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, we’re concluding our series on the Asian financial crisis, with a recap of some of the key themes and takeaways we got from the series. We’ll also discuss Nick’s recent paper, which is on a topic very relevant to the Asian financial crisis.
So Sean, we had a whole variety of different interviews. We talked to economists, we talked to policymakers, investors, journalists. Got a very wide variety of opinions and ideas about things like, how did the crisis start, was the policy advice given to Asian economies during the midst of the crisis correct? What are the risks Asian economies face now, have they kind of overcome the initial issues of the Asian financial crisis? Looking at all this, how can we pull away some key conclusions? What are the takeaways we should have from all of this?
Yeah, so I feel like there are clearly some key themes, right? You read books and newspapers about the crisis. We’ve talked to various people, and some things come up time and time again, so of course the role of foreign currency debt, and fixed exchange rates, capital controls. How corporate governance and regulation could have helped better. How it’s changed since the crisis. The role of policy responses.
So, I think we heard a lot of different perspectives over the series, but definitely some key themes and maybe we can kind of unpack some of that.
Yeah, one of things we heard time and time again is this issue of foreign currency debt. Of how risky it can be for developing economies and emerging markets to borrow in a currency other than their own. And, you know sometimes that’s unavoidable. When we look at economies that have relatively lower savings rates, or interest rates domestically are very high, it can be very attractive to take on that foreign debt. Especially if it’s at a lower rate than you would be paying back at home.
And during good times, the exchange rate can be very stable, it can make that debt seem much less risky than it can be actually when the economy shifts and suddenly the real borrowing cost of foreign debt can be much, much higher than the borrowers initially anticipated.
Yeah, it’s an interesting point and it makes me think of the last episode with Don Hanna, where he kind of thinks about it from the reverse perspective. That is, foreign investors looking at what seemed to them to be attractive rates of investment, rate of return. And some of that may be because they’re coming from environments where rates are lower and they may not actually be thinking about, what’s the risk premium here, what’s the role of inflation in this economy. And they’re not seeing the difference between that nominal rate, versus the real rate of return.
And that’s one of the things David Dollar mentioned during our interview with him, was that for some borrowers in Thailand that the exchange rate between the baht and dollar had been stable for so long that they had completely discounted some of their risks associated with that foreign borrowing…that changed very quickly. And it ties back into this issue of what is the right currency policy for a lot of these emerging markets? A lot of the consensus prior to the Asian financial crisis was that fixed exchange rates are the way to go. That provides stability for the economy. Businesses and individuals don’t always have to be worrying about what the exchange rate is going to be. That can facilitate trade.
But if you become too fixated on this very stable exchange rate relationship, if that changes, that can suddenly generate a lot of different volatility.
Right, and so I think that is definitely a clear point that’s been hammered home by almost all of our guests, is that, generally speaking, floating currencies are probably the better way to go. But at the same time, building up large foreign exchange reserves, which we’ve seen a lot of these Asian economies do since the crisis, doesn’t guarantee that you’ll be immune from rapid flows and some instability there. I know that a few of our guests have talked about China as an example, huge foreign exchange reserves built up over the past two decades, really. And the question of when is it enough? Is there a certain line in the sand that investors will draw and say, okay, you’re stable here at this level, or is it really just a matter of investor sentiment? And that’s something I think we still don’t completely understand.
And also we saw a lot of Asian economies abandon the fixed peg, after the Asian financial crisis, and move towards more flexible exchange rates. But not quite floating. And you mentioned China, that’s an example of it too where the Chinese currency has become more and more flexible over time, but still pretty heavily managed. And I think that’s also the case for many different Asian economies to different extents, where there’s an acknowledgement that a hard peg is no longer the way to go, but it’s still a bit of discomfort with actually letting a full flow happen.
