The Asian financial crisis: Crisis, reform and recovery

Sharma, Shalendra D. Book — Published Version The Asian financial crisis: Crisis, reform and recovery Provided in Cooperation with: Manchester University Press Suggested Citation: Sharma, Shalendra D. (2003) : The Asian financial crisis: Crisis, reform and recovery, ISBN 0-7190-6603-4, Manchester University Press, Manchester, https://doi.org/10.7765/9781526137685 This Version is available at: https://hdl.handle.net/10419/181916 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/4.0/ i The Asian financial crisis ii iii The Asian financial crisis Crisis, reform and recovery Shalendra D. Sharma Manchester University Press Manchester and New York distributed exclusively in the USA by Palgrave iv Copyright © Shalendra D. Sharma 2003 The right of Shalendra D. Sharma to be identified as the author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. Published by Manchester University Press Oxford Road, Manchester M13 9NR, UK and Room 400, 175 Fifth Avenue, New York, NY 10010, USA www.manchesteruniversitypress.co.uk Distributed exclusively in the USA by Palgrave, 175 Fifth Avenue, New York, NY 10010, USA Distributed exclusively in Canada by UBC Press, University of British Columbia, 2029 West Mall, Vancouver, BC, Canada V6T 1Z2 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data applied for ISBN 0 7190 6602 6 hardback 0 7190 6603 4 paperback First published 2003 11 10 09 08 07 06 05 04 03 10 9 8 7 6 5 4 3 2 1 Typeset in 10/12 pt Times by Graphicraft Limited, Hong Kong Printed in Great Britain by Bookcraft (Bath) Ltd, Midsomer Norton v Contents List of tables and figures page vi Acknowledgements vii 1Introduction: issues, debates and an overview of the crisis 1 2Thailand: crisis, reform and recovery 66 3Indonesia: crisis, reform and recovery 123 4Korea: crisis, reform and recovery 180 5The domino that did not fall: why China survived the financial crisis 252 6Beyond the Asian crisis: the evolving international financial architecture 284 7Conclusion: post-crisis Asia – economic recovery, September 11, 2001 and the challenges ahead 340 Bibliography 354 Index 392 vi List of tables and figures Tables 1.1 Rate of currency depreciation 1997–98 page 1 1.2 Changes in real GDP (%) 4 1.3 Asia’s foreign bank borrowing as of June 1997 19 1.4 Short-term external debt and international reserves pre-crisis: 2nd quarter of 1997 32 1.5 Domestic credit and growth-rates 33 2.1 Capital inflows 73 2.2 Structure of Thai exports, 1981–93 73 4.1 Debt/equity ratio of the top 20 chaebols 209 6.1 Official exchange-rate regimes in selected Asian countries 327 Figures 4.1 Major financial liberalization measures in Korea 204 5.1 Structure of China’s banking system 261 6.1 Major exchange-rate regimes 324 vii Acknowledgements This project has incurred debts of gratitude too numerous to mention. Nevertheless, I would like to thank a number of colleagues who graciously took time from their busy schedules to comment on the whole manuscript or the various chapters. All these individuals have made indelible impressions on this study and improved this work immeasurably. I wish to express my appreciation to Barbara Bundy, Rudiger Dornbusch, Barry Eichengreen, Hartmut Fischer, Tetteh Kofi, Richard Kozicki, Michael Lehmann, Man Lui-Lau, Charles N’Cho, Bruce Wydick and numerous colleagues at the IMF, the World Bank, and the Asian Development Bank, and also to the anonymous reviewers for Manchester University Press. Colleagues and friends at Bank Indonesia, the Bank of Thailand, the Reserve Bank of India, Bank Negara Malaysia and the Singapore Monetary Authority opened doors for my research and provided me with many useful contacts and logistical support. None of these individuals bear any responsibility for the flaws in my analysis, albeit they deserve much of the credit for that which proves useful. I would also like to acknowledge the inspiring leadership of Stanley Nel, Dean of College and Arts and Sciences at the University of San Francisco. Dean Nel has not only single-handedly established a supportive environment for excellence in research and teaching at the college; his guidance, stern encouragement and mentoring has made an invaluable contribution to my professional and intellectual development. I could not have completed this project without his consistent support. Thanks also to Tony Mason, Richard Delahunty and the entire team at Manchester University Press for their professionalism and high standards and for shepherding the manuscript into a book. The fact that this book is published by the distinguished Manchester University Press makes my many months of toil on this project worthwhile. My profound thanks also to my mother, sister and brothers for the boundless support and encouragement they have given me over the years. Regretfully, my father, who made a lifetime of sacrifices for his children’s education did not live to see this book. My greatest debt, however, is to my wife Vivian and our son Krishan. They have seen this book’s long journey from the beginning to the end. However, they never wavered once in their support. It is safe to say that without their support and love this book would never have been written. I dedicate this book to them. The Asian financial crisis 6 led to further depreciation of the ruble, bringing in its train Russia’s loss of access to international capital markets, a virtual collapse of the banking sector and the accumulation of large external arrears.14 The widespread expectation among market participants that Russia would receive a rescue package because it was “too big to fail” turned out to be wrong. Indeed, the speed of the Russian collapse brought home the message that no country (not even a nuclear power) was too big to fail. The Russian default was particularly traumatic, sending investors throughout the world scrambling for cover and inflicting heavy losses on a number of large financial institutions. In fact, so severe was the impact of the Russian crisis that interest rate spreads widened significantly, seriously straining the financial markets in the United States and other industrialized countries. With the Russian experience still fresh, investor confidence made another sharp volte-face in perception of sovereign risk. Inevitably, this triggered a new round of large-scale capital outflows from emerging markets, including Brazil, the world’s ninth largest economy (after the G-7 and China), and the other country once deemed too big to fail. Although Brazil’s ambitious inflation stabilization program, the Plano Real (introduced in July 1994), had made exemplary progress towards restoring price stability and productivity growth and reducing inflation between 1994 and 1998 (after decades of out-of-control inflation), it failed to contain the fiscal deficit adequately. The fiscal deficit, estimated at 8 per cent of GDP in 1998, also contributed to a widening of the external current account deficit to 4.5 per cent of GDP in 1998.15 These substantial fiscal and trade deficits and the structure of public debt (which makes the government’s finances extremely sensitive to changes in short-term interest rates and the exchange rate), made Brazil highly vulnerable to changes in investor sentiment – in particular, the widespread sentiment in financial markets that Brazil’s crawling peg was simply not sustainable. To stem the huge outflows of US$12 billion in August and another US$19 billion in September 1998, the Brazilian authorities increased official interest rates to more than 30 per cent in September 1998 and to more than 40 per cent in October, and announced several fiscal measures, including substantial spending cuts, to stabilize the real (IMF 1999, 49). However, this brought only temporary relief. By late September, Brazil’s foreign reserves had dwindled to US$45 billion, below the level of its short-term debt. As the real came under renewed pressure from speculators the Brazilian government sought external assistance.16 In November the IMF announced a US$41.5 billion multilateral loan package (with the IMF contributing US$18.1 billion under a three-year Stand-By Arrangement), to sustain the value of the real and help Brazil with its balance of payments problem.17 However, the calming effects of the IMF program were short-lived. The failure by the authorities to reach political agreement on the fiscal adjustment program prevented Brazilian congressional approval and further undermined Introduction: issues, debates and overview 7 investor confidence. In December 1998 the Brazilian congress again failed to pass a critical component of the fiscal package (pension reform legislation), and in early 1999 the important state of Minas Gerais threatened to suspend servicing its debt to the federal government. Market concerns were immediately reflected in increased capital outflows, and spreads on Brazil’s external debt rose to about 1,000 basis points.18 By early January 1999 Brazil had about US$36 billion in reserves compared to US$70 billion in August 1998. The Standard and Poor’s ratings agency downgraded Brazil’s foreign debt rating, and the Bovespa, Brazil’s leading stock index, fell by 27 per cent in a week. As reserves continued to decline, the government was forced to abandon its exchange-rate policy and float the beleaguered real on January 15, 1999 – just two weeks after President Cardoso’s second inauguration.19 For the G-7 nations and their OECD partners, acting in concert with the IMF, the World Bank and other multilateral financial institutions, managing the crises has been both frustrating and extremely costly.20 If the Mexican rescue package cost an unprecedented US$52 billion (with the IMF and the United States contributing US$17 billion and US$20 billion respectively),21 between August 1997 and December 1998 the G-7 and its partners had already pledged just over US$200 billion to support Indonesia, South Korea, Thailand, Russia and Brazil – with the IMF contributing an unprecedented US$65.3 billion.22 This amount does not include the additional US$30 billion pledged by Japan under the Miyazawa Initiative.23 The frequency and severity of the crises, the enormous size of the rescue packages and the realization that such bailouts could not be continued indefinitely finally forced a reality-check on the complacent G-7 leaders.24 President Clinton, who in November 1997 dismissed Asia’s financial woes as “a few small glitches in the road,” a few months later characterized the Asian/global crises as “the greatest financial challenge facing the world in the last half century.”25 The urgent task facing the global community, President Clinton, the other G-7 leaders, their finance ministers and senior bureaucrats now argued, was to fix the potential flaws and to create a more equitable, sustainable and stable international financial and monetary system.26 Their collective esprit de corps was lucidly captured by the selfeffacing, then United States Treasury Secretary, Robert Rubin, who in his inimitable manner stated that the task before the global community was to construct a “new international financial architecture” that was “as modern as the markets.”27 Rubin’s pithy epigram has generated a veritable cottage industry. An ever-growing list of architects have come up with proposal after proposal on how to reform the existing economic regime and construct a new international financial architecture. Indeed, collaborative initiatives have already been unveiled to reduce susceptibility to financial crisis, and to deal with it more effectively when and where they occur. While there is broad consensus on the motherhood and apple-pie issues such as the need to strengthen the The Asian financial crisis 8 global financial system via more intensive surveillance and monitoring of capital markets and country financial sectors (in particular, the banking system), timely dissemination of financial information under internationally agreed standards, greater transparency in both public and private sector activity, including greater private-sector burden-sharing in order to eliminate (or at least keep within permissible limits) the problems associated with asymmetric information and moral hazard, there is also much disagreement.28 Policy-makers, financial analysts, academic economists and others have been engaged in intense and usually instructive debates regarding the pros and cons of trade liberalization, capital controls, fixed versus floating exchange rate regimes, currency boards, dollarization, the role of the IMF, among other issues. However, before much of the reforms envisioned in the new financial architecture had had a chance to be implemented, Asia was already in the midst of making a remarkable economic recovery – defying even the most optimistic predictions, which predicted the lapse of at least a decade before any meaningful recovery could take place. In this light, the IMF triumphantly noted that “the financial crises that erupted in Asia beginning in mid-1997 are now behind us and the economies are recovering strongly.”29 Major factors behind the recovery include strong exports (partly due to depreciated exchange rate levels), the rebuilding of foreign reserves (partly because of collapsing imports in 1998), fiscal deficits and low interest rates stimulating aggregate demand, reforms to the financial system resulting in foreign direct investment inflows, expansionary monetary and fiscal policy, and an improvement in the global economic environment – at least until September 11, 2001. The focus and organization of the study Why did an apparently localized currency crisis in Thailand soon engulf a number of countries long considered economic miracles? If the economic fundamentals were seemingly sound, why was the crisis so severe, and not a relatively mild correction? If the warning signs of an impending economic slowdown were there, why did no one predict the crisis? What has been the socioeconomic and political impact of the crisis? How effectively did the governments of Thailand, Indonesia and Korea respond to the crisis prior to the conclusion of agreements with the IMF? What were the deficiencies in domestic policies that contributed to the onset of the crisis? How did the international community, especially the IMF, respond to the crisis? What was the content of the IMF policies, and how did it affect the economies under the IMF programs? What has been the nature of the economic recovery in the crisis countries, and what explains the relatively quick recovery? How valid is the claim that the IMF policies are largely responsible for the Introduction: issues, debates and overview 9 recovery? What explains why Hong Kong, Singapore and Taiwan came through such a severe region-wide economic contraction relatively unscathed? On the other hand, what explains why the People’s Republic of China (PRC), which suffers from many of the problems responsible for the crisis, remained conspicuously insulated from the turmoil raging around it? More conceptually, did the Malaysian capital controls work? What type of exchange regime is most suitable in this era of free capital flows? And last, but not least, what types of reforms are envisioned in the new international financial architecture, and what implications does it hold for emerging economies in Asia and elsewhere? The aim of the study is to provide answers to these complex and interrelated questions. Already a large and ever-growing body of literature (academic, policy-oriented and journalistic) has emerged addressing some of these issues – with the question dealing with why the crisis occurred receiving most of the attention. However, much of this literature remains either too general or too country-specific, with the country-specific usually being highly technical and specialized. This study moves beyond the existing literature by highlighting that it was the interactive conjunction of many factors – domestic political and macroeconomic policies, as well as international economic forces – that caused the crisis. Yet it is not always easy empirically to distinguish the various interrelated factors. This study will attempt to make sense of the causes by highlighting what I term the “vulnerability” and “precipitating” factors up to mid-1997. Such an approach requires a broad political-economic framework. Indeed, one of the major strengths of this study is that it adds substantially to the emerging scholarship by providing a broad comparative political-economic perspective on the Asian financial crisis and its aftermath. Chapters 2, 3, 4 and 5 are detailed case studies of individual countries, Thailand, Indonesia, South Korea and the PRC in turn. The chapters on Thailand, Indonesia and South Korea not only examine the factors behind the crisis, but also highlight the underlying similarities and the fundamental differences between the individual cases. Specifically, the chapters illustrate that inappropriate macroeconomic policy responses to large capital inflows, weaknesses in domestic financial intermediation and poor corporate governance resulted in the build-up of vulnerabilities, while banking fragility, high leverage and currency and maturity mismatches made these economies highly susceptible to reversals in capital flows. However, these weaknesses remained unnoticed as long as these economies were growing. Despite these similarities, each country also suffered from its own unique sets of problems, and varied in its response to the crisis. Also, since the most common criticism of the IMF prescriptions was that they were indiscriminately applied, without taking account of the unique problems faced by each country, such detailed case studies provide a useful approach to assessing critically the validity of these criticisms and the overall efficacy of the IMF programs. Chapter 5, The Asian financial crisis 10 with detailed illustrations from the PRC, documents why it escaped the worst of the crisis. The aim of Chapter 6 is twofold: first, to provide a review of the competing perspectives on the new international financial architecture; and second, to document the emerging consensus on a number of fundamental issues and its implications for emerging market economies. For example, a detailed review of the Malaysian capital controls is provided to discuss the pros and cons of capital account liberalization. The Conclusion examines the reasons behind Asia’s remarkable economic recovery, and the challenges that lie ahead. Competing perspectives on the Asian crisis As has just been noted, the Asian financial crisis was caused by many factors and the conjunctural interactions among them. These mutually overlapping and at times competing perspectives can be roughly divided into three broad categories, viz. those that see the crisis as mainly the result of: (1) investor panic coupled with the intrinsic volatility of international capital markets – which can quickly transform a modest liquidity problem into a full-blown financial crisis; (2) unanticipated exogenous shocks and unfavorable external economic developments; and (3) structural weakness and mismanagement of the domestic economies. Because no single variable is likely to have caused the crisis, the issue is the degree to which each of these different factors contributed to its onset and severity. The following section provides an overview of the various perspectives. Investor panic and the instability of international financial markets There are generally two strands to this argument. An asymmetric information view of financial crises defines a financial crisis as being a non-linear disruption to financial markets in which the asymmetric information problems of adverse selection and moral hazard become so severe that financial markets are unable to channel funds efficiently to those who have the most productive investment opportunities. According to Frederic Mishkin (1999), foremost among financial market imperfections is that there are endemic problems of asymmetric information (or differential information among different stakeholders) in international lending that reduce the efficiency of financial markets, and often contribute to overshooting and instability.30 In particular, it is argued that international lenders have limited and poor information about local borrowers. Indeed, in emerging markets, information on the financial positions of banks and corporations is far less adequate than in the markets of advanced countries. Problems associated with asymmetric information are amplified in these economies, resulting in investor assessments that swing from periods of excessive optimism or euphoria to Introduction: issues, debates and overview 11 periods of excessive gloom and panic. This, in turn, often leads to adverse selection, where lenders over-extend credit, often to unsound and poorlymanaged local banks and companies, as well as to panic withdrawals at the first sign of trouble. Indeed, asymmetric information and the resulting adverse selection problem can lead to credit rationing, where some borrowers are denied loans even when they are willing to pay a higher interest rate. Moreover, the widely held belief that there are implicit guarantees by governments to maintain fixed exchange rates and to bail out local borrowers reinforces this process. At the same time borrowers are also encouraged by the same beliefs with regard to exchange rates and government bail-outs in time of crisis. As economic theory tells us: financial intermediaries who receive implicit guarantees will rationally choose investments that would otherwise be too risky. Moreover, implicit guarantees provide adverse incentives to international lenders to lend without implementing adequate supervisory, control and risk-management systems. These market failures not only increase the risks of international lending, but also make the market vulnerable to periodic crises. In such an environment it becomes rational for individual lenders to follow the herd when tell-tale signs of a crisis emerge. According to Mishkin (1999), in the case of Asia this herding phenomenon generated a self-fulfilling panic that led to market overreactions, which were not necessarily warranted by the economic fundamentals.31 The other related view, articulated by Furman and Stiglitz (1998), argues that although some macroeconomic and other fundamentals may have worsened in the Asian economies in the mid-1990s, the extent and depth of the crisis cannot be attributed to a deterioration in fundamentals, but rather to the panicky reaction of anxious domestic and foreign investors. In a similar vein, Radelet and Sachs (1998; 1998a) argue that in Asia the problem was one of liquidity rather than insolvency. That is, banks were not insolvent by any standard. Rather, East Asian financial institutions had incurred a significant amount of external liquid liabilities that were not entirely backed by liquid assets.32 Compounding this problem was the fact that a large proportion of foreign borrowings by corporates and banks were unhedged because of the prevailing expectations of stable exchange rates. When these expectations were disappointed, the scramble to repay these foreign currency loans created a massive market imbalance. In mid-1997, countries that relied on short-term capital inflows were caught in a liquidity crisis when investors refused roll-over lending. For example, in Indonesia, when available foreign exchange reserves were insufficient to cover short-term foreign liabilities, a sudden loss in investor confidence led to a rush for the exits by foreign investors, leading to a dramatic collapse of the rupiah. Many corporations, which would otherwise have been profitable, were made insolvent because over-depreciation of the rupiah increased the domestic value of their foreign debts to unsustainable levels. The Asian financial crisis 12 Thus, the East Asian countries were victims of a shift in investor expectations that became self-fulfilling.33 Radelet and Sachs support their claims by showing that, up until the third quarter of 1997, optimism about the region was expressed by international bankers (as shown by low and falling risk premia attached to loans to East Asia), credit ratings agencies (as shown by ratings that remained unchanged throughout 1996 and the first half of 1997), and securities firms (as shown by their published forecasts). On the other hand, clear evidence of a collapse in investor confidence can be seen in the dramatic reversal of capital flows. In 1996, the capital inflow to the five Asian crisis economies (Korea, Thailand, Indonesia, Malaysia, the Philippines) was US$93 billion. In 1997, the figure was a minus US$12.1 billion, a swing of US$105 billion. This dramatic reversal represented 11 per cent of the combined GDP of the five countries (IMF 2000a). Similarly, quarterly Bank of International Settlements (BIS) data on banking flows show that international bank lending to the five crisis-affected countries was positive, at almost US$50 billion, in the first half of 1997, but swung to minus US$40 billion in the third quarter of 1997, thereafter averaging close to minus US$100 billion for the three quarters that followed (BIS 1999). For Radelet and Sachs (1998a), there is no other way to explain such a swift and massive outflow of capital once the crisis broke except as a classic bank run – where commercial banks and portfolio investors suddenly seized with panic demanded immediate payment, thereby forcing financial intermediaries to liquidate at great loss.34 Compounding the problem of investor panic were the overly harsh fiscal and monetary policies prescribed by the IMF. Radelet and Sachs note (1998a, 4–5): The [Asian] crisis is a testament to the shortcomings of the international capital markets and their vulnerability to sudden reversals of market confidence . . . In this sense, the Asian crisis can be understood as a crisis of success caused by a boom of international lending followed by a sudden withdrawal of funds. At the core of the Asian crisis were large scale foreign capital inflows into financial systems that became vulnerable to panic ...A combination of panic on the part of the international investment community, policy mistakes at the onset of the crisis by Asian governments, and poorly designed international rescue programs have led to a much deeper fall in (otherwise viable) output than was either necessary or inevitable. Radelet and Sachs make a compelling argument. Certainly, the revolutionary advances in computing and other communications technology have enabled investors to access information on macroeconomic data, asset prices and exchange rates at the push of a button. Today, global capital markets operate around the clock searching for the highest rate of return, and financial transactions can occur instantaneously. Among other things, this has made bank and currency runs both easier and faster. Large depositors and other banks can withdraw funds almost instantaneously. Indeed, the highly Introduction: issues, debates and overview 13 competitive and globalized financial world has created individual market participants that are huge enough to mobilize, often with the help of leverage, financial resources larger than the GDP of smaller economies. They can build up dominating positions in the markets of smaller economies and influence short-term market movements singly or through acting in concert. Even small depositors no longer need to line up physically at banks to withdraw their funds. They can transfer their funds to other banks by telephone, computers and automatic transaction machines (ATMs). Not only can funds be withdrawn faster and more cheaply; runs can start upon the receipt of any adverse news about the financial health of financial institutions and countries. Thus, in a world of integrated, securitized and electronically linked capital markets, where in-depth information is expensive to obtain, it may be rational for investors to react to even small news – and move funds in and out of markets with a click of the computer keyboard. Arguably, relatively small bad news can lead to a major speculative attack, even if the news is not related to any important change in economic fundamentals. Thus Calvo (1996) argues that emerging markets are vulnerable to a herd mentality among investors. Since it is too costly for investors to address the state of each economy, it is optimal for them to pull out of a group of related markets simultaneously when they spot signs of trouble in any one of them. Similarly, Masson (1998) argues that small triggers can be precipitating factors for investors, leading to across-the-board loss of confidence and a higher perceived risk of holding investments in a set of countries. As investors follow each other and pull out their funds, the herd behavior pushes these countries into financial distress. The comprehensive study by Kaminsky and Schmukler (1999) analyzes the twenty largest one-day swings in stock prices (in US dollars) in Hong Kong, Indonesia, Japan, South Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand since January 1997 to see what type of news moves the markets in days of extreme market jitters. Of special interest was whether news in one country would affect markets in another, and if so, what type of news. The authors classified news into seven different categories: news related to agreements with international organizations, the financial sector in each country, monetary and fiscal policies, credit-rating agencies, the real sector and political announcements. Their study found that some of the biggest one-day downturns cannot be explained by any apparent substantial news, but seem to be driven by herd instincts of the market itself. Similarly, Goldfajn and Baig (1998) construct dummy variables to represent good and bad news. They find that news in one crisis country affects exchange rates and stock markets in the others, suggesting contagion. Thus there appears to be an element of pure contagion effect at work – that is, a sudden and massive shift in market sentiment unrelated to market fundamentals.35 Their study reinforces the view that, in this era of mobile capital, even countries with otherwise exemplary macroeconomic environments The Asian financial crisis 14 (in Asia, countries such as Singapore, Taiwan and Hong Kong) can become victims of market contagion. There is no doubt that a currency crisis in one country can worsen market participants’ perception of the economic outlook in countries with similar characteristics and trigger a generalized fall in investor confidence. Since financial market turbulence can spread from one country to another via three main channels – monsoonal effects, spillovers and pure contagion effects – the study by Goldfajn and Baig (1998) of financial market developments in Malaysia, Indonesia, the Philippines, Thailand and South Korea from July 1997 to May 1998 provides evidence of high correlations between sovereign spreads across the five countries. This indicates that markets felt that the probability of private debt default increased dramatically in these countries, and nervousness about one market was transmitted to other markets readily. As a consequence, global investors demanded higher risk premiums for all countries. Moreover, in Asia, the rapid downgrading of the region’s sovereign ratings by international rating agencies further fueled the shift in market sentiment, triggering panic selling of foreign-owned local assets. Also, we now know that the most severely affected crisis countries experienced external liquidity crises as investors came to doubt that adequate reserves were available to service maturing foreign debts. As this doubt became widespread, panic set in, soon to be followed by a stampede – to borrow Sachs’s apt metaphor. On the one hand, local residents rushed to buy foreign exchange to cover their dollar liabilities, thereby intensifying exchangerate pressures. On the other hand, instinctively risk-averse and with a low tolerance for uncertainty, the fickle international financial markets and their managers did what they had done in Mexico in 1994 – fleeing the region as fast as they had entered. Seen in this light, Asia’s punishment was in a sense disproportionate to the crime – it became a helpless victim of irrational panic and investor stampede. Yet external shock by itself need not have caused a crisis of the magnitude that Asia experienced – if only its domestic economic and political structures had been robust. Confronted with a contagious external shock the highly integrated economies of Thailand, Indonesia, Malaysia and Korea, with their embedded inefficiencies and weak financial systems, could not withstand the impact.36 The domino effect of the weakening currencies first adversely affected the financial sector, and then the real sector of the national economies. Furthermore, an important component of vulnerability is the credibility of the government with regard to its ability to suffer (or inflict) pain in defense of the currency. A combination of weak banking systems and low reserves can undermine a country’s ability to defend the currency. If a country with low reserves cannot tolerate capital flight, weak banking systems make interest rate defenses more costly. The moral of the story is rather simple: it is difficult to point to any emerging market economy that experienced a financial crisis, but did not suffer from some fundamental Introduction: issues, debates and overview 15 weaknesses. In Asia, the rapid capital withdrawal greatly exacerbated the underlying weakness. Furthermore, it is hard to overlook the contagion stemming from the growing financial integration within the region. As Masson (1998) notes, a crisis in one country may affect the economic fundamentals of a group of countries to which it is closely associated through trade and financial links. For example, depreciation in the value of the currency of one country can affect the price competitiveness of other countries through spillover effects. Financial interdependence can also contribute to the transmission of a crisis, as initial turmoil in one country can lead outside creditors to recall their loans elsewhere, thereby creating a credit crunch in other debtor countries. Also, any major trading partner of a country in which a financial crisis has induced a sharp currency depreciation could experience declining asset prices and large capital outflows or could become the target of a speculative attack as investors anticipate a decline in exports to the crisis country, and hence a deterioration in the trade account. In the case of Asia, the initial baht devaluation certainly affected investor confidence in the Asian region, just as the decline in the Indonesian rupiah made Korean investors suffer large losses. In order to make up the losses, Korean investors started to sell Russian and Brazilian securities, thereby depressing their bond prices. Overall, the deepening recession in the worst-affected countries pulled down their neighbors, further weakening regional economic growth. Indeed, there is substantial evidence that trade linkages are an important reason for the spread of crises.37 Unfavorable external economic developments These included China’s devaluation in 1994, Japan’s prolonged recession and the appreciation of the US dollar, which worked in tandem to make the Asian economies highly vulnerable to shocks. China’s devaluation Central to China’s economic growth has been the liberalization of the foreign trade and investment regime, and the adoption of an ambitious open-door strategy. Prior to the introduction of the Deng reforms, China remained a backward and closed economy, with foreign trade amounting to a minuscule 7 per cent of GNP. However, the liberalization of the foreign trade and exchange-rate regime, followed by further wide-ranging reforms introduced in 1988 (which included increased retention of foreign exchange and easier access to foreign exchange adjustment centers established in 1986), enabled businesses, in particular the enterprises, to buy and sell foreign exchange at a depreciated rate known as swap rate, and thus greatly helped to boost exports. By the early 1990s, foreign trade had grown to an unprecedented $200 billion, or roughly 40 per cent of GNP (Cerra and Dayal-Gulati 1999). The Asian financial crisis 22 1990s, the Sony Corporation was making more color television sets in Malaysia than in Japan.” However, by the mid-1990s the era of the strong yen was over. The third external shock that has contributed to the Asian financial crisis has been the sharp appreciation of the dollar that began in 1995, especially its appreciation vis-à-vis the yen. As the dollar rose relative to the yen in the months before the crisis, the currencies of the crisis countries rose in comparison with the yen also. In some cases the crisis countries followed the dollar very closely; in others the link was looser, because they used a basket peg but still gave the dollar substantial weight.53 This system of a de facto peg or quasipeg against the dollar conferred competitive advantage on these countries when the dollar was relatively weak in the international currency market. However, from April 1995, when the dollar began to appreciate against the yen, the real effective exchange rates of most of the region’s currencies started to appreciate. Since these East Asian economies exported a substantial proportion of their goods to Japan, the resultant loss in export competitiveness contributed to a deterioration in the current account of the Japanese balance of payments. Specifically, after hitting a historic high of 80 yen to the dollar in June 1995, the yen experienced a downward trend, falling to 127 yen to the dollar in April 1997 – just before the Asian crisis broke. The yen’s sharp depreciation led to a marked deterioration in East and Southeast Asia’s export performance and current account imbalances in 1996, paving the way for the currency crisis. For example, in the case of Thailand, although the baht had edged down by about 4 per cent against the dollar in the two years leading up to the July 2, 1997 devaluation, its real effective exchange rate (trade-weighted) had appreciated by about 15 per cent over the same