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 mark the 20th anniversary of that event. We sat down with Simon Johnson.
If we were to have another Asian Financial Crisis or emerging market type crisis, would the IMF advice be the same as 1997? No, I don’t think so. How different would it be? Very hard to say, very hard to say.
Simon is a prominent economist who has studied financial crises and responses to them closely. He is a professor at the MIT Sloan School of Management and is head of the Global Economics and Management group there, and he’s also a Senior Fellow at the Peterson Institute for International Economics. He previously served as the Chief Economist of the International Monetary Fund and has written numerous articles on both the Asian Financial Crisis and the global financial crisis.
I think Simon comes at this topic of the Asian Financial Crisis from a particularly helpful perspective, as someone who has thought a lot about reform in the wake of financial crises. I thought it was really interesting to hear his views on the recent evolution of policy advice given to emerging economies as they develop their financial systems and also as they encounter some sort of crisis. I’d say that this is really a live issue in Asia today, when you look at China’s liberalization of its capital account, or the efforts of various emerging Asian economies to navigate market turbulence, like the taper tantrum in 2013.
Yeah, I was struck by the importance Simon placed on corporate governance reforms, and also improving transparency in the financial system. These issues continue to be significant challenges not only in emerging markets in Asia, but also in advanced economies around the world.
Alright, let’s get to it. Here’s our conversation with Simon Johnson.
Well, thanks for joining us today Simon. Maybe we can start out by talking about … In your opinion, what were the financial and economic conditions that initially led to the outbreak of the Asian Financial Crisis?
Well. if you speak broadly about the origin of the Asian Financial Crisis, of course it’s a boom. It’s a boom of investment. It’s a boom of exports. And there’s a lot of imported capital into, for example, Southeast Asia that was, by and large, used for productive purposes. This was not a real estate bubble or a crazy sovereign debt-borrowing binge by any means. It was productive investment that went a bit too far and in a system with a fixed exchange rate and increasing concerns about the sustainability of that exchange rate, initially in Thailand.
So it was initially productive investment, but what was the catalyst that changed this productive investment then to be viewed as risky and ultimately lead to a recession?
In retrospect, it’s easy to argue there was some overinvestment, too much capacity built in some of these countries, but the real trigger was large current account deficits. Not enough capital flowing in to offset a loss of reserves, particularly in Thailand. The Thai bank of course disguised their reserve positions through various operations, through derivatives. It began slowly to dawn on people that the Thai current account situation and the exchange rate was not as sustainable as previously thought, so this was a classic instance of an overvaluation. The market begins to realize this, people start to speculate against it, the pressure mounts. And when the Thais admitted their problems and they had to move the exchange rate, then market participants started to look around and say “Aha, if this is the issue in Thailand, who else is likely to come under pressure, and where should we expect a larger than previously planned depreciation of the exchange rate?” That’s where the pressure came onto Indonesia; it came onto Malaysia and ultimately, of course, it spread to South Korea.
So why did it spread from less developed economies, like you just mentioned Thailand, Indonesia, Malaysia, to a more developed country like South Korea, also a major financial center like Hong Kong?
That’s a great question. I would take those two things as separate. I would start with Hong Kong and say that Hong Kong, as an entrepot, as a place that handles the flow of cattle within the region, did have some immediate vulnerability, for example, to investments that were going on in Indonesia. Now, I’m sure people in Hong Kong will tell you that those were very minor and there was plenty of equity back in those positions and so on from a Hong Kong position. But the fact of the matter is in a crisis or in a panic, the market doesn’t stop and do the calculations. So Hong Kong was caught, at least initially, in this downward selling momentum because it was part of the Southeast Asian economic sphere.
Same thing goes for Singapore. Singapore has more robustness built into their system and doesn’t have a currency peg, which the British Hong Kong did have and does have, so Singapore was always a bit less vulnerable.
South Korea is a different story. South Korea is really a stretch to think of it as being at all related in economic terms. But there was a panic and people looking for things to sell, and the South Koreans found themselves in a vulnerable position.
So Simon, one thing we know you’ve written about in the past has been the role of corporate governance in a crisis, where concerns about investors being able to get their money back, to avoid asset stripping, that sort of thing during a period of crisis. How big of an issue was that during the Asian Financial Crisis, and were there special things in terms of corporate governance that affected Asia relative to other parts of the world?
