Gillian Tett on Trust and Contagion During 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 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 Gillian Tett, US managing editor of the Financial Times, who was based in Asia at the time of the crisis.

Gillian Tett has now covered a number of financial crises in her role as a senior journalist at one of the world’s leading newspapers. She most recently has been known for her coverage of US and European banks, but she cut her teeth in Japan as head of the Financial Times Tokyo Bureau during the late 1990s.

Gillian Tett gets into the role of Japan’s own domestic banking crisis that was ongoing at the time of the broader Asian crisis, and I think listeners will also enjoy her take on the parallels between the Asian crisis and the more recent 2008 crisis.

She has some fascinating points on crisis management, especially the importance of transparency and reestablishing trust in the financial system. I thought it was really interesting when she mentioned that some of her old Japanese colleagues actually helped her spot some of the warning signs for the global financial crisis before it occurred. So, without further ado, let’s get to our conversation with Gillian Tett.

Okay, well Gillian thanks for joining us today.

No worries, delighted to be on the line.

So, in your view, what were the financial and economic conditions that led to the Asian financial crisis, and what caused it to spread?

Well, the easy way to describe it is that there was a huge buildup of credit, a big bubble, and rising real estate prices, and excessive bank lending, which essentially burst during the course of the 1990s. There were specific triggers to do with devaluations to do with loss of faith in the financial market. But, another way to look at it, in relation to Japan at least, was that essentially from the period of the 1950s to the 1970s or 80s, Japan was dominated by a bank-centered financial system, which worked very well in terms of insuring that companies could grow rapidly in the industrial sphere, and if you like, Japan could catch up with the west and rebuild its economy.

But in some ways, Japan outgrew its post-war, bank-centered, industrial processed financial system, a bit like a child outgrowing a pair of shoes, and by the 1980s, Japanese companies were so big, powerful, global, and successful, that they weren’t needing the same of bank support as before, so a lot of that excess capital and credit swirled around the financial systems, fueling a real-estate bubble that eventually burst. So, the other way to see the Japanese financial crisis—and the Asian problems, but particularly the Japanese one—is a sign of regulatory structures, and the financial system not keeping pace with the development of the economy.

So Gillian, you were based in Japan, right at the outbreak of the crisis. What was the view on the ground at the time? Were people aware of these risks, or did it take everyone by surprise?

There was a realization that the banks were holding bad loans, and there were certainly realizations that the real estate market had been in decline, but there certainly was not any realization at the start of the financial crisis of the scale of the bad loans, the severity of the banks’ balance sheet problems, and the need to take radical action.

During the first, really, seven years, after the Japanese bubble burst, the banks with the blessings of the regulators, had been essentially kicking the can down the road over and over again, and certainly, in 1997, when I arrived at the beginning of the worst of the crisis, there was a very strong hope that they would continue to do that.

Were there any things that stood out to you as an outsider that maybe others kind of based in Japan and from Japan didn’t see at the time?

To me, it was very clear that there was a kind of gap in the way that the financial system operated, which was Western financial markets operate, because faith in the value of asset is built on transparent accounts and liquid markets being able to trade things and create realistic prices, or at least it is part of the time.

The Japanese financial system historically had relied on government fiat and bureaucratic control to create trust in the system, and to have, if you’d like, value of assets decreed by bureaucrats and government officials, and what started to happen in 1997 was, essentially, faith in the bureaucrats being in control of everything began to crack, but there wasn’t enough transparency in the system and enough tradable prices for investors to have faith in alternative sources of value. So, Japan really began to slide into a limbo land, if you like, but to outsiders, it was very clear that things were changing, and quite rapidly.

I think to insiders, who hadn’t really seen a truly deregulated financial system, it wasn’t clear at all.

So people had lost faith in the banking system, but they didn’t necessarily have any alternatives?

People were losing faith in the banking system, were losing faith in their ability to value things, and to know what anything was actually worth, and one thing that began to happen was because people feared that there a lot of buried news buried and hidden. The price of assets began to slowly and gently decline, because everyone thought there was going to be bad news coming out in the future. So, a system where no one really has trust or faith in the value of anything is a system that’s prime for not just freezing up financial markets, but for prices starting to fall.

How do these two events feed off each other? You had on the one hand a slowly unfolding banking crisis in Japan, and then in the broader region, which Japan dominated at the time, a rapidly developing crisis in a number of key economies?