period. This largely reflected its sharp appreciation of approximately 35 per cent against the yen. As a result, export growth decelerated sharply, from over 20 per cent in 1995 to virtually zero in 1996, with the current account deficit reaching 7.9 per cent of GDP. The exchange-rate policy of pegging to a basket of currencies in which the dollar was weighted heavily had constrained the government from allowing the baht to depreciate against the dollar at a faster rate to stimulate exports. Similarly, other Asian countries that had also pegged their currencies loosely to the dollar suffered a sharp slowdown in exports on the back of the weakening yen. The depreciation of the yen against the dollar also affected capital flows. It increased the capital inflow through interbank short-term borrowing, notably from Japan – since depreciation of the yen against the dollar under a de facto dollar-pegged exchange-rate regime was equivalent to the appreciation of the crisis-affected countries’ own currencies against the yen. This prompted banks as well as non-banks in Thailand, South Korea and Malaysia to borrow from Japan in order to invest in high-yielding risky foreign bonds, real estate and consumer loan services. Most of these investments turned Introduction: issues, debates and overview 23 into non-performing loans in these countries after the bubble burst in 1997. Thus, since Asian countries have substantial trade relationships with Japan, the yen depreciation relative to the US dollar meant that these countries on a de facto dollar peg became less competitive vis-à-vis Japan. Korean firms lost ground to Japanese firms as the yen depreciated in 1995–96. Thai firms that lost competitiveness when China de facto devalued its currency in 1994, lost further competitiveness as the yen depreciated vis-à-vis the US dollar in 1995–96. Therefore the yen depreciation from 1993 to April 1995 produced the boom in Asia, while the yen appreciation from April 1995 to 1997 depressed economic activity. Clearly, the business cycles in Asia are fundamentally correlated with the yen/dollar cycle. While these three external factors did not trigger the crisis, they cumulatively contributed to its severity and duration. Domestic structural weakness and mismanagement The fact that no one predicted the crisis is hardly surprising. The celebrated “tiger economies” of Southeast and East Asia were long viewed as the “miracle economies,” with seemingly impeccable economic fundamentals and constituting a model for others to emulate. Between 1965 and 1990 the economies of Japan, the four original tigers (Hong Kong, Korea, Singapore and Taiwan), and the three emerging tigers, or the newly-industrializing economies of Southeast Asia (Indonesia, Malaysia and Thailand) grew more rapidly than any other group of economies in the world, averaging 7 per cent per year growth rates in real terms since the mid-1970s, and over 9 per cent per year since the late 1980s.54 This meant that the fast-growing Asian economies were doubling their real GDP approximately every 7 years during the 1960s and 1970s, and roughly every 7 to 10 years during the 1980s (World Bank 1993). All these economies also experienced dramatic increases in real per capita incomes. In South Korea and Singapore, for example, real per capita income grew more than 700 per cent between 1965 and 1995. Over the same period Taiwan and Hong Kong logged a 400 per cent increase, while Malaysia, Thailand and Indonesia each experienced real per capita income growth of over 300 per cent (Crafts 1999). South Korea’s unprecedented growth in per capita GNP (6.9 per cent over 1960–81 and 8.5 per cent over 1980–94) increased incomes from US$1,700 in 1981 to US$8,260 in 1994. Equally impressively, Indonesia’s per capita GNP rose from US$90 in 1972 to US$880 in 1994, Thailand’s from US$220 to US$2,410 and Malaysia’s from US$450 to US$3,480.55 Not surprisingly, a spate of popular books, including Jim Rohwer’s (1995), Asia Rising: Why America will Prosper as Asia’s Economies Boom and John Naisbitt’s (1995) bestseller, Megatrends Asia, not to mention a growing list of academic tomes, projected the inexorable shift in power towards the The Asian financial crisis 24 Asia-Pacific economies – besides showering laudatory praises on the virtues of the so-called East Asian-style state-guided capitalism. The region’s selfstyled gurus, such as the Malaysian strongman, Mahathir Mohamad, and Singapore’s patriarch, Lee Kuan Yew, found the semiotic imagery of Asianstyle capitalism congenial, as it suggested that their leadership played a critical role. Predictably, they confidently asserted that Asia’s exuberant growth was destined to continue long into the next millennium. The World Bank (1993), along with a growing number of leading economists such as Columbia’s Jagdish Bhagwati (1996), concurred with the sanguine assessments. Indeed, the World Bank’s (1993) influential study, The East Asian Miracle: Economic Growth and Public Policy, praised the prudent role of the state in Asia’s economic development, claiming that the miracle was due to the state’s adherence to the market-friendly policies epitomized by the so-called “Washington Consensus.” That is, by adopting liberalized capital accounts, open trade and foreign investment policies, a single competitive exchange rate and a commitment to the principles of comparative advantage, economic integration and export-led growth, Asia was able to build an economy on solid foundations. In other words, an economy based on both the accumulation of factors of production (especially the massive investment in physical capital), and increases in total factor productivity, measured in terms of improvements in technology and efficiency. In those halcyon days the lone dissenter was the iconoclastic economist, Paul Krugman. In a provocative article published a few years before the Asian crisis (in 1994), he argued that East Asia’s economic growth, impressive as it was, could be explained by basic economic factors such as high savings rates, investment in education and job creation. In other words, growth was achieved as a result of increased inputs, not as a result of increased total factor productivity. Indeed, Krugman likened the experience of the fastgrowing economies of East Asia to the former Soviet Union, which grew rapidly in the 1920s and 1930s through large increases in the employment of capital and labor, rather than increases in total factor productivity. Krugman called this working harder, not smarter – growth as a result of “perspiration rather than inspiration.” This finding prompted him to refer to the highperforming economies of East Asia as a collection of paper tigers. Since there are inevitable limits to expanding growth by raising savings rates, labor force participation, etc., Krugman predicted that East Asia’s growth rates were bound to decline over time. However, Krugman’s model predicted “diminishing returns” or a gradual loss of economic growth, not a sudden and precipitous financial crash.56 As is usually the case, there is always much wisdom after the fact. Before the dust had even settled from the wreckage of the crisis, a veritable cottage industry sprang up virtually overnight to describe and analyze the many ills afflicting the Asian model of development. The one that caught the popular imagination was crony capitalism. Many now argued that the Asian Introduction: issues, debates and overview 25 development model was in fact infected with the virus of cronyism and patronage. Rather than operating on the principles of free market economics, there was widespread political interference with the market process. This included such practices as patronage appointments of relatives and cronies to state-owned enterprises and other businesses, granting lucrative government contracts to political allies, allocating credit to favored firms and industries without prudential oversight, promoting those with nepotistic, factional and personal ties to the well-connected, and engaging in predatory rent-seeking and other activities geared towards embezzlement and selfaggrandizement. Krugman (1998, 74) describes the workings of the insidious crony capitalism in evocative prose: how Asia fell apart is pretty familiar . . . the region’s downfall was a punishment for its sins. We all know now what we should have known even during the boom years: that there was a dark underside to “Asian values,” that the success of too many Asian businessmen depended less on what they knew than on whom they knew. Crony capitalism meant, in particular, that dubious investments – unneeded office blocks outside Bangkok, ego-driven diversification by South Korean chaebol – were cheerfully funded by local banks, as long as the borrower had the right government connections. Sooner or later there had to be a reckoning. The following chapters will illustrate that cronyism and corruption was indeed a big problem and played a significant role in undermining economic development. The lack of transparency in economic management, besides fostering moral hazard in the form of expectations of government guarantees to politically connected lending, also resulted in the fatal mis-allocation of investment, falling returns to investment and growing fragility in the financial system. In each crisis-affected country, the connections between politicians and certain private enterprises created a moral hazard problem, whereby these enterprises were seen as carrying an implicit guarantee against insolvency. Thus there was a strong incentive for financial institutions to lend to these enterprises, regardless of the soundness of their operations. The moral hazard problem arose even more directly when banks and finance companies themselves had close political connections. In some countries, particularly Indonesia, these problems were made worse by direct political interference and official malfeasance in the allocation of credit and in creating monopolies in certain activities. Yet this study departs from the exceptionally sweeping view of crony capitalism in two important regards. First, the case studies will show that both the statist or dirigiste policies that most Asian governments had followed for so long, and the more recent policy shift towards financial deregulation and liberalization were conducive to rent-seeking and cronyism. As is well known to area specialists, the economic success of many Asian economies was built on a particular kind of economic strategy that emphasized The Asian financial crisis 26 export-orientation, centralized coordination of production activities, and implicit (and in some cases explicit) government guarantees of private investment projects. Moreover, there also existed a close operational relationship and interlinked ownership between banks and firms. Hailed as the “Asian developmental model,” this strategy allowed firms to rely heavily on bank credit. Not surprisingly, by international standards, firms in the crisis-affected countries were highly leveraged. Indeed, the pervasive role of government in the selective promotion of industries and in the coordination of investment, including state control over the allocation of credit and capital account transactions, spawned a government–private sector nexus with an affinity for rent-seeking behavior. Second, the evidence unequivocally demonstrates that crony capitalism did not trigger the crisis, albeit it greatly exacerbated it. Towards a synthesis of the macroeconomic perspective When the bubble burst in 1997, a twin crisis emerged in Asia – meaning that the currency crisis was accompanied by a crisis in the banking and financial sector. Soon a vicious cycle emerged, as the depreciation of the currencies exacerbated weaknesses in the financial sector, which in turn fueled further capital outflows and pressure on the exchange rates. The subsequent pages will show that weaknesses in the private sector (in the banking, financial and corporate sectors) were at the heart of the Asian crisis. Specifically, weak corporate structures (where the focus too often was on increasing scale and market share rather than on economic returns), weak regulation of the financial system, connected and directed lending, and implicit and explicit guarantees of financial institution liabilities created an unprecedented degree of moral hazard. The banking sectors in the crisis-hit countries were characterized by poor regulatory supervision, lack of bank transparency and excessive short-term, unhedged foreign currency borrowing. All suffered from liquidity shortages and escalating levels of non-performing loans. In fact, their balance sheets exhibited growing maturity and currency mismatches in the period leading up to the crisis. This meant that they were vulnerable to sharp swings in interest rates resulting from external shocks. Eventually borrowers – whether public (as in Mexico or Russia), or private (as in Asia) – were unable to roll over short-term debt, often denominated in foreign currency and held by a large number of creditors. The roots of this problem date back to the all-too-swift liberalization of the financial sector (a) without having the appropriate prudential supervision and regulation in place, and (b) in conditions such that even where formal rules were in place (for example, legal lending limits, capital adequacy ratios), weak enforcement impeded the development of a healthy banking sector. In this environment, liberalization included reduction of barriers to Introduction: issues, debates and overview 27 entry for banks and non-bank financial institutions, deregulation of interest rates, relaxation of directed credit and reserve requirements on banks, promotion of new financial markets and instruments and the liberalization of the external dimensions of the financial sector. Moreover, some variations among countries notwithstanding, liberalization permitted local residents and non-resident foreign entities to open accounts with commercial banks in either national or foreign currencies. It also permitted banks to extend credit in foreign currencies in the domestic markets; bank and non-bank private sector corporations to borrow abroad; foreigners to own shares listed by national companies on domestic stock exchanges; the sale of securities on international stock and bond markets by national companies; the sale of domestic monetary instruments such as central bank bills and treasury bills to non-residents; and the establishment of offshore banks – which were also allowed (in some cases) to borrow broad and lend domestically. However, the rapid liberalization of the financial and banking sectors created problems. First, many banks were established with very small capital bases. Second, as economic theory suggests, while lower reserve requirements (which allowed the banking industry to maintain a lower degree of liquidity), may be desirable on efficiency grounds, they can also directly exacerbate international illiquidity and increase the possibility of financial runs. Third, banks incurred excessive risks by being overly dependent upon short-term funds to finance long-term investments, many of doubtful viability. This is was not simply due to lack of oversight. Rather, state banks were routinely encouraged to lend imprudentially to questionable state enterprises and to priority projects of various ministries. As Iwan Azis (1999, 80) notes, “too often, governments in the region played favorites. A few highly leveraged and well-connected groups were given special, often nontransparent, access to credit. These private businesses could obtain loans from state banks without difficulty at interest rates that were much lower than the market rate, and under more lenient conditions. This spelled trouble for the lending banks, as the probability of default on such loans was relatively high.” Similarly, private banks, which usually had close relationships with particular business groups, routinely broke prudential rules in terms of amounts and conditions of loans to related companies. In some cases, the large conglomerates set up new banks primarily to serve their own often risky projects. In these so-called banks, lenient disclosure rules and poor banking regulations aggravated bad credit analysis and distorted investment decisions. Compounding all this was excessive lending – which fueled asset price inflation, while the corporate sector overstretched itself by engaging in risky or unproductive projects. Fourth, poor risk management on the part of banks meant that alarm bells did not go off until the situation got out of control. Ineffective banking supervision, political interference and a critical lack of transparency prevented disciplinary mechanisms from operating properly. To make matters The Asian financial crisis 28 worse, both the banking and the corporate sectors were taking excessive currency risks by borrowing in foreign currencies (which had much lower interest costs than domestic currencies) to fund projects that could only generate income in domestic currencies. Implicit government guarantees on exchange-rate stability eroded awareness of the risks arising from currency and maturity mismatches between the banking and corporate sectors.57 Last but not least, weak regulation of financial intermediaries and poor governance in corporate and government sectors induced excess domestic and external debt financing and made these countries extremely vulnerable to changes in capital market sentiment. In fact, this combination of financial system and corporate sector vulnerabilities and weaknesses contributed to the crises and magnified the negative impact of exchange-rate devaluations and foreign capital withdrawals on financial institutions. How did this problem develop; why was it allowed to fester? How did it manifest itself (if at all), and what measures were taken to deal with them? Although the following chapters will flesh out in more detail the similarities and differences across countries, it is useful to sketch out some of the salient features – many of which were common across the crisis-affected countries and beyond. Briefly, three forces interacted to leave a number of countries in the region, notably Thailand, Korea, Indonesia and Malaysia, vulnerable to external shocks. These included: (a) the globalization of financial markets and the easy availability of private capital, especially short-term capital; (b) macroeconomic policies, in particular, haphazard capital account liberalization that permitted capital inflows to fuel a credit boom; and (c) increasingly liberalized, but insufficiently regulated financial markets that were growing too rapidly. Since the post-war period, capital flows to developing countries have undergone some significant changes. From the end of the Second World War until the mid-1970s, the flow of resources into developing countries was dominated by official development assistance (ODA). The oil embargo and the recycling of petrodollars that began in earnest in 1974 gave rise to a new investment regime. The ready availability of funds allowed developing countries either to augment or to replace ODA and direct investment with large-scale bank lending. In 1981, more than half the resource flows to developing countries consisted of private lending. The option of borrowing from private banks abruptly came to an end in 1982, when Mexico declared a moratorium on the payment of its foreign debt, thereby ushering in the era of the debt crisis. It is now recognized that the debt crisis came about because the accumulation of foreign-currency-denominated sovereign banking debt had reached unsustainable levels.58 At the end of 1973 the non-OPEC developing countries carried a stock of net external foreign currency bank debt of US$4.5 billion. By the end of 1982 the figure had reached US$145.9 billion, an increase of US$141.4 billion (Lamfalussy 2000, 2). Introduction: issues, debates and overview 29 With the onset of the debt crisis there was a sharp decline in capital inflows to developing countries – from US$30 billion in 1977–82 to under US$9 billion in 1983–89 (IMF 1995, 33). However, the liberalization of cross-border financial transactions in the late 1980s and early 1990s dramatically reversed this trend. The international diversification of institutional portfolios (mutual funds, insurance companies, pension funds, proprietary trading of banks and securities houses) and the progressive integration of global capital markets led to a dramatic revival and expansion in capital inflows to developing countries. Private capital flows to developing countries increased sixfold over the years 1990 to 1996. Between 1990 and 1994, net capital surges to developing countries skyrocketed to US$524.2 billion, with a disproportionate share going to the Asian economies, which received some US$260 billion, or roughly 50 per cent of all the total capital flows (IMF 1995, 3). Although private capital flows comprise a wide range of instruments, including bank deposits and credits, equities, direct investments, corporate bonds and government securities, what was significant about this new surge was the sharp rise (in terms of both absolute levels and the share of total inflows) in short-term portfolio capital flows in the form of shortterm interbank loans (which can be readily withdrawn), commercial bank debt, tradable bonds and equity shares.59 For developing countries as a whole aggregate private portfolio capital flows increased from $6.6 billion from the base years 1983–89 to $218 billion between 1990 and 1994 to an all-time high of $167 billion in 1996.60 Propelling this expansion was an aggressive search by global capital markets (which operate around the clock) for ever higher returns to capital.61 Large private capital flows to emerging markets were driven in part by low interest rates in Japan, Western Europe and the United States, along with international investors’ imprudent search for high yields. Developed country banks and financial institutions, often trapped in slow-growing but highly competitive home markets, scanned the globe for investment opportunities. Emerging markets, especially in Asia, were booming, and offered greater profitability than investments in the developed countries. Indeed, to facilitate the capital inflows, many Asian countries (with some pressure from the United States) opened their money and capital markets and removed foreign-exchange controls. Indonesia and South Korea gained IMF Article 8 status in 1988, Thailand in 1990, the Philippines in 1995 and China in 1996 – obliging these countries to remove restrictions on current account payments.62 In addition, South Korea opened its securities market in January 1992 (when it permitted non-residents to invest directly in Korean stocks as part of its plan to promote the gradual expansion of its capital market), and was required to submit a schedule of capital liberalization in preparation for admission to the OECD. China, on the other hand, was required to liberalize trade and foreign-exchange regulations in expectation of securing membership in the World Trade Organization (WTO). Other Asian countries The Asian financial crisis 30 earnestly opened offshore markets in order to develop their domestic financial markets and facilitate overseas fund-raising. By the late 1980s, Hong Kong and Singapore were already established as major international financial centers. In 1990, Malaysia established the Labuan market, and in March 1993 Thailand established the Bangkok International Banking Facility (BIBF) to raise funds abroad. In fact, so determined was Thailand to become a leading financial center in Asia that the BIBF was characterized by looser regulations with regard to interest rates, reserve requirements, withholding taxes on interest and foreign-exchange controls than its onshore counterparts.63 Likewise, although Indonesia’s capital account had been opened since 1972, liberalization of the domestic banking system began in 1988, when domestic banks and Indonesian corporations were permitted new entries in the banking system and given much more freedom in their methods of raising financing. Thus, the number of banks increased from 111 in 1998 to 240 by March 1994. Twenty Indonesian foreign-exchange banks also opened branches in 14 countries, including offshore banking units in the Cayman and Cook Islands. The fast-growing Asian economies quickly emerged as the most important destination for private capital flows. International commercial and investment banks, mutual fund managers, securities firms, stock brokers, portfolio investors, currency traders and others in competitive marketing-sales – given their voracious appetite for commissions enthusiastically sold (if not, oversold) the opportunities in Asia’s emerging economies. As R. Johnson (1997) notes, “from the early 1980s on, it was an article of faith that Asia was a miracle...for years, strong economic performance and rising asset prices inspired investors, commentators and economists to uncover more evidence of good news about Asia wherever they looked. This process of mutual reinforcement continued into 1997.” Indeed, the very economic success of Asia and its seemingly unbound potential made it an ideal investment location. According to a World Bank report (1998a, 6–7): East Asia generally absorbed nearly 60 per cent of all short-term capital flows to developing countries. In the mid-1990s, much of the short-term private capital came from Japanese banks as they followed their corporate foreign investors into Korea and Southeast Asia. The Europeans soon followed in an aggressive search for profits. By 1996, the Bank for International Settlements (BIS) reported that European Union (EU) banks’ outstanding bank loans amounting to US$318 billion; the Japanese banks had US$261 billion; and the US banks had US$46 billion. No doubt, capital flows between countries can yield what Larry Summers (2000) has termed “enormous socioeconomic benefits.” The efficiency gains from the reallocation of capital from industrial to developing countries can improve living standards by mobilizing global savings to finance investments in countries where the marginal productivity of investments is Introduction: issues, debates and overview 31 relatively high. Capital flows also allow investors to diversify their risks and increase returns from more productive foreign projects, and allow residents of recipient countries to finance investments, and individual countries to smooth consumption. Portfolio capital flows consisting of international placements of tradable bonds, issues of equities in international markets, and purchases by foreigners of stocks and money market instruments (in particular, securities and mutual funds) can greatly benefit emerging economies by fostering financial integration and improving the returns on investments through knowledge/skills spillover, enhanced competition and market efficiency effects. However, these benefits can be offset by various capital market imperfections, often caused by a lack of information. In the case of herd behavior, foreign investors may react to the actions of others whom they believe to have access to better information. Also, the allocation of savings may be biased owing to incomplete information about proposed projects. Thus adverse selection may take place, as lenders base the cost of credit on the average perceived creditworthiness of borrowers. Moreover, the high volatility of short-term capital flows may negate their beneficial impact. Feldstein (1994) notes that a surge in capital inflow may also increase imports and thereby dampen domestic production and investment. Surges tend to affect a country’s macroeconomic stability by causing inflationary pressure and an increase in the current account deficits. The real exchange rate tends to appreciate in the capital-receiving country, while the traded goods sector of the economy loses competitiveness in international trade. The increase in the current account deficit and the appreciation of the real exchange rate also make the economy more vulnerable to shocks. When the inflow of foreign capital is interrupted, the economy has to go through reverse adjustments in the current account and real exchange rate. On the other hand, sudden outflows may disrupt local financial markets, forcing the authorities to choose between higher interest rates and a depreciation of the exchange rate. Therefore empirical studies have found that capital flows pose fewer problems if they are long-term, in the form of direct investment, propelled by the growth prospects of the economy, and invested in physical assets, rather than consumed and domestically induced.64 However, many of the capital inflows to emerging markets (including Asia) have been described as arbitrage capital flows. That is, capital flows into emerging economies were a reflection not so much of the investors’ confidence in the economic performance of these economies, as of the ability of the governments to guarantee abnormal rates of return. The chain of guarantees included the commitment to a nominal exchange rate target as well as the implicit guarantee of deposits and solvency to the domestic banking system. In Asia (as in Mexico), the crisis erupted when the perception regarding the governments’ capacity to honor the guarantees changed. Thus, short-term capital inflows can be a mixed blessing. In other words, The Asian financial crisis 38 extremely low-interest yen-denominated loans, borrowed through governmentsanctioned channels to invest in real estate. Specifically, the Bangkok International Banking Facility (BIBF), established in 1993, greatly facilitated foreign borrowing by residents. Predictably, financial institutions’ net foreign liabilities rose from 6 per cent of domestic deposit liabilities in 1990 to 33 per cent by 1996 (World Bank 1998a, 8). Korean banks also increased their exposure to foreign borrowing, as regulations favored short-term foreign borrowing by financial institutions and strongly discouraged corporations from borrowing abroad directly. In Indonesia, corporations became the primary borrowers from foreign sources, with much of it coming from offshore. In retrospect, the banks were able to grow their risky loans this rapidly, in part, because they were not fully exposed to market discipline until the governments’ explicit or implicit guarantees lost their credibility. We also now know that the regulations necessary to intermediate capital inflows were not in place, nor were weak firms operating with a high degree of risk sufficiently disciplined through competition and monitoring by shareholders or creditors – foreign as well as domestic. The problem was not simply the failure to develop adequate systems to monitor the extent of borrowing and its term structure; such oversight also created a blind-spot that prevented the growing problem of over-leveraged, unhedged short-term borrowing to be perceived early enough. Thus many firms were allowed to operate while their losses continued to mount. We now know that the licensing and supervision regulation of merchant banks in Korea permitted groups of companies to own both banks and the same groups of firms to whom they were lending. In fact in Korea, many conglomerates (or chaebols) had ownership links that were not confined to non-bank financial institutions: the larger chaebols were often linked with a major bank. Many of these enterprises could continue to borrow, and the banks could continue to overlook the rise in bad loans. In Indonesia, the number of banks expanded very rapidly in the 1990s, but the supervisory authorities failed to carry out prudential screening of applicants to check out their creditworthiness. Rather, in Indonesia, where roughly 50 per cent of banks belonged to a narrow circle of business groups, and the other 50 per cent were state-owned, the system allowed Suharto family members and their cronies preferential access to resources. In this environment, supervisory and regulatory frameworks could hardly stop the well-connected borrowers from getting access to funds, and in the process becoming even more highly leveraged. Similarly, in Thailand (where a small number of families owned both banks and corporations), the scope of finance companies’ activities greatly expanded in the 1990s without commensurate improvement in their prudential supervision. The cozy collaborative relations between governments, financial institutions and borrowers, the weaknesses in bank and corporate governance coupled with poorly enforced prudential regulations (not to mention the Introduction: issues, debates and overview 39 fact that creditors’ rights were weakly enforced because the judicial systems in these countries were underdeveloped), encouraged fiscal indiscipline and excessive risk-taking. Krugman (1999a) has called this the “Pangloss equilibrium” – where implicit (and implausible) guarantees offered by governments were believed by investors. In this environment, banks with insufficient capital adequacy ratios, inadequate asset classification systems, weak accounting standards, especially for loan valuation and disclosure practices, lack of adequate deposit insurance schemes and an overall poor provisioning for possible losses flourished. Claessens and Glaessner (1998) add that the limited role of foreign banks in the local Asian markets reduced the ability of banking systems to absorb shocks, and more generally, inhibited the institutional development of the banking sector. All these, together with the removal of controls over the allocation of credit, increased the channeling of funds into fueling of asset bubbles. Over time these weaknesses contributed to growing systemic fragility in the financial and non-bank corporate sectors. Combined with export slowdown, falling property and stock values, and ultimately the massive loss of confidence in international financial markets when the seeds of doubt were first sowed with the onset of the Thai currency crisis, they triggered large-scale capital flight from the region. They also greatly compromised the ability of these economies to withstand the shock of the large-scale outflow of foreign capital. A political economy of the crisis Behind the complex economic causes of the crisis lie the broader political factors. First, why did the so-called Asian model of development, which generated such high economic growth and equity for several decades, succumb to the crisis so quickly? The distinctive Asian model of development and the so-called “developmental states” it spawned were built around close business–government relations. This relationship had many positive features. For example, Alice Amsden (1989) in Asia’s Next Giant: South Korea and Late Industrialization attributed Korea’s phenomenal export-led economic modernization that began in early 1960 under the authoritarian Park Chung Hee regime to the collaborative relationship or “pragmatic synergy” between a highly centralized, interventionist and fortuitous developmental state and the large private conglomerates (the chaebols) it created. Endowing itself with exclusive authority over the coordination of fiscal, monetary and trade policies, Korea’s administrative state kept a watchful eye over the chaebols, while at the same time nurturing them with generous subsidies and protection from competition in return for utilitarian performance standards necessary to meet the stringent requirements of export-oriented industrialization. The state–chaebol alliance became indispensable to South Korean development. Working closely together, they were seen as formidable The Asian financial crisis 40 partners, with an uncanny ability to follow market signals, to respond preemptively to externalities and to broker relations with foreign investors and creditors. In Korea and in the rest of the high-performing Asian economies, it was believed that such close government–business relationships helped improve the flow of information between the public and private sectors and helped spur rapid capital accumulation. In the banking sector, the so-called “relationship banking” was seen as having several advantages, including the capacity to manage efficiently short-term credit and investment flows. Indeed, the high-performing Asian states’ alleged need to actively mobilize citizens and corporations behind a coherent market-based development strategy became the principal justification of authoritarian rule. Ruling elites and advocates of “Asian democracy” argued that Western-style democracy often leads to undisciplined and disorderly behavior – which are inimical to rapid economic development. On the other hand, a regime insulated from conflicting societal demands and guided by prudent technocratic decisionmaking was seen as ideally suited to providing the requisite order and promoting economic development. It is now clear that the efficacy of the Asian developmental model was greatly exaggerated. The custodians of Asia’s development states (like state elites elsewhere) confirm Naim’s (1997, 309) apt observation that “while economic fundamentals eventually force governments to adopt painful corrections, political calculations make their imprudent postponement all too frequent.” Governments everywhere exhibit politically-induced learning disabilities. The evidence unambiguously indicates that ineffective policy responses and indecisiveness on the part of a paternalistic authoritarian regime (Indonesia under Suharto), a “semi-authoritarian regime” (Malaysia under Mahathir Mohamad), and the two newly established democratic governments (Thailand under Chavalit Yongchaiyudh and Korea under Kim Young Sam) played a big role in generating market uncertainty and eventually a disastrous loss of investor confidence – both domestically and internationally.72 Compounding this problem were the deep socio-structural and institutional weaknesses, and the much-touted close business–government relationship banking – which in the critical months prior to the crisis served to weaken the independence of central banks and regulatory authorities and slowed their ability to respond to early warning signals. The country case studies will show that the implicit government guarantees to private