I think governance was a big part of the story in Asia, particularly the point that when the economy’s expanding, when you’ve got a boom, nobody really cares too much about the governance of your firms. If you’ve got family ownership, if you’ve got a lot of inter-linking behind the scenes or away from the public records of ownership, if you have cash being moved around between different parts of the family empire, investors are generally okay with that or they turn a blind eye to it during the boom. But when times get rough and when they worry about what might be going wrong, then they pay a lot of attention to those governance structures. Those governance structures, which are quite different in Thailand, Malaysia, Indonesia, South Korea. They all have quite different governance, but they all have had, and some few would argue still have, governance structures that when you focus on, when you scrutinize what is really safe here, what should I worry about, then you can get yourself very worried and very worked up, and that’s definitely what happened with regard to many market participants.
Comparing around the world, we thought at the time, and I wrote about this, arguing that many other emerging markets had different but similar governance issues and vulnerability in the downturn. What I, and I don’t think anybody else, fully understood is that the US, actually more subsequently during the 2000s, developed similar governance problems, particularly around large financial institutions. Opaqueness, not being able to determine the value of your claims when the pressure’s on and so on. So the US became, unfortunately, more like an emerging market in the first 10 years of this century, and that really caught up with us and hurt us in 2007, 2008.
So just to drill down a little bit on that. Is it a matter of with some of these Southeast Asian conglomerates of complexity, opaqueness in terms of accounting statements, lack of reliable audits? Just wondering if you could elaborate a little bit.
The heart of the matter in Southeast Asia is the family ownership. Families typically own a lot of companies, the big families. Some of those will be publicly traded, and some of those companies will have quite a lot of information available out them. And they sell shares, but to people who are minority shareholders or pretty disperse in terms of shareholdings. Those companies behave well and treat their investors properly in the good times. But when the downturn happens, there may be some effort to protect other parts of the family empire, there may be some increase in opacity, there may just be panic. Honestly, investors panic about all kinds of things. They panicked about governance, so these things contributed to the sell-off affecting the corporate sector. Because the corporate sector … Because they were the big borrowers, ultimate borrowers, and because the capital inflow come to those firms, you then got a capital outflow away from those firms, away from the country. That put massive pressure on the exchange rate, and because the firms have borrowed in dollars, any exchange rate depreciation greatly increased the amount they had to pay back measured in local currency.
So Simon, one of the things that gets a lot of coverage during the Asian Financial Crisis is the role of currency pegs. For many years, for these Asian economies, the currency peg was a source of stability, but then it turns and then suddenly becomes an acute weakness. Can you talk a little bit about what happened that turned currency pegs from a source of strength and stability to something that ultimately helped precipitate the crisis in several countries?
Yeah, I think this is one of the big lessons from the Asian Financial Crisis, actually, which is while pegs can help you at some moments, for example after a big inflation, they can also be a significant source of vulnerability. It can also creep up on you. It’s not the case that everyone decided overnight Thailand is overvalued. But over time, they came to think that the Thai baht was at a rate that wasn’t sustainable. The exchange rate policies, which is allowed for some devaluation, were not sufficiently taking into account what was going to happen with the current account. The same logic was also applied to Indonesia and to South Korea.
So I’m afraid in these kinds of situations — with sentiment turning strongly against you and all kinds of fears, real and imagined, about the borrowing that’s going on in your country — when that happens and of course you don’t have reserve currency, capital flows out, and there’s a real danger of what people have long called self-fulfilling runs. You run on the exchange rate; you take your money out. That leads to a depletion of reserves if the central bank tries to hold the peg, and that eventually means you don’t have enough reserves, that the peg is broken. The currency depreciates, and that causes problems for people who borrowed for example in dollars, which fulfills the prophecy that motivated the run in the first place.
I’m wondering, when we talk about the peg and dollar, what’s the role of the yen and Japan in all this? At the time, Japan was the dominant economy in Asia, China had yet to grow to its current stature. I’m wondering if you could talk a little bit about the role of Japan in the lead-up to all this and during the crisis itself.