Well, essentially, people viewed them separately, initially, because the things that caused, say, Korea to have the external debt problem, namely the fact that these companies are taking out dollar loans that they couldn’t pay back, was different in some way from the Japanese situation. Similarly, when the Thai markets collapsed and you had the rapid devaluation, again, there was a difference there from what was happening in Japan.

But, they were linked in the sense that as the rest of the Asian markets began to go into free fall and very volatile trade situations, investors became very jittery and nervous back in Japan as well, and the issue of excess debt and unpayable debt very much hit the radar, and it’s a sort of very long-established concept in finance. When investors are forced to confront seemingly impossible situations in one market, they start to project that onto another. So, having seen the unimaginable happen (i.e., South Korea suddenly faced significant defaults), they began to think about what-ifs in Japan as well.

So, some of the more crisis-affected countries like South Korea bounced back pretty quickly, after the crisis, but that didn’t seem to happen in Japan. Can you talk a little bit about Japan’s experience after the crisis?

Well, in Japan’s situation, you had just an enormous scale of bad loans and debt. Just, extraordinarily large. You had a system, which was very slow to realize the magnitude of the loans, and because it was swept under the carpet for so many years, that really eroded faith in not just the financial system, but the government, too.

And, on top of that, as the financial crisis began to explode, you had, essentially, the economy going into a recession, and then stagnation, and prices falling, and when you have deflation in an economy, that makes the debt problem even worse. So, Japan began to slide into this very nasty no-man zombie land, where nobody really quite trusted the value of anything, and without that kind of trust, it became very hard to actually resolve any of the bad loans. It was a very vicious trap.

So, one of the reasons why we’re doing this series is, you know, it’s interesting to look at crisis response, today through the lens of the Asian financial crisis, so I’m wondering if you can talk a bit about how you see crisis response evolving since then. You know, how did your experience of the crisis in Asia affect your own reaction to the global financial crisis?

Well, I’ve ironically there’s been an awful lot of baton passing back and forth, in terms of crisis, experience, and also (to a degree) crisis learning. When I was in Japan in 1997, 98, officials who previously dealt with the US S&L (Savings and Loan) crisis sometimes came over and gave the Japanese officials lectures about what they should be doing, and the advice almost always was, “You have to start by essentially being very transparent about the scale of bad loans,” you know, “confessing the scale of the damage, and then recapitalizing banks, and potentially taking bad loans off the bank’s balance sheet, and maybe selling them in the open market to establish clearing prices.” That was basically what had been done after the S&L crisis, with the Resolution Trust corporation in the US.

And, again, officials came over from Finland and Sweden in that period, and offered very similar types of advice. “You needed transparency, you needed proper accounting, you needed recapitalization, and a way to actually resolve the bad loans and get some kind of clearing prices for what they were actually worth.”

So, officials came and told the Japanese that, and the Japanese completely ignored it for the first couple of years, and it really wasn’t until they actually got essentially a special order of the bank’s books completed and done that you began to get some sense of stabilization in the market and some sense of confidence that the institutions might be worth what they’re actually worth. The banks eventually began to write off the bad loans, they were recapitalized to a degree. (I’m not going to argue not enough, but they were recapitalized to a degree.) Some of the bad loans were even sold and actually established clearing prices.

So, the US lesson was eventually learned in Japan, but it took a long time. The huge irony was that having given that lesson to the Japanese, the US then completely forgot it in 2007, because in the first half of 2007 (and frankly, even the second half of 2007), as it became clear that there were big sub-prime bad loans and problems in the system. Ironically, bitterly ironically, some of the Japanese officials who had been in the core of the 1997 Japanese financial crisis actually started trying to send messages to the US treasure and the feds, saying, “elements of your sub-prime crisis look very similar to Japan.”

I know this because I was in the middle of a number of these conversations, and the Americans brushed it off. I mean, initially, Ben Bernanke from the Fed said that some prime losses would only be 25 billion. There was an assumption that you could basically avoid having to recapitalize the banks, there was a great reluctance on the part of many investors and bankers and, to a degree, some of the regulators to actually crystallize the scale of losses, or even to become entirely transparent.

And, the Treasury instead were instead pursuing initially ideas like super SIVS (Structured Investment Vehicles) or MLEC (Master Liquidity Enhancement Conduit), which was a vehicle to take the bad assets off the bank books and basically free them, and all of that contributed to a sense that the US was just repeating the same mistake that the Japanese had made.

