Home > APSC 1998

Tigers in Crisis

By Jomo K Sundaram

[This paper was presented to the Asia Pacific Solidarity Conference, Sydney, April 12, 1998 by Professor Jomo K. Sundaram, Faculty of Economics, University of Malaya]

Basically, my argument is that the East Asian economic crisis is not what it is often reported to be. There was, in the early weeks after the crisis first broke in early July last year (1997), an assumption that the problem was essentially due to what economists and financial analysts call macro-economic fundamentals gone awry.

This argument was put to rest within the first couple of months, by about August or so, when it became increasingly clear that it could not be sustained since the economies of East Asia were basically doing most of the things the IMF and the World Bank wanted them to do, except for the problem of the current account, i.e. the sum of the merchandise account and the services account, meaning basically everything traded, especially goods and services.

Most of these economies in East Asia were running current account deficits, with the most serious ones in Malaysia and Thailand, while other economies in East Asia were running smaller deficits.

But it is important to point out that 1997 was not an exceptionally bad year, and the Deputy Managing Director of the IMF later acknowledged that the current account deficits in 1997 were lower than the current account deficits in 1995.

As far as other so-called macro-economic fundamentals were concerned however, the East Asian situation seemed basically quite all right. The governments were maintaining fiscal surpluses, high savings rates and relatively low single-digit inflation rates. Hence, there is very little evidence that this was essentially a macro-economic problem.

The second explanation that has become popular since then is captured by the slogan of crony capitalism. Crony capitalism is a catchall term that refers to all kind of things that the individual using it considers to be undesirable. It might be best summed up by other kinds of terms very much used in the financial world, words like ``relationship banking''.

We argue that although crony capitalism does not explain very much, it is not absent from the story. Crony capitalism has been very much a feature of business practices and economic systems everywhere, including this part of the world, and there are, in some important ways, significant differences between East Asian ways of doing business and, say, Anglo American or Australian ways of doing business.

Some of you might be familiar with those who compare business systems like Michel Albert who wrote Capitalism versus Capitalism, where he basically makes an argument about how Anglo American capitalism differs from continental Europe. Other people have put forward arguments about how Japanese capitalism is quite different too, while yet others have argued how East Asian capitalisms are organised differently.

I don't want to throw crony capitalism out completely, but I do not think this argument explains very much. In any case, these systems have been in existence for a long time and their existence cannot explain the crisis as such.

My own view is that the crisis has to be understood primarily as an unintended consequence of aspects of financial liberalisation in the region, partly due to the ascendance of finance capital, particularly in the last few decades. There are many aspects of this. Let me now try to sketch out what I believe to have been important in the long- as well as medium-term. Let me outline trends that set up the situation in mid-1997, for the currency and subsequently, financial and then economic collapse which we have seen in the region.

As all of you know, 1929 was the year of the Great Depression; it too started as a crisis of finance capital. This was recognised by people like Keynes, who talked about problem of casino capitalism. Now, the inability of capital to get its act together is reflected in that it took almost 15 years before a new system could be devised.

The Bretton Woods meeting in 1944 towards the end of the Second World War basically set up the main institutions of governance of the post-war international economic system, and helped ensure US hegemony by making the US dollar and gold the lynch-pins of this system. The price of gold was set at US$35 to an ounce of gold.

This system basically lasted till 1971, when President Nixon withdrew the US unilaterally from this system, which meant the collapse of what many people call the Bretton Woods system. The collapse had a lot to do with the fact that European bankers were no longer prepared to continue to ``bank'' the Vietnam war.

The Vietnam war, much more than the Korean war, demanded tremendous expenditure abroad by the US, which was partly bankrolled by the rest of the world who were quite prepared to accept the US dollar as the de facto world currency. By 1971, this was no longer sustainable, and the reluctance of the Europeans particularly brought about the collapse of the system. A couple of years later, a new system was inaugurated, a system of flexible exchange rates.

One feature of this system important for our discussion today is that flexible exchange rates basically meant you created the conditions for a growing market in currencies/foreign exchange. And so by 1985, for instance, Peter Drucker pointed out that the volume of foreign exchange spot transactions was 11 times the volume of international trade-related transactions. By 1996, The ratio had increased to more than 40 times. Two per cent were trade-related transactions and 98% were not trade-related international currency transactions.

Because there are different ways of measuring and many transactions are not actually recorded, there is so debate about the percentages but no disagreement about the very small percentage of international currency transactions that are trade-related.

Let me very quickly go to more recent developments involving East Asia. The two developments we should recognise are those that basically come out of the debt-related economic crisis of the early 1980s.

In the late 1970s, because of the availability of petro-dollars, which were recycled largely through European and American banks, there was a great deal of money going around. And with high inflation rates at that time, you had relatively low real interest rates and, at moments, even negative real interest rates.