So moving on from the currency issue, but a related one, is capital controls. And another takeaway that I have is the deliberateness of opening up the capital account and how careful you need to be. And certainly that was reinforced by the crisis. One example that I didn’t really understand fully before we started this series was the Korean case, where they were attempting to gradually open up controls, but as we’ve heard from several of our guests, the sequencing may have been a bit off. So, instead of opening up first to foreign direct investment, which we tend to think of as sticky, something that’s there for the long term, that’s not going to flow out very rapidly in the event of some short term volatility …
An example of that would be foreign companies investing in a factory in Korea. And you know it’s hard to pick up your factory and leave during a period of crisis.
Right. You’re making LCD TVs or phone screens or something like that. But instead of opening up to that, they were opening up to short-term bank financing.
Yeah. The idea that the banking system could intermediate some of these more volatile capital flows. That, okay, if we just have kind of, investment in our stock market as soon as the foreigners get spooked, they’ll pull out all their money and that’ll be very disruptive. But if it’s going through the banking system, it’s financial professionals dealing with other financial professionals. They’ll help kind of moderate and adjust some of the risk. And that can provide a buffer from this really kind of historical trend we see with emerging markets inviting capital in to help them develop, but as soon as they hit a bump, that money flows out. People aren’t sticking around for the long term.
Yeah, and so, and this also gets to an issue that I think Andrew Sheng really highlighted and emphasized, which is, there was really a double mismatch in the Asian financial crisis, and this was particularly unstable. So you had, as we already talked a bit about, this foreign currency mismatch, where you have people borrowing in foreign currency, and then expecting that debt to be constant, and then when the currency depreciates against the dollar, they suddenly have a lot bigger interest payment. So, that’s one mismatch.
But then the other is just this short term versus long term. So if you’re borrowing from investors abroad who are thinking of this as short-term financing, but you’re putting it into really long-term assets that are harder to liquidate in the event of some sort of crisis, that can really be difficult to manage. Particularly in a policy response after the crisis, and we saw that too.
Yeah, and you can see from the perspective of the foreign lender how that makes sense. I’m lending to a relatively risky country, I’m going to manage my risk by just doing relatively short term loans, and I can sort of see what’s going on with the borrower and decide, okay, this borrower is getting into trouble, I’m not going to roll over the loan. That’s how I control my risk. But from the perspective of the entire economy, it creates these real issues, where you can have this cycle of financing being pulled back from borrowers, even the relatively good borrowers. Getting to this issue of contagion we talked about, where sort of during the Asian financial crisis, when one economy got into trouble, all the different Asian economies were sort of lumped into the same category.
And we had a bit of push-back on that from guest like Don Hanna that said, “Oh it wasn’t quite that strong, you know some foreign investors looked at Thailand with suspicion, but they weren’t quite as skeptical of Indonesia.” But overall, one thing we heard throughout the interviews, was this issue of contagion and that when you hit a period of crisis, people aren’t doing the careful delineation between the good borrowers and the bad borrowers. They just know that this country has suddenly become risky, and they want to pull out and reduce their risk.
So, thinking about the Korean example, but generalizing it to some of the other countries. And I think another takeaway that I feel like we heard time and again, was the importance of corporate governance, on the one hand. So just from an institutional level, your own corporate governance, but also regulation and making sure these investment decisions, that the financing going into these assets, that there is risk management going on. And I know Simon Johnson is particularly focused on the role of corporate governance. So, this notion that a lot of these firms, whether they be chaebols in Korea, or conglomerates in Indonesia or Thailand, were really not well managed and that some of this money was really just chasing after bad investments.
It also gets to that issue when we talked Barry Eichengreen… he did a very nice job of laying out the different perspectives of what ultimately caused the crisis. And if you talk to a lot of experts in the US and other western countries, the idea is that really the crisis exposed a lot of the underlying economic weaknesses in Asia. As you mentioned, corporate governance. There was a lot of non-economical lending going on. You know, policy based lending, politically influenced lending, poorly run conglomerates. And all this got exposed, but those fundamental root problems were there.
