Andrew Sheng on Hidden Linkages and the Asian Financial Crisis

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

And I’m Sean Creehan. We’re analysts at 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 approach the 20th anniversary of that event. We sat down with Andrew Sheng, a Distinguished Fellow at the Asia Global Institute, to discuss his perspective on the crisis.

Andrew has an extremely unique perspective. He experienced the crisis firsthand while serving as the Deputy Chief Executive at the Hong Kong Monetary Authority. Andrew also worked at the Malaysian central bank and serves as an advisor to a number of Asian financial institutions and regulatory bodies. He’s also a well-regarded economist and has written numerous articles and a book that is one of the best accounts of the Asian financial crisis.

In our conversation, Andrew does a great job of describing the regional interconnectivity that helped drive the crisis. I think this is the perspective that often gets lost when we focus on the experience of an individual country. He also gives us some insight into what Asian regulators like himself were monitoring at the time, as well as what risks actually took them by surprise during the crisis.

Andrew provides some really thought-provoking analysis about the risks to the global economy, risks that remain even after the Asian financial crisis and the global financial crisis.

With that, let’s listen to our conversation with Andrew.

Andrew, thank you very much for joining us. I guess we’ll just kick it off with a high level question, what, in your opinion, were the financial and economic conditions that led to the Asian financial crisis?

Well, the conditions were, we need to understand that in 1989, the Japanese asset bubble peaked. Japan, which was then the second largest economy in the world, excluding the European Union next to the United States, was the elephant in the boat in Asia. It was double the size of the rest of the East Asian economies and the major surplus economy. From the early 1990s, the Japanese banking systems started getting into trouble, and then of course, Japan, the dollar then became, it moved from roughly a 100 yen towards 150 yen to the dollar, which was effectively a massive strengthening of the dollar.

East Asia was fundamentally a dollar zone and in most of the East Asian countries, currency was de facto pegged the dollar, i.e. soft peg not a strong peg. In a sense that they sort of linked to the dollar at very clear levels to each other. So, for example, at one time it was quite easy to understand that the Thai baht for example, was roughly 10 to the Malaysian ringgit. The Malaysian ringgit was 2.5 to the dollar, the Taiwanese currency was 25 to the dollar and the Philippine currency was also roughly 25 to the dollar. The Hong Kong Dollar was pegged to the dollar; the Korean and Japanese, the Korean also maintained this soft peg. When the Yen depreciated, it exposed all the weaknesses of the funding model. In Asia, because as the economies ran larger and larger current account deficits, it exposed three fundamental mismatches in the Asian funding structure. Firstly, there was a maturity mismatch, which means borrowing short to invest on lending long. Secondly, there was a foreign exchange mismatch, which was borrowing foreign currency to invest in domestic currency. And thirdly, there was a debt equity leverage mismatch, which was insufficient equity in the system. The corporate sector particularly ran very large leverage levels.

The Asian financial crisis exposed all the weaknesses of the Asian global supply chain, which Japan had built up since the 50s or the 60s.It was a system based upon a link to the dollar, in which goods were manufactured in Asia and exported to the United States.. When the yen started weakening while Japan was at the center of the Asian supply chain, the whole funding model collapsed as it were. Then we, from the Asian crisis, finally began to understand what the problem was. I think the conditions at that time, going into the crisis, was that the Asian economies, specifically the East Asian economies other than Japan, seemed to be doing very well. Growth was good, and government deficits weren’t particularly bad. Current account deficits did not appear to be too out of line, somewhat out of line, but not too out of line.

But people didn’t monitor the corporate debt levels, thinking with strong governments and reasonably all right banking systems, systems could withstand it. But it was not, and there was contagion all over the place. Suddenly, instead of one country getting into trouble, the whole Asian economy was put at risk.

Andrew, you have the unique experience of actually having served as a regulator during the midst of the crisis, and you outlined a lot of different risks. What, which of those risks do you think were fully understood by regulators at the time, and which risks sort of really took them by surprise?

