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 in 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 Don Hanna, a prominent financial economist for Goldman Sachs’ Emerging Asia research group at the time of the crisis.
The difficulty is that investors, whoever they are, domestic or international, tend to be too myopic, tend to take nominal values as real values far too often and that laziness is exacerbated by fixed exchange rates. So while you can write down the models and say, “Well heck, this is going to work. People will see through this veil and understand real competitiveness, et cetera.” They don’t in practice. Some degree of uncertainty, some degree of movement, of volatility in the exchange rate, I think is particularly necessary if you’ve got a system in which you want to have more liberalized finance.
Don has followed emerging Asia for decades from the perspective of a private sector economist, advising many of the world’s leading institutional investors. Before working for banks like Goldman and Citi, where he finished as the acting chief economist, he spent seven years at The World Bank covering Latin America, Asia, and Eastern Europe. He combines the academic rigor of a macroeconomist with the intuition of a private investor.
So far in this series, we’ve heard from a lot of interesting thinkers, but Don helps us get to the perspective of foreign investors at the time. Investors whose capital flows into and out of Asia were central to the crisis. He covered Latin American debt crises earlier in his career, and he gets to the somewhat novel modern trend for emerging economies to issue debt in their own local currency. This was not common in the 1980s Latin America or 1990s Asia, when Don was covering both regions.
Right. This is about avoiding what economists refer to as original sin, borrowing abroad in foreign currency. I think this was a really interesting point. Don also adds some nuance to the historical record on the role of foreign investors during the crisis. While some investors were famously short the Thai Baht, they had no such position in Indonesia, a country that they considered in sound economic shape from a macroeconomic perspective. With that, let’s go to our chat with Don.
Well, thanks for joining us, Don.
So at the time of the crisis, you were the head of Goldman Sachs EM Asia Research. Did you see the crisis coming in the nineties as you were monitoring these Asian economies and how do you view the origins?
Did I see the crisis coming? No, not fully. There was obviously, in places like Indonesia, big gaps between what you saw in terms of macroeconomic performance on the one hand and the micro underpinnings, the institutional underpinnings, on the other hand, and so there was always that kind of disconnect. The same was true, though probably to a lesser extent, in Malaysia, where you had this nexus between political power, and the efforts by the then government to support the Malay community, that was distorting a lot of investment issues. But like many other people, the focus that I had was on the current accounts, which seemed financeable, and in a world in which the gap that one saw in the current account was largely private investment. It wasn’t a fiscal gap that was driving that gap, and so the general thought was well that’s more sustainable. It became more problematic in ’96 in part because export growth globally decelerated, and then those current accounts looked more complicated to finance, and there was also the case at the time that there was a lot less information in the aggregate about the private external claims that were being put in place, and that became a big Achilles’ heel at the time of the crisis. An amount of that private sector, dollar-denominated debt, that wasn’t financing exports, that was financing domestic activity.
So that amount of foreign borrowing, that was an unknown factor during that time?
In the run-up it was unknown. It was unknown. There was a lot of focus at the time, remember you were in an environment in which, everything in South East Asia, but also Korea, was competing to be the next financial center sector. So you had things like the offshore banking system that the Malaysians set up in Labuan, an island in the South China Sea, and the Thai’s had their offshore banking system, and the Koreans had plans to try and be the financial hub for North Asia. All of that process involved funding in dollars to a large extent, and to a large extent funding, not international activity, but actually local activity. In a backdrop in which the exchange rates were fixed. And people weren’t doing the math on what the cost of finance would be were the exchange rate to move because those exchange rates hadn’t been moving, and so there was a confusion, as there often is, between nominal values and real values that were exacerbating the willingness in combination with this effort at liberalization to use foreign finance to finance domestic activity.
What was the data like at the time? I mean, this is always a challenge monitoring macroeconomic and financial developments in any country, sometimes it’s better in more developed countries, but today there’s a lot of monitoring and surveillance done by multilateral institutions, by private sector institutions of emerging markets. Was it that quality back then, or was it much more of an unknown?
You’ll find with statistics generally that the focus of the statistics that get gathered are a function of what the last crisis was or what the last framework was, and not when you’re liberalizing where the system is evolving to.
