Barry Eichengreen on the East-West Debate over the Asian Financial Crisis

Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Nick Borst.

And I’m Sean Creehan. We’re analysts of the Country Analysis Unit and our job is to monitor financial and economic developments in Asia. Today’s episode is part of our series looking back on the Asian financial crisis as we mark the 20th anniversary of that event. We sat down with Barry Eichengreen, a professor of economics and political science at UC Berkeley, to get his perspective on the Asian financial crisis.

I would say we have learned, we have been reminded that many of the problems that we thought were distinctive to Asia or to emerging markets are global and we have them right here at home in the United States. So many of the things that were said about problems in Asia that they were using construction activity in Thailand to keep the economy going during a period when underlying economic momentum was slowing down, that was true of the United States in the period leading up to 2007.

It was a great opportunity to talk to Barry about the crisis. He’s one of the world’s foremost authorities on Asia’s economic development.

He’s written extensively about the sequencing of financial opening in Asia and the challenges associated with cross border capital flows. He’s also authored numerous articles looking back on the lessons from the Asian financial crisis.

I think one of the interesting things that Barry highlights is that not everyone agrees on what those lessons actually are. In our conversation he contrasts the differences and views between Asia and the West over the root causes of the crisis. In many ways that debate is still ongoing. He also explains why differences within Asia, stymied efforts to create new regional institutions after the crisis.

Barry is also a frequent commentator on current economic issues in Asia. I think listeners will be interested in hearing his thoughts on what currently are the largest risk facing Asia and whether today’s policy makers have fully learned the lessons of previous crises.

Okay, let’s listen to our conversation with Barry.

Well, thank you so much for joining us today.

It’s good to be here. I am happy to follow the San Francisco Fed’s deepening involvement in Asia and revisit my own stories about the Asian financial crisis. I began a stint at the International Monetary Fund on July 2nd, 1997 the day Thailand devalued and I left a little bit over a year later on the day that Russia defaulted. Draw your own conclusions.

Eventful time to be there. In a recent article you wrote on looking back on the anniversary of the crisis. You noted sort of the differing views in the East versus the West of what the primary causes were. Can you help us trace those different viewpoints and also what you come down on what the origin of the crisis was?

I would distinguish three views, the Washington Consensus on the causes of the crisis, the Asian view and my view. The Washington Consensus at the time was that the crisis was symptom and a consequence of crony capitalism. The idea that economies and financial systems were not transparent. That political connections between business and government had been the basis for Asian economic growth, which had been a good thing for years, for decades but now had become a problem due to the lack of transparency, the political basis of exchange and the difficulty of rooting out corruption. Suddenly it was revealed in the Summer of 1997 that these problems were serious. There was a lack of confidence and the crisis resulted.

I think the Asian view at the time, it became the view held in the region even more strongly, subsequently was that the crisis reflected not so much problems with the Asian economy as problems in global financial markets. That financial markets were unstable, they were erratic, they had poured money into Asia in the period leading up to the crisis and then they for no good reason pulled that money back out starting in the Summer of 1997. That hedge funds and other investors were either irrational or they were ganging up on the Asian economies and their erratic, reckless behavior precipitated the crisis. I don’t think those two views are necessarily incompatible, that there were problems in the Asian economy and that there were problems in global financial markets.

My own view therefore attaches some importance to both sets of factors but I would argue that at a deeper level, the problem was a growing mismatch between the traditional growth model in Asia and the circumstances of what were now middle income economies. That traditionally growth had been based on high levels of investment, in some cases high levels of investment financed by foreign borrowing. Foreign borrowing made possible by the maintenance of a pegged exchange rate. But the age when Asia could grow on the basis of perspiration rather than inspiration, high levels of investment rather than innovation were growing to a close in the 1990s.

Economies like Thailand, South Korea, were attempting to maintain their customary rates of growth in the high single digits by ratcheting up their investment rates even more and financing that investment by borrowing abroad, short term sometimes in dollars, which was a risky way of doing business. Rather than accepting that growth rates had to step down modestly, growth based on investment was no longer feasible to the same extent and that foreign borrowing was risky business. So politicians and businessmen were reluctant to accept that reality and the mismatch between the economic strategy, the model on the one hand and the current circumstances of these increasingly mature economies on the other were what set the stage for the crisis.

