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President's Speech
Speech to the Asia Society
of Southern California
Los Angeles, California
By Janet L. Yellen, President and CEO, Federal Reserve
Bank of San Francisco
For delivery February 6, 2007, 12:30 PM Pacific time, 3:30
PM Eastern
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The Asian Financial Crisis Ten Years Later:
Assessing the Past and Looking to the Future
Good afternoon. On behalf of the Federal Reserve Bank of
San Francisco, the Asia Society of Southern California and
the Pacific Council on International Policy, I’m delighted
to welcome you all here. This is the first in a series of
presentations, seminars, and conferences the San Francisco
Fed will be involved with over this year as we explore various
facets of the Asian financial crisis, focusing on the stability
and resiliency of financial sectors today and remaining challenges
in the future.
At the time of the crisis, I was the Chair of President
Clinton’s Council
of Economic Advisers, and, as you may imagine, it was definitely a “front-burner” issue
for us. As the crisis spread from country to country, there was deep concern
about how big the impact would be on the U.S. economy, and the markets certainly
were jittery: that October, the Dow Jones Industrial Average plunged over 500
points. For the five Asian nations most associated with the crisis—Thailand,
Korea, Indonesia, the Philippines, and Malaysia—the toll in both human
and economic terms was enormous: in 1998, these countries saw their economies
shrink by an average of 7.7 percent and many millions of their people lost
their jobs. More broadly, there was concern that the crisis had revealed new
sources
of risk in the international financial architecture. Now that I am a Reserve
Bank President with responsibilities for overseeing financial institutions,
I have an even greater awareness of how these issues remain vital for maintaining
financial stability today.
In my remarks this afternoon, I would like to provide some
background for the discussions that will take place in the
follow-up events marking the tenth
anniversary of the crisis. Let me note that, as usual, these comments are
my own and do not
necessarily represent the views of my colleagues in the Federal Reserve System.
I will first review the major strands of thought in the literature on the
causes of the crisis, highlighting some of the vulnerabilities
that were contributing
factors. Then I will turn to conditions in the affected countries today and
examine how their policy responses to the crisis have shaped the current
Asian financial
environment. I will round out my remarks with some thoughts on lessons learned,
particularly for international financial institutions, and observations on
China in the current environment.
Before I begin, I should note that the subject is not really
a single Asian crisis, but rather several crises. The afflicted
countries obviously differ
very much
from one another, both in terms of their levels of economic development
and their institutional features. Therefore, the causes of
the crises and, likewise,
the
policy reforms that have been adopted in the last 10 years are not uniform
for the region as a whole. Nonetheless, there are some important overarching
themes
in these developments, and I will try to draw them out.
***
Let me begin by looking back. The financial crisis in Asia
was in many ways very different from others. For example,
earlier in the 1990s, both
Mexico
and Argentina
suffered financial crises, largely stemming from their unsustainably high
budget deficits and soaring inflation. By contrast, in most of the affected
Asian
countries, during the years leading up to the crisis, growth in economic
activity was strong,
inflation was relatively tame, investment was robust, and, with their budgets
in surplus, their fiscal houses appeared to be in order.
Indeed, these countries had enjoyed extraordinarily fast
growth for decades. As their success grew, the international
community encouraged them to open
their economies to foreign capital and to liberalize their financial
sectors, and there
was movement in that direction beginning in the late 1980s. With freer
capital markets and fewer distortions in the financial sector, foreign
capital flooded
in, typically as short-term loans to banks; by 1996, capital inflows
had grown to $93 billion.
How, then, did 1997 become the year of the “sudden stop” in East
Asia—that is, the year that foreign investors not only stopped
flooding these countries with capital, but, in fact, reversed course
and pulled capital
out, in a dramatic way, as $93 billion of inflows became over $12 billion
of outflows?
The literature exploring this question is massive, and
has generally offered two kinds of explanations, which are
not necessarily mutually
exclusive.
According to one view, this situation is best characterized as a “liquidity” crisis—much
like a banking panic, where depositors’ fears about insolvency,
well-grounded or not, become a self-fulfilling prophecy as their
withdrawals en masse bring
the bank to ruin. In the case of the East Asian economies, foreign
investors may have lost confidence in their fundamental soundness,
perhaps because of news
about the failures of the Korean chaebols Hanbo and Sammi Steel,
as well as of Thai nonbank financial institutions. This loss of confidence
could have led investors
to unload their holdings of those countries’ securities in
a kind of panic-selling. Thus, in this view, whether or not the loss
of confidence was warranted, it became
a self-fulfilling prophecy, as the downward pressure on Asian asset
prices ultimately led to the deterioration in fundamentals that investors
feared.