One of the things that was difficult to track down was what are the interest rates at which lending was going on in the liberalized, or offshore, systems. The information that you had on intra-firm borrowing wasn’t very good. A lot of focus was on credit quantities in the banking system, but much less on price, and yet you were increasingly moving to using interest rates as a means of tracking. You had very little information about inflation expectations. So you could calculate ex-post real interest rates, but it was hard to know ex-ante real interest rates were. There were calculations with regard to real exchange rate values, but again, with whom were you trading that didn’t have often those measures at least that the central banks were using, didn’t factor in implicit or explicitly any kind of competitiveness factor. Although part of the reason one had those fixed exchange rates, was implicitly a mechanism for ensuring that the competitive basis, at least in nominal exchange rates between one Asian country and another, wouldn’t shift too dramatically. It was an implicit coordinating mechanism for them.
So looking back on this policy of having fixed exchange rates, or managed floats, in a lot of these Asian countries, at the outset maybe provided a lot of stability, but turned out to be quite a critical weakness during the crisis.
How was your thinking, about what emerging markets should do in terms of their currency policy, changed as a result of what you saw during the Asian Financial Crisis?
I still think there are times, certainly in times of financial panic, in which efforts at trying to stabilize the exchange rate makes sense because investors’ perceptions aren’t always based in reality, and so there are grounds for intervention that make sense, but the difficulty is that investors, whoever they are, domestic or international, tend to be too myopic, tend to take nominal values as real values far too often and that laziness is exacerbated by fixed exchange rates. So while you can write down the models and say, “Well heck, this is going to work. People will see through this veil and understand real competitiveness, et cetera.” They don’t in practice. Some degree of uncertainty, some degree of movement, of volatility in the exchange rate, I think is particularly necessary if you’ve got a system in which you want to have more liberalized finance.
So you just mentioned investors sometimes being lazy. We’ve talked a lot in previous episodes about the role of contagion during the crisis, and one thing that surprised people was, it started in Thailand. At that time, kind of a middle-income country. It spread to emerging markets like Indonesia, very sophisticated global financial centers like Hong Kong, an economy like South Korea that had just joined the OECD, so in that sense was considered developed. One common explanation for that is that investors kind of lumped all the problems of Asia together and kind of looked at a lot of these countries as kind of facing similar challenges and therefore made their investment decisions. I’m just wondering, given your role, how do you feel investors were looking at these countries? Was there a sophisticated view of each economy, or did their kind of become a herd mentality? You know, maybe they’re all kind of in the same boat?
I think both things characterized in … There were groups of investors who put it all into one category, sell it. Others who were intimately involved in the process of taking on the fixed exchange rates, who were making distinctions. For example, one of the firms that always gets talked about, one of the hedge funds that always gets talked about as evildoer in this process was the Soros Group, which was placing bets against the Thai Baht.
At the same time, they were not placing bets against the IDR, the Indonesian Rupiah. Why not? Because they thought that the level of imbalance in the Indonesian economy was far less. Didn’t have the level of indebtedness, didn’t have the level of current account deficit, it had fiscal surplus, so their arguments were, there’s no reason, per se, for that currency to weaken, and yet it turned out to be the worst performer. Not so much as a result of the initial conditions that it faced, nor frankly from the contagion, but to a larger degree from the efforts that they put in place to insulate themselves.
Devaluation by the Thai was on July 2nd, of 1997. In November, the Indonesians accepted an IMF Plan Program, which included the closure of 22 of the roughly 220 private banks that Indonesia had at the time, without having any deposit insurance scheme, and with very poor information about the general balance sheet or profits and loss statements of the banks, and that generated a run. It was the flight of domestic capital, not a flight of international capital, that was the Achilles’ heel for Indonesia. So in that sense, and those folks were uninformed, but they were uninformed as a result of a policy of banking secrecy that had precluded giving adequate information for investors to distinguish solvent from insolvent banks, and in a moment of panic there’s no such thing as a solvent bank because they’re all levered.
So what was the trigger that eventually pushed the crisis to South Korea, because you know, there are a lot of people saying, “Oh, when you look at it on paper South Korea is actually a lot stronger, their external position is not as bad as some of these other Southeast Asian countries.” Why did it ultimately spread to South Korea?