Eventually, after 2008, when the US crisis really exploded, there was a real sense of dramatic crisis management in Washington, and you finally began to get the kind of response that was needed, which was proper accounting for bad loans, recapitalization of the major banks, attempts to try and establish clearing prices for the impaired assets, et cetera, et cetera. But it took a very long time, and so perhaps the only big lesson is that not only just, “History repeats itself,” but that governments tend to be terribly slow to learn from history when it comes from other parts of the world.

Yeah, that’s interesting, a real reversal of roles. And also it can be…It seems like, much harder to take your own medicine.

Ironically, insofar as I actually managed to spot the looming 2007 financial crisis—and I was ahead of the curve of many parts of the media in the first half of 2007—but insofar as I managed to spot what was coming down the tracks, it was because I was still closely in touch with my Japanese friends, and in particular, one senior Japanese official who’d been deeply involved in the 1997 financial crisis wrote me an email saying—in the early summer of 2007—saying, “You really ought to be looking at the financial markets. It looks just like what happened in Japan a decade ago,” and that was a real outlier of a view at the time, but it turned out to be unbelievably prescient.

So when you look at Asia today, what are the biggest changes you see in the wake of the crisis? How has Asia changed since the time you were first posted there?

Well, I can address more clearly the issue of Japan. In Japan, there is certainly a clear recognition on the part of the Bank of Japan, and the Ministry of Finance, and the FSA (Financial Services Agency), the Japanese FSA, the chief regulator, that they need to keep tabs on the banks’ books. They are pretty aggressive about looking into the banks and the scale of bad loans. They are pretty aggressive about looking at credit quality. Nobody is cavalier about sending loans out ad-infinitum without worrying about a downside, so that has definitely changed.

At the same time, there’s much better coordination between the different institutions, and in some ways, a problem today is that the Japanese banks are so scarred by what happened, that they’re actually often very reluctant to lend. Now, the problem is that the other sources of potential future losses, namely the fact that Japanese banks are holding large numbers of Japanese government bonds out of the central bank, those dangers to the system aren’t clearly recognized, and in my best guess, that’s the potential vulnerability for the future.

But certainly, the concept of lending ad-infinitum into real estate and the presumption that real estate prices can only ever rise, that has definitely, definitely gone.

If you go across the Asian region more widely, I mean, one thing that’s very clear today is that the Asian government no longer looked to the IMF in quite the same way for help. There’s a growing sense that we ought to help ourselves by building up exchange reserves, by building up their own arsenal of tools and crisis management options. They’ve also a recognition that things like the Asian Development Bank, or the AIIB are needed now, too, and they can play a very valuable role now in trying to stabilize the region; and of course, many countries are increasingly looking to China as the leader of the pack, rather than just the US.

But I’d argue, that one of the big problems in across the Asian region today have been the recent run up in corporate debt, particularly in China, but also elsewhere, and that in many ways represents a future vulnerability. It also shows that people don’t always learn the right lessons fast enough.

So you mentioned AIIB, and I know at the time of the crisis there was some discussion of some sort of Asian monetary fund, Japan had its own views on that as did the United States, did you see that as a realistic option? Is that something today that you could see happening?

Well, the idea was tossed around quite enthusiastically in 1997 and 1998. The problem that there was, though, was that it really would’ve been for Japan to lead it, and Japan wasn’t willing to go against the US then. And, if you fast forward to today, the issue at stake is that Japan is most unlikely to set up anything like that by itself, because China is now such a significant force, and yet, whether Japan and China can cooperate together on something like that is very, very unclear.

China is not really in a position to create something like an Asian monetary fund, because China has plenty of problems of its own, and it may yet produce the most spectacular of all debt crises that anyone can imagine. So, at the moment, at least, I don’t think the idea will be revived; instead, what you have is the AIIB, and the Asian Development Bank, likely jostling with each other, and an awful lot of discussion about infrastructure development and things like that, rather than anything quite like an Asian monetary fund.

The point I would make is that the Asian central banks have created a network of swap arrangements, which have intended to try and stabilize the region in the case of market crises.