The second view focuses more on the vulnerabilities that
existed in these nations’ economic
fundamentals, which threatened to lead to solvency difficulties.
One such vulnerability was the pursuit of risky lending practices
by financial intermediaries. In part
this was due to problems with the quality of supervision and regulation
of the financial sector. For example, in Thailand in the
early 1990s, although regulatory
requirements for banks were rigorous, actual enforcement of those
requirements was less so—sometimes far less so, according
to some studies; moreover, regulation of nonbank financial
institutions was almost nonexistent. But the
problem also lay with the long tradition of so-called “relationship
lending.” Rather
than basing lending decisions on sound information about the fundamental
economic value of specific investment projects, banks and other
financial intermediaries
based them on personal, business, or governmental connections.
As a result, bank loan portfolios became particularly risky. And
these risks became grim realities
when economic conditions slowed in these countries in early 1997,
as many firms, such as the Korean chaebols I mentioned, faced serious
financial difficulties.
In spite of the risky lending practices that prevailed
before the crisis, foreign investors poured money into these
countries at
record rates.
Their willingness
to do so appears to have stemmed in part from a second area of
vulnerability—a
perception that the governments of these nations stood ready
to intervene to forestall bank failures. Here Korea provides
a particularly clear example. Foreign
branches of Korean banks were able to build up huge liabilities
before the crisis, partly because foreign creditors correctly
perceived that if their parent banks
found themselves in financial difficulty—as they did after
the onset of the crisis—they would receive assistance from
the Korean government. Indeed, one study documents that foreign
creditors began refusing to refinance their
outstanding obligations when the level of these liabilities began
to approach the Korean government’s holdings of foreign
reserves. When foreign creditors refused to roll over their
short-term loans,
capital inflows were quickly replaced
by capital outflows.
This brings me to a third vulnerability—explicitly
or implicitly pegged exchange rate regimes, which are subject
to speculative attacks if the markets
perceive that the true value of the currency is misaligned
with its pegged value. One explanation for the attacks that
drove currency values down in Asia is tied
to concerns about possible big government bailouts of the strained
banking sector. If foreign investors expected that the bailouts
would lead to high fiscal deficits,
that expectation, in turn, would raise concerns that the governments
might force their central banks to monetize their deficits,
resulting in higher inflation
and depressed currency values.
As we all know, the speculative attacks on exchange rate
pegs appeared to spread from one country to another, a phenomenon
now commonly
referred to
as “contagion.” Take
the case of the attack on the Korean won that occurred shortly after the Thai
baht fell and the Taiwanese dollar was devalued. One explanation for it hinges
on trade competitiveness; that is, speculators might have expected the Korean
government to be more willing to let the won depreciate once the other currencies
had fallen in order to stay competitive with its Asian neighbors. Alternatively,
speculators might have expected that the crises in those countries would worsen
Korea’s export prospects, leading to an economic downturn
in Korea which would put downward pressure on the won.
Whatever the source of the contagion, the currency depreciations
had devastating consequences due to the prevalence of “currency
mismatches.” These
existed because both domestic banks and their client firms
had been issuing dollar-denominated liabilities to finance
their investments, whose returns were denominated in local
currencies. Presumably, they held these unhedged positions
either because they
had few other options, or, because at the time, they assumed
that the pegs would hold. In any event, once the pegs collapsed,
their balance sheets deteriorated
severely, leaving them unable to service their debt obligations
when their creditors refused to roll over their dollar liabilities.
***
With their economies at such a low ebb, the expectations
that the Asia crisis nations would stage a full and fast
recovery
were,
frankly, not very high.
Yet, remarkably, a full and fast recovery is exactly what
happened. Between 1999 and
2005, these nations enjoyed average per capita income growth
of 8.2 percent and investment growth averaging nearly 9 percent,
with
foreign
direct
investment booming at an average annual rate of 17.5 percent. Moreover, all of the
loans associated with the International Monetary Fund’s
assistance programs during the crisis have been paid back
and the terms of those programs have been fulfilled.
At least part of this success is likely due to policy changes
that have gone some way toward addressing the vulnerabilities
I discussed.
One
such policy
change has been an increasing shift away from targeting exchange
rates and toward targeting
an explicit desired inflation rate. Korea moved in this direction
in 1998, followed by Thailand in 2000 and Indonesia in 2005.