And then a lot of Asian economists would say, “Well actually, the fundamentals of the economy were okay, it was just this reliance on foreign capital inflows to help finance some of the development was the problem, and that proved to be really unstable.” So, it was really a bump in the road on Asia’s long term growth story. And I think Barry did a very good job of highlighting those two when we talked to him and also kind of giving the synthesis, which I thought, got closest to the truth. There are elements of accuracy to both of those. Yes, there were a lot of corporate governance issues, but when you look at Asia’s issues, they weren’t actually that different from a lot of what we saw in western economies.
Yeah, I think that’s interesting too because I think we see this a lot when we have financial crises. Do you focus the blame on the borrower or the lender? And I think the truth always has to be a bit of both, right? I mean we saw that in the US financial crisis. Were people borrowing way too much to buy a second or third property or was it the people that were actually making the decision to lend them that money?
And clearly you need to think about both perspectives when you’re examining a financial crisis and how to prevent the next one.
And we had multiple guests, including Gillian Tett you know, make that exact point. That a lot of the weaknesses that economists here in the US were very eager to point out in Asia, you know, it turned out to be weaknesses in our own economy just about 10 years later during the global financial crisis.
Yeah and I also think we have to end the series with a bit of humility, which I think a lot of our guests have reinforced, and to say that some of these problems that we did, after the Asian financial crisis, associate with emerging markets, and not just the Asian financial crisis, but Latin American debt crisis. That we tend to associate with developing countries, really a lot of these problems are the same ones that we confront here.
One universal truth that I think we picked up from all of this is that high amounts of leverage are dangerous. That it can be a key weakness in the economy. And that leverage becomes even worse if there is currency risk associated with it, or a maturity mismatch as you mentioned.
Yeah, definitely. And I think also that we have to be careful in policy responses. That there’s a delicate balance between defending a currency, particularly when you have a fixed regime. Managing interest rates against that target, versus also responding to a recession that’s just been precipitated by this crisis. So we saw then in countries like Thailand, where in order to defend the baht, you raised interest rates, but that’s coincident to a moment when the economy is really struggling, and that’s just putting further downward pressure.
So, it’s a real confusing mix of challenges.
Yeah, it seems like in some of these cases that the cure was worse than the disease. And there’s been so much controversy associated with some of the IMF rescue packages. And I think what we heard from a lot of the guests was that, in substance a lot of the reforms being proposed to these countries, to these Asian economies during the crisis were correct. If you want to think about, what are the long term reforms that these countries can make to really get back on the path of growth and development?
But, you really have to take into consideration the specific conditions of a crisis and the political sensitivities around making some of these changes. And that you can actually set back the pace of reform over the long term if you push for it too aggressively during really kind of a disruptive period.
Okay, so I think we’ve hit on a lot of the common themes…
Maybe we should just add one more thing. I was very interested in…we talked about a lot of the common wisdom that was prevalent before the crisis. One of the things was having a stable exchange rate versus the dollar. The other thing was capital controls. And really the mantra used to be, open up the capital account, that’s going to help improve the efficiency of your financial system. That’ll filter down to all different parts of the economy. And I think really, after the Asian financial crisis, there was a real, slow but steady reevaluation of actually maybe having a fully open capital account isn’t the way to go. And that a lot of the economies that implemented capital controls during the Asian financial crisis, like Malaysia, fared better than some of the other ones that didn’t.
So, I think there’s been a real change in thinking about the importance of capital controls and that maybe having a fully open capital account isn’t the way to go for emerging markets.
Yeah certainly the Asian financial crisis was maybe the beginning of the end of the broad assumption that free finance is good, that freely flowing finance is good. It’s interesting today, free trade is a controversial topic around the world, but if you talk to most economists, they still would tend to advocate for generally free trade, assuming you can distribute the gains of it fairly, and pay attention to those that lose out.