So one of my then-colleagues at Goldman Sachs was the banking analyst, a man named Roy Ramos, wrote a piece looking at cash flows of the major chaebol in Korea, and just as was the case with the conglomerates in Chile, which had its financial crisis in 1983, the major chaebol were actually, on an operating basis, losing money. They were simply financing in order to keep growing and expansion, even though that expansion wasn’t generating any profit. And in an environment in which credit was then becoming suspect, if you don’t have underlying operational profits, you’re in trouble, and that is precisely then what happened.
How were they able to finance, you ask, when there was no underlying operating profits? And the answer to that was, it’s what you mentioned a moment before about the Korea entering the OECD. Traditionally, the way in which the Korean Government had controlled the chaebol was through finance, because the banks were largely state-controlled, and they would simply limit the amount of financing that the Korean chaebol would do, and the other avenue they used to ensure that there some competitiveness was you had to export. You had to be able to compete elsewhere. With the financial liberalization that was required to enter the OECD, that financial restraint on the chaebol disappeared, so the Korean government essentially was no longer the only source of finance or the marginal source of finance. It was international capital markets. For the reasons that you just brought out, these were major companies, that had major products, that were successful in the international arenas, finance flooded in, but to such an extent that the firms themselves were still focused not on profitability but on growth, and were debt financing that, until oops, they couldn’t, as a result of the reevaluation that stemmed from the difficulties in Southeast Asia.
So then picking up on that, you talked about, in your view, the advisability of floating a currency as opposed to having a fixed rate, and what about capital controls? What’s your take away from there? A lot of people say that the South Koreans … you know the interbank flows were liberalized more than say FDI flows at that time.
And that’s not really the sequence you might prefer if you were going to slowly liberalize a capital account. So that’s the Korean situation. I mean, you’ve got other emerging markets with open capital accounts, what’s your take away?
Okay, just two points to make. Number one, one of the things that changed in the 1980s and into the 90s, or sorry, in the late 80s and into the 90s, was the focus that investors had internationally, and particularly in Asia, that came as a result of the restructurings that were going on in the aftermath of the Latin American debt crisis.
A country like Indonesia actually had an open capital account since the early 1970s. They didn’t have capital account restrictions. They had a fixed exchange rate. They had a fiscal rule that said, thou shalt not finance domestically. They were fine into the mid-1990s and the run-up to the crisis when the magnitude of capital flows and attention was large in relation to the domestic economy, and to the regulatory framework for understanding risk, that they had in place. So one of the key aspects about sequencing is, not so much are you open or closed but do you have a regulatory framework that is robust? That gives investors information, adequate to make sensible decisions. Which if we go back to the question of the fixed exchange rate, one of the problems there is you need some volatility because of an inherent laziness in the use of that information.
With regard to short-term flows, there the issue is I think, again, there’s a necessity for some level of control, particularly in short-term flows that are intermediated by the banking system. And that’s a result of the fact that the banking system plays not only a role with finance, but also as a means of payment, which is a public good, and in crisis then, the state will step in to preserve that means of payment function of the banking system. Which means if you’ve got short-term external obligations that have come into the banking system, the supplier of those funds has an implicit option that they’ve taken out. If the government isn’t collecting a premium on that, it’s free and it will be abused. So you need to have some control simply because of the fact if you’re certainly financing through the banking system, you, the provider of funds, are being provided a subsidy, basically a put of that back to government. That’s the best reason I know of for trying to control short-term flows. There are arguments out there that you control short-term flows, and it just turns into long-term flows, and then this isn’t effective over time, et cetera, but it is the case that, as I made, there’s an essentially options argument for putting in place some level of taxation or grit or fee associated with those short-term flows.
So you’ve written a bit about the restructuring of Asian economies after the financial crisis, particularly banking center clean up. Can you give us an overview of what were the major actions taken and sort of whose moved farther along that road in terms of restructuring?
I can tell you who hasn’t. I mean, certainly the countries that got hit by the crisis, it took differing periods of time, but everyone has got systems that are much more robust in terms of the levels of capitalization, the levels of related lending, the net open position requirements, and the like, relative to what they had. But there was another aspect of the reform process that occurred at varying speeds but was also consequential to economic recovery.