Changing the anchor
for these countries’ monetary
and foreign exchange policies has helped to mitigate the
possibility of currency mismatches by encouraging private
agents to hedge their currency positions, while
also allowing for greater domestic flexibility in response
to external shocks.
Now, it should be admitted that these
countries still manage
their exchange rates to some extent. In fact, recent moves
by the Thai
government indicate
an increased
emphasis on this issue. After a series of foreign exchange
interventions failed to stem the upward pressure on the baht
last year, the
Thai government imposed
controls on capital inflows last month, first limiting sales
of short-term securities to foreign investors and then imposing
a
de facto tax
on portfolio capital inflows
by requiring 30 percent of inflows to be placed in a non-interest
bearing “reserve
account,” refundable in full only after a year. While
an investor sell-off of Thai equities forced the government
to repeal some of the controls the next
day, its determination to limit exchange rate movements appears
to have increased.
The more typical way for these countries
to limit exchange
rate movements has been through intervention and the accumulation
of dollar reserves.
As a result,
between 1997 and 2005, foreign exchange holdings in the five
crisis countries quadrupled to over $378 billion.
While efforts to limit exchange rate appreciation may be
motivated in part by competitiveness considerations, this
build-up in
reserves may
also be
motivated by memories of the crisis, as these funds could
be used to smooth the effects
if another “sudden stop” occurred. In any event,
it is fair to say that the East Asian nations as a group
have come a long way towards achieving
exchange rate flexibility and price stability compared to
where they were in the 1990s, and the improved macroeconomic
conditions likely have played a role
in their superior performance and in their renewed attractiveness
as destinations for foreign direct investment.
Korea, Malaysia, Thailand, and Indonesia have also moved
to improve banking supervision and regulation and to introduce
more market
discipline since
the crisis. Korea’s
progress in strengthening its supervision of financial institutions
is especially significant. Korean
commercial banks have also adopted Western-style board governance
systems, where the majority of board members are outside
directors, and they have reformed their executive compensation
processes, with banks introducing
or strengthening executive stock option programs geared towards
tying compensation more closely to bank performance. Korean
banks also quickly cleansed their balance
sheets of nonperforming loans.
Among the other crisis nations, supervision and accounting
transparency also have improved, and banks in Thailand, Malaysia,
and the
Philippines have
succeeded in ridding their balance sheets of nonperforming
loans. However, recent studies
suggest that there are still weaknesses in enforcement, as
there were before the crisis, which limits the regulatory
gains achieved
through
tightening
accounting standards. Nevertheless, compared to 1997, significant
progress has been made.
Indonesia has rebuilt and recapitalized its devastated banking
sector. Malaysian banks’ new emphasis on lending to
consumers and small and medium-sized enterprises has moved
them away from relationship-based lending that was the
norm prior to the crisis. Thailand has brought its previously
unregulated finance companies under central bank supervision.
Another step towards decreasing the extent of bank-centered
finance and the scope of implicit government guarantees on
investment
has been the
development
of local
currency bond markets. Prices in these markets adjust to
changes in perceived risk automatically and in ways that
can pose substantially
less systemic
risk than foreign-currency-denominated short-term loans.
This solution complements the other reforms, because, in
order to
function well,
bond markets require
timely, honest, and credible reporting of firms’ financial
circumstances—in
other words, a transparent, well-regulated, and well-functioning
set of capital markets. Thus, borrowing in bonds from a large
number of creditors could reduce
the relationship lending problems believed to have played
a role in poor lending decisions made by Asian banks before
the crisis. Indeed, some have even argued
that developed local bond markets could make it less costly
to securitize bank loans and help banks better manage risk
in their lending portfolios.
To promote the development of local currency bond markets,
a group of regional central banks launched the first stage
of an “Asian Bond Fund” in
2003. To date, however, this Fund has not led to much growth
in bond trading and issuance, in part because the fiscal
prudence in a number of Asian countries
has meant that too few government bonds are available to
form a vibrant market in public debt securities. This in
turn limits the corporate bond market, since
government bonds add to the overall volume of bonds issued
in that currency and thereby increase overall market liquidity.
Bond market growth also requires a
solid financial infrastructure, including a sound legal structure,
effective credit ratings agencies, and a strong institutional
investor base. Countries
that develop this infrastructure will likely have a better
chance at seeing meaningful growth in local bond markets.