risk-taking contributed much to the onset and the depth of the crisis. Specifically, the long-standing patterns of business–government relations created a domestic version of moral hazard. In Thailand, Korea, Indonesia and Malaysia the pervasive involvement of government in the financial and corporate sectors created expectations that banks and firms would be protected against failure. However, over time such relationships generated widespread corruption and cronyism. This only served further to undermine the capacity of governments to respond to emerging economic problems, Introduction: issues, debates and overview 41 including the ability of the central banks and regulatory authorities to enforce whatever rules of prudential regulation and supervision did exist on the books. This lack of transparency in business–government relations was less of a problem when the Asian economies were relatively closed, but became a serious problem following liberalization and deregulation in the late 1980s and early 1990s. For example, in Suharto’s Indonesia the line between the public and the private had long become blurred as Suharto governed as the quintessential patriarchal ruler, granting extravagant patronage and protection to loyalists and cronies, and meting out harsh punishment to dissenters. Eventually, the capriciousness inherent in personalism – in particular, the lax distinction between public and private funds and the arbitrary use of state resources for personal aggrandizement – took its toll. Moreover, the complete absence of representative institutions and institutionalized forms of political mediation and accountability in Indonesia further exacerbated the problems of corruption, cronyism and nepotism.73 Yet, what about Indonesia’s famed economic technocrats (the so-called Berkeley Mafia), who were known to have Suharto’s ear, and enjoyed privileged access and influence, especially during times of economic troubles. Why did they not intervene (as they had done in the past) and guide the economy in a more sustainable direction? Like everything else in Suharto’s Indonesia, the technocrats not only lacked an independent power base, their influence “depended entirely on their relationship with Suharto” (Pincus and Ramli 1998, 729). Clearly, over the years this relationship had soured. It seems that in the months before and during the crisis, the respected technocrats were politically isolated and powerless, their influence seemingly eclipsed by Suharto’s children and cronies. In fact, during the height of the crisis, Suharto reneged on implementing the much-needed economic and legal reforms because such policies would hurt the vast economic interests held by his children and cronies. In the end, Suharto’s erratic policy announcements only served to unnerve investors. Given the fact that power was so heavily concentrated in Suharto’s hands, any perceived weakness in his willingness or ability to respond expeditiously (whether real or perceived), resulted in a disastrous loss of investor confidence, both domestically and internationally. In the case of Malaysia, under the ostensible rationale for ethnic redistribution of resources, Mahathir and the Malay political elite built up an increasingly centralized political system based on patronage and cronyism. In their insightful study, Malaysia’s Political Economy: Politics, Patronage and Profits, Gomez and Jomo (1999) note that the emergent class of bumiputera (Malay) capitalists are neither authentic entrepreneurs nor industrial managers. Instead, they function as financial manipulators, engaged in deal-making and asset stripping and as collectors of rents of various kinds, including financial subsidies, lucrative non-competitive contracts from the state and protection from foreign competition. As a group they have failed The Asian financial crisis 42 to contribute to the efficiency, productivity, diversification or international competitiveness of the Malaysian economy. Compounding this problem was Mahathir’s “big growth push” policy to propel Malaysia to developedcountry status by the year 2020. The ever-growing list of extravagant megaprojects designed to facilitate Mahathir’s “Vision 2020” included the Bakun dam (Asia’s largest hydroelectric dam, costing an estimated M$15 billion), Kuala Lumpur’s showpiece, “Petronas,” or the world’s tallest “twin towers,” built at a cost of some M$2 billion, a super-modern airport (estimated at M$9 billion), a new administrative capital for the state of Sarawak in Borneo, and, the most audacious, a M$20 billion national administrative capital near Kuala Lumpur aptly called Putrajaya (or “city of kings”), to be built as a tribute to Mahathir Mohamad himself. Such ambitious projects resulted in massive public investment expenditure and rapid credit expansion.74 Besides the big projects, not only was much of the credit directed to the property sector, which “eventually weakened the financial position of the banks, as this lending led to a property glut,” but bank-lending increasingly took “the form of ‘connected’ (state-directed) lending rooted in the long-standing intimate link between the government and business” (Athukorala 1998, 92–3). Thus, instead of responding appropriately when the financial crisis struck (for a start, limiting the self-aggrandizing projects and connected lending), Mahathir’s first reaction was to find scapegoats. In a fiery speech on 20 September 1997 (before a joint World Bank–IMF annual meeting in Hong Kong), he argued that “currency trading is unnecessary, unproductive and immoral” and that it “should be stopped and made illegal” (Jomo 2001, 14). A few days later Mahathir suggested that there might be an international Jewish conspiracy to financially cripple his predominantly Muslim country. He lashed out against foreign currency traders with a Jewish heritage, in particular, the financier George Soros, branding him as a moron and criminal (Tan 2000, 17–18). As Gomez and Jomo (1999, 189) note, “the ringgit probably fell much further than might otherwise have been the case, as a result of international market reaction to Mahathir’s rhetorical and policy responses to the unfolding crises.” The discussion in Chapter 7 will show that the Malaysian government’s subsequent policy responses further aggravated the crisis. What about the two democracies, Thailand and Korea? Suffice it to note that scholars have long distinguished between two forms of democratic governance. Under procedural forms of democracy, a minimum set of democratic rules and rights are observed, including free and fair electoral competition based on universal suffrage, guaranteed freedoms of expression and association, an independent media, court and judiciary, and accountability through the rule of law. However, a substantive democracy meets more than the basic procedural requirements: citizens in such settings are also broadly included in the political arena, because democratic norms and values are Introduction: issues, debates and overview 43 highly institutionalized and routinized (Karl and Schmitter 1991). Clearly, Thailand and Korea (like most new democracies) have hardly solved the chronic institutional deficit in their polities: the exercise of democratic governance remains imperfect in both countries. Yet if we accept minimalist procedural definitions of democracy, which emphasize competition for national offices (that is, regimes that are freely elected are democratic), then Thailand and Korea crossed this threshold before the outbreak of the crisis, and Indonesia during the outbreak (or in the midst) of the crisis. At the time of the crisis, the deeply fragmented democratic governments in Thailand and Korea – incessantly pulled in all directions by interest groups and legislative and electoral pressures – or what Haggard (2000, 49) has termed “different veto gates” – delayed dealing with the mounting problems in the financial sector.75 Similarly, according to Wade (2001, 69–70), “in Thailand and South Korea, new civilian democratic regimes corrupted the central policy-making technocracy and lost focus on national economic policies. Government–bank–firm collaboration came to be steered more by the narrow and short-term interests of shifting coalitions. Their experience is bad news for the proposition that more competitive politics yield better policies.” In the case of Korea, it has been argued that political gridlock and the “immature and unconsolidated nature of Korean democracy” made for poor economic policy-making. Specifically, “policy gridlock was frequent because of a traditional political culture and weak democratic institutions, which were most pronounced in the legislative process. First, the system of legislative bargaining was not firmly established. Despite its constitutional mandate, the National Assembly continued to be subordinate to the executive branch in the policy-making process. Nor did the bureaucracy provide a stable mechanism of interest intermediation. As a result, disputing parties did not have a place in which to negotiate” (Mo 2001, 468). Compounding these problems were the growing divisions within the ruling party, and the impending general elections (in December 1997) made the government highly sensitive to pressures from corporations and the well-organized working class. Under pressure, the ruling party legislators backed away from introducing the necessary policy reforms, or indeed any policy measures they deemed would damage their chances in the upcoming elections. In the case of Thailand, an incoherent and deeply fragmented party system produced an undisciplined coalition government subject to factionalism, blackmail and policy incoherence. As Haggard (2000, 52) notes, “all of the democratically elected governments [in Thailand] before the crisis . . . were constructed from a pool of approximately a dozen parties, and cabinet instability was a chronic problem. As leader of the governing coalition, the prime minister was vulnerable to policy blackmail by coalition partners threatening to defect in pursuit of better deals in another alliance configuration.” Indeed, weak party discipline made political parties and governments highly sensitive to demands from powerful business constituents. For The Asian financial crisis 44 example, the Finance Minister Amnuay Virawan and the Central Bank Governor Rerngchai Marakanond found that their efforts to close down ten ailing finance companies came to nothing because determined opposition from within the government vetoed their measure. Not surprisingly, under such inauspicious conditions, the Thai government proved slow in reacting to early warning signals before the crisis struck, and had great difficulty in formulating a coherent response once it did. While both democratic and authoritarian regimes in Asia proved equally susceptible to the economic crisis, democracies have, nevertheless, demonstrated a remarkable ability to respond more effectively to the crisis. Specifically, the following chapters will illustrate that the democratic governments in Thailand (under Chuan Leekpai, November 1997–January 2001), in Korea (under Kim Dae-Jung, January 1998–) and to a lesser extent, in Indonesia, first under the “quasi-democratic” interim Habibie regime (May 1998–October 1999) and later under the democratic Abdurrahman Wahid government (October 1999–July 2001), were quite successful in exploiting their new popular mandates (not to mention their honeymoon periods), to implement some important reforms, including taking action against the previously favored vested interests. Thus the crisis opened a maximum window for reform – and given the substantial popular expectations that the new leaders quickly repair the economic damage – helped to empower these governments with a mandate to carry out macroeconomic reforms. This suggests that democracies not only provide legitimacy, moral authority and credibility to a regime, but that, at particular critical junctures, they may also demonstrate a remarkable capacity to formulate and implement significant political and economic reforms. The role of the IMF The principal responsibility for dealing with the Asian crisis at the international level was assumed by the International Monetary Fund. Soon this relatively unknown multilateral financial institution was put into the global spotlight as never before. Its every official utterance and policy move became the subject of intense public scrutiny and scathing criticism – from both the right and the left. With the benefit of hindsight, it is clear that the IMF’s record in dealing with the Asian financial crisis has been mixed. According to the IMF’s former deputy managing director, Stanley Fischer (1998a, 106), “the basic approach of the IMF to these crises has been appropriate – not perfect, to be sure, but far better than if the structural elements had been ignored or the Fund had not been involved.” The subsequent chapters will present a more nuanced picture of the IMF’s policies and its socioeconomic impact. At this stage, it is useful to understand better the role of the IMF, especially what the organization can and cannot do under Introduction: issues, debates and overview 45 its mandate, as well as to outline the basic components of, and the controversies surrounding, the IMF-led rescue packages in Asia.76 Under the institution’s Articles of Agreement, the 182 member countries who are signatories to the charter have committed themselves to promoting global trade and deepening economic integration by maintaining a stable international monetary system.77 This goal is to be achieved by maintaining orderly exchange arrangements among members, to avoid competitive exchange depreciation, and allowing individual national currencies to be exchanged for foreign currencies in the marketplace without restriction (currently only 117 members have agreed to the full convertibility of their currencies). Member countries are obliged to keep the IMF informed of any changes in their financial and monetary policies that may adversely affect fellow members’ economies, and expeditiously to modify or reform national policies on the advice of the IMF in order to facilitate international trade. Nevertheless, as an international organization whose members are sovereign nations, the IMF cannot examine a country’s financial books without explicit permission from the country’s authorities. In fact, the IMF is not even allowed to send a mission to a country unless it has been formally invited by the country’s authorities.78 In effect, the Fund operates much like a credit union for the member countries, serving as a manager of their common pool of financial resources, estimated to be over $220 billion in 2001.79 As in a credit union, member countries are entitled to withdraw their contributions almost at will. Nevertheless, the resource base allows the Fund to establish a stable value for each currency, and to provide confidence to members by making the general resources temporarily available to them, thus providing them with the opportunity to correct maladjustments in their balances of payments without resorting to measures destructive to national or international growth. The Fund’s capital comes almost entirely from “quota subscriptions” or membership fees, assessed on the basis of members’ economic size. For example, the United States, with the world’s largest economy, contributed about 18 per cent (approximately $38 billion in 1997) of the total quota, followed by Japan and Germany, which contributed 5.67 per cent each. Quotas are reviewed every five years, allowing member countries either to increase or to lower their contributions. The size of quotas not only determines what a country can borrow in time of need, but also the voting power of the member country. For example, in 2001, the US executive director held 17.1 per cent of the votes, and Japan’s director was second, with 6.1 per cent of the votes, followed by Germany, with 6.0 per cent of the votes. On the other hand, a director from South Africa representing twentyone African countries held 3.2 per cent of the votes, the Egyptian director, representing thirteen Arab countries, held 2.9 per cent of the votes, and Brazil, representing nine Latin American nations, held 2.4 per cent of the votes. Members can approach the IMF for financial assistance when they experience balance of payments difficulties. Although payments and receipts for The Asian financial crisis 46 imports and exports and long-term private capital flows across national boundaries rarely balance completely, the resulting imbalances are typically covered by short-term capital. However, serious imbalances may result in balance of payments difficulties. The problem may be resolved by largescale use of foreign currency reserves – although a country’s ability to sustain an external imbalance in this way is obviously limited by its holdings of foreign reserves. At, or close to, the point where reserves are exhausted, a country has little choice other than to devalue substantially, or to float its exchange rate. This was the circumstance that confronted a number of Asian countries in 1997 and 1998. Initially governments attempted to defend their exchange rates by resorting to their own means of foreign exchange management. They began their defense against the currency onslaught by way of intervention in the foreign-exchange market, in line with their adherence to a pegged system of foreign-exchange management – a rigid pegged system in the case of Thailand and Korea, and a managed float in the case of Indonesia. After losing substantial reserves in market intervention, particularly in the first two countries, one by one the three abandoned their pegged systems and allowed their currencies to float. As was noted earlier, the massive currency depreciations that followed had severe effects, as large volume of existing foreign-currency borrowing had not been hedged against exchangerate risk. This made many borrowers, including many banks, insolvent overnight. Just before they called on the IMF for assistance, Thailand and South Korea had perilously low reserves, and were on the verge of debt default. Specifically, although the baht was floated on 2 July 1997, it continued to depreciate, forcing the Thai authorities to request IMF assistance on 5 August 1997. The Bank of Korea announced its decision to stop defending the won at the exchange rate of 1,000 won per US dollar on 17 November 1997. The Korean authorities requested IMF assistance on 21 November 1997. On 14 August 1997, Indonesia announced that the trading band for the rupiah was being abandoned. It formally sought IMF support on 8 October 1997 – after the rupiah was already excessively depreciated. Thus, it is important to note that these three economies were already deep in crisis when they called the IMF to “restore confidence.” IMF financing can only be provided if the member country’s authorities commit to necessary policy changes and reforms, and to maintain these policies and reforms on track – adjusting them only if the circumstances dictate. This is called “IMF conditionality.” It involves commitments on both sides. On the one hand, conditionality provides assurances to the country that as long as it implements the agreed-to policies, it will continue to receive IMF financing. On the other hand, conditionality provides safeguards to the IMF that the funds it has lent are being used for the intended purpose and that the member country will be able to repay what it has borrowed from the Fund. Generally, IMF support is organized under a number of facilities. In 1963, the Fund established the Compensatory Introduction: issues, debates and overview 47 Financing Facility (CFF) to help countries overcome shortfalls in export earnings. In the 1970s and 1980s several new facilities were created. Today, regular IMF facilities include the Stand-by Arrangements (SBA), the Extended Fund Facility (EFF), created in 1974, the Supplementary Financing Facility (1979), and the Structural Adjustment Facility (1986), the expanded Compensatory and Contingency Financing Facility (1988), and the Enhanced Structural Adjustment Facility (1998).80 The SBA is designed to provide short-term balance of payments assistance for deficits of a temporary or cyclical nature; these arrangements are typically for 12 to 18 months. The drawing of funds is phased on a quarterly basis, and their release is conditional upon meeting performance criteria and the completion of periodic program reviews. The rationale for such phasing is that it maintains incentives for the authorities to continue implementing the policies agreed under the program.81 The EFF is designed to support medium-term programs that generally run for three years – with the particular aim of overcoming balance of payments difficulties stemming from macroeconomic and structural problems. In the case of Asia, much of the IMF’s support was organized under the Emergency Financing Mechanism (EFM) and the newly created Supplemental Reserve Facility (1997). These mechanisms, with a greatly reduced period of negotiation, review and IMF board approval, permitted the programs to be put in place very quickly. This meant that they forced exceptionally quick analysis and negotiation, and important decisions at times had to be made on “more-than-usually incomplete information” (Lane et al. 1999, 6). Letters of Intent and “Memoranda of Economic and Financial Policies” (or the IMF “conditionality”) laid out the strategies and sequencing of the IMFsupported programs.82 According to the then IMF Managing Director, Michel Camdessus (1998): As soon as it was called upon, the IMF moved quickly to help Thailand, then Indonesia, and then Korea to formulate reforms programs aimed at tackling the roots of their problems and restoring investor confidence. In view of the nature of the crisis, these programs had to go far beyond addressing the major fiscal, monetary, or external balances. Their aim is to strengthen financial systems, improve governance and transparency, restore economic competitiveness, and modernize the legal and regulatory environment. The conditions that the IMF imposed on Thailand, Indonesia and Korea in exchange for IMF-led rescue packages consisted of three basic components. The first concentrated on macroeconomic policy reform, in particular (a) the introduction of tight fiscal and monetary policy (i.e. an increase in interest rates and the adoption of strict limits on the growth of money supply), in order to produce current account surpluses and to stabilize the value of the currency by slowing currency depreciation; and (b) the maintenance of high interest rates to stem (or reverse) the capital outflows. It was believed that such a strategy would improve the current account and the The Asian financial crisis 54 problems, whether market confidence would be regained without the affected countries’ agreeing to implement transparent auditing and accounting practices, improve corporate governance and reform (if not dismantle) their shaky banks, finance companies and government monopolies.86 The IMF has argued that, without its determined intervention, it was highly unlikely that Thailand and Indonesia would close their insolvent banks and finance companies or that South Korea would rein in its greatly over-leveraged and out-of-control chaebols, or that Indonesia would dismantle the corruptionridden and inefficient government monopolies in plywood and clove. Thus, in response to Radelet and Sachs (1998), who claim that the IMF’s misguided three-pronged approach only exacerbated the panic by giving investors the misleading impression that something was fundamentally wrong with these economies, the IMF has argued that to the extent that the Asian crisis was attributable to structural problems rather than the traditional macroeconomic imbalances, an effective reform strategy had to address the “structural problems that lie at the heart of the economic crises in the three countries” (Fischer 1998a, 103). That is, IMF bailout packages would have served no purpose if the weaknesses of the financial sector were not corrected by the appropriate structural reforms, not to mention the fact that half-hearted reforms would not have helped to re-establish market confidence. As Fischer (1998a, 103) notes, “to ignore the structural issues would invite a repetition of the crisis.” Beyond these policies, IMF bailouts are seen as creating moral hazard. “Moral hazard” refers to a situation where people can reap the rewards from their actions when things go well, but do not suffer the full consequences when things go badly. Hence investors do not have to exercise due diligence, since they would expect a bailout in the case of default, or for that matter, debtor countries can choose to pursue risky economic policies with the expectation that they will not have to pay the full costs of their debts and investors will not lose the full amount invested if a financial crisis occurs. According to this reasoning, the history of IMF bailouts, especially the bailout of Mexico following the peso crisis (where the IMF and the G-7 effectively guaranteed in full the dollar-denominated Mexican government securities, the so-called tesobonos), convinced lenders that they would be able to get their money back regardless of whatever happens in a borrowing country.87 Jeffrey Sachs (1998, 16) comments on “the failings of recent IMF bailout loans, in which private sector creditors walked away with the IMF money while debtor countries in effect nationalized the private sector debts . . . the IMF money went out to foreign creditors as fast as it arrived to the debtor governments.” Thus the IMF, by cushioning the losses of imprudent lenders and borrowers with generous bailout packages, only encourages reckless behavior – with Asia and Russia being the most recent cases in point.88 It is undeniable that IMF bailouts have created the problem of moral hazard – after all, despite weak underlying fundamentals, investors purchased Introduction: issues, debates and overview 55 large amounts of Russian government securities under the expectation that geopolitical and security concerns would prompt the G-7 and the IMF to provide funds – and they were not wrong. Yet, it is important to note that not all investors in emerging market securities escaped losses as a result of the Mexican and Asian rescues. It is almost impossible for investors to ignore the fact that IMF financial support, even when exceptionally large, tends to be much smaller than what would be needed to imply a full and credible guarantee.89 Nevertheless, it is critical that market participants do take a bigger hit (or receive a bigger haircut) to ensure that they do not escape all losses as a result of multilateral assistance for the crisis country. Also, in all fairness, the IMF cannot exclusively be held responsible for creating moral hazard. Bailing out the foreign holders of tesobonos and letting the Russians sell ruble-denominated treasury bills to foreigners had the strong support of the IMF’s main shareholders, the G-7 countries. Finally, it should be noted that, unlike other forms of insurance, disbursements of IMF resources are not a cash payoff. Rather they are loans, to be repaid with interest. Thus, if investors are eventually bailed out of crises, it is not by the Fund, but by debtor countries themselves – that is, any “bailout” is funded by a member’s own savings flows, as reflected in its external current account. This study will show that (a) moral hazard is a far more complex problem, and (b) it was not as pervasive or as severe as some have made it out to be. The study will also critically assess the IMF’s efforts to reduce moral hazard. Notes 1 During 1992–93, the countries of the European Monetary System spent US$150– 200 billion on intervention in foreign-exchange markets in an unsuccessful effort to stave off the devaluation of 10 European currencies. The crisis brought down the ERM, and forced the United Kingdom and Italy out of the system. 2 Prior to its floating, the baht was pegged to a dollar-dominated basket for almost 13 years. On July 11, less than two weeks after the baht was set free to float, the Philippine central bank widened the band within which the peso was allowed to fluctuate. Three days later, the Philippines became the first crisis-hit Asian country to receive financing from the IMF. The Bank of Indonesia widened its intervention bands from 8 per cent to 12 per cent in July 1997. However, on August 14, 1997 the rupiah was floated and immediately went into a free fall. In Malaysia, the central bank (Bank Negara) also intervened in order to prevent the ringgit from depreciating too quickly. In July 1997, following the devaluation of the baht, the ringgit fell 2 per cent to 2.25 against the dollar. Bank Negara spent 10 per cent of the country’s foreign reserves propping up the ringgit. On July 14, the ringgit was de-linked from its dollar-denominated currency and allowed to float. 3 Under competitive devaluations, exports of countries whose currencies undergo a devaluation become more competitive in world markets as against the exports The Asian financial crisis 56 of countries whose currencies do not undergo a devaluation to the same extent. This puts tremendous pressure on countries with stable currencies to devalue in order to make their exports competitive in world markets. 4 By end of 1997, the New Taiwanese dollar had depreciated by 15 per cent, while the stock market fell by 30 per cent. 5 The design of the currency board and linked exchange-rate system in Hong Kong is as follows. The three note-issuing banks in Hong Kong can surrender a certain amount of US dollars to the Exchange Fund of the Hong Kong government in exchange for an equivalent amount (at the official exchange rate of 7.8) of Certificates of Indebtedness – which will entitle them to print the said amount of Hong Kong dollars. With the Certificate of Indebtedness, the three note-issuing banks can use the same amount of Hong Kong dollars to redeem the equivalent amount of US dollars. According to the design, any discrepancy between the market and official exchange rates would be removed by cash arbitrage. However, in actual practice, the HKMA sells US dollars and buys Hong Kong dollars whenever the market exchange rate comes close to the intervention rate of 7.75. Thus, the currency board system operates with a selfadjustment mechanism to restore exchange-rate stability when it comes under pressure. That is, when there is an outflow of funds and the domestic currency is sold to the currency board, the monetary base will contract and interest rates will rise automatically. For details, see Yam 1998a. 6 The HKMA was sharply criticized for relying on this single tool, the interest rate, to defend the Hong Kong dollar. However, what is not always recognized is that the currency board’s automatic adjustment mechanism would require local interest rates in the interbank market to go up in the event of a capital outflow – which would take the form of Hong Kong banks’ selling Hong Kong dollars to the HKMA for US dollars at the fixed exchange rate. Moreover, the Hong Kong authorities also took several other steps, such as asking banks to limit loans to the speculative property and stock markets, strengthening prudential standards for non-performing loans of banks, increasing bank reporting requirements, and insisting on greater transparency of the banking sector. 7 According to theory, any speculative attack that bid up the domestic interest rate would attract capital inflows (thereby bringing the domestic interest rate back to the US level), making speculative attack unprofitable. However, such a process did not materialize. The huge gap between the Hong Kong dollar and US dollar interest rates was due to the so-called “Asian Risk Premium.” Also, it should be noted that while the speculative attack on the forward currency market was the prime mover of the crisis, most of the profits came from the speculative selling in the stock futures market. For example, a fall of the Hang Seng Futures Index by 1,000 points would mean half-a-billion Hong Kong dollars’ profit for every 10,000 contracts. If speculators altogether sold 50,000 contracts and gained 4,000 points in the futures index, the profit would be HK$10 billion. 8 On October 23, 1997, stock prices in Hong Kong fell by 10.4 per cent, a larger fall than what occurred following the Tiananmen incident. However, nothing better illustrated the crisis in Hong Kong than the spectacular collapse of Peregrine Investment Holding. This regional investment house, known for its risk-taking, fell because of its unsound investment in the ironically named Indonesian taxi company, Steady Safe. On the eve of its collapse, Peregrine held $270 million in Introduction: issues, debates and overview 57 promissory notes, denominated in US dollars, from Steady Safe – or about onethird of its capital assets. In addition, it held an estimated US$400 million in other Indonesian debt securities. Because of the sharp decline of the value of the Indonesian rupiah and its failure to hedge against currency risk, Peregrine’s investment became worthless virtually overnight. 9 Since Singapore and Taiwan competed directly with Korea in a wide range of export products, the fact that both had allowed their currencies to depreciate put Korea at a serious competitive loss. 10 Since 1990, South Korea had operated a managed floating system known as the “market average rate system (MARS).” Under this system the Bank of Korea would intervene actively if exchange-rate fluctuations exceeded the permitted plus or minus 2.25 per cent band against the preceding day’s closing price. 11 The Malaysian Prime Minister Mahathir Mohamed lamented that “the financial turmoil had reduced the Asian Tigers into whimpering kittens, and . . . that the massive damage to their economies will take decades to restore”: Singapore Straits Times, March 3, 1998, p. 11. 12 According to Gopinath (1999, 82), “Nowhere was the US influence more evident than in the decision to bail Russia out. The Clinton administration wanted to keep President Boris Yeltsin and his so-called economic reformers in office. The IMF staff, including Michel Camdessus and Russia expert John Odling-Smee, were reluctant because they worried they wouldn’t be able to monitor how the money would be used. But with its largest donor urging it to go ahead, the IMF had little choice but to agree to pledge $11.2 billion to a $22.6 billion Russian rescue.” Also see Bueno de Mesquita et al. (1999, 27), and IMF Survey, vol. 27, no. 17, August 31, 1998, pp. 275–6. 13 Illarionov (1999) argues that the refusal by the Duma (Russian Parliament) to accept key fiscal measures in the modified economic program worked out by the IMF and the Russian government in early July 1998 was the final straw. 14 The devaluation exposed the insolvency of the banks by leaving them with dollar obligations on forward contracts many times greater than their capital. For details, see IMF Survey, vol. 28, no. 15, August 2, 1999, pp. 241–3. Also see IMF 1999, 55–8. 15 See IMF Survey, vol. 27, no. 23, December 14, 1998. 16 In October 1997, speculators attacked the Brazilian real with the aim of profiting from an expected devaluation by selling the currency “short” – that is, borrowing the currency and selling it with the hope of repurchasing it more cheaply before repaying the lender. While this strategy is usually not sufficient to force a devaluation, it can put tremendous pressure on a currency. The outcome depends on the government’s response. It can defend its currency by selling reserves and/or raising interest rates, or it can allow the devaluation to occur. 17 For details, see IMF Survey, vol. 27, no. 21, November 16, 1998; IMF Survey, vol. 27, no. 23, December 14, 1998; IMF Survey, vol. 28, no. 6, March 22, 1999. 18 Also, on January 6, 1999, when Itamar Franco, governor of the state of Minas Gerais, announced a moratorium on debt payments owed to the federal government (totaling US$15 billion), market confidence in the success of Brazil’s fiscal stabilization plan waned further. And when a number of other Brazilian states joined the request of Minas Gerais, the net outflow of capital intensified. The Asian financial crisis 58 19 The disorderly exit from the peg caused the real to overshoot (the real lost over 50 per cent of its value in a few months), hurt economic activity, and propelled unemployment to a decade-high 8.3 per cent in February 1999. For details, see IMF Survey, vol. 28, no. 3, February 8, 1999. 20 The G-7 (or Group of 7) countries comprise the United States, Great Britain, Germany, Japan, France, Canada and Italy. The OECD countries include the G-7 plus 15 other major economies of the world. 21 The US$20 billion was funded through a conditional collateralized loan funded from the US Treasury’s Exchange Stabilization Fund. 22 Prior to Mexico, the largest IMF stand-by credit arrangement was the US$4 billion agreement with the United Kingdom in 1977. It is important to note that while the IMF and other multilateral institutions provided the rescue packages to ailing Asian economies quickly, the amount and timing of disbursements depended on the countries’ performance under IMF-agreed reform programs. Between August 1997 and October 1998, Thailand received some 60 per cent of the financing committed for that period by the IMF and the World Bank. Korea received almost 90 per cent of the financing committed in the very early stages of the crisis. By contrast, official lending to Indonesia was held up, after an initial disbursement of US$3 billion in early November 1997, owing to the slow implementation of reforms. IMF disbursements resumed only in May 1998, and stepped up during the summer, after major political reforms took place in the country. For details on IMF lending, see IMF Survey, vol. 28, no. 5, March 8, 1999. 