It was very attractive to borrow money in those days, and there was so much money lying around that they were actually people going around pushing debt. Some of you might remember the famous Bob Marley song about the debt-pusher going around from capital to capital with their James Bond attache cases basically pushing debt. If bankers did not lend the money in the banks, they wouldn't make money. At that time, because of relatively low real interest rates, there were many willing borrowers, particularly governments in the Third World, mainly Latin America and certain parts of East Asia.

This situation changed after the appointment of Paul Volcker as the chairman of the US Federal Reserve, who tightened up liquidity. Real interest rates went up, and this precipitated the crisis that we often associate with Latin America, but which actually started in 1981 in Poland, followed by Mexico in 1982, and the rest of the debt crisis story, which you are all familiar with.

That experience led to an analysis of currency crises which focused very much on public sector debt. Ever since then, there has been a near obsession on the part of the Bretton Woods institutions, particularly the IMF, with bringing down public sector debt.

This whole situation also allowed these Bretton Wood institutions to bring about a number of reforms, with the IMF in charge of short-term reforms often referred to as stabilisation programmes, mainly referring to price stability, i.e. bringing down inflation.

Meanwhile, the World Bank came in with medium term reforms often referred to as structural adjustment programmes or SAPs. And these reforms have dominated and transformed the South since the 1980s. These reforms have had, as a centre piece, financial liberalisation. And you have particularly from the 1980s, a subsidiary of the World Bank, the International Finance Corporation (IFC) promoting emerging stock markets. This has happened in many developing countries, but also, especially after the collapse of the Berlin Wall, in the so-called transitional economies. So you have this big promotion of newly emerging stock markets by the IFC.

At the same time, there has also been a significant growth in lending, this time not to the public sector, because of what happened in the early 1980s, but primarily to the private sector. Now, coupled with this has been a proliferation of many new financial markets. (I emphasise markets because I am talking about a whole variety of options.) In their book The Global Trap, Schurman and Martin estimate that by 1996, there were about 17,000 markets to choose from. Now in each market, you have a variety of options, which are available to a fund manager. So you have a tremendous movement of funds which has been taking place since then.

For a number of reasons, since the mid-1980s, Southeast Asian economies, mainly Thailand, Malaysia and Indonesia, have undertaken, in most cases voluntarily, the kinds of reforms that were imposed elsewhere by the Fund and the Bank, as well as other reforms considered to be attractive and desirable to fund managers.

These three countries in Southeast Asia all had very major devaluations in the mid-1980s. Indonesia had three beginning from 1983, Thailand had a devaluation in 1984, and the Malaysian government devalued the ringgit from RM2.4 to RM2.7 against the US dollar from around the time of Plaza Hotel Accord of September 1985. These devaluations were followed by the massive depreciation of the US dollar against the Japanese yen as well as other currencies.

To get some sense of the magnitude of this devaluation, in 1984, the Malaysian ringgit was at about RM1 to 100 yen, but by 1986, RM1 could only get you 50 yen, i.e. there was a massive devaluation, by half, against the yen.

This resulted in tremendous direct foreign investment, which means investment in productive capacities in Southeast Asia. Originally primarily from Japan, and then subsequently from the first generation East Asian newly industrialising economies (NIEs), mainly Taiwan and Singapore, and, to a lesser extent, South Korea and Hong Kong, which had pegged its dollar to the US dollar from 1983. Besides the consequences of the appreciation of their currencies, there were other pressures on the first generation newly industrialising economies of East Asia.

For example, withdrawal of privileges under the General System of Preferences, or GSP, made their exports much more expensive in the importing economies. There were also labour shortages, which meant that wage costs were going up. So, there was a tremendous relocation of production capabilities into Southeast Asia, where a boom began in the late 1980s.

In the early 1990s, the US dollar continued to remain weak against the other major currencies. And so the virtual peg of the Southeast Asian currencies against the US dollar maintained their competitiveness.

The situation began, however, to change from around 1994-95. 1994 was also important because China had its second major devaluation that year, the first having been in 1990. This was followed by the appreciation of the US dollar from mid-1995. The US economy had been begun to strengthen from 1993, and by 1995, there was pressure on the US dollar to rise. At the same time, the Japanese economy was in serious trouble. Sakakibara, now the Japanese Vice-Minister for Finance (International Affairs), arranged for the US to allow the yen to go down since then. In the second quarter of 1995, the yen was somewhere around 79 yen to the US dollar. Today, it is well over 130 yen against the US dollar. A similar development happened in early 1997 with the Deutschmark.

But the Southeast Asian economies had pegged their currencies against the US dollar throughout this episode. I would argue that the one of the main reasons for this has been the ascendance of finance capital in Southeast Asian economies and the relative weakness of exporting industrial capital. Industrial capital in Southeast Asia, one has to remember, is not very internationally competitive, with its exporting component heavily dominated by foreign investment.