So there were some growing pains that these countries faced as they had this sort of transition in their growth model but that also sounds like there were some key potential policy mistakes that maybe worsened the crisis, exacerbated along the way.

I think that most important mistakes were made before the crisis. They were made both by national policy makers in Asia and by international organizations like the OECD, the Organization for Economic Cooperation and Development and the International Monetary Fund. I think Asian countries were encouraged to relax their capital controls and open their economies to foreign finance before they had sufficiently strengthened their domestic markets, before they had moved far enough in the direction of more flexible exchange rate and before they had distanced business and government. So South Korea became a member of the OECD in 1994 and it was obliged as a member to remove its capital controls. The banks turned around and borrowed offshore, short term and followed the money toward the big Korean conglomerates. I think better advice from the OECD and the IMF about going slow on capital account liberalization and moving faster in terms of strengthening domestic financial regulation would have been better. To my mind those were the key mistakes and there’s lots of blame for them to go around.

We’re sitting here in your office in Berkeley and I’m looking on the wall, a poster of an old event commemorating it and there’s this reference to the Asian flu in the global financial crisis, the Asian financial crisis. Could you talk about the role of contagion, why did this flu spread? Why did it go from maybe a less developed economy like Thailand, of course Korea maybe was in an earlier stage of entering OECD but maybe a little bit more developed and then of course financial centers like Hong Kong. Why did it spread so quickly and what was the linkage there?

The contagion from the crisis, the ferocity of the contagion, I think was one of the surprises to many people. There had been contagious crises before notably in the European Monetary System in 1992/93 but I don’t think people had seen anything like the Asian flu. How the crisis spread very quickly from Thailand to economies with more reserves and smaller current account deficits like Indonesia and much better developed economies like South Korea. I think there was an economic basis for the contagion that these economies had a number of similar problems or weaknesses, inadequately supervised and regulated banks and financial systems. Corporations that were over-leveraged, too much reliance on short term external debt.

But other their circumstances were very different and I do think Asian critics have it right when they say there was a failure or inability on the part of participants in the international financial markets to tell these economies apart. Some investors, the only thing they knew were that these were all East Asian economies and if something was rotten in Thailand it was fair to assume, the logic ran, that maybe something was also rotten in South Korea or Indonesia or maybe in Hong Kong. There was a third element in the crisis, in the contagion that a number of these economies had common creditors, they had borrowed from the same international banks. So when one country got into trouble and that weakened the balance sheet of the international lenders, they withdrew funds from other economies in the region to which they had lent. So it’s not only common financial vulnerabilities, not only inability to tell these economies apart but also that they had common creditors.

I’m wondering—we addressed this in previous podcasts but I guess there’s different opinions on this—but what do you see is the role of Japan in all this? Do you see an impact of Japanese investment, do you see there’s something that’s occurring in parallel or do you see any sort of causality to Japanese capital flows throughout the rest of Asia at this time, following the bursting of the bubble in the late 80s. What do you see as the role of Japan in all this?

I would not attach great weight to the role of Japan in the crisis. One thing that happened in the run up to the crisis was that the Yen weakened and that increased the competitive pressure on other Asian exporters so I think Japan played a role there. Japan attempted to play a constructive role as the crisis began to unfold by contributing to the credit lines that were extended to other Asian economies and then through creative proposal to establish an Asian Monetary Fund, that didn’t go anywhere but kind of presaged what would happen a couple of decades later with, a decade later, with the Chiang Mai Initiative, multilateral session and more recently with the Asia Infrastructure Investment Bank.

You mentioned some of the policy advice given to Asian countries before the crisis but there was also a lot of advice given during the crisis and immediately after often in conjunction with international assistance, sometimes basically a requirement as part of international assistance. Looking back on the advice that was given during and after the crisis, how well did it hold up? In retrospect was it the right advice?