23 The Miyazawa Initiative announced by the Japanese government on October 3, 1998 was designed to help the crisis-affected countries restructure corporate debt, reform financial systems, strengthen the social safety net, increase employment and ease businesses’ financial constraints. To achieve this quickly, the initiative provided for US$15 billion in short-term swap arrangements and the rest for medium and long-term use. Japan’s Export–Import Bank was selected to guarantee loans to Southeast Asian nations as well as purchase bonds issued by their governments. In fact, an important element of this initiative is that it allows official Japanese institutions to guarantee bond money raised by crisis-hit Asian countries at rates available to the Japanese government. As of April 2000, only US$6.75 billion remain unused. 24 Gilpin (2000, 145) notes that “as early as the spring of 1997, Japan urged joint action to prevent a crisis, but the Clinton Administration, fearing a negative domestic reaction, failed to act.” He adds that “the Clinton Administration was very slow in recognizing the serious nature of the unfolding crisis; indeed, as late as the November 1997 Asia-Pacific Economic Cooperation (APEC) Summit in Vancouver, the President dismissed the crisis as a few small glitches on the road” (p. 146). 25 Quotations cited in CPER (1998, 2), Gilpin (2000, 143) and Council on Foreign Relations (1999, 23). According to Tan (2000, 207), “one possible reason for the lack of interest and concern on the part of the Americans was the fact that US banks were the least exposed to countries affected by the currency crisis. At the end of 1996, total lending by US banks to Thailand, Malaysia, Indonesia and South Korea was US$22 billion. This was only about a quarter of the total lending of Japanese banks (US$92 billion), or European banks (US$82.3 billion) to these countries.” Introduction: issues, debates and overview 59 26 At the Birmingham summit in May 1998 the G-7 leaders and finance ministers stressed the need for reforming the international monetary system. 27 Robert Rubin, “Strengthening the Architecture of the International Financial System,” public statement delivered at the Brookings Institution, April 14, 1998. 28 The terms “moral hazard” and “asymmetric information” will be elaborated later. 29 IMF, 2000d. “Recovery from the Asian Crisis and the Role of the IMF,” IMF Issues Brief, June. 30 “Asymmetric information” emerges when one party to a financial contract does not have the same information as the other party. 31 “Herd behavior” suggests that investors’ decisions are not always rational. 32 As is well known, even well-managed banks or financial intermediaries are vulnerable to panics, because they traditionally engage in “maturity transformation.” That is, banks accept deposits with short maturities (up to three months) to finance loans with longer maturities (up to one year or longer). Under normal conditions banks should have no problem managing their portfolios to meet expected withdrawals. However, if all depositors decided to withdraw their funds from a given bank at the same time (as during a panic), the bank would not have enough liquid assets to meet its obligations – threatening the viability of an otherwise solvent financial institution. 33 Radelet and Sachs (1998, 4) note that there is “a critical distinction between illiquidity and insolvency. An insolvent borrower lacks the net worth to repay outstanding debts out of future earnings. An illiquid borrower lacks the ready cash to meet current debt servicing obligations, even though it has the net worth to repay the debt in the long term. A liquidity crisis occurs if a solvent, but illiquid, borrower is unable to borrow fresh funds from the capital market in order to meet current debt servicing obligations.” 34 Implicit in the Radelet and Sachs (1998) account is the view that investor behavior was irrational. It should be kept in mind that when the currency crisis is analyzed as a bank run, investor behavior does not have to be irrational. Given that other creditors are withdrawing funds, it is rational for an investor to withdraw funds. In fact, it may be rational to be first in line. 35 “Contagion” refers to the spread of market disturbances from one country to another, which is observed through movements in exchange rates, stock markets and interest rates. Empirical examination of the evidence for contagion consists of four types of tests. The first estimates correlation coefficients of financial variables. According to this approach, a marked increase in correlations among markets of different countries is regarded as evidence of contagion (Calvo 1996). Eichengreen and Rose (1998) define contagion as a case where knowledge of a crisis elsewhere increases the probability of a crisis at home. The third type of tests estimates levels of volatility among financial markets. This approach examines whether conditional variances of financial markets are related to each other during the crisis period (Edwards 1998). Finally, a fourth type of test examines whether foreign news affects financial variables at home (Kaminsky and Schmukler 1999a). 36 Fratzscher (1998) has found that the financial markets in Southeast and East Asia are highly integrated, meaning that the financial channel of contagion is highly influential. While Fratzscher also found that Asian economies are close The Asian financial crisis 60 trade competitors in terms of the similarity of export structures and export destination (including intra-regional trade), the size and significance of the coefficients in his econometric equations however suggest that the financial link was the most important channel of contagion in the Asian crisis. 37 Various factors may account for crises spreading across countries. First, simultaneous crises may be triggered by a change in the external environment such as increases in international interest rates. Second, crises can spread through trade and financial linkages. Portfolio reshuffling by investors in response to developments in one country may affect another country’s access to flows. Third, the similarity of fundamentals with affected countries, such as geographical proximity or common development strategies, can lead to contagion. 38 At the time the official rate of the RMB (renminbi = yuan) was at 5.8 RMB per US dollar versus the 8.7 RMB per dollar at the swap center. 39 For a discussion of how China’s pre-emptive devaluation contributed to the Asian financial crisis, see Corsetti, Pesenti and Roubini (1998). 40 The tax change meant that exporters could claim a refund of the VAT paid on inputs. 41 Data compiled from World Bank (1998, 1996), IMF (1997) and Zhongguo Jinrong Nianjian 1997 (1997). 42 The quotation is from Mattione (2000, 185). 43 The classic bubble economy is one in which real estate prices continue to rise well beyond levels justified by the productivity of the assets. However, so long as the prices continue to rise, existing investors are rewarded and collateral is created for new loans to finance further investment, and so on – until the inevitable crash. 44 For the first four decades following the Second World War, Japan’s overall economic growth was spectacular: a 10 per cent average in the 1960s, a 5 per cent average in the 1970s, and a 4 per cent average in the 1980s. For details, see Posen (1998). 45 Until the outbreak of the Asian financial crisis, the Japanese authorities had managed to cover up the seriousness of the banking crisis by a series of government-sanctioned takeovers of smaller failed banks by larger banks under the so-called “convoy system.” Why has Japan failed to address its loan problem effectively? According to Lincoln (1998), politics is at the root of the problem. That is, Japanese politicians have incestuous relations with borrowers and the banking community. For example, investment banks commonly lend money to politicians to buy a particular stock and then ramp up stock prices, allowing the politicians to sell out, repay the loan, and make a profit. If the non-performing loan problem were cleared up, many such illegal transactions would come to light, causing embarrassment to those involved. 46 Grenville (1999, 3) notes that “the interest differential between the major industrial countries and the emerging market economies was the greatest for Japan – hence, the rise of the yen-carry trade – borrowing at low interest rates in yen, and on-lending at high returns in other countries, particularly in Asia. When local-currency borrowing rates were around 20 per cent (which was the case, for example, in Indonesia), yen-based interest rates seemed extraordinarily attractive.” 47 Dobson (1998, 153) notes that “in 1996, only three out of twenty major Japanese banks recorded positive rates of returns on equity, and the rest had negative Introduction: issues, debates and overview 61 rates ranging from −19.4 per cent to −3.15 per cent. In 1995, 13 trillion Yen of loan write-offs and loan loss provisions more than offset the operating profits of all Japanese banks, which led to a net loss of 3.8 trillion Yen.” 48 The Basle Accord, an international agreement that set common standards by which to evaluate capital adequacy, was introduced in 1988. In order to create a “level playing-field” it requires that all internationally active banks satisfy the same two (minimum) risk-based capital ratios. 49 See “Japanese banks and market discipline” in Chicago Fed Letter, no. 144, August 1999 (publication of The Federal Reserve Bank of Chicago). 50 “Asia Trembles Again,” The Economist, June 20, 1998, pp. 81–2. 51 Japanese investors did not need to worry about risk associated with overvaluation of a host country’s currency as long the authorities succeeded in keeping inflation rates in line with the appreciation of the dollar. 52 Japanese manufacturing companies also shifted their production to North America, partly to avoid trade conflicts and partly to prepare for the North American Free Trade Area (NAFTA). 53 A study by Frankel and Wei (1994) on the exchange-rate policy of nine East Asian countries during the period 1979 to mid-1992 has shown that the weight that was attached to the US dollar in the currency baskets of most East Asian countries ranged from 0.9 to 1.0. The only exception was the Singapore dollar, which assigned slightly more weight to the yen. A study by Kwan (1995) further confirmed the dominant position of the dollar in East Asian currency baskets. 54 The only exception was the Philippines, which during 1991–95 posted a mere 2.2 per cent annual growth rate. 55 Within a broader historical perspective, the fast-growing Asian economies were doubling their average incomes approximately every 11 years. On the other hand, it took Great Britain about 60 years to double its average income after 1780; the United States took about 50 years to double its average income after 1840; and Japan took roughly 35 years to double its income after 1885 (Tan 2000, 23). 56 Krugman’s findings have been questioned. According to Sarel (1997), Singapore, Malaysia and Thailand all had a TFP (total factor production) growth of 2 per cent to 2.5 per cent between 1978 and 1996, compared with only 0.3 per cent in the United States. 57 When private investors borrow short-term, they may fall into maturity mismatch difficulties. Maturity mismatch difficulties arise when the assets backing short-term debt obligations are longer-term, and therefore less liquid than their liabilities. Illiquid assets (such as real estate) cannot be sold quickly at fair value. 58 That is, governments in the developing world (especially, Latin America), which had borrowed heavily from foreign commercial banks during the 1970s (encouraged by very low real interest rates and by high prices for their commodity exports), were unable to service their debts when real interest rates rose sharply at the end of the 1970s, and a world-wide recession reduced demand for developing country exports. 59 Since the 1990s, the international bond market has been the largest provider of net financing to emerging markets. It has also served as the mainstay of external financing for sovereign borrowers (in marked contrast to the 1980s, when syndicated bank lending performed this role). The Asian financial crisis 62 60 The 1996 figure is from the World Bank (1996a, 11–12). The other figures are from the IMF (1995, 2–4). 61 Calvo, Leiderman and Reinhart (1993) found that declines in US interest rates were correlated with increases in proxies for capital inflows (foreign reserve accumulation and real exchange rate appreciation) to Latin America in the early 1990s. Fernandez-Arias (1996), who studied a broader sample of emerging markets, estimated that global interest rates accounted for nearly 90 per cent of the increase in portfolio investment flows for the “average emerging market” in 1989–93. 62 Hong Kong, Japan, Singapore and Malaysia were accorded IMF Article 8 status as early as the 1960s. 63 Nidhiprabha (1998, 195) notes that “by the end of 1995, the short-term debt through the BIBF amounted to $41 billion, out of a total debt of $80 billion.” 64 Lipsey (2001) finds that direct investors, especially those who operate manufacturing facilities in foreign countries, are much more likely to ride out economic crises than those involved in foreign bonds, equities, bank loans and other forms of investment. The major reason for this appears to be that much of the direct investment is bound up in enterprises that, in times of instability, can redirect sales from a country’s local markets to export markets. Lipsey also credits the direct investors with being more willing to hang tough in the midst of seeming chaos. For example, he finds foreign direct investors operating in Asia “to be much less skittish than other investors in responding to the crisis.” 65 Illiquid assets cannot be sold quickly at fair value. One common example of an illiquid asset is real estate – where it takes some time to locate a buyer willing to purchase the asset at its fair value. 66 There are a number of different instruments and approaches that can be used to manage currency risk in international trade transactions. These include (1) forward foreign-exchange contracts, (2) structural or balance-sheet hedges, (3) invoicing in local currency, and (4) use of foreign-exchange option contracts. Aforward foreign-exchange contract involves contracting today to buy or sell a foreign currency at a future date at an exchange rate agreed today. Thus, for example, exporters can contract today to sell the foreign-exchange proceeds they expect to receive at a future date so as to insulate themselves from fluctuations in the exchange rate in the interim. Generally, the forward exchange rate on a given day will not be the same as the spot rate. The difference stems directly from the interest rate differential between the two currencies. However, it is also the case that forward contracts are generally favored for shorter-term hedging of trade flows, while borrowing or lending in foreign currencies is normally seen as a way to establish a long-term structural hedge. One reason why forward contracts are used to establish shorter-term hedges is their relative flexibility. Contracts can readily be rolled forward, or closed out according to the firm’s view of the exchange rate. Also, forward contract maturities can be managed flexibly, through the use of swaps contracts. For example, a common practice for a firm is to enter into a spot contract immediately it sees a favorable opportunity in the market. Later, by executing a swap contract, the spot contract can be turned into a forward contract, with a maturity date that matches the underlying export receipt or import payment date. Introduction: issues, debates and overview 63 The arrangements under which banks will deal with firms in foreign exchange, including in forward contracts, are also more flexible than those under which they will establish debt facilities. The documentation and security that banks require to support a foreign exchange dealing line often are less demanding than those required for debt facilities. For these reasons, managing foreign-exchange risk by managing the currency composition of the balance sheet through foreign currency borrowing tends to be limited to large corporations with the financial strength and profile to access offshore debt markets, or with offshore operations that can fund themselves directly in the markets in which they operate. Invoicing in local currency is another possible way to manage exchange-rate risk by passing it to the trading counter-party. However, invoicing in local currency does not of itself provide complete protection against exchange-rate risk. What matters, therefore, is not just the currency of invoicing, but the ability to negotiate a pricing arrangement (either in foreign currency or local currency), that leaves the effect of exchange-rate changes with the trading counterpart. Another hedging possibility available to local exporters and importers facing foreign exchange risk is foreign exchange options. As the name suggests, an option contract differs from a forward contract in that it gives the holder the right, but not the obligation, to buy or sell one currency in exchange for another at a specified exchange rate, and at an agreed point in the future. Under a forward contract the holder must buy or sell on the agreed date; with an option the holder has the choice. 67 Of course, in Mexico, the capital inflows fueled a consumption boom. 68 The underlying rationale is that the flexibility in exchange rates would introduce some uncertainties that might discourage purely speculative and highly reversible inflows. It also allows the monetary authorities a greater degree of independence in exercising control over monetary aggregates as they become relatively free from preoccupation with the stability of the exchange rate. 69 Intervention can be sterilized or left unsterilized. Unsterilized intervention will increase the monetary base, resulting in lower interest rates. The stimulating effect of lower interest rates may cause inflation if the economy is already at the full capacity of production – which is often the case for emerging market economies that attract massive capital inflows. 70 Suppose the initial capital inflows were in the form of FDI. The domestic end of sterilization is most likely effected in the short-term money market. Then, the short-term interest rate may increase, while the long-term interest rate will decline. The higher short-term interest rate will invite more capital inflows in the form of portfolio investment. Hence, sterilized intervention may increase capital inflows. 71 Montiel and Reinhart (1997) argue that the sterilization policies followed by the host (capital inflow) countries played an important role in setting the stage for the subsequent crisis. Specifically, sterilization operations kept domestic interest rates in the host countries higher than would otherwise have been the case, thereby inducing both larger net inflows and a high share of interest-sensitive short-term flows. 72 The Malaysian political system is sometimes referred to as “semi-authoritarian” or “semi-democratic” because it contains features of both systems. That is, although the constitutional framework of the Malaysian political system is essentially democratic (elections have been held regularly, the government is responsible to The Asian financial crisis 70 The investment and export-led boom If large and sustained rates of economic growth, to quote Paul Krugman (1994), are usually the result of both “inspiration” and “perspiration,” in Thailand’s case they took a lot of perspiration from both the civil society and the state.9 The Thai government has long used policy instruments to influence the direction of economic activity. For example, the Board of Investment (BOI), created in 1959, used a combination of various investmentpromotion schemes, tariff policies, tax regimes, and trade and price controls to direct the pattern of private investment, besides supporting extensive public investment in infrastructure. During the 1960s and early 1970s, industrial policies strongly supported capital-intensive import-substitution industrialization (ISI). Import tariffs were sharply raised to protect local industries, with special incentives for the production of final goods based on imported intermediate and capital goods. Indeed, as Christensen et al. (1997, 354) note, “the BOI’s most significant power was over imports. It could exempt particular firms or industries from import duties on machinery, components, and raw materials, as well as imposing bans and surcharges on competing imports.” The officially stated emphasis on ISI was shifted towards the promotion of exports with the passage of the Investment Promotion Act of 1972. Local businesses responded eagerly to these opportunities, both on their own and through joint ventures with foreign firms – investing in agro-processing industries, trade, banking and other activities centered on the domestic market. In the late 1970s, the Thai government introduced a further series of measures designed to speed up the growth of manufactured exports. These included industrial export incentives, such as tax and tariff rebates and preferential interest rates on short-term loans. In the early 1980s, the Thai government implemented another round of export incentives, including tax incentives and currency devaluations in 1981 and 1984. For example, the BOI gave priority to export projects, granting numerous exemptions to export-oriented projects, including duties and business taxes on imported raw materials or components, business taxes on domestic input, export duties, and certain deductions from taxable corporate income.10 The government also reformed the customs procedures and removed cumbersome regulations to help exporters expedite their processing and shipments. In addition, it established export processing zones (EPZs) – where businesses enjoyed exemption from import/export duties and business taxes. EPZ firms and factories also benefited from good infrastructure, and were entitled to get a 20 per cent reduction in their energy bills. All domestic exporters received concessionary credits and marketing assistance.11 Finally, a major incentive to export came from the changes in the real exchange rate. Specifically, throughout the 1960s and 1970s, the baht was tied to the US dollar, with occasional minor adjustments. While this policy Thailand: crisis, reform and recovery 71 served Thailand well during the era of fixed exchange rates, it became problematic once the major currencies began to float following the collapse of the Bretton Woods system. Linking the baht to the dollar led to an increase in the real effective exchange rate in the early 1980s, despite the 8.7 per cent devaluation against the dollar in 1981. In response, the Thai government changed the real exchange rate in 1984 by tying the baht to a basket of major currencies – albeit the US dollar weighed heavily in the basket. The aim of the new managed float was to maintain the baht–dollar parity within a somewhat wider band. The new exchange rate resulted in an immediate 15 per cent devaluation of the nominal exchange rate against the dollar – providing Thai firms with a real incentive to export.12 Nevertheless, a prolonged slump in world commodity prices saw overall export growth, especially exports of natural resources and some semimanufactures, decline during the period 1980–86. Export growth recovered after 1986, but this recovery was not led by either exports of natural resources or semi-manufactures, but by a rapid growth of manufactured goods, such as clothing, textiles, office machinery, integrated circuits, and telecommunications and computer components. Indeed, Lall (1999) notes that this high export growth was based on a shift in the structure of the export sector – where complex activities began to replace simple production. The sector encompassed four types of technologies: resource-based (food processing), low (textiles, footwear, leather and plastics), medium (the automotive industry), and high (complex electronic and electrical products). Between 1985 and 1996, the share in exports of products manufactured using medium and high technology rose from among the lowest in the region (20 per cent) to the highest (50 per cent). Thailand’s mediumand high-technology product export shares exceeded those of China, Hong Kong and Indonesia. What explains the change in the pattern of exports? Generally, the production of manufactured exports requires higher levels of worker skills. Yet human resource development, particularly education levels and worker skills development (as measured by average years of adult schooling), remained weak in Thailand. In fact, although Thailand’s investment in physical capital as a ratio of GDP has long been one of the highest in the world, not enough resources have been devoted to human capital or skill formation. Thus Thailand’s secondary and tertiary school enrollment as a percentage of population have consistently been much lower than those of other high-growth Asian economies, including Indonesia and Malaysia, and have also lagged behind low-income countries such as India.13 Rather, the impetus for the expansion of manufactured exports in Thailand came from outside – in the form of foreign capital. Indeed, in the 1980s capital inflows doubled, rising to US$4.5 billion per year, and between 1990 and 1996 they tripled to US$14 billion per year (Mahmood and Aryah 2001, 256). First, Thailand needed foreign capital, since its domestic savings were not high enough to finance the high level of investments necessary for The Asian financial crisis 72 rapid growth. Second, there was the appreciation of the yen vis-à-vis the weakening US dollar after the 1985 Plaza Accord, during which time the baht was effectively pegged to the dollar at a rate of roughly 25 baht per US dollar.14 Third, as Japan, South Korea, Hong Kong and Taiwan faced sharply rising labor costs and protectionist barriers, this increased the cost advantage of exports from Thailand, Malaysia and Indonesia. Fourth, and most importantly, export expansion was fueled by massive inflows of foreign capital from Japan and the other newly industrializing countries, searching for lower labor costs and lower protectionist barriers in importing countries. For example, Taiwanese investors saw Thailand as “a key linkage between Asia and Europe, comprising abundant raw materials as well as good quality staff, reasonable land prices and wages, together with accommodative government policies” (Mahmood and Aryah 2001, 257). Similarly, for the Japanese, Thailand offered all the above, in addition to fulfilling their need to spread production bases overseas and to take advantage of Thailand’s unfulfilled quotas under the Multi-fibre Arrangement (MFA), as well as to utilize the privileges under the Generalized System of Preferences (GSP) to which Thailand was entitled as a developing country.15 Indeed, by the late 1980s, Thailand was one of the chief recipients of Japanese FDI, and by 1988 Thailand attracted more FDI than the four Asian newly industrialized countries combined. As Tables 2.1 and 2.2 show, by the late 1980s capital flows (mostly in the form of private sector borrowing) increased dramatically, fueling a rapid expansion of exports of labor-intensive manufactured goods. Indeed, the two were intimately related, as much of the foreign investment was in the labor-intensive manufacturing sector – producing everything from textiles (in particular, garments), to wood products, rubber products, processed foods, canned goods, plastic goods, toys, shoes, leather products and confectionery, as well as medium and high-tech products such as computer components, electronics, automobile parts, telecommunications and sound equipment, machinery and electrical goods.16 By the end of 1996, the manufacturing sector employed more than 4 million workers, accounted for 29 per cent of GDP and more than 70 per cent of export earnings (OECD 1999a, 22). In terms of export growth, between 1988 and the end of 1995 export growth averaged an extraordinary 28 per cent per annum, and as a share of GDP exports increased from 23 per cent in 1988 to 34 per cent in 1995 (Warr and Nidhiprabha 1996). Leading the expansion were technologyintensive exports: High-technology industry has grown rapidly in Thailand during the 1990s. Technology-intensive exports increased on average by 31% per year between 1992 and 1995, accounting for 54% of the total manufactured exports in 1996, up from 42% in 1992. The development of high-technology industry in Thailand was built on foreign capital, foreign technology and foreign product designs; final products, moreover, relied significantly on foreign markets. For Thailand: crisis, reform and recovery 73 Table 2.1 Capital inflows (% of GDP, period averages) 1980–86 1987–92 1993–96 Public sector 2.4 −0.3 0.4 Private sector 2.6 8.1 9.7 Total 5.0 7.8 10.1 Source: BOT (1998). example, the electronics sector absorbed nearly 40% of foreign direct investment in manufacturing in Thailand between 1995 and 1997. On average, imported contents accounted for 80% of the value of high technology exports (OECD 1999a, 23). Table 2.2 Structure of Thai exports, 1981–93 (percentage of total exports) 1981 1985 1988 1990 1993 Agriculture Rice 17 12 9 5 4 Tapioca 11 9 5 4 2 Total 48 38 26 17 12 Labor-intensive manufacturesa Textiles and garments 10 14 16 16 14 Jewelry 3 4 6 6 4 Footwear 0 1 2 3 3 Total 15 21 29 31 27 Medium/High technology manufactures Machinery and appliancesb014810 Electrical 0 1 2 6 7 Electrical circuitryc44768 Vehicles and parts 0 0 1 1 2 Total 5 7 15 22 30 Manufactures as percentage of total exports 36 49 66 75 80 Notes:aAgriculture has been omitted. bMainly computers and parts. cMainly integrated circuits. Source: Jomo (1997, 69). The Asian financial crisis 74 The massive surges of capital inflows fueling export-promotion found a hospitable environment in Thailand. Long before it was fashionable (in the early 1980s), Thailand, in sharp contrast to most developing economies, already had relatively open current and capital accounts – although exchange controls still applied to the repatriation of interest, dividends and the principal of portfolio investment. In 1984, the government embarked on an ambitious stabilization program, including measures to liberalize further both the current and capital account transactions. As was noted earlier, the baht, which had been pegged to the dollar since the mid-1950s, was devalued by 15 per cent in nominal effective terms and then pegged against a basket of currencies that were weighted heavily (about 80 per cent) towards the US dollar.17 The Exchange Equalization Fund, chaired by the deputy governor of the Bank of Thailand, determined the exchange value of the baht each working day in accordance with fluctuations of major currencies. With regard to portfolio investment, in 1986 the authorities reduced tax impediments to portfolio flows, in particular, for purchasing Thai mutual funds. The acceptance of Article 8 of the International Monetary Fund (IMF) Agreement by the Bank of Thailand on May 20, 1990 served as a catalyst to further financial liberalization. The acceptance required Thailand to observe three conditions: (1) to allow unrestricted payments and transfers with respect to international current transactions; (2) to refrain from preferential treatment regarding international payments, including the use of a multiple exchange rate system; and (3) to accept local currencies of other member countries through current transactions. The period 1991–92 saw the liberalization of financial controls, the lifting of ceilings on interest rates, substantial relaxation of exchange controls, and major improvements in the tax treatment of dividends, royalty payments, capital gains and interest payments on foreign debentures.18 By the end of 1992, the repatriation of investment funds, interest and loan repayments by foreign investors was fully liberalized. With regard to foreign direct investment, in addition to amendments in the Investment Promotion Act to promote more foreign investment, the government authorized (in 1991) 100 per cent foreign ownership of firms that exported all their output, while direct investment by Thai residents was gradually liberalized between 1991 and 1994. In April 1991, most controls related to capital account transactions were lifted. This meant that for the first time unincorporated Thai entities could open foreign-currency accounts, provided that the funds originated offshore. With the establishment of the Export– Import Bank of Thailand (EXIM Bank) in 1993, exporters not only had access to direct loans, loan guarantees and export insurance, but were also allowed to accept baht payments from non-resident baht accounts without prior approval from the central bank and to use their export proceeds to service external obligations. By early November 1994 all foreign-exchange restrictions on current account transactions were eliminated.19 Now, commercial banks were able to freely extend credits and accept deposits in foreign Thailand: crisis, reform and recovery 75 exchange to and from foreigners, and foreign nationals could hold and operate non-resident baht accounts to facilitate international trade and investment. Thai citizens were now allowed to transfer up to US$5 million abroad for direct foreign investment purposes. The passage of the Securities and Exchange Act in May 1992 marked a major step towards the establishment of a unified legal and institutional framework for the development of the capital market. The Act established the Securities and Exchange Commission (SEC) as an independent agency responsible for supervising capital market activities, including equities, bonds and derivatives, and permitted, for the first time, companies access to direct finance by issuing common stock and debt instruments.20 The Securities and Exchange Act was a driving force for issuance for common stocks and debt instruments, and resulted in the rapid expansion of the Thai capital market. For example, new capital raised in the Stock Exchange of Thailand (SET) surged from 17.5 billion baht in 1990 to 55 billion baht per year between 1991 and 1993 and to approximately 130 billion baht per year during 1994–95. Market capitalization expanded rapidly, from 29.4 per cent of GDP in 1990 to 85.9 per cent in 1995. The SET index rose from 612.9 in 1990 to a peak of 1,682.9 in 1993 (Vajragupta and Vichyanond 1999, 44). Also, in keeping with the advances in information technologies, the Bank of Thailand (BOT) instituted improved clearing and settlement systems such as the BAHTNET and THAICLEAR (established in 1993), which greatly reduced transaction costs and facilitated business expansion. Also in 1993, the government established Thailand’s first credit-rating agency, the Thailand Rating and Information Service (TRIS). This agency helped to promote the issuing of bonds and other debt instruments of private companies and public enterprises to private and institutional investors. Finally, liberalization also allowed Thai banks and non-banks greater access to international financial markets for funds. In March 1993, an offshore banking center, the Bangkok International Banking Facilities (BIBF) was established, (1) to facilitate the growth of international banking business in Thailand by encouraging foreign-currency denominated bank loans into Thailand (out–in loans) to meet the funding needs of Thai firms and to finance domestic infrastructure development, and (2) to attract foreign banks with international reputation, technology and know-how to Bangkok in order to introduce more competition into the banking system and to transform Bangkok into a major financial center that could rival Hong Kong and Singapore. In February 1994, all foreign exchange restrictions related to outward direct investment and travel expenditures were removed. Given the fact that Thailand’s capital account was fully open on the inflow side and there were no restrictions on foreign borrowing by the private sector, the creation of the BIBF led to rapid expansion in the number of financial institutions that could borrow and lend in foreign currencies, both onand offshore. The government granted generous incentives to BIBF operations. The Asian financial crisis 76 These included reduction in corporate income taxes from 30 per cent to 10 per cent, exemptions from specific sales taxes, exemptions from special business tax (including municipal tax), exemptions from stamp duties, reduction of withholding tax on interest on foreign loans for countries without double-taxation agreements with Thailand from 15 to 10 per cent, and exemptions from taxation on the permanent establishment of offices in Thailand (BOT 1998, 18). On top of all this, the facility enabled Thai investors to borrow in foreign currency at rates lower than the domestic interest rate.21 Thai businesses shifted their foreign borrowing from loans to BIBF, and some capital inflows, particulary from Japan, were rebooked under the BIBF category so as to gain access to tax privileges, and then lend at low rates to Thai institutions through the BIBF. Overall, the establishment of the BIBF greatly helped to expand the volume of foreign bank loans into Thailand. Initially, 46 BIBF licences were granted to 15 Thai banks, 11 foreign banks that already had branches in Thailand and 20 new banks from overseas. By December 1996, 49 banks had been granted BIBF licenses, including Thai commercial banks and foreign banks with and without local branches in Thailand (BOT 1998, 18). While BIBF banks were allowed foreign investment in Thai securities markets, and permitted to engage in other standard offshore banking activities such as loan syndication and foreign-exchange transactions in third-country currencies, the Thai authorities would have liked the BIBF to generate a balance between out–out and out–in activities. However, as it turned out, a large part of the BIBF activities was in “out– in” transactions – or borrowing from abroad and lending domestically. As Blustein (2001, 59–60) notes, “the officials who concocted the BIBFs evidently assumed that much of the money would be relent outside of the country; instead, most of it ended up being lent to Thai businesses and converted into baht.” Predictably, the BIBF’s out–in transactions doubled in