I think the major risk that took all of us by surprise was contagion. We didn’t understand the nature of the contagion and the fundamental problem was an analytical problem. The analytical problem was that, if you look at an economy, and economy A looks okay, you should be okay and economy B looks okay, you should be okay, economy C looks okay and then the whole … A plus B plus C must be okay. That is fundamentally wrong, because if A is not okay and A collapses, B will collapse with it and C will collapse with it because of contagion. If the key players in the East Asian economies get into trouble, the whole region would be at risk. In reality, majority of these countries, including Japan, was indeed troubled. At that time, it was initially assumed that the Asian Monetary Fund would help in Asia. But, in the end, it became quite clear Japan itself was also in trouble. In the end, one had to call on the IMF.

The whole issue was eventually discovered to be a liquidity issue. There was, the definition of solvency of course, is still controversial. Can countries go bankrupt? The answer is that countries itself may not be insolvent but they can be highly illiquid in foreign currency. Since none of these individual countries can print money, you can’t solve a huge foreign exchange liquidity problem. I think we’ve learned somewhat from this experience, but we haven’t grasped the full extent of the problem. Although the Asian crisis exposed huge problems in the way we look at financial systems, I think we still have the room for improvement in analyzing the interconnectivity and interdependence of the world.

There are forces clashing in the monetary system. It’s not something we can solve overnight because there are very, very different ways of looking at the problems. That’s why my book is called “From Asian to Global Financial Crisis,” because the 2007 crisis repeated the problems from the Asian crisis somewhat, and the solutions that were adopted for the Asian financial crisis were reversed for the North Atlantic financial crisis. As you know, the standard prescription initially geared toward the two gap up model problem. If you have a fiscal deficit, as well as a current account deficit, you devalue and raise interest rates and squeeze the fiscal deficits.

So the lesson drawn from the Asian crisis was that, if there was willingness to provide liquidity, the liquidity crisis can be contained, but it doesn’t solve the solvency issues. Furthermore, Asians then took the major lesson that the IMF did not have enough resources to give us without very strong conditionality. The Asian economies then went into massive current account surpluses. The system went into a spider-web-like swing. These policy swings then had a major impact on the world, and on the rest of the world.

In your book, you talk about the dual crises at work in 1997-98. You talk about this at several points. On one hand, there’s a balance of payments, currency driven crisis across the region, but there are also serious problems in the banking sector. So, why is a dual crisis particularly dangerous to an economy and challenging for policy makers and regulators in their response?

The current account deficits can be funded if somebody is willing to finance it from abroad. The Asian economy, the miracle economies, the ones that eventually got in trouble, were the ones that were able to fund themselves, not only because banks were willing to lend, but also because foreign banks and foreign asset managers were willing to lend, right?

After the 1994 crisis in Mexico, lots of funds then went to Asia. The Asian economies had so much money pouring into them that the banks started lending. As you know, if foreign money comes in, the foreign exchange reserves of the central bank goes up, the deposits of the banking system goes up, the banks then start to lend. The locals look at this massive liquidity and then said, “Wow! Asset prices are going up! I can borrow and speculate on domestic asset bubbles, stock markets, etc. I can’t lose.”

If the bankers lose their heads and the foreign asset managers go for momentum rides, you have a perfect storm of both a massive current account deficit—which can easily become a capital outflow— and a banking crisis because the banks become overexposed, under-capitalized and exposed to non-performing loans. If at that particular time, you impose the traditional standard procedure of raising interest immediately and government expenditure, guess what? The whole economy gets a heart attack and comes crunching to a halt. You’ve got a massive deflation, which squeezes out the current account deficit because you can’t import anymore, the exchange rate devalues and when it devalues, anybody who borrowed foreign exchange become bankrupt.

The whole stability of the system went overboard. So, if you have this kind of twin crisis, it wasn’t a just twin crisis, but also a banking crisis since a lot of the corporate sector was having very large leverage.

In a way, the Asian financial crisis was a precursor to the global financial crisis. At the time, the interconnectivity and the system as whole was not fully understood. I think we understand it better now. The diagnosis is better understood today, but the prognosis is still very controversial.

Andrew, I’m wondering if you can talk about the role of currency pegs during the crisis. Where in some Asian countries like Thailand, the decision to depeg was sort of a catalyst for the spread of the crisis, whereas in other countries, or economies like Hong Kong, were able to defend their peg throughout the crisis. Has the thinking around currency pegs changed? What explains the difference between these two different instances?