Yeah, it’s a good question. I don’t put too much weight on Japan myself, but there are people who would argue that it was capital flows out of Japan, for example into Thailand, Indonesia, that contributed to the boom. There are also people who argue that some of the downward pressure on the yen, which certainly happened around this time because of the other problems in the Japanese economy, that put competitive pressure on some of the Southeast Asian economies. I think it was a contributing factor, but I would look much more at the nature of global capital flows, the way that governance functioned in those countries, the fact that investors were willing to lend into all kind of shaky arrangements in a boom and then, when sentiment changed, they wanted out.
So some of the other activities in Japan were more coincident during the Asian Financial Crisis.
Look, with any crisis here, you can find a thousand factors that were going in a certain direction, and you can argue that to some degree, all thousand of them played some role. My assessment is the Japanese factors were relatively minor compared to what else was going on, specifically in those countries and with regard to the structure and nature of global capital flows, the way that capital goes looking for opportunities and then wants to run for the doors when a certain kind of trouble hits.
So Simon, you wrote a great article comparing the policy advice given to Asia during the Asian Financial Crisis versus the policy advice during the global financial crisis. I’m wondering if you can start by telling us what was the policy advice given to Asia during the Asian Financial Crisis? What were the positive, non-controversial aspects, and then what were the more controversial items?
Well, this is one of the great controversies of macroeconomic policy of the past 20 or 30 years. Of course the controversy is centered on the International Monetary Fund where I worked subsequently, but I wasn’t working at the time. The IMF applied what I think you can reasonably regard as pretty standard macroeconomic advice for an emerging market, so a country that doesn’t have a reserve currency. They said look, you’ve got a run on your currency, capital’s trying to leave, therefore raise interest rates. And in order to demonstrate that you’re completely fiscally prudent, even with the possibility of substantial bailouts or supports going to be provided to the financial sector, you need to adopt various forms of fiscal austerity and swing the budget into surplus or, in some cases, more into surplus.
I don’t think any part of that advice today, looking back, is uncontroversial. The IMF also said you should open your market to foreign investment, and you should allow large global companies to come in, and this will bring competition and other benefits. I think that piece is also pretty hotly contested. In my personal opinion, the advice the IMF gave on improving governance, on better shareholder protection, more transparency, and so on for the large corporates, I think that was some of the best advice. That’s advice I would give today absolutely to anybody. You don’t have to be in a crisis, I think it’s just good advice. However, that advice is also regarded by some people in countries who were affected by crisis as being inappropriate, having gone too far, and a lot of pushback on that dimension also.
And the aspect of advice, with regards to banking, it seems like much of it was focused on shutting down failing institutions, re-structuring them, rather than later approaches would seem to focus more on replenishing capital and things like that.
Yeah, that’s correct. I would characterize what the IMF did there as being fairly sensible and not inconsistent with what the FDIC does or leads the way on in the US sometimes in our historical episodes with banking, although not in 2007, 2008. What you want to do is figure out which banks are truly insolvent, close those down, which assets can be taken over, and where you can get better value through some sort of resolution trust corporation, asset management company, people sometimes call those. Of course, you need to protect retail depositors, otherwise they’re going to panic. And you may need to improve the mechanisms you have for determining who loses among all the creditors because when they don’t know what’s going to happen, there can also be panic in that part of the market. So I think on the whole, the IMF did some sensible things there, although there’s no question some of it also contributed to the sense of panic, for example, in Indonesia in the fall of 1997.
So you’ve talked about some examples of the advice, but how effectively was it followed? Can you compare and contrast maybe the example of South Korea with some of the Southeast Asian countries?
Well, South Korea was arguably the country that least needed this typical IMF prescription because it’s relatively higher-income and a relatively well-run country. They did, however, follow the advice. And there was a re-negotiation of the initial IMF program, actually within the first month, to better reflect Korean realities and also the market pressure they were facing. So the Koreans sort of overachieved: they got a budget surplus who quickly swung to a current account surplus. Their changes within the chaebol big business conglomerate sector were not so substantial, but they did make some changes. They did their best to demonstrate that the extensive government, implicit government guarantees in that space were limited, and I think they had some success there. And they got an economic recovery, so South Korea turned its economy around pretty quickly, although I don’t know any Korean policy makers who would be keen to repeat that experience or who would even regard the IMF as having given them entirely appropriate advice.