It is not simply the balance sheet of the financial and intermediaries that needs to be improved, but it’s the balance sheet of the borrowers, and this is something we sort of mangled in the US with mortgage debt. If you don’t clean the balance sheet of the borrower, they can’t operate either. So simply going in and recapitalizing the banks and altering their regulatory frameworks to make more robust without dealing with a bankruptcy procedure that cleans the debt from the borrower, is only half the solution, and not necessarily the most important half.
In that regard, the countries that did a much more effective job in dealing with the borrower’s balance sheet, as well as the financial intermediary’s balance sheet, was Korea, where KAMCO (Korea Asset Management Corporation) was quite effective, and Malaysia did a good job as well. Indonesia was probably the most complicated. And dealing with a borrower’s balance sheet gets complicated because the politics of that are usually more difficult because it’s one thing for a government to go into a bank and say look the bank’s there, we need to have these banks operate so you can get cash out so that you, Joe Q Public, can operate in your day to day activities. It’s another to say that this corporation over here needs to have its debt taken down because that’s viewed as a transfer, as to some degree it is, to those shareholders potentially, or to those associated with that entity, and there’s a political question of why. The answer to why is because without that cleaning of the balance sheet there won’t be the production, there won’t the jobs, there won’t be the activity, but that’s a level of argument that when you make it specific, immediately brings in questions of, “No, choose him, not her.” That’s the kinds of issues that generally slow the restitution of private sector balance sheets. Non-financial private sector balance sheets.
This is getting a little bit outside of our typical area of coverage, but is the explanation for the differing successes then politics? The strength of the local government and their ability to push through these kinds of difficult decisions?
Absolutely, it’s often the case. Why is that Indonesia’s crisis was worsened? I mentioned the issues associated with the treatment of bad banks, but there was also, of course, the political crisis of the middle of May of 1998. I was actually there the night that the riots broke out. Luckily got on an airplane and was out before the full brunt of the turmoil ensued, but that change in political transition, in the midst of the financial and economic crisis that was occurring, made it very hard to recover initially. That crisis was what when I spoke at the beginning about the gap between macroeconomic performance and microeconomic stories that businessmen would tell you, that came up and bit you in the end, and that’s what was the issue that led to Suharto’s downfall ultimately.
Can you give us your sense of how effective these different regional initiatives after the crisis have been in terms of creating swap lines? There’s been a big push to create more robust Asian bond markets. We were chatting a little bit before the episode about if you look at the Latin American crisis, that was very much bank lending driven. Even to some extent during the Asian Financial Crisis, banks were still pretty much in the thick of things-
But moving forward you have much bigger bond markets, you have higher percent of foreign holdings. How has that changed things in Asia?
Sure, let’s see. A couple of things I’d say. Number one, there was a big focus at the time on the idea that gosh, there was Asian savings and it was going into New York, or London, or Tokyo, and coming back, and that was generating exchange rate mismatch that was integral to the problems of balance sheet disruptions that exacerbated the problems.
To some degree though, the initiative, the Asian bond fund and like initiatives, didn’t deal with the fact that there was an overall current account deficit in the region. And so, Malaysia’s gonna buy Indonesia’s debt, and Indonesia’s gonna buy Thailand’s debt, but the aggregate current account doesn’t change. You didn’t solve the problem.
What you needed … The focal point, I think what mattered in terms of moving forward with deepening bond markets, was less the idea that there was gonna be a sort of mutual support group, cause what you really needed to do was change savings and investment balances. How were you going to do that? The better way to do that was either fiscal contractions, which at this time you didn’t need, over time you did, but not in the middle of the crisis. The other was, strengthen the regulatory framework so that you would actually have greater clarity about what it is that you were buying. Better rules that would deal the event that your contract went into default, so you could collect more easily, and with that then be able to finance at a lower cost. Spur investment.