But you don’t necessarily see as many economists who are really gung-ho about really free finance in all its forms. And purely liberalized financial systems for countries that maybe aren’t ready for it.
So, we asked I think every guest we had on, we asked them to talk about how far Asia has come since the financial crisis and what did they see as the main risk. And I think we heard some definite similarities and themes across a lot of the answers that we got.
Yeah, I think it was natural for guests to try to think of an example of a country that may face some of the same risks moving forward, and I think we heard a few people mention China. Of course, the situation is different for a few different reasons, the role of capital controls, and the huge foreign exchange reserves. But also, there are some specific vulnerabilities there.
Yeah, you know, circling back to the issue of debt and rapid increases in credit and leverage, I think a lot of people see the developments in China over the past couple of years where the economy has started to slow down. It’s still growing relatively rapidly, but it’s not what we were seeing a decade ago, so you know, China’s slowed from 9-10% GDP growth to 6 and a half percent now.
But at the same time, the credit, lending, the overall financial system has grown very quickly. So, not only has the formal banking sector more than doubled since the financial crisis, but then we also see lots of developments in the shadow banking sector. All sorts of kind of market based, outside traditional lending lines, financial developments that a lot of people have focused in on as potential risk points.
Yeah, and I think Don Hanna talked about this specifically, but the role of innovation in spurring productivity growth and the importance of some financial innovation in that process. But also the risk that can create. And we talked with him as well as David Dollar and others about the role of shadow banking, as you just mentioned.
I think another interesting challenge that China faces, to the extent we want to think about the risks 20 years later after the Asian financial crisis and how that crisis can inform our forecast for the future, unlike any of these other Asian economies in the late 90s, China now is, depending on how you look at it, the second or the largest economy in the world, while their financial system is still relatively closed to the global financial system, they move markets, and to be undergoing a very challenging transition for an economy of any size, but to be doing it when the Chinese economy itself moves the markets against which you’re managing, it’s a really difficult, and you could probably comfortably say, it’s an unprecedented challenge.
Yeah, and tying it back to the Asian financial crisis, one of the arguments we heard for what led to crisis in the first place, was that a lot of these Asian economies were trying to make the transition from their high-growth developing country period, into more middle income status. Moving away from reliance on exports and investment and trying to promote consumption in a balanced growth model. And when that transition sort of stalled or didn’t happen as quickly as people thought it would, that was one of the key weaknesses that eventually allowed the crisis to occur. And China is very much right in the middle of that transition. And so there’s a lot of talk in China about the middle income trap, you know, can China shift its entire growth model from this export-oriented, investment-focused growth model to something that’ll be more sustainable over the long run.
And I think the Asian financial crisis provides a lot of lessons for how difficult that transition can be.
So, one of the trends since the crisis, and one of the goals I think of Asian regulators and policymakers was to create a little bit more resilience in the financial system through alternative means of financing economic activity. And so, we’ve seen a lot of efforts over the past 20 years to develop non-bank financial markets in these countries, and you’ve actually just completed and published a research paper on the topic. So maybe we could talk a little bit that, and how that links into all of this.
Sure, yeah. So, I think one of the interesting things about the Asian financial crisis, is it really exposed how bank dependent a lot of financial systems in Asia were at that time. That, to use the famous words of Alan Greenspan, Asia had “no spare tire.” So much of credit intermediation in the economy was done entirely through the banking sector; that capital markets were relatively underdeveloped. That during the crisis, when the banking sector got into trouble, there was no other channel to get credit to the economy, so the entire economy sort of seized up and it had really enormous ramifications throughout the entire region.
So, after the Asian financial crisis, there was a lot of soul searching and saying, Well what we really need is…One of the solutions to prevent this from happening again is to really develop an equity market so that when companies need financing they’re not entirely dependent on these banks who have proven that they can basically get into situations where they’re completely frozen up and unable to make the loans that the rest of the economy needs.