the first year of its operation, from 197 billion baht in 1993 to 456.6 billion baht in 1994 to 1.4 trillion baht in 1997 (BOT 1998a, 12). Initially, this expansion in part reflected a shift in FDI to BIBF lending as intra-company loans (a component of FDI) were replaced by BIBF loans, thus indicating a rebooking of FDI through BIBF. However, as BIBFs were permitted to lend in virtually unlimited amounts to residents, their lending exposures grew rapidly. This was especially the case with the new BIBFs, which believed that volume growth would qualify them for an upgrade to a full-branch status. In January 1995, the authorities further expanded the offshore banking business by granting 37 licences for the Provincial International Banking Facilities (PIBF) to 22 commercial banks in order for them to operate outside the greater Bangkok area. Just prior to the crisis, 30 PIBF offices were already in operation in the 5 provinces: Chiang Mai in the Northern region, Chonburi and Rayong in the Eastern region, Ayutthaya in the Central region and Songkhla in the Southern region. It should be noted that while the PIBF’s Thailand: crisis, reform and recovery 77 and the BIBF’s funding had to be from overseas, the PIBF could extend credit in both baht and in foreign currencies, but the BIBF could only extend credit in foreign currencies (BOT 1998, 18–19). As was noted earlier, all these changes helped to deepen significantly Thailand’s financial system (given the country’s level of income), besides causing a rapid growth in the domestic money supply. The ratio of M2 to GDP increased from 62.2 per cent in 1987 to 74.7 per cent in 1992 to 79.5 per cent in 1996.22 Even more impressive, the ratio of M3 to GDP rose from 73.2 per cent in 1987 to 107.6 per cent in 1996 – reflecting a more active role of finance companies and crédit fonciers in tapping domestic savings.23 Moreover, the liberalization of the capital account coupled with the liberalization of interest rates in 1992 led to a lending boom. Total credit outstanding grew on average 22 per cent per annum in real terms over 1985 to 1996. The loan portfolio of finance companies grew at an even faster pace – on average 30 per cent in real terms per annum (Alba et al. 1999, 26). Thailand’s adoption of such market-friendly measures promoted massive capital inflows. Domestic borrowers were only too eager to borrow offshore, because the lower interest rates made such borrowing cheaper. Domestic corporate borrowers discovered that they could borrow at an interest rate of 5 per cent to 8 per cent instead of paying more than 13 per cent when borrowing domestically.24 They could earn money simply by borrowing from abroad and depositing baht in Thailand. Domestic borrowers saw none of the problems that a strategy such as Thailand’s fixed exchange-rate policy (which encouraged foreign borrowing denominated in US dollars) carried, as it gave the impression of carrying little or no exchange risk. In the absence of a well-developed domestic debt market, the stability of the baht exchange rate together with lower interest rates abroad encouraged Thai investors to tap foreign funds aggressively and without hedging, and then to speculate in local real estate, securities and other baht-denominated assets. For external investors, Thailand’s exchange-rate stability (given the fact that the baht was pegged to the dollar) and booming growth rates offered a profitable venue for interest arbitrage and speculation. As Gilpin (2000, 145) notes, “anticipating strong economic growth and believing that their investments were secure, foreign banks, hedge funds, and other financial institutions were only too delighted to flood Thailand and other emerging markets with money.” Beginning in the late 1980s, foreign direct investment increased dramatically. From annual rates of inflow varying between US$100 and US$400 million over the previous fifteen years, the annual rate of inflow rose more than fivefold, to over US$2 billion per year, and remained at roughly these levels over the next eight years. In fact, between 1988 and 1996 Thailand was the recipient of the largest capital inflows relative to GDP in the world. According to the Bank of Thailand, between 1988 and 1996 Thailand received a staggering cumulative amount of US$100.3 billion, about 55 per cent of The Asian financial crisis 78 1996 GDP, or 9.4 per cent of GDP on average per annum. Between 1987 and 1990, inflows increased to some US$11.1 billion. In 1994, but especially in 1995, capital inflows surged to over US$21 billion, but declined sharply in 1996 (Alba et al. 1999, 21). Banks and finance companies not only played the key role in intermediating the capital inflows, they also borrowed heavily (in US dollars and yen) in the world interbank market, to a total of some US$69 billion by June 1997.25 Of this, about US$46 billion was in maturities of between 30 days and one year, although the reported official foreign exchange reserves stood at US$31 billion – of which (as we now know) a substantial fraction had already been committed to the forward market (Cooper 1999, 19). Also, many Thai firms who could not directly access overseas capital markets were now able to borrow from BIBF Thai banks. As a result, foreign bank loans through the BIBF soared from US$8 billion in 1993 (its first year of operation) to US$50 billion in 1996 (Alba et al. 1999, 23). Indeed, according to the World Bank, the Thai economy was transformed from one that was “partially integrated” in 1985–87 to one of the most integrated emerging market economies by 1994 (Alba et al. 1999, 3). Capital inflows and policy responses Such massive inflows of foreign capital carry important macroeconomic implications. Under fixed exchange-rate regimes rapid capital inflows can be inflationary, as prices of domestic tradeables are bid up in the wake of capital surges. Emerging economies may have difficulty allocating the capital to productive uses. Massive surges of inflows may quickly enlarge the current account deficit and aggravate the balance-of-payments problem. As economic theory maintains, financial liberalization means more competition, and ideally a more efficient use of funds; but it also reduces the ability of monetary authorities to adjust interest rates. Domestic interest rates become subject to international market fluctuations, while new financial instruments mean that monetary aggregates such as M2 reflect the actual state of the economy less accurately. In the case of Thailand in 1994, M2 growth fell to 12.9 per cent per year from its previous rate of 18.4 per cent – although both inflation and the current account deficit were on the rise, from 5.6 per cent of GDP in 1994 to 8.0 per cent in 1995 and 8.5 per cent in 1996 (Vajragupta and Vichyanond 1999, 52). Indeed, the Thai monetary authorities were aware of the growing problem. For instance, the Bank of Thailand in its 1993 Annual Report noted that “with increased capital flows and the resulting volatility in the financial markets caused by monetary conditions abroad, it is important that the authorities maintain a cautious approach in their formulation of monetary policy” (BOT 1994, 8). Again, the 1994 Annual Report (BOT Thailand: crisis, reform and recovery 79 1995a, 7) noted that “high credit growth was recorded in 1994, made possible by the increased use of foreign capital by the banking system. Therefore, to ensure that domestic demand does not rise too rapidly, commercial bank credit should grow at a more moderate pace in 1995. At the same time, commercial banks and finance companies should ensure that credit is channeled to productive uses and not to luxury consumption or speculative ventures.” Moreover, as the Mexican peso crisis in 1994 had illustrated, maintaining a fixed exchange-rate policy once the capital account is opened is imprudent, since the reserves of foreign exchange are finite. In fact, in their comprehensive study, Warr and Nidhiprabha (1996) warned of the dangers inherent in Thailand’s program of capital market liberalization in combination with a fixed exchange rate. They explicitly warned that, if capital market liberalization was to be maintained, Thailand would require a more flexible-exchange rate system. Of course, there was a failure to respond effectively to such warnings. The sheer magnitude of capital inflow exceeded all expectations, forcing Thailand’s monetary authorities to respond quickly to too much of a good thing. Cognizant of the fact that massive inflows of short-term capital or hot money have destabilizing side-effects, such as rapid monetary expansion, an excessive rise in aggregate demand, inflationary pressures, an appreciation of the real exchange rate (which can result in the loss of export competitiveness and give rise to inflation), and a widening current account, the Thai monetary authorities introduced a number of measures aimed at discouraging such inflows and influencing the maturity structure of banks’ foreign borrowing.26 Specifically, given the limited policy options, the authorities attempted to cope with capital inflows through a combination of monetary, prudential and market-based capital control measures. To slow credit growth, restrict short-term capital inflows and reduce the inflationary impact of the inflows, the Bank of Thailand raised the policy rate in March 1995 and extended the coverage of the credit plan to include larger finance companies and the BIBF banks. A maximum credit-todeposit ratio was also introduced to restrict banks from extending loans requiring foreign borrowing. In August 1995 the authorities began to introduce restrictions on capital inflows. Effective from August 8, 1995 the minimum amount on foreign borrowing on the BIBF was increased from 500,000 baht to 2 million baht to shake out small borrowers. Commercial banks were required to deposit at the Bank of Thailand (with no interest) 7 per cent of their non-resident baht deposits with a maturity of under one year. Also, reporting requirements were imposed for short foreign-currency positions. This measure, aimed explicitly at increasing the cost of raising shortterm deposits from abroad, led to lower rates for short-term non-resident deposits. On April 4, 1996 the measure was extended to finance companies. In a measure effective from June 23, 1996 non-resident baht accounts with less than a one-year maturity and all commercial banks, BIBF, and finance The Asian financial crisis 86 growth. For example, while some of the foreign loans were invested in a wide range of manufacturing industries (for example, steel and petrochemicals), in which there was a growing world over-supply, much of this money went into the unproductive non-tradeable sector, in particular, into property construction and real estate – commercial as well as residential property. Assets in the property sector grew by 115 per cent during 1993–96 as profits declined by 69 per cent (Nabi and Shivakumar 2001, 14). Greatly compounding the problem was the fact that such investments were not generating the foreign-exchange earnings to service the foreign borrowing.33 Rather, “greater access to funding prompted many real estate companies to enlarge their land banks, invest in speculative and unproductive purchases such as vacant land, initiate projects without seeking adequate information on market conditions and demand, and subsequently become highly engaged in projects with inferior risk-return trade off ” (BOT 1998b, 8). On the demand side, the facts that interest payments on housing loans were tax-deductible up to 7,000 baht per year; that commercial banks were encouraged to extend more housing loans to middleand low-income earners; and that the limit of foreign ownership in condominiums was raised from 25 per cent to 40 per cent fueled investments in property and real estate (BOT 1998b, 90). Inevitably, “as a result of the rapid buildup of assets, Thailand had one of the highest ratios of capital to output among the middle-income countries” (Nabi and Shivakumar 2001, 14). Between 1986 and 1990, the construction sector expanded on average by 14.9 per cent per annum, and land prices soared 3–4 times within 7–8 years (BOT 1998b, 15). At the end of 1997, real-estate related wealth in Bangkok stood at 2.2 trillion baht, equivalent to about 45 per cent of GDP and greater than the total capitalization of the country’s stock exchange of an estimated 1.1 trillion baht. In the residential sector, the number of housing units in greater Bangkok increased by some 1.25 million between 1988 to 1997 – raising the vacancy rate to around 14 per cent in 1997. At the height of the recession in 1998, the number of new vacant housing units stood at 350,000, a vacancy rate of 28 per cent (Nabi and Shivakumar 2001, 13). In the commercial sector rapid increases in office space construction (even though the price of office space had peaked in 1991), led to an increase in the vacancy rate to around 20 per cent before the crisis (IMF 2000, 5). According to one account, in the Bangkok CBD (Central Business District), completed first-grade office space “was less than 1.5 million square meters in 1991. By the end of 1997, total supply had quadrupled to 6 million square meters, with nearly 2 million of those located in the CBD. Around 900,000 square meters of office space were added to the stock each year for three consecutive years up to 1995 . . . Between 1991 and 1997, an average of 360,000 square meters of shopping area were added to the city [Bangkok] every year” (Renaud 2000, 189). Similarly, Blustein (2001, 57) notes that “the most spectacular real estate boondoggle was a $1 billion-plus development Thailand: crisis, reform and recovery 87 on the city’s [Bangkok’s] outskirts called Maung Thong Thani Estate, which was designed to house hundreds of thousands of people and included highrise condominium buildings, townhouses, retail shops, and a sports complex. Sales were abysmal, and with weeds growing high amid the unoccupied buildings, the desperate developer – allegedly a major contributor to the ruling party – furiously lobbied for government deals to move Parliament and part of the Defense Ministry onto the property.” In fact, over-expansion resulted in over-supply, creating a classic “bubble economy” – where realestate prices continued to rise well beyond levels justified by the productivity of the assets. As Lester Thurow (1998, 22) notes, “Bangkok, a city whose per capita productivity is about one twelfth that of San Francisco, should not have land values that are much higher than those of San Francisco. But it did – as did other Southeast Asian cities. Grossly inflated property values had to come down.” However, as long as the prices continued to rise existing investors were rewarded and collateral was created for new loans to finance further investment – until the inevitable bursting of the bubble. Indeed, when the investments went sour, bad loans proliferated as interest rates on debt rose sharply, while occupancy rates and rental fees fell rapidly. The worst part was that most of these loans were denominated in foreign currency (about US$49 billion at the end of 1997 – equivalent to 33 per cent of GDP), with usually no hedging against currency depreciation. The bursting of the bubble destroyed many of the companies that had undertaken real-estate construction, and others who had provided the finance. According to one study, in spring 1996 approximately 54 per cent of the outstanding property credit originated from banks and 46 per cent from finance companies. To put it bluntly, the Thai banking and financial sector now faced the problem of both exchange-rate risk and domestic default. Specifically, the increased level of bank’s foreign indebtedness relative to the lending base of the banks increased their exposure to exchange-rate risk, and the increased level of bank credit to GDP increased their exposure to domestic contraction. While weak domestic financial intermediation and poor corporate governance of Thai banks have been widely blamed for their difficulties, it was the increased exposure of the Thai banks that was primarily the reason behind their problems – something that could not have been corrected by tighter supervision alone. The gradual meltdown The continually rising value of the baht created major problems. By mid1996, Thailand’s current-account deficit had reached 8.5 per cent of GDP – much of which was financed by large inflows of short-term portfolio investment and foreign loans. In fact, Thailand’s current account deficit was at the same level that was responsible for the Mexican peso crisis in 1994. The Asian financial crisis 88 Also, as was noted earlier, the export growth-rate had plummeted to virtually zero in 1996. This combination of widening current account deficit, export slowdown (while imports continued to grow), the worsening debt situation and currency appreciation caused widespread expectation that the central bank could not defend the baht much longer. As foreign investors became concerned over Thailand’s ability to repay its huge foreign debt, they began to move their money out of the country. By the second quarter of 1996 the considerable appreciation of the baht against non-US currencies induced active speculation, as the non-resident baht account (NRB) became heavily used by foreigners as a means of speculative transactions. It was now a matter of time before more sustained speculative attacks would begin. The attack came in several waves: first on May 10, 1996, when the country’s ninth-largest commercial bank, the Bangkok Bank of Commerce (BBC) collapsed (despite the massive injections of liquidity by the BOT), under the weight of non-performing property loans that totaled nearly half its US$7.2 billion of assets (Economist 1996, 77). Though the BBC was run by a well-connected former central bank official, Krikkiat Jalichandra, it came to public light “that the central bank knew in 1993 that nearly 40 per cent of BBC’s total assets consisted of nonperforming loans, many of which consisted of loans to Krikkiat’s associates, other bank insiders, and influential politicians to finance speculation in real estate and corporate takeovers. Yet the central bank had refrained from taking any serious enforcement actions” (Blustein 2001, 57–8). While the collapse of the Bangkok Bank of Commerce was the result of gross mismanagement and fraud, the government’s decision to bail out depositors, creditors and shareholders of the failed bank, and its reluctance to prosecute those responsible, sent a bad signal to the financial community. Compounding this, rumors in Hong Kong about an imminent baht devaluation in response to the large debt, mounting current account deficit and poor export performance only served to further fuel the attack. Foreign investors began by selling baht for dollars, causing a serious liquidity shortage in the domestic money market. Speculation against the baht took the form of direct position-taking in the forward market, which created downward pressure on the forward rate, and use of explicit baht credits, which, when converted into foreign currency, created a short position on the baht. Foreign speculators sold baht for dollars in the Hong Kong market, while many Thai banks borrowed heavily from money markets to purchase dollars, sending the interbank rate up to 25 per cent. Thus, the conversion of baht credit into foreign currency represented a capital outflow, placing downward pressure on the spot exchange rate. To defend the baht, besides periodically denying devaluation rumors and making written commitments not to devalue the baht, the BOT also raised short-term interest rates and intervened heavily in the market, bringing billions of baht forward. In particular, the BOT took the unprecedented step of intervening in Singapore and Hong Kong by selling dollars in the Thailand: crisis, reform and recovery 89 forward markets, where some commercial banks were speculating on the baht/dollar exchange rate by dumping baht for dollars. On August 1, 1996 alone, the BOT spent some half a billion US dollars from its international reserves to defend the baht. Of course, ipso facto, this resulted in a decline in reserves and/or increase in the central bank’s forward commitment. Moreover, commercial banks were advised to refrain from accommodating foreign speculators’ demand for foreign exchange, and the onshore and offshore foreign-exchange markets were split, with credit restrictions imposed upon non-residents. The resultant domestic credit squeeze reduced asset prices and collateral values and increased the levels of non-performing loans. This only served to put additional pressure on the already weak financial institutions, and several more finance companies collapsed. Nevertheless, the BOT’s intervention pacified the market as “market participants perceived that if the BOT were planning to devalue the baht it would not favor speculators by cheapening the cost of speculation. Confidence in the baht was restored because of the swift and massive intervention in offshore markets where daily transactions tripled the size of domestic foreign transactions” (Nidhiprabha 1998, 207). However, this was just a lull. With large and rapidly increasing shortterm debts, shrinking foreign reserves, and an exchange rate that was pegged within a narrow range of around 25 baht to the US dollar, the baht remained a prime target for currency speculators. Indeed, the second wave of attack occurred in December 1996, as more than half the 500 companies on the stock exchange reported declining earnings, and rumors of a currency devaluation spread. This prompted withdrawal of investments out of Thailand. However, quick stabilization of the baht through direct market intervention, coupled with announcement of a substantial budget cut, helped to restore foreign investor confidence – as reflected in the renewal of inflows in early January 1997. However, this was short-lived. In February 1997, one of Thailand’s largest finance companies, Finance One, found itself in deep trouble.34 Burdened with a huge debt (Finance One had borrowed about US$600 million from abroad), excess exposure to sectors sensitive to the asset-price inflation of the 1990s, and weak underlying capitalization made Finance One (and other finance companies) particularly vulnerable to the slow-down in economic activity and asset-price decline that began in mid1996. By early 1997, “Finance companies were saddled with $4.8 billion in margin loans to stock investors, many of which couldn’t be repaid” (Blustein 2001, 57). To save it from collapse, the Finance Institutions Development Fund (FIDF) was forced to inject 40 billion baht into Finance One, besides ordering it to merge with Thailand’s twelfth largest commercial bank, Thai Danu Bank, to overcome the sharp liquidity crunch.35 On March 3, 1997, Finance One was dissolved and merged into Thai Danu. The BOT also made public the names of nine finance and one crédit foncier company (or housing loans broker) facing similar difficulties with high exposure to The Asian financial crisis 90 property loans, and ordered these companies to raise their registered capital. All this seemed to further aggravate market instability. However, the attacks, the most intense yet, started again in mid-February 1997, when the Somprasong Land Company failed to make a US$3.1 million interest payment on its Euro-convertible debentures owing to cash-flow constraints caused by conditions in the Thai property market.36 The market appeared to be convinced that a depreciation of the baht was imminent. To fight off the speculative pressure and to preserve the integrity of the exchange rate system (and thereby maintain investors confidence), the BOT had to intervene heavily to keep the baht exchange rate within the EEF’s band. Moreover, domestic liquidity was tightened, sending overnight interbank rates to as high as 30 per cent from the 9–15 per cent at the beginning of the year. Yet, the pressure on the baht continued unabated. Foreign exchange reserves which stood at roughly US$40 billion in the third quarter of 1996 had fallen to US$38 billion at the end of February 1997. However, the government had also incurred forward obligations amounting to over US$12 billion. This meant that the net foreign exchange reserves had fallen from US$40 billion to US$26 billion (BOT 1998a, 26–8). With the bursting of the property bubble following the Somprasong Land Company’s dramatic default, excess capacity was prominently visible in the real estate markets, especially in Bangkok. This was followed by the rapid decline of the SET index. On March 3, 1997, the Thai government, for the first time in the SET’s 20-year history, suspended trading on the stock exchange for all banking and finance companies’ shares. To reassure jittery investors, the Finance Minister Amnuay Viravan and the BOT governor Rerngchai Marakanond and deputy governor Chaiyawat Wibulswasdi went on national television to announce a series of measures to shore up banks and finance companies. Measures included higher reserve requirements for all financial institutions, capital mobilization for finance companies, and an increase in the liquidity of finance companies. They also permitted ten undercapitalized finance companies 60 days to increase their capital reserves. In early April 1997, the government established the Property Loan Management Organization (PLMO) to deal with the property sector crisis by purchasing and managing property loans from financial institutions, thereby helping to ease pressure on their balance sheets. The funds for the PLMO were to be raised by issuing seven-year zero-coupon bonds guaranteed by the government.37 However, this failed to prevent a further loss of confidence. Rather, as Arphasil (2001, 183) notes, it “translated into an increase in withdrawal of funds from other finance companies as well as smaller banks and deposit of them into larger domestic and foreign banks. This flight resulted in the build-up of excess liquidity in some institutions. Larger banks were reluctant to lend their liquidity to other financial institutions.” Furthermore, the PLMO’s limited funds and the fact that property loans eligible for purchase by the PLMO had to possess collateral and be able Thailand: crisis, reform and recovery 91 to repay the debt within 5 years made the PLMO operation limited, and as Lauridsen (1998, 148) notes, “ultimately a failure.”38 The final nail in the PLMO’s coffin was the failure of the merger between Finance One and the Thai Danu Bank. As this merger, considered a “model for further mergers, collapsed in May, the strategy collapsed with it” (Lauridsen 1998, 148). Indeed, it can be argued that the government’s weak response only served to increase investor anxiety. Not surprisingly, in late April and early May 1997 there was a run on deposits of finance companies. Domestically, the deposit withdrawal represented more a flight to quality, as households and businesses moved their savings out of finance companies and into the larger commercial banks. However, foreign investors now sensed that the government could not effectively deal with the property sector problems – not to mention their recognition that the exchange rate was misaligned and that a correction was overdue. It seemed that, at long last, investments and expectations that had been based on extrapolations of past performance were now being based on a realistic assessments of actual demand and supply in goods and asset markets. On May 7, 1997, Finance Minister Amnuay announced that Thailand would not be able to achieve a balanced budget for the year – as had been earlier promised. As DeRosa (2001, 93) notes, “the market took the news hard. The bank was immediately confronted with ferocious selling of the baht and their stocks.” In response, the BOT decided to switch its intervention from spot foreign-exchange transactions to forward transactions, buying baht against dollars for value in three and six months. In hindsight, this was a fatal error, as the BOT was now exposed to the fate of its own currency. Since, the bank negotiated these forward contracts at off-market forward exchange rates (fearing that its presence in the foreign-exchange market would drive up Thai baht interest rates), speculators “thereby effectively received a subsidy from the bank to take short positions in the baht. Thanks to its own central bank, the baht turned into a true one-way bet for short sellers” (DeRosa 2001, 97). During the second week of May 1997, in an all-out attack, international hedge funds, including Soros’s Quantum Fund and traders at US financial institutions such as J. P. Morgan and Goldman-Sachs, took short positions in spot, forward and options markets, betting as much as US$10 billion on Thailand devaluing.39 In return, on three different days, May 8, 13, and 14, the BOT used or committed US$6.1 billion, US$9.7 billion and US$10 billion respectively defending the baht’s dollar peg – considered key to maintaining the confidence of foreign investors. However, this was to no avail. Blustein (2001, 70–71) notes that “May 14, 1997 was an unforgettable day for the top management of the Bank of Thailand . . . everyone panicked, and some even cried. On that day, the central bank threw $10 billion into the fray, using various markets, without beating back the speculators.” Now having almost exhausted its reserves, the BOT desperately imposed selective The Asian financial crisis 92 capital controls (on May 15, 1997), prohibiting commercial bank lending on bahts to non-residents, and segmented the onshore and offshore foreignexchange markets in order to make it more costly for offshore speculators to borrow the baht. More specifically, the BOT ordered all twenty-nine local and foreign banks in Thailand to refrain from and then altogether suspend (in early June 1997), transactions with non-residents that could facilitate a build-up of baht positions in the offshore market (including baht lending through swaps, outright forward transactions in baht and sales of baht against foreign currencies). Second, any purchase before maturity of bahtdenominated bills of exchange and other debt instruments required payment in US dollars. Third, foreign equity investors were prohibited from repatriating funds in baht (but were free to repatriate funds in foreign currencies). Finally, non-residents were required to use the onshore exchange rate to convert baht proceeds from sales of stocks. All this meant that the baht would cease to flow outside Thailand, unless there was a genuine, trade-related reason such as payment for imports. These measures effectively created a two-tier foreign exchange market: the onshore market, where there was normal supply of baht, and the offshore, where the baht was scarce. No doubt, these measures were clearly targeted at decoupling the onshore and offshore markets. The two-tier system attempted to deny non-residents without valid commercial or investment transactions in Thailand access to domestic credit needed to establish a net short domestic currency position, and to inflict punitive costs on speculators – while allowing non-speculative credit demand to be satisfied at normal market rates.40 These measures reduced the volume of trading in Thailand’s swap market, where foreign investors often buy and sell to hedge currency risks for investments in Thailand. It also temporarily ended speculative attacks on the baht by causing losses for speculators, as both onshore and offshore banks (in response to official pressure) segmented the two markets by refusing to provide short-term credit to speculators.41 In particular, the banks’ refusal to provide baht credit imposed a severe squeeze on offshore players who had acquired short baht positions during the speculative attacks and had to close their forward positions. As a result of the squeeze, offshore swap interest rates rose sharply relative to onshore rates. In fact, the offshore baht overnight interest rates rose to over 1,000 per cent (BOT 1998a, 25). This forced investors who had taken positions against the baht in expectation of a devaluation to unwind their forward positions at a loss. Thus, in the absence of extensive liquidation by domestic holders of baht positions, the authorities were able to withstand the pressures on the baht by relying on extensive application of the selective capital controls until early June. However, as DeRosa (2001, 94) notes, while “the Bank of Thailand had won the battle, it was soon going to lose the war.” After the initial shock about what the Bank had done faded, attention began to turn to whether Thailand: crisis, reform and recovery 93 the new two-tier market was stable. The major concern was the prospect of a baht devaluation. Now hedge funds were no longer the problem. Rather, it was the domestic borrowers, namely, Thai banks and corporations, that needed to acquire billions of dollars to pay their short-term debts that were falling due soon. Compounding the problem was the fact that foreign creditors (who had earlier lent willingly) were now demanding immediate repayment, besides refusing to extend further loans. By mid-June the pressures regained momentum as panicked local corporations continued to buy US dollars to hedge their foreign-exchange exposure. This resulted in a heavy loss of reserves through the EEF window. Concerns about the stability of the baht reached fever pitch on June 19 when the Finance Minister, Amnuay Viravan, resigned in a dispute over tax policy.42 His replacement, the unknown Thanong Bidaya, who took up office on June 21, did not inspire confidence. This caused another wave of speculative activity, and the stock market suffered a large 11 per cent decline. By the end of June, Thailand’s net foreign-exchange reserves stood at only US$2.8 billion – just 7 per cent of their late 1996 value (BOT 1998a). On June 26, 1997, in an effort to stop further liquidity drain, the Bank of Thailand suspended for 30 days the operations of 16 finance companies (including Finance One) on the basis of their capital inadequacy and the need for liquidity. These 16 companies were required to submit rehabilitation plans to the Bank of Thailand by July 11. Companies that failed to submit plans, or whose plans were rejected by the BOT/Ministry of Finance, would have their licences revoked and be absorbed by Krung Thai Thanakit, a majority-government-owned finance company. Further, to reassure creditors and depositors and to avoid financial panic, the government stated that the remaining banks and finance companies were financially sound and all their credits and deposits would be guaranteed by the government. However, these measures failed to calm the markets, largely because there was increasing uncertainty over the exact extent of the guarantees, owing to inconsistencies in official statements. With inconsistencies among the various announcements unresolved, official assurances only heightened market apprehension. As rumors of an anticipated baht devaluation grew, this triggered a wave of capital outflows, as investors sought to liquidate shortterm foreign debts or to speculate against the baht. The capital outflows resulted in a sharp drop in the Bank of Thailand’s foreign-exchange reserves, in large part because more than US$23.4 billion out of almost US$39 billion of total international reserves was used to defend the baht. Moreover, it was disclosed that the BOT through the FIDF had extended more than 430 billion baht (or 10 per cent of GDP) to rescue debt-ridden finance companies (Lauridsen 1998, 148). In the face of serious difficulties in rolling over short-term debt and a rapid depletion of net foreign-exchange reserves, it was only a matter of time before Thailand would be forced to float the baht. Yet “on July 1, 1997 The Asian financial crisis 94 Prime Minister Chavalit Yongchaiyudh announced that the baht would never be allowed to devalue” (Tan 2000, 66). Yet, in the face of a serious liquidity crisis, such claims could not be honored. In the early hours of July 2, 1997 “Bangkok’s top bankers were awakened before dawn and summoned to a 6.30 a.m. meeting . . . the nervous group was told that the government was abandoning the baht’s peg to the US dollar” (Chanda 1998, 8). When the markets eventually opened on the morning of July 2, 1997, the baht immediately depreciated by 18 per cent from Bt 24.5 to Bt 28.8 per US dollar, plunging the country into a serious recession.43 In desperation, Prime Minister Chavalit secretly sent emissaries to Japan and China to request bilateral loans of hard currency – without success. In late July, the Thai authorities finally requested the IMF for assistance. As Phongpaichit and Baker (2001, 85) observe, “there was no significant voice raised in opposition. The IMF was tacitly welcomed as savior.” On August 14, 1997, after Thailand signed its first letter of intent with the IMF, the Thai government (now led by Chaiyawat Wibulswasdi, who was installed as BOT governor after Rerngchai resigned on July 29), and the IMF announced mutually agreed economic adjustment programs, which included tight monetary and fiscal policies and financial sector restructuring.44 On August 20, 1997 the IMF’s Executive Board approved a 3-year stand-by arrangement totaling US$17.2 billion with Thailand. Of the total, US$1.6 billion was made available immediately, and a further US$810 million was to be available after November 30, 1997 – provided that end-September performance targets were met and the first review of the program completed. The IMF also made it clear that subsequent disbursements were to be made on a quarterly basis, again subject to the attainment of performance targets and program reviews (IMF 1997a). The BOT: the price of irrational exuberance Unlike earlier financial crises in the developing world, where governments over-borrowed until they were forced to seek a bailout from the IMF, or a multilateral debt rescheduling from externally-based creditors, the Thai crisis was rooted in the private sector. That is, it was based entirely on excessive private rather than public debt. Therefore, when Thai policymakers tried to assure the markets that Thailand’s economic fundamentals were sound, it sounded rather hollow, because