The situation in Indonesia was obviously massively complicated by the fall of Suharto, the long-time dictator. That made it harder to follow through on the policies, although on the whole, they did a fair amount of what they were supposed to. Thailand, also more messy, but did fine. Malaysia chose not to go with the IMF, but they followed quite similar policies of relative austerity. There was some political turmoil: the financial minister was fired and actually put in prison halfway through, or the early fall of 1998, but the economy also managed to turn around.
I think the broad lessons is these were four very export-oriented economies. They had a big exchange rate appreciation, they were able to hold the line of appreciation. So they had a big depreciation in the real exchange rate, which made them very competitive, and they took advantage of that, and those exports helped them bounce back.
At that time, there was some talk of an Asian monetary fund, particularly early on in the process, and that obviously never happened. I’m wondering, in your view, would that have made things any better, or would it have just complicated things? Is that a useful structure?
That’s a pretty interesting question. Regional monetary funds of various kinds have been discussed on and off since the 1950s. The real issue though is who stands behind such a fund. Not just what’s the paid-up capital, but who is the ultimate lender or supporter of that fund. You need a reserve currency country, so you need somebody like the US or the Europeans or maybe Japan that’s willing to put in a lot of support when needed and that can reach some sort of governance accommodation with potential borrowing countries. Obviously, the US relationship with the IMF and through the IMF with other countries has been fraught with difficulties over a long period of time, but it has proved to be sustainable. We’ll see what happens going forward, of course. Asian Monetary Fund, they could never get past initial expressions of mutual goodwill. Mutual goodwill does not save the day in a crisis. What saves the day in a crisis is a lot of credit provided on generous terms and changes in policies that countries want to do.
So even though these regional initiatives haven’t gotten quite as far as people thought they initially might, it looks like Asian economies have actually done a lot to self-insure: building up large reserve stockpiles, making their economies less dependent on foreign capital, and things like that. How effective have these measures been so that, if there is a new period of financial volatility, are Asian economies better situated to withstand that now than they were in the past?
Yeah, I think they are better prepared for potential crises. Of course, you don’t know exactly what’s going to hit them, but 2008 was a major stress test for all economies everywhere. Asian countries that had built up larger foreign exchange reserves found those to be very helpful even though they were not at the epicenter of the problem, which was around US real estate and associated derivatives. Capital runs for the doors. Capital runs toward safe havens — which ironically includes the United States, but in that recent instance … — and away from a place like South Korea or Indonesia.
So they have learned that self-insurance works, and some of them will say, at least in private, that they, next time perhaps, should have more reserves, which it’s hard to object to, but there is an adding-up problem, which is that not every country in the world can run a current account surplus. Someone has to run a deficit, so who’s running a deficit and how is that deficit regarded by the policymakers in that country? This brings us of course to the policy today and to Wilbur Ross, the Secretary of Commerce. Apparently emphasizing that the trade deficits and current account deficits on the part of the United States are unacceptable and reflect unfair trading practices whereas, for the most part, they reflect what we’re talking about, which is current account balances, imbalances, and macroeconomic policy around the world.
So you’ve hinted at this already, but how would you sum it up as the evolution of advice around crisis response since this period or over the last 20 years?
It’s a very good question, and I’m afraid to say, extremely hard to answer because the … I’d like to be able to say that the policy advice has changed a lot, but I’m not really sure that it has. Our main subsequent crisis in which the IMF was involved was the European crisis, the Euro area crisis, and the IMF did give different advice to Greece and other countries compared to what they gave to, say, South Korea. But was that advice different because it was the Euro area, and the dynamics of the Euro area and the politics of the Euro area are different, and the management of the IMF, to be blunt, is European? Or did they give different advice because they’ve changed their mind about what’s the nature of crisis and how countries should be helped in a crisis? I think the jury’s out. If we were to have another Asian Financial Crisis or emerging market type crisis, would the IMF advice be the same as 1997? No, I don’t think so. How different would it be? Very hard to say, very hard to say.
One thing that seems to have changed is there seems to be a growing consensus around the potential risks of opening your capital account too early. Is that something that has taken hold within the international economics community, or is that still an issue of debate?