At that time, everyone thought that the solution would be just to float. Now, we’re also seeing the problems resulting from everybody floating at the same time. There are no perfect solutions to anything. The orthodoxy at that particular point of time was that pegs could not be held. We saw that in the Mexican crisis. Most people tend to forget that the economy adjusts around the peg, not the exchange rate adjusting around the economy. In the flexible exchange rate system, you somehow think that you can devalue your way out of the problem if you have low productivity in the economy. If everybody does that, then the continued devaluation creates low productivity in the system. Therefore, the flexible exchange rate system does not necessarily always work either.

That was the orthodoxy at that point of time, unless you have the conditions to hold the peg like Hong Kong, which had the peg since the ’83 crisis. In Hong Kong, the governments were willing to run very large fiscal surpluses, as well as effectively no debt. Even that was a strain during the crisis, but that’s another story.

The big lesson from all this is that, if you want to have a peg, you better be prepared to take a lot of pain. I think we learned this lesson then. However, a similar mistake was made again in Europe. While having a de facto fixed peg for countries within the Euro zone, the adjustment process is not devaluation but closer to deflation, until you squeeze out all the imbalances in the system.

I wonder if you could talk to us a bit about the policy advice that various Asian countries are getting at this time, both from your perspective in Hong Kong, but also the rest of the region. There is a very diverse range of economies in Asia at this point. You have developing markets like Indonesia, middle income countries like Malaysia, then a country like South Korea that had just become a member of the OECD, and Hong Kong of course is a sophisticated global financial center. In your view, what was some of the more positive policy advice given? And some of the more controversial ones? Give us your thoughts on that.

Well, I think the standard policies on their own sounded very reasonable but they don’t add up. I think the fundamental policy mistake was that if you look at country A and what the numbers looks like, you could think “well, you look overweight and you might have a heart attack.” What’s the conclusion? You either slim down, or you change your diet and you have a different lifestyle. You could also assume, “life, so far so good, why should I change?” Then you don’t realize, if you’re interconnected with somebody else, and somebody else gets a heart attack, and suddenly draws you into the problem, you can also be subject to the same panic problems. Nobody, and I think this included the fund, saw this as an interconnected crisis and this was not just an East Asian crisis, it was a Japan crisis plus.

That’s where my book had a very different perspective. I said the narrative at that time surely must be wrong. How can you keep on saying, de facto, the analysis “Thailand you’ve got a problem and you’re overexposed, but we’ll give the advice to Malaysia and Indonesia, you look reasonably okay.” Then literally overnight after Thailand devalued, Malaysia, Indonesia got into trouble and then Hong Kong was under attack the same time as South Korea, which was considered to be reasonably strong as it just became an OECD country. It was connected. Therefore, the analytical thing addressing the crisis needed considerable tweaking and re-assessment

It’s not just the global supply chain, which was very successful as a growth model. Although Asia grew from creating the global supply chain, the funding model of that supply chain was problematic. That made everybody in the supply chain have problems. We saw this was the heart of the analytical problem, which I identified by mapping out the credits of the Japanese system. Japanese banks were willing to fund Japanese manufacturers for the global supply chain. They funded not only their manufacturing investments, but also their trade credit. Of course, Japanese manufacturers based in Thailand, Indonesia, Malaysia, Korea, etc. or Korean subcontractors were able to get trade credit from their Japanese banks through the Japanese manufacturers. When the assemblers and the cluster firms were able to get credit, you get a banking splurge, and lots of liquidity pumped into the system.

Everybody thought the capital output would be led by the hedge funds. Yes, the hedge funds did play a role, but the silent credit withdrawal, which is why Hong Kong was affected, resulted from having a lot of Japanese credit to the rest of Asia funded through offshore financial centers like Hong Kong. When the Japanese banks got into trouble and the yen devalued, their dollar assets grew larger and larger in yen terms and the Japanese banks didn’t have capital. So, what did they do? They cut credit. And where did they cut credit? They cut credit to the supply chains.

When they cut the credit to the supply chain, guess who was at the end of the food chain, the one that gets killed? The East Asian economies like Thailand, which was the major center for Japanese credit. Also, Malaysia, Indonesia and then Korea. Philippines was already on the intensive care at the time of the IMF program, so it wasn’t directly hit.