they conveniently forgot to add that the fundamentals could be considered sound only if one ignored the private-sector component of the current account. Moreover, it is now a matter of public record that as early as November 1996 the IMF warned the Thai government about the vulnerability of its large current account deficit, particularly given the stagnant export growth (Blustein 2001, 51–83). In addition, the IMF urged the Thai government to adjust its exchange-rate Thailand: crisis, reform and recovery 95 system by lowering the weight of the US dollar in the fixed-rate currency basket and widening the intervention bands (Cooper 1999, 19). Surely the Thai monetary authorities must have been aware of the growing economic disequilibrium. Even if they ignored the IMF’s warnings, they could hardly ignore the downward pressure on the exchange market. The question that is begging to be asked is: why was the exchange rate so badly mismanaged, in the sense it did not reflect Thailand’s patterns of international transactions or the relative prices of the major trading nations. For example, the weight the baht assigned to the yen was only 13 per cent compared to 80 per cent to the US dollar, despite the fact that Japan had become Thailand’s principal trading partner. Moreover, why did the Thai policy-makers fail to respond quickly and decisively to these mounting financial disintermediation? Why did they chose to continue to support the dollar value of the baht by significantly drawing down central bank foreign-exchange reserves? A large part of the blame must go to the overly sanguine assessments of the Thai monetary authorities. From the Bank of Thailand’s own published reports, we can extrapolate the thinking at the BOT at the time (1998; 1998a; 1996a; 1996b; 1996c; 1995; 1992). First, why did the BOT tolerate such high current-account deficits for so long? In the inaugural Fall 1995 issue of the Bank of Thailand’s Economic Focus, the Bank’s Economic Research Department outlined what it considered to be the key factors behind the high deficit and why it believed the deficit to be sustainable both in the short and the long term. The BOT argued that with exports rising rapidly by 25.3 per cent (1995 figures), the rise in the trade deficit did not reflect a change in Thailand’s international competitiveness. On the contrary, it reflected the strength of domestic demand. It also noted that private investment was the most important factor behind the growth in imports and the deficit, while private consumption and government imports were only secondary factors. Finally, external factors, namely, higher import prices and the appreciation of the yen and the deutsche mark during the first half of 1995 had contributed significantly to the deficit. On the basis of these findings, the BOT concluded that Thailand’s current-account deficit was sustainable because the deficit reflected the strengthening of investment, rather than increases in consumption. Moreover, the BOT argued that the deficit occurred in the context of strong GDP growth and export performance, and that Thailand had sufficient international reserves with low external debt. Hence, the BOT claimed that the current-account deficit should not be allowed to mask the strong economic fundamentals of the Thai economy. Indeed, so confident was the BOT that Bandid Nijathaworn, then the deputy director of the Bank of Thailand’s economic research department, dismissed Thailand’s 10 billion-baht balance of payments deficit in the first quarter of 1995, when he stated that the current-account deficit would shrink rapidly as investment reached its cyclical peak and started to slow down.45 The Asian financial crisis 102 required to suspend the infusion of liquidity to ailing financial institutions and to disclose the size of the reserves every two weeks. To achieve these ambitious targets the managed-float exchange-rate regime adopted on July 2, 1997 was maintained. Indeed, with Thailand’s foreignexchange reserves almost completely exhausted, there was no alternative to floating the baht.46 The balanced budget was to be achieved through a combination of public expenditure or spending cuts by an amount equal to 3 per cent of GDP and tax increases – primarily an increase in the rate of the value-added tax (similar to a national sales tax) from 7 per cent to 10 per cent – while exchange-rate stabilization was to be achieved through tight money and high interest rates. Financial sector restructuring included plans to close insolvent financial institutions, and a temporary guarantee to protect remaining financial institutions. The plan also took steps to minimize the moral hazard risks of the guarantee, while ensuring the viability of those remaining institutions through early recapitalization and more transparent regulatory and supervisory requirements. The Bank of Thailand was given authority to order a commercial bank or finance company to write down its capital below the value stipulated by law, to allocate share increases without a shareholders’ meeting and to remove directors or executives and appoint replacements – subject to approval by the Minister of Finance. This authority allowed for timely intervention in inefficient financial intermediaries that experienced large losses, endangering the public interest. In addition, the Bank of Thailand Act was amended to reaffirm the government’s commitment to have the Financial Institutions Development Fund (FIDF) guarantee depositors and creditors with full financial support from the government. In fact, the adoption of international standards for asset classification, loan-loss provisions, capital adequacy, bankruptcy and deposit insurance were to receive priority under the plan (IMF 1997a). After much foot-dragging the Chavalit administration temporarily suspended the operation of a total of 58 (out of 91) debt-ridden finance companies, 16 of them on June 27, 1997 and an additional 42 on August 5, 1997 – after a comprehensive guarantee was issued on deposits and liabilities of financial institutions.47 Blustein (2001, 77) notes that the idea of a guarantee on deposits and liabilities “triggered another battle – this one within the Fund itself, pitting the mission in Bangkok against much of the top brass at headquarters.” The mission preferred having a guarantee to prevent a financial panic, while the headquarters saw a guarantee as a classic case of moral hazard, a giveaway to investors who had gambled on high-yielding deposits in shaky financial institutions. However, under the compromise, the Financial Institutions Development Fund (FIDF) was entrusted with the task of providing a guarantee of the deposits and liabilities of the financial institutions (with full financial support from the government), preventing further bank runs, and restoring market confidence. Yet the guarantee came with conditions. The holders of promissory notes were not fully bailed out, Thailand: crisis, reform and recovery 103 and only a general guarantee was issued to depositors and other creditors in all financial institutions. Overall, the FIDF provided nearly 400 billion baht in liquidity support to troubled financial institutions in the months preceding the suspension of 58 finance companies in June and August of 1997. Rapid and credible resolution of the position of the 58 suspended finance companies was critical to restoring confidence. In order to create the legal and institutional framework for this resolution, the government issued six emergency decrees in October 1997. The decrees established two new institutions, the Financial Sector Restructuring Authority (FRA) and the Asset Management Corporation (AMC), to serve as the focal points for resolving the position of the suspended companies. Not unlike the approach adopted in the United States by the Resolution Trust Corporation to deal with the assets of the failed Savings and Loans Associations, FRA’s task was: (1) to review the rehabilitation proposals of the 58 suspended finance companies; (2) to assist bona fide depositors and creditors of the suspended companies; (3) and to administer the liquidation of companies whose proposals were rejected by FRA – hopefully, by returning the non-performing assets to the marketplace at market-determined valuations and prices. FRA was given one month to assess the plans submitted and to make a recommendation to the ministry of finance on how many finance companies should be allowed to resume their operations. Thus Thailand opted for a strategy of virtually closing the non-bank financial sector, but letting banks deal with problem loans on a decentralized basis. This meant that commercial banks had to meet Bank for International Settlements (BIS) capital adequacy ratios through raising additional capital, from foreign investors among others. To facilitate this, the Thai government also increased the limit of foreign ownership from 25 per cent to 100 per cent of total equity. The AMC was established to bid for the purchase of the impaired assets of finance companies that the FRA deemed no longer viable. In effect, the AMC became the buyer of last resort for impaired assets, as its major task was to buy the bad assets and then manage, restructure and sell them under the direction of FRA. The AMC was also entrusted with the responsibility of bidding for the lowest-quality assets as a buyer of last resort, to prevent fire sales of assets of the closed finance companies – which in turn could undermine underlying collateral values.48 The government authorized 1 billion baht in capital for the new corporation, of which 250 million baht was approved immediately (Nabi and Shivakumar 2001, 32). While there is general consensus that the financial restructuring was necessary, opinion remains deeply divided on the efficacy of the IMF’s fiscal and monetary policies. From the IMF’s perspective, high interest rates were required to stabilize the value of the currency, and budget cuts were necessary to make room in the budget for the interest costs of financial restructuring. It is difficult to quibble with the fact that, in the case of Thailand, high interest The Asian financial crisis 104 rates were probably unavoidable, because of its large current-account deficit caused by excessive private investment over saving. Indeed, macroeconomic theory teaches us that, with a current-account deficit that is fundamentally caused by an excess of a country’s domestic demand over its output, the necessary prescription would have to be a restrictive monetary policy, since the imbalance is caused mainly by excessive private investment. Thus, when a currency suddenly loses half its value amidst massive capital outflows and collapsing confidence (as was the case in Thailand, Indonesia and South Korea), easing is not a prudent policy. The negative effects of high interest rates on a weak economy and a fragile financial system must be carefully weighed against the probable consequences of a large depreciation on the burden of foreign-currency indebtedness. Moreover, the appropriate extent and duration of monetary tightening is very difficult to assess. For Thailand, which entered the crisis with a current-account deficit of 8 per cent (much larger than the current-account imbalances of Indonesia and Korea), a larger fiscal effort seemed appropriate. Yet the critics also raise some valid points. For the critics, the IMF’s orthodox fiscal and monetary policies worsened the crisis (Radelet and Sachs 1998; Nidhiprabha 1999). As prerequisite conditions for the loan package, the IMF attached: (1) a tight monetary policy and correspondingly high interest rates, to stabilize the baht and rein in the inflationary pressures; and (2) a restrictive fiscal policy aimed at restoring a budget surplus. This tight monetary policy was continued for the next several months, only to be relaxed gradually between May and August 1998 in the face of a severe economic recession. Critics argue that the IMF’s monetary and fiscal policies were typical of the program devised earlier for Latin American countries burdened with external imbalances associated with massive public-sector debt, hyperinflation and low rates of private savings. However, they correctly point out that the external imbalance in Thailand (as with most of its neighbors) lacked any of these features. That is, the Thai crisis arose from a build-up of short-term private debt, rather than profligate government spending and lack of monetary control, as in Latin America. This misguided policy, it is argued, only propelled the economy toward a low-level equilibrium. Tight monetary policy reduced credit for the private sector and raised interest rates, which reduced output. Tight fiscal policy reduced incomes, and therefore lowered total demand. With weak exports, the lowering of output and income trapped the economy in a new low equilibrium – which produced a massive contraction in private spending and literally choked the Thai economy. Hence, instead of restoring confidence, the resultant credit crunch paralyzed the corporate sector. Warr (1998, 59) notes: The IMF package added a public sector contraction, by requiring a budget surplus equivalent to 1% of GDP. Moreover, at a time when confidence in the financial sector was essential, the IMF required the problem institutions be Thailand: crisis, reform and recovery 105 closed. Given the circumstances of the time, this requirement seemed to many observers to be as irresponsible as crying “Fire” in a crowded theater. No doubt, these are valid criticisms. First, it is hard to distinguish the IMF’s initial policy prescriptions for Thailand from those applied to Latin American countries in the 1980s. Second, there is some agreement that the recession in Thailand would have been less severe had the IMF not imposed such tough fiscal restraint. It is clear that the old-fashioned contractionary policy to accompany devaluation is inappropriate. And, third, since the underlying assumption of the tight fiscal stance had been that the foreignexchange correction would stimulate external demand and get recovery going, with the benefit of hindsight it is clear that the IMF program did not correctly anticipate the region-wide recession. Nor did it anticipate the weakening of the country’s terms of trade, or the collapse in domestic private consumption. It is hard to disagree with the view that instead of contraction, a fiscal expansion was needed to stimulate aggregate demand. Yet, having noted this, it is important to recognize that only detailed empirical studies will shed further light on these complex questions, the case in point being a recent study by Dollar and Hallward-Driemeier (2000). The authors conducted a detailed survey of some 1,200 manufacturing firms in Thailand between the last quarter of 1997 and the first quarter of 1998. Asked to rank the causes of the current output decline (out of four possibilities), the most important factor cited by both exporters and non-exporters was the effect of the exchange-rate depreciation on input costs, followed by lack of domestic (or foreign) demand. The high cost of capital was ranked third, and lack of access to credit was ranked last. Finally, why did the US$17.2 billion IMF package failed to restore market confidence? Obviously, the market deemed the IMF package to be inadequate – in large part because it did not cover the risk of private capital outflow. It seems that what the IMF did was to provide Thailand with financing just enough to keep the public sector liquid and just enough for it to have a bare minimum international reserve. This obviously failed to generate market confidence. On the other hand, since the baht defense was conducted largely through forward swap transactions, Thailand’s true foreign-exchange reserve position was not apparent from official figures – the IMF may have thought that the liquidity it was providing was enough. The IMF and the Chuan government: phase two Despite the comprehensive and ambitious nature of the restructuring plans, the economic decline continued unabated. It seemed that neither the IMF program nor the political gridlock and bickering amongst the six-party coalition partners that made up the Chavalit administration failed to inspire The Asian financial crisis 106 market confidence. As the power struggle between Chavalit’s New Aspiration Party and its main coalition partner, Chart Pattana, intensified, “economic policy-making by mid-October was in complete disarray” (Haggard 2000, 94). Not surprisingly, on October 31, the baht passed the US one dollar to 40 baht psychological threshold. In fact, the spot exchange rate was 41 baht per one US dollar, as compared to 26.5 baht during the middle of July 1997. As domestic and international pressure against the Chavalit government mounted, the besieged Chavalit on November 3 announced his resignation – ignominiously leaving office on November 6. As Chavalit left office without dissolving the House and setting the date for new elections, both the existing government coalition and the opposition parties tried to form a new governing coalition. In fact, for several days it was not clear which group of parties would form the next government. Indeed, two competing coalitions even held separate news conferences within hours of each other suggesting that they would form the next government. Eventually, it was Chuan Leekpai’s Democrat Party that formed the government. However, Chuan required the support of five other political parties to form his coalition government – which took office on November 15 with a slim majority of 208 seats in a 393-seat parliament. Despite such inauspicious beginnings, Chuan’s administration, in sharp contrast to its predecessors, was able to provide a far more effective leadership in the macroeconomic arena.49 Even before assuming office Chuan send the right signals to the IMF and the international financial markets by appointing two highly respected technocrats to head his government’s economic team: Tarrin Nimmanahaeminda (a professional banker and former finance minister) as finance minister, and a former central bank governor, Supachai Panitchpakdi, as deputy prime minister and minister of commerce.50 On November 25, 1997, the Chuan administration sent the Thai government’s second “letter of intent” (GoT 1997), signed jointly by finance minister Tarrin and BOT governor, Chaiyawat Wibulswasdi, to Michel Camdessus, managing director of the IMF. The primary objective was to signal to the market that the government was again firmly in charge and that the days of indecision were over. Although, the letter noted the “slower return of confidence” and a “much sharper decline” in private investment and consumption than originally anticipated, it nevertheless clearly stated the Thai government’s full commitment to the earlier IMF conditions as specified in the first letter of intent of August 14, 1997 (GoT 1997, 1). Indeed, not only did the Chuan government pledge to follow the IMF orthodoxy very closely (tight monetary and fiscal policies and strict enforcement of high standards of financial sector governance), the second letter also noted that “the new economic team is determined to take a number of additional measures to strengthen the policy package and reinforce public confidence in the program . . . and is determined to proceed rapidly with implementation” (GoT 1997, 1). Thailand: crisis, reform and recovery 107 The second letter outlined in some detail the economic plans and goals. It stated that the government planned to work towards a 1 per cent surplus in the 1997–98 budget, because “this will ensure an orderly offset to the anticipated costs of the financial sector restructuring, while also providing a clear signal of the government’s intent to implement the economic program” (GoT 1997, 2). The 1 per cent surplus was to be achieved by increasing taxes, cutting the funding of state enterprises, raising utility prices, and lowering real wages in the public sector. In the area of monetary policy, the letter stated that “within the framework of our flexible exchange rate policy, monetary policy will need to play a greater role in stabilizing conditions in the foreign exchange market and containing the inflationary impact of the exchange rate depreciation . . . As part of the BOT’s resolve to maintain such a tight monetary stance, interest rates will principally be set with the objective of helping to stabilize the exchange rate and restore confidence in domestic financial assets” (GoT 1997, 3). With regard to external sector policies, the letter noted that the BOT planned to maintain gross international reserves of at least US$23 billion (equivalent to about four months of imports), and “remove as quickly as possible the restrictions on purchases and sales of baht by non-residents as well as the restrictions on baht denominated borrowing by non-residents and on the sale of debt instruments and equities for baht” (GoT 1997, 3–4). In the area of financial sector restructuring the government stated its objective to “move ahead as expeditiously as possible with the restructuring of the 58 suspended finance companies,” and elaborated a strategy to recapitalize and strengthen the remainder of the financial system “so that its regulatory framework can be brought fully in line with international best practices by the year 2000.” In addition, the letter explicitly noted that “the BOT will have a clear mandate to carry out the necessary restructuring of the sector, including (i) the tightening of loan classification rules, (ii) timetables for the recapitalization of all undercapitalized financial institutions during 1998, (iii) streamlining of bankruptcy procedures, (iv) reaffirmation of disclosure and auditing requirements for all financial institutions, and (v) the expeditious disposal of assets of closed companies and reorganization of good and bad assets of remaining firms” (GoT 1997, 4–5). With these commitments, Thailand became a cooperative partner of the IMF, and soon, as Flatters (2000) notes, the IMF’s “star pupil.” The Chuan administration began to implement these measures aggressively, despite the fact that “opposing groups came out of the woodwork to block its passage” (Bunbongkarn 1999, 63). On December 8, 1997, the Thai authorities announced that only two of the 38 rehabilitation plans submitted to the FRA had been approved; the other 36 had been rejected. Thus FRA and the ministry of finance announced the permanent closure of 56 out of the 58 finance companies (with a book value of 600 billion baht) that had failed to meet the tough new loan classification provisions.51 Eligible The Asian financial crisis 108 claimants were given the option of exchanging their bahts for notes issued by two publicly controlled financial institutions, the Krung Thai Thanakit (KTT) and the Krung Thai Bank (KTB), under two distinct note-exchange schemes.52 In early February 1998, with the assistance of international firms, FRA began the liquidation of finance company assets through public auction, in which the AMC participated as the bidder of last resort. The auction of assets began with automobiles, followed by bonds, securities and other collectable items. In fact, to encourage investors to participate in the auction, the FRA organized road-shows in the major world financial centers (BOT 1998, 12). In early 1998, twelve additional finance companies that were deemed insolvent were merged with a state-owned finance company into a new state-owned commercial “good bank” named Radanasin – set up to purchase and manage the good assets of the suspended finance companies (BOT 1998, 13). In mid-January 1998, the authorities nationalized four insolvent medium-sized banks (Bangkok Metropolitan Bank, First City Bank, Siam City Bank and Bangkok Bank of Commerce), in order to prepare them for sale to foreign financial institutions – despite the fact that their owners vociferously accused the government of selling Thailand to foreigners. Finally, cognizant of the fact that even the country’s banks and finance companies that had not been suspended faced significant risks, the Bank of Thailand tried to shore up confidence through strengthening prudential regulations and supervision. On March 31, 1998, in order to bring Thai practices up to international standards by the end of 2000, the Bank of Thailand made rules governing loan classification, provisioning and reporting more stringent.53 For example, the definition of non-performing assets was changed to cover loans three or more months in arrears, instead of, as earlier, 6–12 months. Loan classification was tightened by requiring provisioning for, and prohibiting accrual of interest on, all loans more than six months overdue. Moreover, commercial banks and finance companies were required to increase provisions for sub-standard loans from 15 per cent to 20 per cent. Doubtful loans now required a 50 per cent provision, while local banks had to increase their capital by as much as 80 billion baht by the end of 1998, on top of the 129 billion baht previously added. Finance companies were required to add 42 billion baht of new capital in addition to the 20 billion already mandated. Also, banks had to set aside roughly 100 billion baht in new provisions for loan losses, and finance companies 43 billion baht, and all financial institutions were now required to submit quarterly (instead of annual) audits and credit reports to the central bank. The new rules also included guidelines for restructuring corporate debt – with special emphasis placed on financial institutions tightening their lending practices and credit analysis procedures. New prudential regulatory and accounting standards for specialized banks were quickly developed – paralleling those for commercial banks. The new standards addressed loan classification, provisioning, and interest accrual requirements. Thailand: crisis, reform and recovery 109 The IMF had forecast that, if its conditions were followed, Thailand would experience a speedy V-shaped recovery (IMF 2000). However, the IMF had obviously underestimated the depth of the recession or the ferocity of the contagions spread in the region. Despite the Thai government’s faithful adherence to strict monetary and fiscal discipline – as the finance minister and BOT governor noted in the third letter of intent to the IMF: “we have adhered strictly to the program ensuring that all performance criteria for December 31, 1997 related to monetary, fiscal and external policies as well as financial restructuring have been observed,” the much predicted quick recovery did not materialize.54 In fact, market confidence, instead of bouncing back, continued to erode. The baht continued its precipitous fall, hitting an all-time low of 56 to the dollar in mid-January 1998 (losing 55 per cent of its value since being floated on July 2, 1997) – despite a rapid rise in short-term interest rates.55 Given the fact that many of the domestic debts were denominated in foreign currency, the rising interest rates and the collapsing baht savaged debtors’ balance sheets and aggravated the already serious non-performing loan problems in the banking and financial system. This resulted in the banks and the remaining finance companies accumulating substantial losses. The resultant credit crunch made the cost of bank credit extremely high, while the near collapse of the baht made the cost of foreign loans simply unbearable. With the steep declines in manufacturing, exports, imports and investment (indeed, the overall deterioration of the real sector of the economy), the GDP, which started its decline in the second half of 1997, continued its downward spiral through the first half of 1998 – constantly outpacing the official projections. It was clear that Thailand was in a much deeper recession than had been anticipated in August 1997, when the IMF rescue package was put in place. The socioeconomic distress caused by the continuing economic decline was devastating. Labor market adjustment took several forms. The number of those of working age shown as being “not in the labor force” increased by 600,000 between the February rounds of the labor-force surveys of 1997 and 1998. This was equivalent to a third of the numbers of unemployed in May 1998. There were also major reductions both in hours worked and in nominal wages. Mahmood and Aryah (2001, 246) note that “the crisis generated approximately 90,000 redundancies, raising the level of unemployment to 2.2 million as of June 1999. Real wages declined following the pre-crisis tightening of the labor market. Real wage growth, which stood at over 2 per cent per year in 1996, reversed itself. The real wage fell by more than 7 per cent in 1998 and by 1.5 per cent in 1999.”56 While the initial labor-force impacts were largely in urban areas, the effects were also felt in the countryside, through both return migration of urban workers and reduced remittances. Since Thailand does not have a well-developed formal social safety net (there is no unemployment insurance, and many social benefits such as health care are tied to employment), the vast majority of the The Asian financial crisis 110 displaced and unemployed workers were left to fend for themselves.57 For those fortunate enough to be working, the rise in inflation in the context of a considerably weakened labor market exacted a further toll in terms of falling real wages and incomes. The combined effects of higher unemployment and inflation pushed large numbers of people into poverty. The most vulnerable in the workforce, including the country’s 1.3 million foreign workers (mainly Burmese), were informed by the Labor Ministry that they would be forcibly repatriated. As Phongpaichit and Baker (2001, 93) note, “in March 1998, the ministry began rounding up Burmese and pushed over 200,000 across the border.” Not surprisingly, by the spring of 1998 public support for the Thai government’s IMF program began to deteriorate. Business leaders “mounted a broad attack on the IMF program for concentrating too much on fiscal discipline, external stability, financial restructuring, while paying no attention to the real economy.” Some even accused the IMF program of being “neo-colonial” and “imperialist” – designed to “decimate local firms and create fire-sale conditions for foreign purchasers.” Rather, the critics proposed that “Thailand should declare a debt moratorium to give domestic firms a breathing space to recover” (Phongpaichit and Baker 2000, 46–7). In the countryside, farmers’ organizations came together on a call for agricultural debt relief, and “then proposed to mount a massive demonstration in the capital if their demands were not met.” Similarly, in the urban areas the hard-hit middle-classes and the growing ranks of the urban unemployed were quickly mobilized against the IMF program, widely perceived as “saving the rich at the expense of the poor” (Phongpaichit and Baker 2000, 47, 94). It is clear that by the time the Thai government signed its fourth letter of intent to the IMF, on May 26, 1998, it was deeply concerned by the alarming contraction of the real sector of the economy, the rapid growth of non-performing loans, and the growing popular agitation against the IMF’s allegedly harsh measures. The fourth letter of intent noted that “the conditions in the real economy are still deteriorating as the economic decline during the first half of 1998 is proving to be deeper than previously anticipated . . . thus the focus of policies will shift to adopting macroeconomic settings, strengthening structural policies and ensuring the adequacy of the social safety net” (GoT 1998a). It is important to reiterate that the initial IMF program in Thailand called for fiscal tightening that allowed little room for increased social expenditures. It was only the force of subsequent events – the deeper-than-anticipated recession, the rapidly mounting job losses, the accumulating indicators of widespread social distress and growing popular discontent – that forced the Thai government to shift the policy focus. Indeed, the Thai authorities increased the target fiscal deficit to 3 per cent of GDP in May 1998, a sharp contrast to the targets of a fiscal surplus of around 1 per cent of GDP when the IMF program was first agreed with Thailand: crisis, reform and recovery 111 Thailand (GoT 1998a). It should be noted that this loosening of fiscal policy was not motivated solely by the need to increase social expenditures. Fiscal stimuli was also needed to moderate the unforeseen depth of the contraction in the real economy, especially since monetary policy could not be eased within the macroeconomic framework agreed with the IMF. From June through to August 1998, while the Thai government began publicly (yet politely) to suggest that in the light of the huge negative aggregate demand shocks, the IMF’s insistence on tight monetary and fiscal policies was misplaced, behind the scenes it “fought a pitched battle with the IMF over the crisis strategy.” It seems that after much “hard bargaining” the Thai authorities were eventually able to persuade the IMF to “overturn its stringent macro conditions” (Phongpaichit and Baker 2000, 48). Indeed, in the summer of 1998, the strategy for economic recovery was broadened to halt the collapse of aggregate demand. This goal was to be met by relaxing contractionary fiscal policy, extending the ongoing reform of the financial sector, addressing the problems of Thai firms mired in debt, strengthening corporate governance, reforming state enterprises in preparation for privatization, and a major relaxation of the macroeconomic policy regime, especially on the revenue side.58 In keeping with the new policy thrust, the fiscal deficit targets were further reduced to −3.5 per cent on August 25 and −5 per cent on December 1, 1998. Monetary policy was switched from targeting the exchange rate to targeting money growth – with a view to producing sharp reductions in interest rates and increases in bank lending. Although the authorities realized that the fiscal deficit would increase, they felt that the overall goal was to assist the real sector through lower interest rates and to stimulate domestic demand. Also, lower interest rates were seen as a means of easing loan payments burdens on debtors. These new policy modifications were made explicit in the Thai government’s fifth letter of intent, filed with the IMF on August 25, 1998 (GoT 1998b). The fifth letter of intent described in great detail the policies that Thailand intended to implement in the context of its request for financial support from the IMF. In addition to the reversal of monetary policies, the government announced additional initiatives intended to speed up the recapitalization of the banks, restructure corporate debts and increase bank lending. Also, the government’s earlier commitments to providing liquidity support for troubled financial institutions and a comprehensive guarantee to depositors were clarified and reaffirmed. Without doubt, the most important new fiscal initiative was the allocation of funds for a “targeted social safety net,” while avoiding entrenching new costly schemes that could introduce distortions into the labor market (GoT 1998b, 2). A significant part of the total social expenditure (roughly 12 billion baht or US$300 million) was allocated for employment creation through the Social Investment Program. The Social Security Fund, “as part of the broader effort to strengthen the social safety net” was also expanded (GoT 1998b, 4). The Asian financial crisis 118 13 See, for example, Lall (1990, 45–50). Tan (2000a, 166–67) also notes that “Thailand’s secondary school enrolment ratio is very low (only 37 per cent in 1993) . . . in recent years rapid economic growth has led to acute shortages of skilled labor in Thailand. In 1991, there were about 3,800 engineers in Thailand, while the demand for engineers was about 6,200.” 14 The dollar–baht rate, though fairly constant, was not rigid. Rather, it depended on a special formula that included a small weighting for the value of the yen, the mark and a few other currencies. 15 Taiwanese garment firms invested in Thailand, because, in part, Thailand had not used up its quotas under the MFA. See the quotations cited in Siamwalla, Vichyanond and Vajragupta (1999, 6). 16 Thailand’s contribution to the production of such medium-tech products was largely assembly work. The design, complex manufacturing processes and international marketing were located elsewhere. Hence, unlike South Korea, Taiwan or Singapore, Thailand’s limited technological capability meant that it lacked the “inspiration” so critical for industrial upgrading. 17 Exchange-rate policy since 1984 has been officially described as a “managed float.” However, after the devaluation, the baht stabilized at around Bt 25 per dollar. Since 1984, the Exchange Equalization Fund (EEF) served as a mechanism through which the basket-peg exchange rate policy was implemented. The EEF daily announced the mid-rate for US$/Thai baht, and stood ready from 8.30 to 12.00 a.m. to buy and sell US dollars in any amount with banks at 0.02 from the mid-rate. 18 Under the first three-year financial reform plan, the Bank of Thailand fully liberalized the interest-rate structure, thereby enabling the domestic financial system to adjust interest-rate movements on the basis of supply and demand conditions. Ceilings on commercial bank deposit rates were removed during 1989–91. In June 1992, ceilings on finance and crédit foncier companies’ deposits and lending rates and on commercial banks’ lending rates were removed. Similarly, several foreign-exchange controls were relaxed. For example, residents could now open foreign-currency accounts in Thailand (Alba et al. 1999, 18). 19 Until 1990 Thai citizens were not permitted to hold foreign-exchange deposits or to purchase foreign currencies for investment overseas. Thus they were unable to take much advantage of differentials between domestic and foreign rates of interest. For details, see Wibulswasdi (1995). 