So, both, within many Asian economies, and together as a region, there was an effort to develop local currency bond markets. So it’s important that it’s a local currency so we don’t get into this issue of currency mismatch that we mentioned before. So if you’re borrowing in your own currency, if you get into trouble economically, you’re not suddenly going to face a huge increase in the real debt burden because your exchange rate has depreciated.
And then the other benefit from developing bond markets is also that bond issuance tends to be longer term. So we talked about many of the foreign loans in Asia prior to the Asian financial crisis were pretty short term, of about a year or less. That can be very difficult if you’re investing in a business that’s going to take 5, 10, 15 years to actually pay off your investment. So, being able to issue a longer term bond provides you a much more stable system of financing. So across Asia there was an effort to create these local currency bond markets as a way to solve one of the key and fundamental risks of Asian financial crisis.
So, let’s talk a little bit about how that looks. What are the sizes of these bond markets now, who are the typical borrowers, and who are the people investing?
So, I think at a high level you would have to say that it’s been very successful. If you look at the growth of local currency bond markets in Asia, it’s been tremendous. Since the Asian financial crisis, most markets have seen an increase of many, many multiples and so from that perspective you would say, “Well yeah, these policymakers really achieved their goals.” They were able to create this new channel for financing separate from the banking system. But what I found in the paper is when I looked a little deeper, that it wasn’t quite the success story that you would initially believe it to be.
If you look at the issuance of government bonds, government bond markets in Asia, I think that’s actually been pretty successful. So, many Asian governments have been successfully able to build government bond markets so that they can finance their normal operations in their own currency at relatively reasonable rates, given the different risk profiles. When you look at the corporate bond markets, it’s been a different story. Some corporate bond markets in Asia have grown very quickly. I think the Korean corporate bond market is a great example of that.
Then you look at the Chinese corporate bond market, which has grown quickly, but is not as efficient or robust as you might initially like. So it tends to be dominated by state owned issuers. It’s not much of a secondary market. There are some real concerns about risk pricing and the overall sort of robustness of the market.
Yeah, so one question is, do we see many defaults? How do we know how the markets respond to a big creditor going under? Are we seeing that?
So, corporate bond defaults in China are increasing but they’re still pretty limited given the relative size of the overall market. And then there’s a real kind of lack of transparency once these defaults happen. A lot of times they’re kind of worked out behind the scenes. There’s not a very well-established bankruptcy and recovery procedure that you would see in more developed bond markets.
Yeah. I mean I think it’s interesting on the spare tire argument because I guess the question is, in the event of a really big banking crisis, would that be coincident with a broader economic downturn where the markets in general would be entering a risk-off kind of status. I guess one real, theoretical question is, in practice, how do these markets serve as a spare tire? Is it always the case that they’re going to be functioning at the time that the banking system is under distress?
Yeah, it’s a good point. So we talked about the development of bond markets in China and Korea, but then if you look at some of the Southeast Asian economies, the ones that were in some ways the most impacted by the Asian financial crisis, the development of bond markets, particularly corporate bond markets there has been much more limited.
And so I think it’s very much an open question whether they’ve achieved their goal of creating a spare tire. And in the periods of instability we’ve seen since the Asian financial crisis, whether it’s the global financial crisis or the Taper Tantrum in 2013, these economies are still the ones sort of experiencing the most financial volatility during these periods. So, I think it’s not very clear cut that these economies have achieved their initial goal of creating these sort of sustainable, resilient forms of financing that aren’t impacted by global volatility.
So thinking about this from a domestic investor perspective, in all of these economies, but we’ll look at China of course as the biggest bond market in the region. What does the typical investor look like? When you look at the Chinese equity market for example, while institutions may hold a lot of outstanding stock, the trading is really done by retail investors. And that’s not always a good thing from the perspective of volatility, for example. But I’m wondering, so what do the bond markets look like in terms of who’s investing and who’s trading?