Well, the advice that the IMF and other international organizations gave during the crisis was highly controversial, highly criticized because it was offered in the midst of what was a very painful economically and socially devastating crisis. So it’s tempting to blame messenger and I think there was an element of that involved. The advice given overall I think looks pretty good with hindsight. Let the currency depreciate because you know in the crisis countries, local demand is going to weaken so you have to substitute external demand and letting the currency decline as a way of doing that. Tighten monetary and fiscal policies to try to help to restore confidence and move quickly to clean up the financial system.

That advice I think is pretty sound and still looks sound overall. One of the nicknames in Asia for the IMF is “I’m fired.” Another one is “it’s mostly fiscal” that the IMF often emphasizes and even over emphasizes the importance of fiscal consolidation, arguing that budgetary excesses are the root of all crises and therefore budgetary consolidation has to be part of the solution. I think the fund probably went a little bit too far in advising Asian economies to cut their budget deficits in a period when local demand was already weak. But it’s kind of a second-order criticism. In addition, there’s been a lot of discussion about detailed, structural conditions that were attached to IMF programs. So the famous one is Indonesia, where they demanded that the timber monopoly be broken up and people referred to a veritable Christmas tree of ornaments of conditions. Dozens and dozens and hundreds of hundreds of structural conditions that were demanded of the country.

If you subscribe to the crony capitalism view of the crisis then it was necessary to break up monopolies and strengthen regulation and fundamentally remake these economies. If you subscribe to other views like unstable financial sector was the problem, then conditionality should have focused mainly on the financial sector. I go back and forth between those views. I think what we’ve learned is that detailed conditions are imposed from the outside, even if there is economic logic for them, are politically problematic that countries resent it and you’re liable to encounter political backlash against very deep invasive structural conditionality. That was true in Indonesia, that’s been true more recently in Greece.

You mentioned the Asian Monetary Fund idea that Japan was promoting and, for a variety of reasons, was unworkable at the time–probably not a great idea to form a fund like that in the middle of a crisis. But if it had existed in an idealized form, what do you understand that to have been, would that have made a difference? Would a more local, regional fund that maybe was more sensitive to some of the political issues that you are talking about, would that have made a difference or is it just something that’s really difficult.

I think fundamentally it’s a difficult problem to solve. Another case in point would be Europe, the Troika and the European Stability Mechanism. When it came to conditionality, the Europeans know plenty about the structure of the European economy decided to outsource the design and negotiation of conditionality to the IMF. Because it’s politically difficult for European countries to make demands of other European countries and I think the same would have been true in Asia. People in Korea wouldn’t have reacted well to Japanese government officials coming in and demanding structural changes as a condition for rescue loans.

So does that explain maybe some of the struggle of some of these multilateral institutions in Asia to emerge post crisis?

I think it does. We have a system of swap lines and credits now in Asia, the Chiang Mai Initiative multilateralization. But it’s never been used because countries are reluctant to lend real resources without conditions attached. But it’s delicate to negotiate conditions. Part of the debates in Asia and in Washington and in Europe for that matter is how can the multilaterals like the IMF work together with regional entities? Because I think we’re learning that we need both and we need to figure out how they can work together.

You’ve studied quite a few economic crises whether it’s Asian financial crisis, global financial crisis or the European crisis. Looking back, has your thinking and know how these crises occur and how we should respond to them changed it all?

Well, I think over time, the emphasis has changed both in my mind and in analytical work that’s being done focusing more on pegged exchange rates as a weak point. Countries in Asia have moved to greater exchange rate flexibility. Focusing on short term dollar denominated debt as a problem especially for countries that don’t have high levels of international reserves. Beyond that, I would say we have learned, we have been reminded that many of the problems that we thought were distinctive to Asia or to emerging markets are global and we have them right here at home in the United States. So many of the things that were said about problems in Asia that they were using construction activity in Thailand to keep the economy going during a period when underlying economic momentum was slowing down, that was true of the United States in the period leading up to 2007.