Now that would paradoxically require more foreign funding, but you would have a more robust bond market that would result from it. The other things that have changed dramatically, more dramatically for the bond market, is what you mentioned, is a shift towards local finance rather than dollar finance, which was also supported by having a more robust regulatory framework. So more generally across emerging markets, there’s the economic literature that talks about original sin, the idea that investors would never trust an emerging market to invest in its own currency because of the risk of an inflationary outburst or default that would erode the value of the claims. Original sin, you could say the emerging markets have been Catholic, and they can go every Friday and forgive that, and actually finance in their own currencies. So that’s a bigger domestic bond market, but you need the regulatory backing for that to occur and to keep that original sin at bay.
So I take it from your comments a little skepticism towards the need for fiscal contraction during the crisis that maybe you didn’t completely agree with some of the IMF package conditions?
No, I did not. Although, truth in advertising, I worked in the World Bank in the early 1990s and helped to author the annual economic reports that we would put together, which would come with a laundry list of changes, some macro, some micro, that we thought would improve the overall performance of the Indonesian economy. The January IMF program, so the second one that came, with the famous photograph of Camdessus, with his arms akimbo, leaning over Suharto as he signs the deal, that had pretty much every recommendation of at least five or six years of World Bank reports, and part of the difficulty with that wasn’t so much a question whether or not there was fiscal contraction, it was just simply overwhelming to try and do a whole array of changes that the country hadn’t politically been able to manage in the previous six years. In the midst of a crisis. That’s just silly design.
The other issue of course, when you’re dealing with countries where the level of private debt, per se, wasn’t the problem. It’s not as if there was going to be a high-risk premium in the local currency bond financing for the government. Which is typically the argument you would use to say, “No, no no, we can’t do debt-financed fiscal expansion in a crisis and an emerging market because the interest rate will rise and that will offset any kind of positive effect from fiscal stimulus.” In general, that’s much more of an issue that one associates with the Brazil’s or Argentina’s and much less with the Asian countries because many of them didn’t have explicit public debt in the run-up to the crisis.
So you’ve given us your assessment of some of the changes since the crisis, so generally an improved financial regulatory architecture in a lot of these countries, more local financing of debt, you add in a build-up in foreign exchange reserves in a lot of the central banks, all very helpful developments. What do you see as the biggest vulnerabilities today in Asia? Emerging Asia? Developed Asia? What do you see as the biggest risks?
There’s two things I think. One is, we still haven’t solved the problem that, as far as finance is concerned, we need financial innovation to spur productivity, but that financial innovation is necessarily uncertain in its implications. Uncertain in the Fischerian sense of we can’t look at history and provide some guide. It’s not a question of risk. It’s fundamentally unknowable. And a number of the crisis we can think about are a result of not necessarily global innovations, innovations for particular areas or regions, in some cases global, that generate uncertainties that come back and create vulnerabilities that we’re unaware of until the moment. In that context then, any set of economies, which is improving and trying to innovate in the financial sector, is going to be subject to the risks that that uncertainty generates. So Asia, as well as other parts of the world are subject to that.
In the Asian context, I know David Dollar, who was giving an earlier talk about his views about the Asian Financial Crisis, mentioned that China was a source of stability in 1997-98 because it chose to fix its exchange rate in that period rather than to devalue as everyone else in the region was doing, and I would agree with that assessment. Today however, I think that the Chinese economy and its financial system are a source of potential instability because while there were financial sector reforms that went on in China, it tried to learn the lessons from the Asian Financial Crisis, in its efforts to liberalize and improve the functioning of its domestic financial system the growth of leverage in that economy is far too high. The associated debts are far too high. And the efforts at growing the economy at a level above its potential growth rate risks not only the continuation of expansion of this financial vulnerability, but layering on potentially a cyclical vulnerability if inflation begins to rise and you then have to choose between managing your debt payments or manage your inflation problem, and that I feel in terms of financial sense is the biggest risk for the region, certainly for China, but for the region because of the importance of the Chinese economy to the rest of Asia and the rest of the world.
So then how do you view the steps China has taken toward capital account opening over the past couple years? Is that premature, or do you think it could actually help improve things?