***
So far I have discussed several policy changes that the
Asia-crisis nations have made to strengthen their financial
systems and
thereby avoid another
crisis. But even with these measures in place—indeed, even with eventual improvements
in these measures—there will always be some residual
risk of systemic crises. Therefore, an assessment of the
state of Asian financial markets today must include
an examination of the capability of the international financial
architecture and its major institution, the International
Monetary Fund, to handle future
financial crises.
Some lessons have clearly been learned. One relates to
the conditions for opening a country’s capital markets.
With a strong financial system, the arguments in favor of
unfettered capital flows are strong. But during a transition
from
a financial system with evident vulnerabilities, the path
to the liberalization of capital accounts should be gradual
and carefully managed. Failure to do so
can expose the regulatory and moral hazard difficulties experienced
in Asia.
Another lesson is one that the Fund has learned,
namely,
that its adjustment programs should be tailored to individual
nations’ characteristics. For
example, some critics have charged that while the austerity
measures it advocated may have worked well in other financial
crises, in the case of Asia they may
have actually exacerbated the downturn. Although that claim
remains controversial, the Fund has adopted new guidelines
to ensure that its adjustment programs are
shaped by individual country characteristics and that local
authorities have a voice in steering adjustment policies
during Fund-supported lending programs
going forward.
A third lesson is that transparency concerning both overall
macroeconomic conditions and individual firm accounting is
needed to guide
successful domestic investment
decisions. Here, too, the Fund has adapted by strengthening
its international surveillance activities to provide early
warnings
of impending crises.
In 1999, the Fund, together with the World Bank, launched
the Financial Sector
Assessment
Program, with the aim of assisting emerging market economies
in identifying weaknesses in their domestic financial sectors.
Of course, in the decade since the Asian financial crisis,
there have been other crises, and these, too, have led to
some reforms
in the
international architecture.
A notable episode was the Argentine crisis of 2002. This
was the first large modern default where creditors were not
primarily
banks,
as they
were in
Asia, but rather a multitude of bond claimants from many
countries. On the positive
side, the contagion issues that were prevalent in Asia did
not arise, as
the Argentine risk was well diversified across a large group.
On the negative side,
renegotiation efforts were hindered by the need to address
the economic and legal differences of a large and disparate
set of
claimants.
Anticipating the challenges raised by the movement toward
predominantly bond-based finance from bank-based finance,
the Fund has explored
the question of lending
workouts; it has even considered the possibility of formalizing
sovereign debt renegotiations with mechanisms analogous to
the bankruptcy procedures
that
prevail in domestic bond markets. For now, however, it appears
that the problems of renegotiating
with a broad set of claimants are being addressed in a less
centralized manner, as governments such as Mexico have successfully
issued
bonds containing “collective
action clauses” that establish at issue the procedures
for orderly renegotiation in the event of default.
***
In assessing financial conditions in Asia ten years after
the financial crisis, one must consider the ascendance of
China
as a key economic
power in the
region. I did not mention China earlier in my discussion
because China was not drawn
as deeply into the financial crisis that spread through the
region, even though it, too, had problems with its financial
sector.
The reason it
stood apart
is that it differed from the crisis countries in two important
respects. First, its capital account was more closed, and
second, much of the
foreign investment
was not short-term loans but direct investment, which in
many cases involved actual plants and factories—“steel
in the ground.” Today, despite
China’s recent successes, it still shares some of the
vulnerabilities faced by the Asia crisis countries in the
1990s. For example, although it has made
significant progress in reforming its banking sector through
reducing nonperforming loans, the government still has a
degree of influence in Chinese bank lending
decisions, and some have expressed continuing concern over
the health of the banking sector. Commenting on the challenges
China faces in its corporate governance
and accounting standards, Chairman Bernanke noted recently that progress has been made in these areas, but large benefits
could be achieved from further concentration
on these issues.
While China has increased the flexibility of the renminbi,
permitting it to appreciate by 6.5 percent against the dollar
since it was
officially unpegged in July 2005,
it is still much less flexible than the currencies of the
Asia crisis countries.
The central bank has resisted pressures for more rapid appreciation
of the renminbi by intervening in the foreign exchange market
and building up its
holdings of
foreign reserves. Limiting appreciation of the currency in
this manner complicates the use of monetary policy to produce
an orderly
slowdown
in China’s currently
booming economy.
As an emerging leader within the region, China could also
play a major role in promoting regional exchange rate flexibility.
For example,
Thailand’s Finance
Minister recently argued that his nation’s economic
conditions would be helped by a faster pace of renminbi revaluation.