So you wrote a very interesting book, ‘Saving the Sun,’ which touches on a very specific anecdote around this time involving Japan’s banking system, and foreign efforts to turn around a failing Japanese bank, and I’m wondering; one of the pieces of policy advice during this time, from the IMF and other foreign institutions was that, perhaps a little bit more foreign competition in Asia’s banking systems and Asia’s financial systems might be helpful, and improve the financial system.

I’m wondering, kind of given your own experience, writing that book, researching that book, just being in Japan, what do you make of that? Do you think that’s true? Has that over the last 20 years improved Asia’s financial system, increased foreign competition, increased foreign investment?

Well, Asia in general, and Japan in particular, didn’t need more banks in the system, because actually, in 1997, the system was already massively over-banked, there was just too much capacity, so just bringing in more banks didn’t necessarily improve the situation. What did improve the situation in some ways, or actually accelerate reform, was having other banks come in and try to measure the value of assets in a more transparent, consistent way, and so the main value of having non-Japanese banks in the system was simply to bring in sunlight.

Now, some Japanese might say that wasn’t actually valuable, because guess what? It actually accelerated the crisis, but having that sunlight, having people coming into the system who were trained to price risks on a yield curve rather than operate with a very binary vision of money, which was basically you either gave it to your favorite friends or you didn’t…In that respect, the introduction of non-Japanese banking and finances into the system was very, very helpful.

So, Gillian, now looking back 20 years after the crisis, what do you think are the enduring lessons, and what should we take away from this?

Well, I think the first enduring lesson is hubris is endemic and deadly, because the Japanese thought that they were on top of the world with their financial system in the 1980s, and of course, precisely because they were so cocky and so confident and (I’m going to say) arrogant, they created the mother of all bubbles that then burst. In the aftermath of the Japanese bubble bursting, the Americans were then pretty confident that they had the ultimate financial system, and much of the ‘naughties’, if you like, was all about the Americans telling the Japanese what to do and celebrating their brilliance with their financial system. And of course, they then created a huge bubble that then burst as well.

I suspect that China is heading that way, now. Chinese banks have had a pretty big footprint on the global stage, recently the Chinese economy seem to be going ever-upwards.

I fear that we may be seeing history repeat itself, and there are many parallels between China today in terms of it having outgrown its old bank-centered, tightly controlled, financial system as the economy matures…There are parallels between that and Japan in the 1980s.

So that’s one lesson from the crisis.

Another big lesson is that if a system has bad loans, sweeping it under the carpet indefinitely doesn’t usually work, unless you’ve got rapid growth and high inflation to enable you to grow yourself out of the problems. If you have deflation and a stagnant economy, sweeping the problems under the carpet and trying to pretend they don’t exist can make the bad loans bigger. It can also lead to a very subtle loss of confidence in the system, as people lose trust that anything’s worth what it really says it’s worth, and that can create a very deflationary, very nervous mindset, and that makes economic growth even harder to achieve.

Another problem is that—another key lesson is that—anyone looking at a financial system has to think very hard about what the pillars of faith are, that they’re propping up faith in banks and faith in asset values, because the bank-centered system that was created by Japan after World War II worked very well for many decades because it was so tightly controlled by bureaucrats, that people were essentially trusting in the bureaucrats for the faith in assets to be maintained.

It was basically a system run by fiat. The problem came when they tried to move from a system based on bureaucratic fiat to one based on markets, and they didn’t have enough market transparency or credible accounting systems, and so they basically ended up in limbo land without anything to create a pillar of faith in anything.

So, thinking about “What is a source of faith in a system?” Again, it’s a very, very important lesson from what happened in Asia.

Yeah, and I think those issues are definitely impacting a lot of emerging markets as they transition.

There’s been a lot of work done by the IMF, by the central bank community looking at the issue of capital flows in and out, and certainly, the other lesson I would say from Asia is that the era of unsettled enthusiasm for liberalizing your financial markets, having unfettered capital flows in and out, that’s clearly declined significantly, and people now recognize that there’s actually a merit to having some element of control of capital flows, or at least recognizing up front that these so-called trilemma that central banks can’t hope to have everything at once; they have to hope to have maintained control of their monetary policy and their currency and their financial system, all at once with open markets.

But I do think this question about people thinking about what happens in transition economies as the source of faith in finance, that hasn’t been discussed enough, and it needs to be put on the table much more openly.

Great, well, thank you so much for your time, Gillian.

Okay, thank you very much indeed. Thank you.

We hope you enjoyed today’s conversation with Gillian. 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!