affected East Asian economies),
the rescheduling of short-term foreign debt, and reductions in foreign
borrowing through painful reversals of current account deficits. For example,
in South Korea, foreign reserves were nearly depleted at the end of 1997.
Adjustment efforts strengthened the balance of payments position to such
a degree that by the second quarter of 1998, the South Korean won began
appreciating, to the discomfort of South Korean exporters. (A similar
rebound in the exchange rate is apparent in Thailand.) Nevertheless, there
are few signs of growth in South Korea because credit flows have stopped.
Restoring credit flows and investment requires repairing the balance
sheets of banks and borrowers. Lenders are saddled with bad loans, and
even those in a better financial position will not lend to firms whose
net worth is negative, even if these firms have profitable projects. Bankrupt
institutions need to be weeded out, non-performing loans have to be written
off, and financial institutions and borrowers recapitalized so that normal
operations can resume.
In a market economy, recapitalization happens automatically, as stronger
and more efficient firms take over bankrupt institutions at low prices,
setting the stage for renewed investment and recovery. However, East Asia
faces a number of obstacles to such a market adjustment. In several countries,
the lack of effective bankruptcy provisions has made it difficult to dispose
of properties. The true value of assets being offered for sale is hard
to determine, due to a lack of transparency and deficient accounting and
reporting. In some cases, the high debt ratios of corporations make them
unattractive buys. For example, earlier this year, Ford Motor Corporation
withdrew its bid to purchase bankrupt Kia Motors in Korea because of Kia's
extremely large debt. Investors also have been deterred by labor market
conditions that make it very difficult to restructure firms.
While East Asian policymakers are working to overcome these obstacles,
progress has been slow. One reason is that these characteristics of East
Asian economies are part of institutional arrangements associated with
decades of rapid growth. It is still not entirely clear whether the current
crises have produced a consensus on the value of abandoning these arrangements.
As the costs of recapitalization after a major financial crisis are often
very high (they have reached 25% of GDP or higher in major banking crises
in other regions), government funds also are needed. In the short run,
central bank funds have been used to assume bad loans and pay off depositors
of failing institutions. In order to keep the central bank balance sheet
healthy and limit money creation, the central government at some point
assumes the costs directly through deficit financing or tax revenues.
Financial sector repair thus raises questions about the extent to which
policymakers should resort to money creation, raise taxes, or rely on
deficit financing. This is closely related to the hotly debated question
of the appropriate fiscal and monetary policy response to the crises.
Macroeconomic policies
In dealing with the crises, East Asian policymakers face a policy dilemma,
as they must simultaneously (i) stimulate the economy and (ii) stabilize
the exchange rate as well as inflation, the latter being important to
restore voluntary credit flows. (The double-digit inflation in Indonesia
suggests that, in spite of economic contraction, the threat of inflation
is real.). To resolve the dilemma Moreno, Pasadilla, and Remolona (1998)
suggest that fiscal policy be assigned to restore growth (including financial
sector repair and the social safety net) and monetary policy to stabilize
exchange rate expectations and inflation. The latter implies maintaining
a predictable monetary policy stance with some clear nominal target, given
that exchange rate targeting is too costly. (For example, in Mexico after
1994, the monetary base was targeted, but some other target also may be
considered.) However, the overall degree of tightness or ease in macroeconomic
policy needs to be determined case by case.
Macroeconomic policies in East Asia were initially tight, but have since
eased considerably. For example, anticipated 1998 fiscal deficits in the
IMF program for Korea rose from 1% of GDP in February to 5% of GDP in
the latest program. In Indonesia, an originally anticipated fiscal surplus
of 1% of GDP switched to a deficit of 8.5%. As for interest rates, these
rose in the early stages of the crises, when currencies were under pressure,
but have since declined in a number of economies. For example, after reaching
a peak of 35%, the Korean interbank rate at this writing had fallen to
just over 8%, compared to around 14% when the crises broke out. Nominal
interest rates in Indonesia are still high--close to 70%--but are much
lower after accounting for inflation.
Have current policies worked?
Have the strategies for overcoming the crises worked so far? It is now
generally recognized that fiscal policy was too tight in the early stages
of the crises, in part because growth forecasts were too optimistic. As
occurred in Mexico after the peso collapse in 1994, many observers initially
failed to recognize that the sudden reversal in capital inflows and related
disruptions in the flow of credit would cause severe economic contraction.
While interest rates also have fallen to their pre-crisis levels, initially
tight monetary policies have been criticized. But it is not clear whether
calls for much more aggressive monetary stimulus should be heeded. With
an open capital account, lowering interest rates can further destabilize
the exchange rate, which will not restore investment confidence nor output
growth.
To allow for greater monetary stimulus without destabilizing the exchange
rate, some economists (Krugman 1998) have called for the imposition of
capital controls, a step recently adopted by Malaysia. Under the new rules,
central bank approval is needed to convert Malaysian ringgit into foreign
exchange, and transactions involving foreign currency or foreign residents
are generally restricted. (The government still permits (i) general convertibility
of current account transactions, (ii) free flows of direct foreign investment,
and (iii) repatriation of interest, profits, and dividends and capital.)
This prevents the sudden outflow of capital even if Malaysian interest
rates fall below world interest rates. The Malaysian ringgit has been
fixed at 3.80 to the U.S. dollar, and the government has adopted a number
of measures to stimulate credit.
This strategy reflects the perception that in the current uncertain global
environment, investors (both domestic and foreign) whose capital has left
emerging markets are not likely to bring these funds back in the near
future. It thus relies on domestic macroeconomic stimulus, rather than
the resumption of private financing, to restore economic activity. This
strategy involves at least two risks.
First, the restoration of capital inflows may turn out to be crucial
in ensuring an early recovery after all. Indeed, it can be argued that
one reason Mexico recovered so quickly from the 1994 peso crisis is the
large foreign investor participation in its export sector. These well-capitalized
producers experienced no interruption in their access to credit. East
Asian producers with viable plants, in contrast, are having great difficulty
securing working capital or other financing because of the disruptions
in their balance sheets. Capital controls may discourage foreign equity
financing (or the repatriation of East Asian capital) that could help
overcome this problem, thus delaying the recovery. Monetary stimulus may
offset these effects, but the sluggish growth of Japan in the 1990s suggests
that such stimulus may not easily overcome weaknesses in the financial
sector.
Second, capital controls may insulate economies that adopt them so effectively
that they will lose the incentive to restructure their economies in a
manner that will help prevent future crises. Given the high costs of the
current crises, this is an important consideration in choosing policy
responses.
Ramon Moreno
Senior Economist
References
Krugman, Paul. 1998. "Saving Asia: It's Time to Get Radical." Fortune
(September 7).
Moreno, Ramon. 1998. "What Caused East Asia's Financial Crisis?" FRBSF
Economic Letter 98-24 (August 7).
_____________, Gloria Pasadilla, and Eli Remolona. 1998. "Asia's Financial
Crisis: Lessons and Policy Responses." In Asia: Responding to Crisis.
Tokyo: Asian Development Bank Institute. Also Working
Paper PB98-02, Center for Pacific Basin Monetary and Economic Studies,
Federal Reserve Bank of San Francisco.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