20 The regulatory authority of the SEC covers all aspects of the capital market, including, (1) issuance of securities by means of public offering and private placement; (2) securities trading, both in the Stock Exchange of Thailand and in the over-the-counter market; (3) securities business, including securities companies and mutual fund management companies; and (4) information disclosure and prevention of unfair trading practices. 21 High domestic interest rates were the result of the Bank of Thailand’s pursuing a tight monetary policy to keep inflation in check. 22 M1 is the measure of the US money stock that consists of currency held by the public, travelers’ checks, demand deposits and other check-able deposits, including NOW (negotiable order of withdrawal) and ATS (automatic transfer service) account balances and share draft account balances at credit unions. M2 is the measure of the US money stock that consists of M1, certain overnight Thailand: crisis, reform and recovery 119 repurchase agreements and certain overnight Eurodollars, savings deposits (including money-market deposit accounts), time deposits in amounts of less than US$100,000 and balances in money-market mutual funds (other than those restricted to institutional investors). 23 M3 is the measure of the US money stock that consists of M2, time deposits of US$100,000 or more at all depository institutions, term repurchase agreements in amounts of US$100,000 or more, certain-term Eurodollars, and balances in money-market mutual funds restricted to institutional investors. 24 The 7–8 per cent differentials were the result of weak competition in financial markets and a government policy of maintaining high domestic interest rates in order to control inflation and rising current-account deficits. The relatively high domestic interest rates, together with fixed foreign-exchange rates, attracted shortterm foreign funds, especially in the form of non-resident baht accounts. 25 Thailand’s organized financial markets are made up of eight main financial institutions: commercial banks; finance, securities and credit companies; specialized banks; development finance corporations; the stock exchange; insurance companies; saving cooperatives; and mortgage institutions. The commercial banks make up the largest component in terms of total assets, credit extended and savings mobilized. In 1990 they accounted for 71 per cent of total financial assets in the country. The second largest are the finance companies, which began operation in 1969 (Warr and Nidhiprabha 1996, 39). 26 The theoretical distinction between short-term and long-term capital flows is usually intended to differentiate between flows that are easily reversible and sensitive to fluctuations in expected risk-adjusted international yield differentials (flows that are sometimes referred to as speculative or hot money), and flows that are not easily reversible and that are determined more by longer-term fundamentals. 27 The BOT (1998b, 16) notes that while “for the year 1996 as a whole, monetary base growth slowed to 12 per cent compared with 22.6 per cent in 1995, indicating an adjustment in the desirable direction, the stock of private external debt had already accumulated to US$73.3 billion by end-1996, more than half of which was accounted for by 27 foreign banks, BIBFs and 15 Thai BIBFs.” 28 Commercial banks were permitted to hold net foreign assets up to 25 per cent of their capital funds, while the maximum percentage of net foreign liabilities was raised to 20 per cent. 29 Why did wage increases outstrip productivity increases in Thailand? According to Warr (1998), in the 1980s agriculture had already experienced low labor productivity, and the labor surplus that could be transferred to manufacturing was. This raised average productivity without a proportional increase in the wage rate. As the supply of surplus agricultural labor ran out in the early 1990s, the tighter labor market pushed up wages. In addition, labor productivity was constrained by a relative lack of skilled workers in Thailand. In 1995, Thailand had the second-lowest secondary school enrollment ratios in the region (only Indonesia’s were lower), and an almost total absence of vocational education and R&D. For details, see Mahmood and Aryah (2001). 30 After hitting a historical high of 80 yen to the dollar in June 1995, the yen experienced a downward trend, falling to 127 yen to the dollar in April 1997 – or just before the Asian crisis broke. The yen’s sharp depreciation led to a marked The Asian financial crisis 120 deterioration in East and Southeast Asia’s export performance and currentaccount imbalances in 1996, paving the way for the currency crisis. 31 In hindsight, it can be said that if the baht exchange rate had been determined in such a way as to reflect Thai inflation relative to US and Japanese inflation, then the depreciation of the yen against the US dollar might not have caused the deep problems it did for Thai exports, and the current-account deficits might have been smaller than they were. 32 The finance companies raised huge sums of money by selling interest-bearing “promissory notes” to the public, besides borrowing large amounts from local banks and foreign investors – much of it in the form of short-term loans. 33 One measure of return on capital investment is the incremental capital output ratio (ICOR), which compares the increases in investment relative to the increases in GDP. A rising ratio implies that investment is becoming less productive, or of lower quality. The ICOR rose steadily in Thailand from 2.8 in 1988 to almost 5.0 in 1991, to 6.2 in 1996 (Alba et al. 1999, 27). 34 Founded in the mid-1980s, the assets of Finance One quickly grew to US$4 billion by the mid-1990s (Blustein 2001, 56). 35 The FIDF was established in 1985. It was set up as a separate juridical entity (but with its operation housed in the Bank of Thailand) to ensure proper coordination in policy implementation, especially during a financial crisis. 36 Somprasong was the first Thai Company to miss payments on its foreign debt. Why did such a premier company collapse so suddenly? In large part because property loans only appear “safe” since the values of the loan collateral keep rising. However, these property prices are rising only because of the reckless lending itself, creating an “asset bubble.” When the bubble bursts, the loans cannot be repaid from selling the collateral, C, which already plummeting in value. 37 The operating fund of the PLMO came from three sources: an initial capital of 1 billion baht allocated from the government budget; contributions from the member financial institutions of 1 million baht each; and the issuance of PLMO bonds worth 1 billion baht and guaranteed by the government (BOT 1998, 10). 38 In the early months of its operation, the PLMO purchased three projects worth 500 million baht from three financial institutions (BOT 1998, 10). 39 Of course, it would have been practically impossible for the short-sellers to accumulate such an enormous short position in the baht had it not been for the sales that the Bank of Thailand made. Reminiscent of the “blunder” made by the Central Bank of Mexico in issuing the dollar-linked tesobono bonds, the Thai Bank’s forward contracts constituted a financial bomb that the bank itself had planted underneath the state treasury (DeRosa 2001, 97). 40 The controls exempted genuine underlying business related to current international transactions, foreign direct investment flows and various portfolio investments. Banks were required, however, to maintain documentary evidence supporting such transactions for audit and inspection. 41 According to Blustein (2001, 71), Thailand’s “move inflicted acute pain on the hedge funds, to the tune of $400 million to $500 million in losses.” Thus DeRosa (2001, 94) cites Soros Quantum Fund portfolio manager Stanley Druckenmiller, who states, “they [the Bank of Thailand] kicked our butts and they’ve taken a lot of profit we might have had. They did a masterful job of squeezing us out.” Thailand: crisis, reform and recovery 121 42 Lauridsen (1998) mistakenly notes that Amnuay resigned after failing to persuade the cabinet to introduce a managed-float foreign-exchange system. The fact was that he was a vocal supporter of the fixed exchange rate. 43 On July 2, 1997, the baht depreciated by 18 per cent. By the end of July, the baht had fallen by 25 per cent (relative to January 1997); in August, the baht had dropped to 38 baht to the US dollar (a fall of 34 per cent); and by the end of September was 42 per cent below its 1997 start level. From July 2, 1997 to its most depreciated rate in January 1998, the baht went from 25 baht to 54 baht per US dollar. That is, over the course of the following six months, the baht depreciated by almost 100 per cent against the US dollar. 44 The fact that Wibulswasdi had to negotiate with the IMF’s Stanley Fischer (Wibulswasdi’s professor at MIT) raised questions as to whether the Thai authorities had to submit meekly to all the IMF’s demands (Phongpaichit and Baker 2000, 37–8). Indeed, “the initial negotiations with the IMF in August 1997 were cloaked in secrecy, and the first letter of intent was never published in full . . . the Thai ministers and officials involved gave the impression that they simply acceded to all IMF demands” (Phongpaichit and Baker 2001, 85). 45 “Thailand,” in The Far Eastern Economic Review: Asia 1996 Yearbook, pp. 217– 18. 46 It is important to keep in mind that throughout the first half of 1997 the IMF urged a continuation of a pegged exchange rate – but with a widened band and less weight given to the American dollar. The big fear was that a floating rate could easily swing out of control. However, once it became known that Thailand’s foreign-exchange reserves were almost gone, there was no choice but to float. 47 There was delay in implementation because one of the coalition partners in the Chavalit administration, the Chart Pattana, some of whose senior MPs had large interests in the financial sector, including some of the suspended finance companies, tried to derail the restructuring plan. 48 The AMC began with a total funding of 1 billion baht as a buyer of last resort, to focus on the lowest-quality assets in the liquidation process organized by the FRA. 49 What made the coalition administration of Chuan Leekpai more capable in dealing with the growing financial turmoil? There are several interrelated explanations. First, the likeable and urbane Chuan’s reputation as a honest man and a consensus-builder served him well. Second, Chuan’s Democrat Party, as the oldest and most institutionalized political party in the country, was not only free of the more egregious corruption, but also had a track record of championing prudent macroeconomic policies. Third, although in a coalition arrangement, “the Democrat Party was the largest and he [Chuan] was able to insist that it occupy all of the top economic positions as a precondition for forming government” (Haggard 2000, 94). Finally, there was popular expectation that the new government cooperate and move with dispatch to deal with the growing economic turmoil. 50 Phongpaichit and Baker (2000, 45) note that “Tarrin Nimmanhaeminda had been Thailand’s leading professional banker . . . [and] was an open advocate of financial liberalization, and quickly established the personal confidence of the IMF, Washington, and the financial markets.” The Asian financial crisis 122 51 The new loan classification was tightened by lowering the period after which a loan is non-performing from 12 to 6 months and keeping a high capital-to-risk assets ratio of 12–15 per cent (compared to the international norm of 8.5 per cent) in order to bring the sector gradually into line with international standards by 2000. The two finance companies that were re-opened were Kiatnakin Finance and Securities Public Company and Bangkok Investment Public Company Limited. The 56 of the 58 companies that were closed down were required to sell their assets by the end of 1998. 52 When the 16 finance companies were suspended on June 27, 1997, the government announced that depositors’ claims on the companies would receive priority, but that creditors’ claims would not. However, when 42 more finance companies were suspended on August 5, 1997, both creditors and depositors received priority. Creditors of the first 16 suspended finance companies that did not have the option of exchanging their claims had to modify their claims under a shareholder rehabilitation program or try to collect from the proceeds of the FRA’s liquidation of assets. And finally, although the KTT and the KTB were in charge of administering the note-exchange programs, the FIDF was made responsible for servicing payments of interests and principal on the notes. 53 Although, the rules were announced on 31 March 1998, they were effective as of the end of 1997. 54 The third letter of intent was signed on February 24, 1998. For details, see GoT 1998. 55 The overnight central bank repurchase rate reached 22 per cent (Nabi and Shivakumar 2001, 29). 56 Flatters (2000, 264) also notes that “significant decreases in wages and hours worked are widely acknowledged. Wage reductions of 20 to 30 per cent have been common in many sectors.” 57 Tan (2000, 113) notes that “poor farmers in the drought stricken villages in the country’s northeast were venturing into minefields on the Thai–Cambodian border in search of an edible root called kloy. Many Thais were resorting to selling their organs illegally in order to survive.” 58 As Flatters (2000, 265), notes, “the relaxed fiscal targets, however, were more in the nature of a passive recognition of the devastating effects of the crisis on revenues than an active attempt to provide a fiscal stimulus.” 59 It turned out that few banks resorted to the capital enlargement opportunities offered by the government, in particular, the tier 1 option. It seems that banks have been reluctant to write down their capital in return for public money and accept the resultant dilution of ownership. Rather, banks choose to raise capital through the issuance of preferred stocks linked with subordinated debentures – or the so-called SLIPS (Stapled Limited Preferred Shares) and CAPS (Capital Augmented Preferred Shares). Although these new instruments are appealing in the presence of low deposit interest rates, they still have risks, as they receive no government guarantee, and returns are mostly performance-based. 60 In coalition with Yongchaiyut’s New Aspiration Party, and the Chat Thai Party of Banhan Sinlapa-acha, Thaksin controlled over 300 seats. The July 2001 merger with the small Seritham Party added 14 members to parliament, increasing the Thai Rak Thai seats in the house to 263. Indonesia: crisis, reform and recovery 123 3 Indonesia: crisis, reform and recovery In Indonesia, state-owned banking gave way to a system where anyone with $1 million or so could open a bank (Little 1997, 10). In mid-1998, a World Bank study (1998) grimly noted that “Indonesia is in deep economic crisis. A country that achieved decades of rapid growth, stability, and poverty reduction is now near economic collapse . . . no country in recent history, let alone one the size of Indonesia, has ever suffered such a dramatic reversal of fortune.” There is bitter irony in Indonesia’s fall from grace. Long hailed as a model of successful economic development, it was widely expected to escape the fate of Thailand.1 Between June and August 1997, as Thailand’s economy unraveled and the virulent Asian flu sent shock waves through the region, the Indonesian economy remained relatively stable – seemingly a veritable rock in the stormy sea. Even the World Bank (1997) remained upbeat about the short-term outlook, believing that a modest widening of the intervention band (from 8 per cent to 12 per cent) within which the rupiah was allowed to be traded would be sufficient to ward off contagion. The Indonesian government, which received much praise for its swift and decisive response to the crisis, went to great lengths to assure jittery investors “that Indonesia was not Thailand.” Then the unthinkable happened. Indonesia suddenly succumbed to the contagion, and measured by the magnitude of currency depreciation and contraction of economic activity, it emerged as the most serious casualty of Asia’s financial crisis. In fact, with an economic contraction of 15 per cent in output in 1998, Indonesia experienced the most severe economic collapse recorded for any country in a single year since the Great Depression of the 1930s. What happened? Why did Indonesia (and the other high-performing Asian economies) collapse like hollow dominoes? In the numerous post-mortems that have followed, analysts have identified a number of related factors behind the region’s dramatic reversal of fortune. In the case of Indonesia, The Asian financial crisis 124 the variable that soon acquired particular salience was “crony capitalism.” Initially popularized by The Economist (1998), the term quickly took on a life of its own. Soon thereafter, Paul Krugman would argue that crony capitalism lay at the root of Indonesia’s, indeed, East Asia’s, financial woes. Krugman’s emphasis on crony capitalism, while not without merit, is too simplistic. After all korupsi, kolusi dan nepotisme (corruption, collusion and nepotism), has long been pervasive in Indonesia. It was hardly an obstacle when Indonesia notched up impressive economic growth-rates for some three decades prior to the crisis. Back then, crony capitalism was politely referred to as the “government–private sector nexus” and viewed as a unique feature of the East Asian “developmental states” and even a necessary prerequisite for development. Rather, this chapter argues that a more nuanced understanding of Indonesia’s economic crisis can be gained by differentiating between the sources of “vulnerability” and the “precipitating” factors. A careful review of the events leading to the crisis shows that both these factors converged during the critical period between late August 1997 and March 1998 – and practically everything that could go wrong did over these months. The greatest source of vulnerability, indeed, the fundamental weakness lay in Indonesia’s over-guaranteed but under-capitalized and underregulated banking sector. The precipitating factors were the contagion, but also, more importantly, poor macroeconomic management by the Suharto regime; and to a lesser extent the International Monetary Fund exacerbated the crisis. The background The fact that nobody saw Indonesia’s impending collapse is hardly surprising. Hal Hill (1999, 8) notes that before the crisis “almost every technical economic indicator looked safe.” Likewise, Furman and Stiglitz (1998) found that the Indonesian crisis was the least predictable out of a sample of 34 potentially troubled economies. Indeed, for a country that was dismissed during the Sukarno era (1949–65) as a “chronic dropout” and one that “must surely be accounted the number one failure among the major underdeveloped countries,” Indonesia’s economic development in the post-Sukarno era was nothing short of miraculous.2 In the first half of the 1960s, foreignexchange reserves shrank to zero (in 1965), inflation skyrocketed to over 600 per cent annually, government deficit rose to some 3,000 per cent of revenues, and per capita income fell by 15 per cent between 1958 and 1965 (Bhattacharya and Pangestu 1997, 390–3; Prawiro 1998, 1–18). In sharp contrast economic growth averaged 7 per cent between 1970 and 1989 and 8 per cent between 1990 and 1996 (Booth 1999, 110–12). This growth occurred alongside substantial industrialization and structural change, as agriculture’s share of GDP declined from 55 per cent in 1965 to 19.4 per cent in 1990, Indonesia: crisis, reform and recovery 125 while industrial output expanded from 13 per cent to 42 per cent – with a corresponding rise in the share of manufactures in GDP from 8 per cent to 20 per cent by 1990 (Jomo 1997, 133; Booth 1999, 113). By 1993, manufactured exports reached US$21 billion and accounted for 53 per cent of total exports (World Bank 1996, 216). It is important to note that, unlike what happened in many other developing countries, Indonesia’s proportional shift from agriculture to industry did not come at the expense of agriculture. On the contrary, the first five-year plan (or Repelita 1) introduced in 1969 emphasized agricultural and rural infrastructural development. Not surprisingly, agriculture accounted for almost 30 per cent of the rapid economic growth achieved from 1967 to 1973. While Indonesia was a major beneficiary of the oil and commodity boom of 1973–81, unlike many other oil exporters it used the earnings prudently – avoiding the familiar “Dutch disease” problem (or how to protect the competitiveness of the non-oil economy from the adverse consequences of oil windfalls) by wisely investing in manufacturing and agricultural production as well as in improving social services. As Booth (1999, 114) notes, after 1973, “revenues from oil company taxes were used to increase agricultural productivity.” New high-yielding and pest-resistant varieties of rice were developed and distributed. These efforts contributed to a burst of growth in rice production between 1979 and 1985, when total output of the crop increased by 49 per cent. By the mid-1990s, manufacturing had been the leading engine of growth in Indonesia for more than a decade, contributing roughly one-third of the increase in GDP from 1983 to 1995. However, this rapid expansion of manufacturing was not simply the result of growth of industries based on processing petroleum and natural gas (in 1995 these two activities accounted for less than one-tenth of total manufacturing output); the other nine-tenths comprised a diverse range of manufacturing industries. Some of these, such as motor vehicles, were oriented largely toward the domestic market, while wood products, garments, textiles, footwear and electronics were mainly sold abroad. As a result, by the late 1980s the economy had become more trade-dependent, with total trade flows as a percentage of GDP rising sharply from 14 per cent in 1965 to 54.7 per cent in 1990. These developments increased the capacity of the economy to mobilize savings, as reflected in the rise of national savings as a percentage of GDP from 7.9 per cent in 1965 to 26.3 per cent in 1990 (Jomo 1997, 133). Equally impressively, the quality of life for the average Indonesian improved greatly, as per capita income rose from US$75 in 1966 to US$1,200 in 1996. These gains were spread fairly equitably. For example, between 1976 and 1990 income per person in the poorest quintile of Indonesia’s population grew by 5.8 per cent per year, whereas the average income of the entire population grew by 4.9 per cent per year. To put this success in some comparative context: in 1967 per capita income in Indonesia was less than one-half that of India, Nigeria or Bangladesh. By mid-1997, it was five times The Asian financial crisis 126 that of Bangladesh, four times that of Nigeria and three and a half times that of India (Kenward 1999a, 73). With such growth, the proportion of population living below the official poverty line declined from 64 per cent to an estimated 11 per cent between 1970 and 1996 – one of the largest reductions in poverty recorded anywhere in the world during the period.3 Other socioeconomic indicators bear out this success. For example, consumption of foodstuffs such as rice, meat and dairy products rose continually since the late 1960s. Between 1968 and 1995, daily protein intake per Indonesian improved by more than 60 per cent – from 43.3 to 70.0 grams (Booth 1999, 129). Infant mortality declined from 145 per 1,000 live births in 1970 to 53 per 1,000 in 1995, life expectancy rose from 46 to 63 years during the same period, and the country achieved universal primary education in 1995. While Java, in particular greater Jakarta, was the main beneficiary, the benefits of economic growth extended to all Indonesia’s twenty-seven culturally diverse and far-flung provinces (World Bank 1998, 75). Mills (1995, 7) sums up Indonesia’s achievements in these words: Indonesia’s growth rate over the past 25 years has transformed a desperately poor society in which malnutrition, illiteracy and infant mortality were widespread into one with a large middle class, one in which nearly all children are educated and in which infant mortality and malnutrition have decreased dramatically. The benefits of such relatively rapid growth are not shared equally in any society, but all major groups benefitted greatly: farmers, factory workers, industrialists, small business owners, government employees and the urban poor. One of the repeated boasts of Suharto New Order Government (1965–98) was its defeat of the rampant hyperinflation of the Sukarno era, and its ability to keep budget deficits low and in balance.4 Indeed, prudent macroeconomic management kept the budget broadly balanced for an unprecedented 30 years – or the entire length of the Suharto era. Immediately on assuming office, the Suharto regime eliminated the fiscal deficit through drastic expenditure cuts and passed a “balanced budget” law in 1967 prohibiting domestic financing of the budget in the form of either debt or money creation. Again, effective macroeconomic management helped Indonesia steer through the difficulties of the steep oil price increases and declines in the 1970s and 1980s, and kept the macro-economy largely in balance right up to the onset of the crisis in mid-1997. As was noted earlier, the government essentially proscribed domestic financing for the budget throughout – a strategy that kept both expenditures and monetary growth under relative control. Moreover, the government also adopted a stringent monetary program to bring down inflationary pressures. By 1969, inflation had been reduced to less than 20 per cent and external accounts were brought into balance (Bhattacharya and Pangestu 1997, 394). Since the mid-1980s, inflation has been kept within single digits, and on the eve of the crisis was about Indonesia: crisis, reform and recovery 127 6 per cent (McLeod 1999, 209). Finally, the exchange-rate was adjusted to realistic levels through large devaluations, while the administered system of foreign-exchange allocation was gradually replaced by a market mechanism. Following the unification of the exchange rate in 1970 and a further devaluation in 1997, the capital account was fully liberalized. In 1967, Indonesia rejoined the World Bank and the IMF, which enabled it to receive substantial foreign assistance for its adjustment program and work out arrangements to reschedule its foreign debt. In contrast with those of Thailand and Malaysia, Indonesia’s current account deficit in the 1990s averaged only 2.6 per cent of GDP. In fact, not once in any year between 1990 and 1996 did its annual current-account deficits ever exceed the average over the period 1983–89. The 1996 current account deficit of 3.5 per cent was comparable to those of previous years, and less than half the level in Thailand. Thus, the deficit on the current account of the balance of payments looked healthy and manageable. Also, unlike the case in Thailand, there was no serious exchange-rate misalignment, as Indonesia’s exchange-rate policy was gradually relaxed (via widening of the intervention band) by Bank Indonesia, the country’s central bank. Two large devaluations of the rupiah in 1983 and 1986, and the ensuing policy of allowing it to float (within a band) downward relative to the US dollar led the exchange rate to decline steeply over time in real terms. Because of this policy, which lasted until the rate was freed in August 1997, Indonesian exports could be competitively priced in dollar terms on world markets. This policy enabled Indonesia to compete successfully with producers of labor-intensive manufactures in the region, including China.5 Finally, Bank Indonesia had substantially increased its stocks of international reserves. Indeed, international reserves, both in absolute terms and in months of merchandise imports, were comfortable and rising just prior to the crisis. The external debt to GDP ratio was gradually declining, and was appreciably lower than during the difficult adjustment period of the mid-1980s. And, with the exception of 1990, Indonesia had an excess of private savings over investment in the period 1990–96. The budget surplus averaged over 1 per cent in the four years prior to the crisis, and credit growth was modest. In short, the traditional economic indicators looked sound. Sources of vulnerability With such an enviable record of development and seemingly sound economic fundamentals, what went wrong? The roots of the crisis can be traced back to the mid-1980s, when Indonesia embarked on an ambitious economic reform program. The reforms were designed to diversify the economy in order to reduce its dependence on the oil sector, encourage the development of a competitive non-oil export-oriented industrial base that would absorb The Asian financial crisis 134 year from 1992 to 1996. Part of the credit expansion was financed by foreign borrowing, and when restrictions on lending were lifted, banks began to expand credit to property and real estate, including ambitious and costly infrastructure projects. Bank Indonesia’s own figures show that bank lending to the property and real estate sector increased by roughly 40 per cent from 1995 to 1996 (Djiwandono 1999; 1999a). While the competitive, if not speculative, market environment (not to mention the easy availability of bank credit), increased the pressure on banks to lend without careful riskassessment, Nasution (1999, 80), notes that “Indonesia’s prudential rules and regulations were poorly implemented and largely unenforced . . . bank credit officers who were reared in the pre-reform environment may have lacked the expertise to evaluate new sources of credit and market risk.” Furthermore, the comparatively poorly compensated officials at the stateowned banks, who viewed their job security and career advancement as being essentially dependent on their ability to satisfy powerful individuals and the well-connected, hardly bothered to assess the creditworthiness of the borrowers. Not surprisingly, in the case of the state-owned banks, risky lending practices were often the result of both explicit and implicit pressure exerted by members of the Suharto family, their cronies and other highranking military and government officials to make loans to favored borrowers. Indeed, the practice of making loans based on political pressure became known as “memo lending,” because such loans were extended on the basis of a “memo” sent by the powerful and well-connected. Soon memo lending and other illegal practices led to high levels of non-performing loans at the state-owned banks. The case of a government-owned development bank, Bank Pembangunan Indonesia (also known by its acronym as Bank Bapindo), is illustrative. In 1994, Bank Bapindo lent some US$436 million to the Golden Key group, at that time a little-known Indonesian konglomerat (conglomerate) owned by a colorful businessman, Eddy Tansil, with close links with senior military and government officials. The loan was never repaid, and a later government investigation alleged that the loan had been extended on the basis of fraudulent documentation and with the complicity of key Bapindo executives and government officials, including the former minister of finance, Johannes Sumarlin – who at the time was also a member of Bapindo’s board of commissioners (Habir 1999). Regulators and central bank supervisors were also involved in fraud and collusion. However, instead of closing down or restructuring the bank, the government allowed the bank to continue to operate. Also, only bank officers (but not the managers) were punished for corruption. Similarly, in the case of commercial paper issued by PT Bank Pacific, PT Bank Arta Prima and PT Bank Perniagaan, only four supervisors of Bank Indonesia were arrested in early August 1997 for allegedly taking bribes during inspections between 1993 and 1996. Nasution (1999, 83) supplies the macro dimension of the problem: Indonesia: crisis, reform and recovery 135 Despite average annual economic growth of over 6 per cent since 1990, the volume of problem loans held by Indonesia’s banks remained considerable. In 1995, 8.8 per cent of total bank credit outstanding was classified as substandard, doubtful, or bad debt. As of November 1996, the bad debt of the banking system amounted to Rp. [rupiah] 10.4 trillion (equivalent to about 2 per cent of GDP or around 10 per cent of total loans). Of this amount, state-owned banks held Rp. 7.1 trillion (68 per cent). Thus the rapid growth of the private banks was achieved at the expense of sector soundness. That is, in the case of the private banks, risky lending practices usually involved banks making loans to affiliated companies – which also included affiliated property companies. Specifically, since liberalization increased the attraction of the financial sector to commercial and industrial concerns, many of Indonesia’s large business conglomerates opened one or more private banks. Most of these banks were not managed on an independent basis, but as funding sources for the affiliated businesses – extending loans to suit the funding needs of the businesses and on terms dictated by the affiliated businesses’ senior office-holders, rather than on the basis of diligent risk-assessment of the companies’ creditworthiness. While there were rules regarding the aggregate amount that a bank could lend to its affiliated companies, there were no clear provisions to enforce the rules. Not only were the staff and resources of the central bank insufficient to allow for adequate inspections of the banks under its supervision; indirect or intra-group lending could in any case easily be concealed. Thus, loans to affiliated companies were among the riskiest loans held by the private banks. The case of Bank Summa is illustrative. This bank was one of the first private banks established after the enactment by Bank Indonesia of the 1988 banking reforms. Prior to its collapse, Bank Summa was one of the ten largest banks in Indonesia. It was owned by the influential Soeryadjaya family, who also had major controlling interest in Astra International, one of Indonesia’s largest conglomerates. In the second half of 1990, Bank Summa began to face serious financial problems, mostly as a result of the deteriorating quality of its large portfolio of loans. Many of the “bad” loans were in the real estate sector, and 70 per cent of these loans had been extended to related parties, exceeding the legal limit by far (Enoch et al. 2001, 23). For two years, Bank Indonesia relied on its traditional approach of holding talks with the shareholders and trying to persuade them to solve the bank’s problems while continuing to provide liquidity support – which by the end amounted to 25 per cent of the bank’s total liabilities (Enoch et al. 2001, 24). In June 1992, a memorandum of understanding formalized the owners’ commitment to repay the non-performing connected loans and recapitalize the bank. However, the owners failed to meet their commitment. Faced with a fast-growing liquidity need, Bank Indonesia decided in November 1993 not to grant any additional liquidity support, and revoked Bank Summa’s license. In December 1992, Bank Summa collapsed. At the time of Bank The Asian financial crisis 136 Summa’s liquidation, it was estimated that more than 70 per cent of its loan portfolio was non-performing and that a high percentage of these loans had been made to its affiliated companies. In total, Bank Summa had amassed more than US$750 million (0.6 per cent of GDP) in non-performing loans (Enoch et al. 2001, 23). Nasution (1999, 85–6) notes: Indonesia’s weak market infrastructure, malfeasance and malversation together have allowed the emergence of so-called “swindle” banks. The typical swindle bank makes loans to non-bank companies owned by its principal owner(s) to finance questionable investment projects, usually at inflated prices. Liabilities of such banks are mainly deposits owned by the general public, liquidity credit from Bank Indonesia, unsecured commercial paper sold to the general public (including foreigners), and equity shares owned by Bank Indonesia and other state-related institutions . . . Such banks typically have negative net worth. By the early 1990s, Bank Indonesia was quite aware that the country’s banks, given their high level of exposure to property companies, faced a potentially disastrous problem. As is well known, investments in property and real estate are long-term and highly risky, because they are very sensitive to future growth expectations. In contrast, the liabilities of the banks were mostly short-term and denominated in US dollars, Japanese yen and other foreign currencies. Also, in many cases, banks had taken no collateral, and those that had taken collateral took a pledge over property as collateral for loans. In any case, they could hardly collect, because a fall in real estate prices would mean that by the time of default the property used to secure a loan would be worth only a small fraction of the outstanding principal amount loaned. Moreover, as was noted earlier, short-term borrowing from abroad was a relatively inexpensive source of funds provided that the banks did not incur additional costs purchasing hedging instruments to protect themselves from any depreciation of the rupiah against the currency they had borrowed. Unhedged foreign-currency borrowing posed an obvious risk to a bank, in that any depreciation of the rupiah during the term of the loan would mean that the amount in rupiahs needed to repay the loan on maturity would be far greater than the amount the borrower received upon drawing the loan. In short, Indonesian banks were faced with an unhedged funding mismatch between borrowing short-term from abroad in foreign currency and lending long-term in rupiah. All these asymmetries of the banks’ balance sheets added greatly to their overall riskness. In an effort to address these problems, the Indonesian government enacted the Banking Law (known as Banking Act No. 7) in 1992. The Banking Law allowed sanctions to be imposed on bank owners, managers, and