If China were to move more quickly,
it could well encourage even greater exchange rate flexibility
among the East Asian fledgling inflation-targeters, as they
would be able to pursue their goal
of reaching price stability without losing export competitiveness.
In conclusion, the crisis illuminated the importance of
sound financial policies, including strong accounting
principles
and adequate regulatory
oversight,
as well as the importance of sound macroeconomic policies,
including exchange rate flexibility. The good news is that,
since the crisis,
the Asian countries
as
a group have made great progress in these areas. Still,
there are reasons to
believe that continued vigilance will be required to prevent
or ameliorate crises in the future. First, there is some
risk that
the policy reforms
that were achieved
in the wake of the disastrous crisis could be scaled back
in the current era of relative regional prosperity. Second,
private
agents
may respond
to the
relatively tranquil current economic environment by dropping
some of the prudent investment
practices that were adopted following the crisis.
The Asian financial crisis had a profound effect on the
people and economies of the region. For that reason,
it is worthwhile
exploring
the fundamental
causes of the crisis, the recovery paths countries have
adopted, and any current vulnerabilities
that could undermine the stability of the financial system.
The two conferences in June and September at the San
Francisco Fed
will delve
more deeply
into these issues. By looking ahead with that tumultuous
event in mind, we hope
to provide
important insights for countries within the region, for
the U.S. and Europe, their trading partners, and for
emerging market economies
around
the world.
1. Source: Radelet and Sachs
(1998). These inflows correspond to 8.32% of GDP for the
five Asian nations in 1996 (based on World Development Indicators).
2. See Chang and Velasco (2000), which
analyzes the Asian financial crisis by building directly
on old models of bank runs.
3. Radelet and Sachs (1998).
4. Dooley and Shin (2001).
5. See, for example, Corsetti, Pesenti, and Roubini (1999)
and Burnside, Eichenbaum, and Rebelo, (2001).
6. Some Asian banks did denominate their loans in dollars.
However, their claims were still primarily on firms that
earned revenues in local currency. As such, in the wake of
a local currency depreciation, the quality of these loans
deteriorated as default risk increased. In this way, even
banks that issued local loans denominated in dollars faced
a currency mismatch.
7. Investment measured as gross fixed capital formation.
Figures are from 1999-2005. FDI figures are from 1999-2004.
8. ECB Occasional Paper #43, Annex 1, p. 26, February 2006.
9. For example, Aizenman and Lee (2005) demonstrate that
holdings of foreign exchange reserves are more closely related
to
country characteristics, such as the degree of capital account
liberalization, that would indicate the need for a precautionary
war chest.
10. Hosono (2005).
11. Choe and Lee (2003).
12. For example, see Ball, et al. (2003).
13. Eichengreen and Luengnaruemitchai (2004).
14. This group is known formally as the Executives’ Meeting
of East Asia-Pacific Central Banks and Monetary Authorities,
and it includes Australia, China, Hong Kong, SAR, Indonesia,
Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore,
and Thailand.
15. For example, see Independent Evaluation Office of the
IMF report on “The IMF and Recent Capital Account Crises:
Indonesia, Korea, Brazil,” (2003).
16. Stiglitz (2002).
17. Bernanke (2006).
References
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Ball, Ray, Ashok Robin, and Joanna Shuang Wu, (2003), “Incentives
versus Standards: Properties of Accounting Income in Four
East Asian Countries,” Journal of Accounting and
Economics,
36, 235-270.
Bernanke, Ben, (2006), “The
Chinese Economy: Progress and Challenges,” remarks
at the Chinese Academy of Social Sciences, Beijing, China,
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Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo, (2001), “Prospective
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Chang, Roberto, and Andrés Velasco, (2000), “Financial
Fragility and the Exchange Rate Regime,” Journal
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Choe, Heungsik, and Bong-Soo Lee, (2003), “Korean
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Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini,
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Dooley, Michael P., and Inseok Shin, (2001), “Private
Inflows when Crises Are Anticipated: A Case Study of Korea,” in
Glick, Moreno, and Spiegel, eds., Financial Crises in
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Eichengreen, Barry, and Pipat Luengnaruemitchai, (2004), “Why
Doesn’t Asia Have Bigger Bond Markets?” NBER
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Hosono, Kaoru, (2005), “Market Discipline to Banks
in Indonesia, the Republic of Korea, Malaysia, and Thailand,” mimeo,
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International Monetary Fund, Independent Evaluation Office, “The
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Radelet, Steven, and Jeffrey D. Sachs, (1998), “The
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