FRBSF Economic Letter
2004-38; December 24, 2004
After the Asian Financial Crisis: Can Rapid Credit Expansion
Sustain Growth?
Pacific Basin Notes. This
series appears on an occasional basis. It is prepared under the
auspices of the Center
for Pacific Basin Studies within the FRBSF's Economic Research Department.
In the years following the Asian financial crisis
of 1997-1998, the governments of South Korea and Thailand each
have sought to generate economic recovery by expanding domestic
credit. The rapid credit expansion in both countries has created
concerns about the extent to which their economies can channel
these funds efficiently and sustain economic growth. In particular,
if banks are unable to supervise the allocation of resources effectively,
there is a risk of widespread bankruptcies and a financial system
crisis. Previous experience shows that these Asian economies indeed
may be at risk of a credit boom and bust cycle.
This Letter discusses the sustainability
of the credit-led economic expansions in South Korea and Thailand.
First, it discusses the experiences of South Korea and Thailand
as they attempted to recover from the 1997-1998 crisis and boost
domestic demand through credit expansion. Then, it assesses the
risks that these two countries may face if their credit-led expansions
collapse and discusses steps they are taking to reduce exposure
to these risks.
Boom and bust
In the decades before the Asian financial crisis,
South Korea and Thailand experienced sustained economic growth
based largely on export-oriented policies, productivity gains,
and investment growth, which was financed by relatively high levels
of private saving as well as by foreign borrowing.
The rapid expansion of foreign borrowing is seen
by many as the primary cause of the Asian financial crisis. Because
the financial sectors of the affected countries proved to be too
weak to monitor the effective investment of foreign credit, funds
were directed to unproductive projects. Consequently, international
creditors lost confidence, prompting higher costs of borrowing,
and leading to a wave of bankruptcies among many seemingly sound
firms. This further undermined international investor confidence,
and led to a rapid outflow of short-term capital and a sharp depreciation
of domestic currencies. The ensuing crises led to the collapse
of the financial sector and of economic activity.
During the Asian crisis, South Korea and Thailand
were hit very hard, as their economies experienced large and prolonged
output collapses: In South Korea, output fell by 8% between 1997:Q4
and 1998:Q2 and did not return to its pre-crisis level until 1999:Q2;
in Thailand, total output fell by 14% between 1997:Q3 and 1998:Q3
and did not return to its pre-crisis level until the end of 2000.
In addition, consumption and investment contracted sharply in both
countries. The International Monetary Fund (IMF) implemented severe
austerity packages as part of bailout programs that reduced government
outlays and severely curtailed social programs. The long-term cost
of the bailout of the financial sector amounted to an estimated
30%-40% of output in both countries.
Government-encouraged credit expansion
to pump economy
Output was slow to pick up in the aftermath of
the crisis. Because of the rapid outflow of foreign funds and the
collapse of the financial system in both South Korea and Thailand,
the effect of a large currency depreciation was not sufficient
to boost output. Furthermore, the global slowdown of 2000-2002
restrained export growth and limited the amount of foreign funds
available to these countries. Finally, to limit further vulnerability
to capital flow reversals, South Korea and Thailand became reluctant
to rely on foreign funds. In fact, Thailand rapidly reduced its
stock of foreign debt even though the interest rates charged to
many emerging markets were down to pre-crisis levels. Thailand
went so far as to pay off the IMF early for the debt it incurred
during its restructuring program.
With foreign financing precluded, both countries
sought economic growth by stimulating domestic demand. However,
the governments faced restraints in using fiscal policy stimulus
because of IMF-recommended policies that called for greater fiscal
austerity. Consequently, Thai and South Korean policymakers stimulated
domestic demand by increasing public credit and by encouraging
commercial banks to increase credit to private firms and domestic
consumers. One such program in South Korea involved giving tax
breaks for consumers for payments by credit cards. The result:
between 1999 and 2002, the number of credit cards doubled to four
per every adult and credit card use increased sixfold to 114% of
GDP; by 2002, household debt rose to over 70% of output, a stark
contrast to the pre-crisis period when South Korea enjoyed a very
high saving rate and household debt of only about 40% of output.
Getting banks to extend credit rapidly was hampered
by the large amount of nonperforming loans (NPLs) on commercial
banks' books that remained from the aftermath of the Asian crisis.
To address this problem, both countries set up government-run asset
management companies to buy NPLs and recapitalize the banks. The
experience of one government-owned commercial bank in Thailand
is illustrative. Krung Thai Bank received large injections from
the government to clean up its balance sheet after the Asian crisis.
After the transfer of assets to a government asset-management company,
Krung Thai's NPLs decreased from 50% to less than 10% of deposits.
This provided Krung Thai a competitive advantage over other private-owned
and foreign-owned commercial banks. Krung Thai was encouraged by
the government to increase credit to individuals with credit problems
and unable to borrow from other banks, and it now controls about
20% of the Thai commercial bank market.
The domestic credit expansion policies worked in
both countries. Led by private consumption, both economies expanded.