So the US Government’s argument that you need financial liberalization to improve the effectiveness of your economy in the Chinese case is ludicrous. Simply because of the fact that you don’t have the underlying regulatory architecture that really makes that a prudent step, and so I take the pronouncements from the Chinese officials about the pace of financial liberalization and capital account opening with a huge grain of salt because they’ve read the same stuff that we have and-
Yes, and in that sense then, while it is the case … Also, think about China. They’re running a current account surplus. They’re exporting savings. One of the main macro arguments for having capital account liberalization is you can cheapen finance. You get the world interest rate, which would be lower, well, actually that benefit won’t accrue. One of the things they’re trying to struggle with is more effective investment, not cheaper financing for it. So there’s a lot of arguments against moving very aggressively towards capital accounts liberalization, and of course, since last year they’ve been moving the opposite direction because of the pressure that the yuan came under.
Some of the capital controls we saw earlier this year and end of last year?
Exactly. So that was an effort really at not so much introducing new controls, as simply tightening the enforcement of existing rules, and that’s very much a reaction to the kinds of difficulties that capital flight associated with a, a shift in the expectation about the exchange rate, but b, concerns about the viability of the asset side of Chinese banks by Chinese depositors.
You mentioned innovation a little bit earlier.
We talk about the global financial crisis, we think of things like CDO-squareds, and NINJA loans, and those sorts of financial innovations.
In the contexts of Asia, could you give us maybe some examples of innovations that you think could be positive or potentially risky? I mean are we talking about shadow banking type products? Wealth management products in China?
Sure. The most prominent one is the one you just mentioned, shadow finance, which when I went to school we used to call that non-bank finance or non-bank financial institutions. I wrote a number of World Bank reports arguing that one needed to deepen financial systems by strengthening contractual savings institutions and non-bank financial intermediaries, and those are a natural outgrowth of the system.
You’ve got different levels of risk among potential borrowers, and you have different institutions designed to charge different rates and take on different risks. So there’s nothing inherently evil about quote shadow banking or non-bank financial intermediation. The question that arises, however; is transparency about pricing, actually understanding the risks, and developing a capacity both among those who are operating the institutions and in the regulatory side to manage those risks and to have the information to effectively manage those risks.
With shadow banking normally the issues aren’t innovation in the global sense, they’re innovation in a local sense, and so there’s ways of handling that through trying to import experts, but there’s also a case to be made that experts won’t understand the local intricacies or the politics that often get enmeshed in finance, and that you’re better off having some sort of speed bumps or brakes, like driving your golf cart and it will automatically slow you down when you try to go too fast. Simply to give the system overall time to understand the nature of the activities that are going on and the risk that can evolve.
So looking back now, 20 years since the Asian Financial Crisis, 10 years basically since the Global Financial Crisis, what are the enduring lessons we should take away from all this? What are things we’ve learned and maybe lessons we should have learned but haven’t yet?
I think the most important thing that I take away from this is that we still live in a world in which investors and other actors in financial markets are often going to confuse nominal and real values, and that therefore; if you have a fixity of some nominal value, and yet the real value is fluctuating, for example, as a result of inflationary shocks and the like, that you can generate unintended risks that build up, and that the typical macroeconomic models that don’t allow for that money illusion can lead you astray as a regulatory framework for thinking about things. That’s one problem that we haven’t fully addressed.
I think there’s also this underlying tension, as I mentioned, associated with innovation that’s truly global innovation, and the uncertainty that that will inject into a system. There’s no way around that, we’re going to always have a trade-off between trying to improve the productivity and innovation that we have within finance and the necessary uncertainty that that will engender, and that the push therefore for having greater degrees of cushion, which are associated with higher bank capitalization and the like, as well as restrictions on some flows that we now can be volatile and lead to public intervention ex-post. I think that that is a lesson that’s come out of the crisis that’s much more broadly in place and hopefully will continue to be in place as we go forward.
And that efforts to roll back things like Dodd-Frank don’t go too far and that keep in place those cushions that will be necessary because the other lesson that I take from these crises is that the political systems are much easier focused on trying to assign blame ex-post, then they are on creating a framework, that is itself more robust. That’s simply because politics is to a large degree always about trying to shift responsibility or authority from one group to another, and in the moments of crisis, that’s the last thing you need to do. You need to square the ship and then move on. Not worry about who’s to blame. That’s for the economist 20 years on to focus on.
Well great, thank you so much for joining us today.
We hope you enjoyed today’s conversation with Don. 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, look up our Pacific Exchange Blog, available at FRBSF.ORG. Thanks for joining us.