Andrew, what’s your assessment of the various regional initiatives taken after the crisis? Initially there was talk of forming an Asian monetary fund, that didn’t quite happen, but there are things like the Chiang Mai Initiative, the Asian Macroeconomic Research Office, various swaps agreements, etc. How effective do you think these sort of regional organizations are in facing future financial instability?

The swap arrangements was not a fully operationalized, but it was psychologically pretty important for people to appreciate. The scale of capital flows, free flows, is a problem.

The Asian initiatives on the swaps on the Asian monetary fund were a Japanese led solution at that particular point of time. Although the Chinese were cautious, the rest of Asia favored it going forward. In the end, this became quite clear at a crucial meeting in Manila, which is discussed in my book. It became also clear that politically the Japanese parliament was reluctant to fund such a large program. At the time, the largest surplus economy was clearly Japan. If Japan was not willing to join, it was clearly not enough for the rest of Asia. Of course, since then, the Asian economies have become very large surplus economies, despite the decline of current account surpluses in recent years.

The swap arrangement, for example, the People’s Bank of China swap arrangement, is useful as precautionary liquidity arrangement. But in the end, I think the world really needs a better liquidity program. That’s a huge geopolitical problem. When do you provide that liquidity and under what conditions remain the huge problem. We’ve seen this even in a monetary union like Europe, because the surplus countries maintain very large disciplines on the borrower countries, and desperate economies. It’s politically highly controversial.

So I guess on that note, we could probably talk for several more hours on this topic with you, but maybe we will ask one more question. Then our listeners can seek out your book for more. What would you say are the enduring lessons of the Asian financial crisis both for Asia and the rest of the world?

I think the Asian financial crisis exposed a major flaw in the way we look at economic problems. That we can no longer look at economies as standalones, but how they interact with each other in very complex ways. I think the enduring part of the Asia crisis, is the revelation that global supply chains are funded through global or regional financial chains, and that we are all interconnected and interdependent with each other.

The solutions to these issues have still not been resolved, but drawing from lessons from the Asian financial crisis, I think we could have a better understanding in the near future. . The IMF managing director at that time called the first crisis as the financial crisis of the 21st century, which was right. We have not fully understood, and applied 20th century lenses to look at a 21st century problem. That looms large and grew larger in the 21st century when the North Atlantic crisis occurred and the solutions to it, in my personal opinion, including the financial reforms, have magnified the problems rather than solve the underlying roots of the problem. We have moved into very complex economies and financial systems, which current neoclassical class theories and models are simply too simplistic to explain, not just to explain, but to offer solutions. So we’ve gone into behavioral economics, agent based models, very complex regulations and quantitative easing without good theory.

And that’s where we are. Everybody’s muddling through one way or the other. The Asian crisis exposed that but we don’t have a good solution. I think the lesson from the Asian crisis was that —in hindsight was quite correct—it wasn’t a global crisis but more a regional one. It exposed the weaknesses of the interconnected global system without global central banking and fiscal systems.

We really do need a 21st century sort of thinking and tools for 21st century problems and we will keep on, I guess, muddling through until we get a better set of analytics for the issues.

Macroeconomics and microeconomics are incomplete models of the economy. Policies framed on naïve macroeconomics and microeconomics theory are inadequate when the way you think about the problem is wrong and the way the bureaucracies implement or fight against each other or delay problems; itself is a fundamental a whole part of the problem. We do need a new political economy solution that is much widely applicable.

We now know that crisis is inevitable; it’s not a matter of if, but a matter of when. Whether we have put the right institutions and the policies to deal with this has not been resolved. We know that we can solve some of it through liquidity provisions. When solvency issues are at stake, I think it’s very fashionable to talk about liquidity crisis simply being solved by simply central banks printing money. However, that’s not a real solution. We need to go back to very basic issues of how to solve the challenges of the 21st century. The solutions will remain controversial for some time to come.

Well, it sounds like you have another book in you Andrew. Thank you very much for joining us.

It is. That’s what I’m writing right now.

Great, well we look forward to reading it.

Thank you very much, indeed.

Great, thank you so much.

We hoped you enjoyed today’s conversation with Andrew. For more episodes like this, you can find us on iTunes, Google Play, and Stitcher. For even more content, look up our Pacific Exchange blog available at FRBSF.org. Thanks for joining us.