Problems in financial and securitization markets they were every bit as evident in the United States and for that matter in Europe after 2007 as previously. Problems with bank regulation and supervision, that difficulty of cleaning up financial system once it’s broken. I think we’ve learned that we have all of the same problems in the advance countries and in the United States, that from that point of view there is nothing special about Asia.

So this kind of mental frameworks we had of emerging market crisis versus advanced economy crisis that they are not quite as distinct as what we maybe thought in the past.

That’s the lesson over the last 10 years.

Looking at today, what do you see as the biggest economic and financial risks facing Asia?

Clearly the biggest factor in Asia for better and for worse is China. I think China today still displays many of the potential problems that led to the crisis in 1997/98 in other countries in the region. So they’ve been relying on liquidity to keep economic activity going. They have problems regulating in their case, the shadow banking system. I would know that non-bank financial institutions were also very important in Asian countries like South Korea, Indonesia, Thailand 20 years ago. They are relying on high levels of investment to keep economic activity going at a time when the circumstances of the country no longer fit so well with the traditional growth model. So like other people I’m worried about the debt problem in China. Where in China’s case it’s mainly a corporate debt problem. I’m worried about the condition of financial institutions where it’s mainly non-bank financial institutions and I wonder how long they can keep growth going at 6.9% purely on the basis of high investment and high exports.

China is also a force for good in the region because it is now effectively promoting economic cooperation through the institution building we were talking about before and through foreign direct investment. I think at this point it’s all about China.

It seems like one reaction to the crisis by many Asian countries was to self-insure, to build up large foreign exchange reserves. Given that you say that some of this same risk still exist in Asia today. How useful are those foreign exchange reserves. Can they really prevent risks, are they only part of the solution?

I think they are only part of the solution and that they are an expensive part that every time an Asian country actually uses its reserves it discovers that using them can excite financial markets in a bad way rather than reassuring them. So during the global financial crisis, Korea had nearly $300 billion worth of reserves but all over sudden for some reason 200 billion became a redline below which it wasn’t safe to those reserves to fall. So you can accumulate them but that doesn’t necessarily you can use them.

One consequence of the Asian financial crisis was to create something called IMF stigma where Asian countries are more than reluctant, they refuse to go to the IMF to help and I think effective reserve pulling through the IMF would be a better solution, with now that Asian countries starting with China are getting a louder voice in the fund. Maybe finally after 20 years that problem of IMF stigma can be addressed.

One difference between China today and those economies 20 years ago, you’re talking about small open economies. Today China is a large, relatively open economy. Is that distinction helpful or more of a disadvantage to China in the event of a similar crisis?

The fact that China has not dismantled its capital controls, that its financial markets are not as open to the rest of the world as say Korea’s were in 1997 is an advantage from the point of view of economic management. It means that domestic financial problems are less up to be triggered by financial events abroad the subprime crisis and the global financial crisis didn’t bring down the Chinese economy or Chinese financial system but it doesn’t protect, for the reasons that I describe before, China from homegrown financial problems, from potential collapse of trust companies, other important financial institutions, highly leveraged corporations and the like. So were there to be a financial crisis in China? I don’t attach a high probability to that happening any time soon. But we’ve learned not to rule such things out. It would take a different form than the crisis in east Asia 20 years ago. But the factors setting the stage for such a crisis are in some broad sense similar.

Maybe to sum things, what do you take away as the enduring lessons of the Asian financial crisis?

I think countries have to keep working to modify their economic models and financial systems as their economic circumstances change. That growth model that worked well in the past may not be suitable for current circumstances. Secondly, pegged exchange rates, which a bunch of Asian countries had in the 1990s are a weak point and that with rare exceptions, like Hong Kong, it would behoove emerging markets more generally to move further in the direction of flexible exchange rates. Number three, good financial supervision and regulation is key, something that the economies of the region unfortunately did not have at the time.

Thanks for joining us.

Thank you.

Thank you so much.

We hope you enjoyed today’s conversation with Barry. For more episodes like this you can find us on iTunes, Google Play and Stitcher. And if you like what you hear, please leave a review. Feedback from listeners like you will help more people find us. For even more content lookup our Pacific Exchange blog available at frbsf.org. Thanks for joining us.