So, the largest holders of Chinese bonds tend to be banks, insurance companies, and other types of financial institutions. And one of the key problems sort of handicapping the development of the market is they’re buy and hold. So sometimes they’re buying it for liquidity purposes or for banks sometimes to count towards capital. But they’re buying bonds and holding them and there’s no secondary market. And so it’s really hard to get those…to get a healthy dynamic market with real yield curves if people just buy a bond and hold on to it, and there’s no secondary market trading.
It’s also interesting to hear you say that about the banks because, how much of a spare tire is it if a lot of the investment is coming from the banks that are the normal tire, right?
Exactly. So a lot of people would argue that it’s just an alternative form of bank lending if, instead of a bank making you a loan, you issue a bond and the bank buys the bond. Economically that’s not a whole lot different than just getting a bank loan in the first place.
Right. It gives accountants more things to do, but at the end of the day what is…yeah.
So, one of the conclusions I came to on this paper was that, yes on this kind of idea, this goal of creating these robust bond markets, there’s been a mixed amount of progress. Some Asian economies have done very well; some of the smaller more affected economies haven’t done as well. But the big change between the Asian financial crisis then, and what we see in Asia now is that Asia’s really emerged as a large net creditor to the rest of the world. And the initial problem of having to rely on foreign financing to fund your development, for a lot of Asia is no longer an issue. Some of this has been response to the crisis where Asian policy makers have really increased their financial reserves…foreign exchange reserves as a form of self insurance.
But yeah, the overall result now is that a lot of Asian economies, instead of needing to borrow, are actually big lenders to the rest of the world.
Yeah. I mean it’s a sea change. It’s also interesting again, thinking of this as a zero sum game, as you sometimes do, but if you read someone like Ben Bernanke in talking about the 2008 crisis, he puts some explanation on the growth of Asian savings and the build-up in these reserves, as sending money into US capital markets and the banking system and the imbalances there. And how that may have contributed to our own crisis.
So it’s kind of this constant game of cat and mouse, I guess you might say. And it’s interesting to see how one region’s response to a crisis, which is rational and in a lot of ways, healthy, can lead to problems in other parts of the world.
Yeah, exactly. So they…A lot of Asian countries solved the initial problem of this foreign funding vulnerability, but through the process, they’ve created some new problems. So, one thing is, once you have all these foreign exchange reserves, you have to find a way to invest them. And that can often be difficult. That means you have to become a big player in things like the US treasury market, or you have to create sovereign wealth funds to find ways to invest all these reserves that you’ve accumulated.
The other issue is that, if you are building up foreign exchange reserves through careful management of your currency, that can have all these sort of domestic ramifications. You can skew your own development in ways that kind of suppress consumption and promote exports and investments in a way that’s, ultimately for long-term economic development, probably not the best outcome.
Alright, well it sounds like if you’re interested in this discussion you should go find Nick’s paper. It’s excellent. Very well written, very clear, a lot of good data in there. But yeah, I guess to sum up, there’s been significant progress made, but by no means is the work over and there’s a lot to monitor as these bond markets continue to develop.
Yeah, and that the lessons and ramifications of a crisis that happened 20 years ago, and I think is often overlooked by many people, are still extremely important for what’s probably the most dynamic economic region in the world today.
So we hope you enjoyed the Asian financial crisis series in general and this recap as well as some analysis of Nick’s recent paper. And I’m sad to say that this is actually Nick’s last episode hosting the podcast and we’ll be sad to see him go. This has been a lot of fun and hopefully you guys have learned a lot from him.
Yeah it’s been a great experience. I’ll definitely miss doing this. But I hope people continue to come back and listen because there’s a lot of great content coming up for Pacific Exchanges.
Well thanks so much for joining us today.
We hope you enjoyed today’s conversation. For more episodes like this, you can find us on iTunes, Google Play and Stitcher. If you like what you hear, please leave a review. Feedback from listeners like you will help more people find us. And for even more content, look up our Pacific Exchange blog, available at frbsf.org. Thanks for joining us.