No, you’re quite right. Views on that changed. They changed quite early. They were already changing in 1997, 1998. Prior to that, there had been a lot of emphasis on liberalizing your capital account, and I think that the experience of the 1980s, early 1990s had convinced some people that you should have more capital account liberalization earlier. That was demonstrated to be a problem by what we saw in 1997, 1998, and many people backpedaled away from that very quickly and re-assessed that.
We got valuable new data and important experiences that demonstrated there were real side effects, substantive side effects that we should worry about and try to prevent if you open too much capital inflow in various ways. Of course, the irony is that the South Koreans had been extremely careful about capital inflows and have been very restrictive on direct foreign investment for a long time. But they had, in the mid-1990s, joined the OECD, and they’d increased their bank borrowing across borders, and that was a big part of their vulnerability.
So as part of the macroprudential thinking for emerging markets, among other things, limiting capital inflows, particularly in the good times, particularly in the booms, that’s increasingly on the radar of policymakers.
So I guess to extend that a little bit or flip it, and maybe a little bit more of a conservative approach into gradually opening, but what about for countries that already are pretty open? Can they reverse the use of capital controls during a crisis? What’s the thinking there, to the extent that they’re already pretty liberalized?
I think the thinking on that is you’ve got to be very careful. If you slap on capital controls, it might slow down the outflow of capital for a while, but people can find their way around it quite quickly, and you’re going to introduce a lot of distortions. I’m not saying there could be some circumstances in which it might be recommended, but that’s really quite fraught with danger. I think the smarter approach is limit the capital inflows during the boom, during the upturn, and then you’re going to have less by way of speculative capital trying to flow out when things go bad.
So Simon, looking back now, 20 years since the crisis, what do you think we should take away as the enduring lessons, both for the countries involved, but also the international community thinking about financial integration and all these things?
I think it comes back to governance, and governance … Sometimes we call it regulation in our US discussions. I actually prefer the term governance. I think it’s more general and also makes it clear that it’s not just about the public sector trying to get you to do things, it’s also about private sector decisions, private sector structure. Also, what global capital, people making investments in London or Tokyo or New York or Hong Kong or Singapore, what they are willing to finance. What’s regarded as a vulnerable structure, what’s regarded as a dangerous structure.
I think we need more transparency, less opacity. I think we need better ways to make clear who owes what to whom through derivative markets. We’ve put a lot of effort into trying to make derivative markets safer in the United States and elsewhere since 2008. I think there’s a lot more work to be done there. And our ability to see financial risks, understand financial risks across borders remains fairly limited, unfortunately.
And finally, I would emphasize capital. How much equity do you have in your banks? That’s really a fundamental issue. That’s actually less of a problem in many emerging markets than it is in the US and Western Europe because emerging markets have learned the hard way that, if you run your banks with very little capital so they’re extremely leveraged, they are more vulnerable to collapse. So high, robust capital requirements and funding policy on the part of bank management. That’s a really important part of preventing or reducing the impact of crises when they hit.
Just a quick follow-up. So we’re sitting here in the Country Analysis Unit at the San Francisco Fed. One of our major roles is surveillance of some of these build-ups and these risks that we’re talking about, and you know that there’s still a lot of progress that could be made. I’m wondering are there specific reforms or improvements to data quality, or is it a matter of off-balance sheet exposures? Could you talk a little bit more about that?
Well, if we’re talking about emerging markets, I think transparency — knowing who owes what to whom and being able to track that in realtime, not just for officials, but also for people in the market — that’s probably the most fundamental issue. Second would be the functioning of the court systems so that when there are claims to be made against a firm or a set of assets or some collateral has been pledged, you’re actually going to get your money back and how long will that take. And thirdly, of course, politics. There’s not much you can do about that, but the politics of protecting powerful interests in particular countries helps them in the boom and can turn into a problem pretty quickly when some of those people prove to have over-borrowed and sentiment shifts dramatically against the country.
Well, thanks so much, Simon. This was a great conversation.
I enjoyed it. Thanks a lot.
We hope you enjoyed today’s conversation with Simon. 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 as frbsf.org. Thanks for joining.