This contrasts with the situation in the first generation newly industrialising economies, as well as in Japan, where you have significant indigenous manufacturing capability that is internationally competitive. You don't really have that in Southeast Asia, though perhaps a bit more in Thailand, and a bit less in Indonesia.

This dominance of finance capital as well as the prevailing ideology at this time favours stability, with a virtually pegged exchange rate against the US dollar, and low interest rates. So, although it was against the interests of the Southeast Asian economies, especially those who want to export, the peg continued to be maintained after mid-1995.

The first economy to suffer, it is now generally agreed, was Thailand, partly because it had the most domestic manufacturing capacity owned by Thais, who were less able to compete after the 1994 devaluation, with the baht going up with the US dollar against other currencies. So Thailand had difficulty competing, and the failure to invest much more in education and training of human resources also meant that they could not generate the increases in productivity which would have made them much more competitive. By 1996, Thai export growth was coming down, and Thai growth in general was also being adversely affected, though not as dramatically, because of the continuous build-up in construction which had begun much earlier.

One also has to remember that the region has had very high domestic savings rates, at least 35 per cent of GNP. The massive flow of capital from abroad, came to somewhere around 4 to 6 per cent more. So in addition to your high domestic savings rate, you had foreign savings coming in, and an investment rate of something above 40%, 45% in the case of Malaysia in 1996, for instance. That is an incredibly high investment rate by any standard, but most of this was going into economies losing international competitiveness.

Because internationally competitive manufacturing capacity was dominated by foreign capital, most of it was not being traded on domestic stock markets in Bangkok, Jakarta, Kuala Lumpur or anywhere else. And so you had these funds going into the system, contributing to asset price inflation. The International Monetary Fund (IMF) and others were very pleased that this was not contributing to consumer price inflation. The money was going into the stock market and the property market. The middle class was partaking in this because there was also a great deal of consumer credit available. So you had a lot of car purchases, house purchases, and so on and so forth.

In Thailand and Indonesia, the financial system was more bank-based, whereas in Malaysia and the Philippines, it is more stock market oriented. This is partly due to the colonial heritage and post-colonial influences. Malaysia was colonised by the British, and the Philippines by the Americans.

Now, many of us favour a bank-based financial system because bank-based financial systems are better able to direct funds for productive investment that enhance the productive capacities in an economy. However, most of the money being lent was not really enhancing the productive capacities of

these economies. In the case of Malaysia, about 22% went for manufacturing, another 2% for agriculture, i.e. less than 26% actually went into productive investment. The rest of bank credit went to buy houses, to buy stocks, consumer durables, etc.

As for as the foreign money coming in, one knows even less about what was actually happening to the money, but you can be sure that the share of foreign financial resources actually going into productive purposes was even less. So the consequence of all this was that on the one hand, growth was going down, while the current account deficit was not necessarily growing but certainly not diminishing drastically.

This situation, with all the foreign money coming in, was very desirable for governments like Thailand and Malaysia to bridge the gap due to construction activities and increased import substitution manufacturing. Construction activity does not directly bring in foreign exchange except perhaps for tourism. There was a current account deficit, and the foreign money coming in was closing this current account deficit.

This situation seemed very desirable from the point of view of the domestic financial and monetary authorities. So the Ministries of Finance and the central banks, which many foreign observers thought to be the embodiment of financial integrity, endorsing the Titanic. In the case of Thailand for instance, they always talk about how everybody else is corrupt except the Ministry of Finance and the Bank of Thailand. But these people, the paragons of integrity, were basically responsible for sustaining this potentially disastrous situation.

The over-valued Southeast Asian currencies, especially the baht, were thus ripe for currency attack. Fund managers saw the opportunities, and tried to take advantage of them, betting against the currencies very successfully. In November 1996, there was the first attack on the baht, in February 1997, the second attack, in May 1997, the third attack. And finally, with the fourth fatal attack beginning in June 1997, the Bank of Thailand had run out of reserves and couldn't defend the baht anymore.

The Malaysian monetary authorities tried to defend the ringgit, unsuccessfully, and lost over RM8billion doing so. The Indonesian authorities lost about US$1.5billion in a one-day defence of the rupiah. The peso too went down without much of a fight. This spread to the other economies of the region called contagion can be attributed to herd behaviour, related to what Keynes used to call the animal spirits of investors.

In a situation of uncertainty, these people control a tremendous amount of funds and basically bake safe options, usually following what everybody else is doing. There is a strong tendency to encourage conformist behaviour, and the incentives for fund managers are usually structured in such a way as to encourage conformist or herd behaviour.

Now, the Southeast Asian economies are poorly integrated among themselves. Trade among Southeast Asian economies as a proportion of their total trade actually declined until the mid-1990s when the ASEAN Free Trade Area (AFTA) got going. And if you take out trade with Singapore, you find that intra-Southeast Asian trade was quite negligible. Southeast Asia s major trading partners are actually Japan, the US and Europe.