In South Korea, output grew by over 6% in 2002, and consumption
grew by 6.7%. In Thailand, output grew by 5.4% in 2002 and by 6.7%
in 2003, and consumption grew by 4.9% and 6.2%, respectively.
What are the risks of a credit-led output
expansion?
A study by the IMF (2004), examining historical
evidence on the cost of deflating credit expansions in emerging
markets, finds that, if private credit booms too rapidly above
a historical trend, the expansion usually deflates under its own
weight, just as stock market bubbles eventually burst. For example,
if capital inflows are attracted by expected returns, and if expectations
are not met or there are large negative shocks to the economy,
the financial flows may reverse. The highly leveraged financial
systems in emerging markets are usually particularly vulnerable
to such developments because of poor risk management and implicit
government bailout guarantees. As investors realize that a financial
system is deteriorating, financial outflows accelerate, leading
to a credit bust. The IMF study finds that private credit booms
in emerging markets are associated with consumption and investment
booms (70% probability) followed by banking crises (75% probability)
and currency crises (85% probability).
In the cases of South Korea and Thailand, the recent
credit expansions could be a threat to fiscal health because much
of the new loan activity represents increased implicit fiscal liabilities.
If the economy slows, leading to an increase in NPLs and a simultaneous
fall in tax receipts, the governments may be forced to bail out
the banks again.
Are South Korea and Thailand in a credit
boom?
The answer to this question is not so simple. In
South Korea, real private credit grew by 11% in 2002 and by about
10% in 2003. While this may seem like fast growth, in fact it does
not meet the benchmark of a "credit boom" as defined
in the IMF (2004) study, which compares credit growth to a measure
of its long-term trend growth. Thailand's credit was almost 8.3%
above trend in the fourth quarter of 2003, which does come close
to qualifying as a credit boom by the IMF benchmark.
One caveat to these calculations is that it is
hard know with certainty the trend level of real credit. Another
caveat to note is that aggregate credit data may be misleading.
Government actions may have led to a shift towards riskier forms
of credit, even if the aggregate numbers do not indicate that the
country is experiencing a credit boom. In South Korea, most of
the credit expansion was in the form of increased credit card use.
In 2003, 8% of the population was delinquent on credit card payments.
By 2003, 34% of the assets of credit card companies (about 3% of
GDP) were impaired, up from 11% of assets in 2002. LG Card, the
largest credit card issuer, had to be rescued from insolvency with
a $3.9 billion package from the government at the beginning of
2004.
In Thailand, Krung Thai Bank's NPLs have almost
doubled since 2000 and represent about 18% of its deposits; foreign
creditors suspect that the true level may be closer to 36%. Also,
the Thai government has made a large number of direct loans to
consumers and firms, making it hard to ascertain their quality.
In 2002 and 2003, while credit by commercial banks (including Krung
Thai) increased by 7% and 2%, respectively, credit by three large
government-controlled banks (the Government Savings Bank, the Government
Housing Bank, and the Bank for Agriculture and Agriculture Cooperatives)
grew by about 10% each year.
Policy options for South Korea and Thailand
Both countries have taken measures to avoid a credit
bust. South Korea has taken some steps to curb its rapidly expanding
credit card business to avoid a hard landing. In fact, the problems
created by the credit card boom have led to an extended period
of slow economic growth, mainly due to falling private consumption.
Thailand's central bank, the Bank of Thailand, has also taken some
steps to rein in the growth in consumer debt by increasing the
interest rate and pressuring commercial banks to take a more aggressive
stance towards improving the quality of their loan portfolios.
Two factors favor the success of government actions
in South Korea and Thailand in avoiding a crisis and limiting its
effect should it occur. First, the current expansions in South
Korea and Thailand are mostly financed by domestic residents in
the form of debt denominated in domestic currency. Thus, these
countries are not as vulnerable to a rapid depreciation of the
exchange rate that would inflate the real cost of making debt payments.
Second, the currencies of Thailand and Korea have tended to appreciate
against the dollar, and their current accounts have recorded large
surpluses. Thus, South Korea and Thailand have accumulated foreign
assets to pay off debts and recapitalize the banks in the event
of a crisis.
Conclusion
In the aftermath of the 1997-1998 Asian financial
crisis, the governments of South Korea and Thailand took steps
to encourage demand in their countries by increasing domestic credit.
However, they do face some risk that the credit expansion may turn
into a credit boom, which could cause output and consumption to
contract yet again, if the boom later ends and a financial or banking
crisis ensues. Although the governments of these countries have
taken steps to cool the credit expansion, the risks of a credit
bust still linger.
Diego Valderrama
Economist
Reference
[URL accessed December 2004.]
International Monetary Fund. 2004. "Are
Credit Booms in Emerging Markets a Concern?" In World
Economic Outlook (April) pp. 147-166. Washington, DC: IMF. http://www.imf.org/external/pubs/ft/weo/2004/01/pdf/chapter4.pdf
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