In the nine months since mid-1997, we have seen a tremendous outflow of funds from the region. And although the proportion of funds that has come out of the region is probably no more than around 20% to 30% of the amount of money that has went into the stock market, for instance, the influence of this minority share is actually quite huge.

As far as the stock market in Malaysia is concerned, the index at its highest point in early 1997 was over 1,300. At its lowest point, it collapsed to below 500 early this year. In other words, it lost more than two-thirds of market capitalisation less than a year. And the same, with some variations, is true for the rest of Southeast Asia. In the case of Thailand, the baht fell much more. The stock market fell much less because Thailand s stock market is less important. In Indonesia, one could say likewise. The currency dropped much more, but the stock market dropped much less.

What is dragging down the stock market? Initially, it was the rapid withdrawal of funds from the region. In the case of Malaysia, however, Prime Minister Mahathir's remarks aggravated the situation. This doesn't mean he was necessarily wrong in everything he said, but only that he was not saying what the markets wanted to hear. So he, his country and the region were punished. He was the favourite regional demon from around the end of August right up to the beginning of December 1997, when Suharto took over.

What the situation shows us is the power of markets to bring about conformist behaviour. Much of the discussion in East Asia generally has been about confidence restoration. What is confidence restoration? Confidence restoration desires to restore the status quo ante, i.e. the previous situation as if that was desirable. And if the previous situation could be restored, it would eventually develop into a similar type of situation ripe for a similar crisis at a future point.

But as far as the people who dominate policy-making are concerned, this is what is desirable. So confidence restoration is the priority. If you do not conform or do things that are regarded as desirable, then you get punished. This is what happened to Mahathir, and not only to Mahathir, but also to other Southeast Asian economies and markets. So there was pressure from others in Southeast Asia to tell Mahathir to shut up. The situation in Indonesia since late 1997 has had similar consequences for the region.

All this has been due to a particular view of what has been desirable, namely financial liberalisation. Financial liberalisation is the ideology and policy of the contemporary ascendance of finance capital. The proponents of financial liberalisation claim a number of gains from financial liberalisation, which have been false, erroneous and misleading:

1. There would be a net flow of funds from the capital rich to the capital poor countries. The record does not bear this out. There has, in fact, been a flow of funds in the opposite direction, though not huge. But as far as East Asia is concerned, before mid-1997, there was a significant flow of funds into the region. In other parts of the world, e.g. Russia, when they opened up its capital account, there was a massive outflow, i.e. capital flight.

2. The cost of funds would decline. In fact, the cost of funds has actually gone up.

3. With innovation in the financial markets, particularly with financial derivatives, the sources of volatility and instability in financial markets would be reduced. The record, however, suggests that while specific sources of volatility have been reduced, the new derivatives have in fact contributed to greater instability.

Let me give you a simple example. Hedge funds have basically reduced some risks due to changes in the exchange rate. But hedge fund managers now have huge funds at their disposal which they then deploy in ways so as to make money to offset likely losses due to exchange rate instability, and that in turn introduces a great deal of instability into the market.

4. Financial liberalisation is supposed to be good for growth. In fact, it has been shown that financial liberalisation has introduced a persistent deflationary bias into the system. Growth has been much slower throughout the world with greater financial liberalisation since the 1980s. This is true of not only the developing countries of the Third World, but also of the advanced capitalist countries, continental Europe for instance. In fact, until recently, one could say the same thing about the US or UK. So there is no basis for this claim that financial liberalisation will actually enhance growth.

5. Financial liberalisation at the global level has also greatly reduced the scope for national economic initiatives, for industrial policy, for instance, which has been quite crucial for the late industrialisation of East Asia. It is true that in Southeast Asia in particular, we have seen much more abuse of government initiatives than elsewhere, particularly compared to the first generation of East Asian newly industrialising countries for different reasons.

In Thailand for instance, probably due to the political situation. In the case of Malaysia and Indonesia, stable regimes have abused governments to aggrandise themselves besides embarking on policies which are growth oriented and which may bring certain advantages in terms of bringing political credibility to the regimes by ensuring certain benefits to the public at large.

Let me conclude by saying that there is a huge debate now on what is being done by the IMF. The IMF is literally being criticised from the Left, Right and Centre. It is a completely unprecedented situation in many ways. The criticisms are quite different and there is a tendency in some of the discussions of the role of the IMF to almost opportunistically collect as many possible criticisms of the IMF as possible even though some are mutually contradictory.

I have not gone into the South Korean case, partly because its timing is different, the origins of the crisis are different, the magnitude of the debt situation is different, the organisation of the economy and business, i.e. capitalism, there is different, and so on and so forth.