commissioners for violations of laws and regulations related to bank management. Also, the law contained provisions designed to restrict the aggregate amount that a bank could lend to affiliated companies to 20 per cent of the bank’s capital, and converted some state banks to limited liability companies and Indonesia: crisis, reform and recovery 137 permitted them to lend only to non-priority sectors. In October 1992, as part of the project to limit the number of banks, the capital required to set up a domestic bank was increased fivefold. In 1995, reserve requirements were raised from 2 per cent to 3 per cent effective February 1996. In addition, the minimum capital required for banks with foreign-exchange licenses was tripled, and the capital adequacy ratio for these banks was raised from 8 per cent to 12 per cent – with both these measures to be phased in over a five-year period ending in 2001. Bank Indonesia also developed a supervisory system patterned on the United States CAMEL system (Capital, Asset Quality, Management, Earnings, Liquidity), including annual on-site examinations of banks. Moreover, the system stipulated necessary qualifications of bank owners and managers, a schedule to meet the Bank for International Settlements (BIS) capital adequacy requirement (CAR) of 8 per cent on risk-weighted assets, stricter information and reporting requirements, and tougher limits on lending within a corporate group or to one individual. In fact, by the end of 1996 prudential practices in Indonesia’s banking sector were largely in line with those recommended by the Basle Committee, and comparable to those adopted in the United States and the European Union. However, the Indonesian government’s efforts to improve and promote best practice came when the sector was already deeply troubled by high levels of non-performing loans. Moreover, the enforcement of these measures was generally quite lax, and violations rampant. Bank Indonesia’s own report acknowledged that as of March 1997 a significant number of banks remained undercapitalized and not in compliance with the prudential rules. While these figures very probably understate the extent of non-compliance, according to Bank Indonesia 15 banks did not meet the required 8 per cent capital adequacy ratio in April 1996, while 41 banks did not comply with the legal lending limit, and 12 licensed foreign-exchange banks did not meet the rules on net open foreign-exchange exposure (Montgomery 1997, 13). Also, many of the banks continued to maintain their high level of exposure to the property and real estate sector. During 1996, even as the glut in the property market became apparent and real estate prices began to nosedive, Indonesian banks continued to lend to property companies. In 1997, despite large-scale losses reported by the property industry, bank lending to the property sector totaled about 19.4 trillion rupiah, a 21 per cent increase from 1996 (Hammond 1997). In July 1997, Bank Indonesia issued a decree that was intended to restrict bank credit to real estate developers severely; but it was too little too late. Undercapitalized and, in large measure, burdened with poorly diversified and badly performing loan portfolios, Indonesia’s over-guaranteed but under-regulated banking system lay exposed and highly vulnerable to economic shocks. Finally, lurking menacingly beneath were the political vulnerabilities. Specifically, as Indonesia’s patrimonial-authoritarian regime succumbed to The Asian financial crisis 138 favoritism and cronyism, this began to take its toll on economic activity. Specifically, in the late 1980s and early 1990s, Suharto’s children and the regime’s close allies rapidly expanded their business activities. Soon Suharto’s children and cronies were involved in almost every economic activity in the country – first in natural resource-based ventures, then in manufacturing, and later in a range of services, from construction to the operation of toll roads, telecommunications and financial services.11 Richburg (1998, A40) lucidly describes the nature of “Suharto Incorporated.” The Suharto children are all reputed to have become multi-millionaires by trading on their direct line to the presidential palace, which involved everything from clove cigarettes to toll roads, from petrochemical plants to automobile manufacturing. So pervasive is the first family’s reach into the Indonesian economy that a long-running joke here is that the corruption begins as soon as you arrive at Jakarta’s international airport: You can buy a pack of cigarettes, hop in a taxi, take a toll road to the city and check into a hotel, putting money into a Suharto family member’s pocket with each step. Indeed, as Blustein (2001, 91) notes, “by the 1990s, the Suharto family’s avarice was so pervasive that almost any foreign firm investing in, say, a power plant or phone system or petrochemical factory had to hand over lucrative partnership rights to one presidential relative or another to grease the project’s way through the country’s bureaucracy.” Yet, as was noted earlier, while corruption and cronyism were hardly new in Indonesia, what differentiated the late 1980s and 1990s was Suharto’s unwillingness to make prudent economic decisions when his children’s and cronies’ business interests were at stake. Indonesia’s “national car” policy is illustrative. In February 1996, Suharto announced a national car policy designed to provide competition in the automotive industry, especially to the monopoly held by the Astra Group, led by an ethnic-Chinese Indonesian entrepreneur, William Soeryadjaya, and its Japanese partners, Toyota, Daihatsu and Isuzu. The program gave a three-year exemption from import duties and luxury taxes to those Indonesian companies that manufactured cars locally using an Indonesian brand-name and local parts. The conditions attached to these exemptions were demanding. They required companies to attain a local content of 20 per cent after the first year, 40 per cent after the second year, and 60 per cent after the third year. However, as Hale (2001, 631) notes, “it was what happened next, however, that really stunned the domestic business community and international observers.” On February 27, 1996, the national car policy promulgated in the Presidential Instruction No. 2/1996 gave a “pioneer” status to PT Timor Putra Nasional (TPN) – jointly owned by Suharto’s youngest son, Hutomo (“Tommy”) Mandala Putra and the KIA Motor Corporation of South Korea. This special status gave TPN a oneyear exemption on tariffs and taxes, despite the fact that the company did not even make cars. Moreover, this exclusive status exempted the company Indonesia: crisis, reform and recovery 139 from paying the 65 per cent maximum import duties for car spare parts, and the 35 per cent maximum import duty and luxury goods sale tax that make up over 60 per cent of the cost of car production in Indonesia. Also, as Hale (2001, 632) notes, “adding insult to injury, in June 1996 President Suharto issued the presidential decree that allowed the national car to be assembled in Korea for the first year of operation.” In effect, TPN was given permission to import CBU Kia sedans from South Korea and sell them under the Timor brand-name for one year. Furthermore, TPN could sell these cars at a duty-free price that significantly undercut those of its competitors; to boost the sale of the car, the public sector was required to purchase it.”12 Finally, fully backed by the Indonesian government, Bank Indonesia, and a consortium of 4 state-owned banks and 12 private domestic banks, the company received an initial US$960 million for its production and assembly facility. Despite these advantages, “the inability of Tommy’s newborn firm to organize itself quickly or well enough to assemble Kia’s components in Indonesia had led Suharto to indulge his son: For one year, Tommy could bring up to 45,000 finished Timors into the country from South Korea for sale free of the stiff tariffs and luxury tax that other such imports would still have to face” (Borsuk 1999, 149). As King (2000, 617) notes, “this cronyism was so brazen ...as to anger even the regime’s staunchest supporters.” Indeed, in July 1997, with Thailand already in the early stages of the crisis, “Indonesia’s biggest state and private banks were arm-twisted by the government to supply US$650 million to Tommy to build a Timor factory east of Jakarta” (Borsuk 1999, 149). Likewise, against the advice of respected economists, Suharto continued to support the lucrative monopolies his children and cronies enjoyed over the soybean and cloves industries. Specifically, since the mid-1980s, PT Sarpindo Soybean Industri – owned jointly by two of Suharto’s children and his wealthiest and oldest friends, Liem Sioe Liong of the Salim Group and the plywood magnate, Mohamad (“Bob”) Hasan – had been the sole processor of soybeans into bean curd (a major source of protein for Indonesians), and the sole producer of soymeal, an important ingredient in animal feed. Moreover, while only the state food distribution agency (Badan Urusan Logistik or BULOG), was allowed to import soybeans to meet the growing demand, it had to use Sarpindo’s crushing facility for processing soybeans. As Borsuk (1999, 150) notes, “Bulog paid a fee substantially higher than the world price for crushing soybeans. Sarpindo got a further bonus in the form of the soybean oil that crushing yielded, which Sarpindo was allowed to keep and sell at a handsome profit.” Besides this, Liem controlled Indofood, the world’s largest instant-noodle maker and Bogasari Flour Mills, the world’s largest flour-milling operation, which held effective monopolies in the Indonesian market thanks to government contracts, special import licenses and subsidies. Cloves, on the other hand, are the key ingredient used in the manufacture of Indonesia’s distinctive spice-flavored cigarettes known as The Asian financial crisis 140 kretek. In order to corner this lucrative market for his son Tommy, Suharto designated cloves an “essential commodity,” to be regulated by the state. This decision was followed in early 1991 by the creation of the Clove Support and Marketing Agency (Badan Penyangga dan Pemasaran Cengkeh or BPPC), with Tommy as chairman. As Borsuk (1999, 152) notes, “to keep the monopoly going, Suharto ordered the central bank to give more than $350 million in subsidized credit to the BPPC. Thus did Tommy’s scheme make losers of the farmers, the firms, the government, and the smoking and non-smoking public. The only winners were Tommy himself and the BPPC.” The trigger and the fallout All the growing vulnerabilities now needed was a trigger. The trigger was the contagion from Thailand. On July 2, 1997, when the Bank of Thailand abandoned the baht’s peg to its traditional basket, the baht immediately depreciated sharply against the US dollar. Pressure then quickly intensified against the Philippine peso and the Malaysian ringgit – each of which received only limited support from their central banks. On July 8, the rupiah came under pressure. Although Indonesia had stronger macroeconomic fundamentals than Thailand (as these pertained to exports and the fiscal balance), and only a modest current account deficit, the rupiah was, nevertheless, vulnerable for two principal reasons. First, the huge foreign-debt burden of the private Indonesian corporations (much of it short-term and not hedged against exchange-rate changes), and second, the fundamental weakness of the financial and banking sector raised doubts about the government’s ability to defend the currency peg. The Indonesian government’s initial reaction to speculation against the rupiah was decisive. Unlike Thailand, rather than defending its currency and squandering a large portion of its reserves, Bank Indonesia, on July 11 widened the trading band for the rupiah from Rp. 192 (8 per cent of the central rate) to Rp. 304 (12 per cent of the central rate), in a pre-emptive move designed to deter speculation. It also limited non-resident transactions in the forward market and introduced an array of tight monetary policy along with administrative measures to limit the external borrowings of commercial banks.13 Indeed, Indonesia was widely praised for its strategy of “deft macroeconomic management” (Blustein 2001, 97). Yet it was too early to celebrate. Despite the vigorous defense the rupiah continued to slide. As the then Governor of Bank Indonesia, J. Soedradjad Djiwandono (1999a, 145) noted, “the market reaction to the central bank (Bank Indonesia) move was contrary to experience.” Every time the Bank Indonesia intervention band had been widened previously (five times from 1994 to 1997), an appreciation of the rupiah followed. This time, the rupiah rapidly depreciated instead. This was in large part because foreign creditors began to reduce Indonesia: crisis, reform and recovery 141 their exposure to Indonesia, and large domestic conglomerates, fearful that they would not be able to repay their foreign debts if the rupiah fell significantly, rushed to hedge these debts by buying US dollars. In fact, as unhedged domestic borrowers jumped into the market to try to cover their positions, this pushed the rupiah even further downward. By July 21 the rupiah fell by 7 per cent, in effect sharply depreciating to near the bottom of the new band. This only made domestic capital flee to safer havens offshore. In response, on July 23, Bank Indonesia raised interest rates from 12 per cent to 13 per cent, and intervened heavily in support of the rupiah. But this was to no avail, as the panic selling of rupiah and assets denominated in rupiah continued. When the rupiah depreciated by 13 per cent (from 2,400 per US dollar in July to 2,700 on the August 13), it was the last straw. On August 14, the Indonesian authorities, reluctant to squander more foreign reserves, allowed the rupiah to float.14 Immediately the rupiah depreciated sharply against the US dollar and other currencies in which the Indonesian banks had borrowed. As the currency depreciated, the rupiahdenominated value of the interest and amortization of foreign debts surged, causing a serious balance-sheet problem in both the corporate and banking sectors. In particular, because of the depreciation, the amounts of rupiah that Indonesian banks earned on their long-term loans to the property sector and other industries were no longer sufficient to service their short-term foreign borrowing. Moreover, the banks could no longer attract new funds from abroad that could be used to repay the short-term borrowing coming close to maturation. In response, the Indonesian government raised shortterm rupiah interest rates in order to attract rupiah deposits and stabilize the currency. For example, on August 11, 1997, the overnight Jakarta interbank rupiah rate (or JIBOR) was 15.8 per cent. A week later, on August 18, the overnight JIBOR was 51.4 per cent, and by August 22, the overnight JIBOR was 87.7 per cent. However this failed to bring much reprieve, as the rupiah continued to weaken. The Ministry of Finance responded by cutting government spending by rescheduling projects worth about US$16 billion and limiting routine expenditures on non-priority items (Pincus and Ramli 1998, 725). It also further tightened liquidity by instructing the public sector (including state-owned enterprises) to shift their deposits from (mainly stateowned) commercial banks to Bank Indonesia. However, this also proved ineffective, as the rupiah continued to slide – gaining renewed momentum downward on August 21. In desperation, on 29 August, Bank Indonesia issued a new rule limiting the forward sale of dollars to non-residents to US$5 million in order to reduce currency speculation. It is not clear if the Indonesian authorities were in consultation with the IMF regarding the tight money policy. Bank Indonesia argued that the tight money policy was necessary to keep inflation under control and to stem the tide of large shifts into dollar holdings by residents. This is similar to the long-held IMF position that stresses the importance of high interest rates in The Asian financial crisis 142 keeping domestic currency holdings attractive, even if this complicates the situation of weak banks. In hindsight, an “overshoot” in the interest rate rise, through the tightening of liquidity by the Indonesian authorities, was very much responsible for the severe financial crisis that ensued. More than anything else, the tight money immediately exposed Indonesia’s weak financial and banking systems. Bank runs emerged as early as the second half of August 1999, when the process of “flight to safety” began. Faced with the prospect of widespread bank failures, Bank Indonesia had to scramble quickly to supply banks facing liquidity problems with funds, and by the end of August 1997 had put up some US$500 million for the troubled banks (Soesastro and Basri 1998, 9). The injection of new liquidity and the lowering of short-term interest rates (the JIBOR rate fell to 40 per cent in the first week of September) did provide temporary reprieve.15 On September 23, the finance minister Mar’ie Muhammad unveiled a comprehensive policy program to deal with the crisis (Muhammad 1997). The program included: (a) stabilization of the rupiah at a new equilibrium level; (b) strengthening of fiscal policies and fiscal consolidation; (c) reduction of the current account deficit; (d) strengthening of the banking sector; and (e) strengthening of the private corporate sector. To achieve these objectives, the government made a pledge further to “loosen liquidity gradually and in accordance with the situation through fiscal and monetary instruments.” Furthermore, the government made a commitment to reduce interest rates and to cancel or postpone over 200 public sectorrelated development projects that would save the government some US$37 billion. These included the postponement of costly mega-projects such as the construction of the Jakarta Tower, of the bridge between Sumatra and the Malaysian peninsula, and of the Menara Jakarta bridge. With regard to the banking sector, the government announced its intention to merge state banks and liquidate the insolvent ones. Also, it made a commitment to follow up quickly on the plan to encourage weak private banks to explore the possibility of mergers. Finally, in a dramatic move, the 49 per cent foreign ownership limit on Indonesian stocks was scrapped in order to increase foreign investment in the stock market. These announcements succeeded in bringing a measure of calm to the markets. As the rupiah stabilized around Rp. 3,000 per US dollar some thought that the worst was over. However, it was only a temporary reprieve – the calm before the storm. Part of the dilemma was that Indonesia was facing a confidence problem, and despite all the concerted effort, the government failed to restore confidence. However, a bigger problem was that, ambitious as the finance ministry’s program was, it did not go far enough. For example, rather than postponing or dismantling inefficient and profligate monopolies, such as the Suharto protégé, Bacharuddin Jusuf Habibie’s, pet project, the state-owned aircraft manufacturer Industri Pesawat Terbang Nusantara (IPTN), or the national car project owned largely by Suharto’s Indonesia: crisis, reform and recovery 143 youngest son, the government reaffirmed its commitment to continue to support these projects. Equally blatant was the government’s approval of the 1,350 megawatt Tanjung Jati C power plant (in which Suharto’s daughter, Tutut, had a major stake), when the Java–Bali power grid was facing up to 70 per cent over-capacity (Tan 2000, 172; also Eklof 1999, 101). As regional currencies and stock markets continued to plummet, and amidst reports that Indonesian banks and private companies were having great difficulty in meeting their external debt-service obligations, the pressure on the rupiah re-intensified. By early October the rupiah had fallen by more than 40 per cent since July (the fastest depreciation among the crisis countries), while the Jakarta Stock Market Index dropped by 44 per cent (Soesastro and Basri 1998, 10). On October 6, the Indonesian government sold another US$650 million in the foreign-exchange market to stabilize the external value of the rupiah (Nasution 1999, 88). Again, this was to no avail. On October 8, when the exchange rate passed 3,800 rupiah to the US dollar, Indonesia turned to the IMF for “consultation and technical assistance.”16 On October 31 (after some three weeks of discussions), the Indonesian government negotiated a financial bailout package totaling some US$43 billion in international assistance with the IMF and bilateral donors. The package consisted of US$23 billion of the so-called “first line of funds” negotiated with the IMF and a “second line of funds” negotiated with bilateral donors. These included Japan (US$5 billion), Singapore (US$5 billion), United States ($3 billion), Malaysia (US$1 billion), Australia (US$1 billion), Brunei (US$1.2 billion) and China and Hong Kong SAR.17 Of the US$10 billion from the IMF, US$3 billion was to be disbursed immediately, and a further US$3 billion was to be made available after March 15, 1998, provided the Indonesian government met the program’s economic targets. The rest of the money was to be disbursed on a quarterly basis, provided the targets continued to be met (IMF 1997c). The entire agreement was to be implemented over a three-year period and carefully monitored jointly by the Indonesian government and the IMF, including experts from the World Bank and the Asian Development Bank. The mood was one of cautious optimism after the signing of the October 31 agreement. It was widely believed that the agreement would restore investor confidence and arrest the rupiah’s continuing plunge. The IMF Managing Director, Michel Camdessus, summed up the prevailing mood when he noted that “these measures should restore confidence in the Indonesian economy and contribute to the stabilization of regional financial markets” (IMF 1997b, 3). Indeed, initially the program received positive response from the market, resulting in the rupiah strengthening from Rp. 3,700 to Rp. 3,200 per dollar. However, it was too early to celebrate. The economic program the Indonesian government had committed to in its “letter of intent” to the IMF (which now became part of the agreement) was quite extensive, given the IMF’s objectives of restoring market confidence The Asian financial crisis 246 the chaebols a top priority (Haggard and Moon 1990, 226). However, as Beck (1998, 1019) notes, “when Chun Doo-hwan seized power in 1980, he threatened to prosecute the chaebols’ owners for illicit wealth accumulation. A few groups were forcibly restructured or dissolved, but in the end the effort failed. Chun’s democratically elected successors, Roh Tae-Woo and Kim Young-sam, also pledged to take on the chaebol, only to experience similar results.” 28 The DLP now controlled 217 of the 299 seats in the National Assembly. 29 President Kim not only won a convincing victory over his principal opponent, Kim Dae-Jung; he was also less indebted for his power to the various factions of the party. Not surprisingly, the twenty-five-member Kim cabinet had new faces who were “progressive outsiders” and “reform-oriented men and women” (Oh 1999, 131). 30 The NBFIs were established in the 1970s to reduce the importance of the informal credit markets. They were allowed greater freedom in their management of assets and liabilities and could apply higher interest rates on deposits and loans than could banking institutions. 31 Although an accurate measurement of the size of the Curb market is difficult, estimates suggest that in the mid-1990s the total lending in the Curb market was between 2 and 5 per cent of the total loans of the formal financial sector. In contrast, in the mid-1970s, the Curb market was estimated to account for more than one-third of all credit extended in the economy. As was noted earlier, Curb market loans are characterized by high interest rates and risks – to satisfy the credit demands of individual households and small and medium-size firms that have been excluded from the formal credit market (Balino and Ubide 1999, 11). 32 Although specialized banks can borrow from the government, deposits constitute their main source of funding. Funding for development banks, which are wholly government-owned, comes mainly from government-guaranteed bonds (Balino and Ubide 1999, 9). 33 The market share of banking institutions for Korean won deposits fell from 71 per cent in 1980 to 32 per cent in 1996, while that of NBFIs increased from 29 per cent to 68 per cent (H. Smith 1998, 73). 34 Specifically, Kim Young Sam’s merger of the Economic Planning Board (EPB) and the Ministry of Finance (MOF) into a super-ministry, the MOFE, did not bring policy coherence. While the “MOF segment within the MOFE consistently warned of the danger of foreign exchange and financial crises and urged immediate counter-measures including IMF rescue financing . . . the EPB segment, which dominated the MOFE decision-making machinery, ignored MOF warnings by pointing out the ‘fundamental health’ of macroeconomic indicators. If the MOF had remained as a separate bureaucratic agency, the liquidity crisis could have been avoided” (Moon and Rhyu 2000, 94). 35 Joining the OECD requires, as a precondition, free capital markets. 36 Before the deregulation, the top 15 chaebols were not allowed to own and control life insurance companies, while the next top 15 chaebols were allowed to have only up to a 50 per cent ownership of life insurance companies. However, by May 1996, all chaebol but the top 5 were allowed to own or control life insurance companies. Also, before the deregulation only the commercial banks could own investment trust companies. However, in early 1996 the restriction was lifted. Korea: crisis, reform and recovery 247 37 It is important to note that short-term borrowing rates were lower than longterm rates, and short-term funds could be raised relatively easily through the international money markets. This resulted in domestic banks channeling external short-term funds to long-term loans financing investments by domestic corporations. 38 The economic policy that put the first priority on the competitiveness of the export sector forced the monetary authority to intervene frequently in the market and to maintain stable exchange rates. During the first half of the 1990s, the real effective exchange rate of the Korean won had depreciated, unlike the currencies of the other crisis countries, partly owing to the appreciation of the Japanese yen during the period and the government’s policy of supporting the export sector. 39 Kyung-Hwan Kim (2000, 107), notes that “unlike those in Japan, Thailand, or Indonesia, Korean financial institutions had been prohibited from lending to finance real estate purchases except for land for new housing. This regulation was repealed in January 1998, right after the economic crisis began. Due to this and other regulations, Korea’s exposure to real estate was relatively small.” However, this does not mean that the chaebols did not engage in land speculation. E. C. S. Kang (2000, 89) notes that “in the period 1985–95, land prices increased by 250 per cent, with industrial land prices increasing even more, by 310 per cent. This rapid increase in prices was driven largely by investments by the chaebol, which could not find a more productive use for their money, much of it borrowed. The chaebol bought land to use as collateral and a hedge against inflation. Indeed, they bid up the land prices to offset the interest rates on their bank loans.” 40 According to a recent report by the Korea International Trade Association, the foreign-exchange earnings ratio of Korean exports, which is defined as the ratio of value-added created net of export-induced import to the total value added, started to decline continuously from the peak of 67.9 per cent in 1989 to the level of 55.9 per cent in 1997 (Pyo 2000, 20). 41 Bustelo (1999, 167) notes that in Korea, “total labor costs increased at an average annual rate of 8.2 per cent between 1985 and 1995, a period in which labor productivity grew substantially less, at 6.5 per cent.” 42 Until the mid-1980s, Korea had enjoyed cheap labor costs compared with competing countries such as Hong Kong, Singapore and Taiwan. However, the rapid rise in wages after 1987 increased unit labor costs, and Korea could no longer count on cheap labor to give the country an edge in international competition. After the democratization of 1987, trade unions were often successful in getting relatively advantageous collective bargaining contracts – and real wages came close to doubling between 1987 and 1997 (Kang et al. 2001, 97). During the period 1985–95, unit labor cost in manufacturing increased by 46.0 per cent in Korea, while the corresponding figures were 22.1 per cent in Japan, 25.1 per cent in Taiwan and 4.4 per cent in the United States. The situation became even worse when other countries such as China, Thailand, Malaysia and Indonesia adopted an export-oriented economic strategy. In the process, Korea was sandwiched between the developed countries (with their superior technological base) and the newly-industrializing countries, with their very low wages (Suh 1998, 13). As the dollar became stronger, particularly against the yen, The Asian financial crisis 248 Korea’s export competitiveness suffered, and the country experienced an accelerated increase in its trade deficit. 43 The electronics exports declined from US$43.6 billion in 1995 to US$41.2 billion in 1996, an annual decrease of 5.5 per cent, after 30.4 per cent and 41.1 per cent annual increases in 1994 and 1995 (Yoon 1999, 412). 44 See “Semiconductors: Chips on their Shoulders,” The Economist, November 1, 1997, p. 62. 45 For example, Samsung spent 4 trillion won building a car-manufacturing plant in Pusan when there was already an excess supply of cars, not only in South Korea, but in the world. With a capacity of 240,000 units per year, it sold only 60,000 units in 1998. Not surprisingly, Samsung Motors lost 156 billion won in the first six months of 1998. Its debt rose to nearly 4 billion won, taking its debt/ equity ratio to 555 per cent (Tan 2000, 130–31). 46 Mathews (2001, 161) notes, “why the banks had continued to lend to such a poor risk subsequently became clear: they were being bribed by Hanbo’s founder, Chung Tae Soo, to do so. Chung, it turned out, had been indicted twice before for bribery, but somehow had managed to stay in business. Eventually he was forced to default because even the banks, despite the bribes, refused to go on lending to him, and demanded his removal from the company’s management. Eventually, the bribery scandals spread, reaching even into the President’s office, thus effectively tying the hands of the government at the very moment when strong leadership was called for to stem the mounting crisis.” 47 On April 21, the Jinro group faced near-collapse, but was saved from bankruptcy owing to an Anti-Bankruptcy Accord hastily imposed on the creditor institutions by the Korean government to prevent a ripple effect in the economy. 48 Chae-Jin Lee (2000, 190) notes that “the government’s crisis management capability during Kim Young Sam’s presidency was lacking: when he replaced the chief economic planner (the deputy prime minister) seven times and the senior economic secretary to the president six times in five years, confusion, inconsistency and unpredictability ensued. And rampant corruption, particularly government– business collusion, undermined rational economic decisions.” 49 The quotation is from Moon and Rhyu 2000, 91. Also Doowon Lee (2000, 11) notes: “at first, the Korean government repeatedly denied the existence of a crisis. For example, the prime minister assured the National Assembly that the economy was not in trouble. Deputy Prime Minister Kyong-sik Kang mentioned many times that the economy’s fundamentals were sufficiently strong and there should be no worry about an economic crisis. In addition, the government refused to reveal the true situation of the economy to the public. A government report inflated the amount of available foreign exchange reserves.” 50 Moon and Rhyu (2000, 92) note that “Kim Young Sam failed to ensure bureaucratic and policy stability. Macroeconomic policy instability and the subsequent economic crisis were in fact aggravated by frequent reshuffles of the economic cabinet. During the Kim Young Sam government, deputy prime ministers in charge of finance and the economy were reshuffled seven times for reasons of policy failures such as price instability, current-account deficits and the Hanbo scandal, and their average tenure was less than eight months. It was virtually impossible for the Ministry of Finance and Economy to formulate and implement consistent and coherent economic policy with such a short tenures.” Korea: crisis, reform and recovery 249 51 KAMCO was first established in 1962 to manage and dispose of bad loans of the state-run Korea Development Bank. Its function has been increasingly expanded over the years, and in November 1997 legislation was passed to entrust KAMCO with the administration of a Non-Performing Asset Management Fund (NPA Fund). The objective of the NPA Fund is to purchase and dispose of nonperforming loans of all financial institutions covered by a deposit guarantee as efficiently as possible. In August 1998 the reorganization of KAMCO as a “bad bank” was completed and KAMCO adopted a structure similar to the US Resolution Trust Company. 52 Doowon Lee (2000, 10) notes that “when the Hong Kong stock market collapsed in October 1997, many foreigners thought that Korea would be next.” 53 With the collapse of the Thai and Indonesian currencies, a large volume of loans made by Japanese banks to these countries became non-performing. This led the Japanese banks to collect their mature loans from Korea. According to In-June Kim and Rhee (1998, 363), Japanese banks collected short-term lending of some US$9 billion from Korea between October 1997 and December 3, 1997. 54 These deposits were not usable as foreign reserves. 55 See Lindgren et al. (1999, 71). 56 The quotes are taken from Nicholas Kristof, “Seoul Plans to Ask the IMF for a Minimum of $20 billion,” The New York Times, November 22, 1997, p. B2. Also Chae-Jin Lee (2000, 191) notes that “in November 1997, when IMF Managing Director Michel Camdessus secretly visited Seoul and informed South Korean economic officials that South Korea’s crumbling finances required the IMF’s intervention, they flatly responded, ‘you’re crazy; our system works’ . . . This response betrayed either overconfidence or blind nationalistic pride.” Camdessus’s secret visit to Seoul is also discussed in Blustein (2001, 127–8). 57 Nicholas Kristof, “Package of Loans Worth $55 Billion Set for South Korea,” New York Times, December 4, 1997, p. C6. 58 The change in Kim Dae Jung’s policy should not be surprising. As Blustein (2001, 197) notes, “there were some powerful advisers within the presidentelect’s camp who favored breaking the power of the chaebol. Indeed, DJ’s [Kim Dae Jung’s] main economic adviser, You Long Kuen, a provincial governor and former Rutgers’s economics professor, had been trying since the election to convince the Treasury and IMF that the populist DJ would prove far more willing than the existing government to endorse those kinds of reforms.” Second, as Samuel S. Kim (2000, 245) notes: “faced with a likely financial meltdown in late 1997, President-Elect Kim Dae Jung quickly reversed his earlier stand against the International Monetary Fund (IMF), becoming perhaps the world’s most outspoken champion of the controversial institution.” 59 That is, in exchange for the interbank loans they held, the foreign banks received equal amounts of bonds, fully guaranteed by the Korean government. In addition, these bonds paid attractive yields, at an average interest rate of 8.2 per cent, which was 2.25 per cent over the London Interbank Offered Rate (LIBOR) for one-year bonds, 2.50 per cent over LIBOR for two-year bonds, and 2.75 per cent over LIBOR for three-year bonds. 60 In Korea, SMEs are defined as companies with fewer than 300 persons and assets of less than 80 billion won. As of 1996, there were 2.64 million SMEs – which accounted for more than 98 per cent of enterprises and 78 per cent of The Asian financial crisis 250 employment. Of these, nearly 100,000 were in the manufacturing sector, representing 47 per cent of total value added and 42 per cent of total exports. However, the overwhelming majority of manufacturing SMEs employ between 5 and 50 workers (World Bank 1999, 5). 61 Figures from Balino and Ubide (1999, 58). However, it is important to note that since a large number of people gave up searching for another job upon becoming unemployed and thus became part of the economically inactive population, the unemployment rate was a significant understatement of the actual degree of unemployment. 62 Lister (2001, 3) notes that “the incoming administration of President Kim Dae-Jung had no difficulty, in conjunction with the IMF adjustment program and emergency World Bank loans, in articulating sensible reforms to the financial and corporate sectors, the labor market, and state-owned enterprises. The authorities readily adopted principles that had become basic tenets in most of the industrialized world, even though these principles clashed in many respects with traditional way of doing business in South Korea.” 63 Mathews (2001, 165) aptly notes that “the clarification of the role of the Bank of Korea, and its separation from any supervisory function, is likely to diminish the scope for bribery and corruption.” 64 Until new institutions consisting of a Financial Supervisory Board (FSB) and Financial Supervisory Agency (FSA), together with a Securities and Futures Trade Commission are established, the FSC will act as financial watchdog and to direct reforms of the industrial conglomerates. 65 Deposit protection was amended and, with effect from August 1998, interest on deposits over 20 million won was no longer protected (World Bank 1999, 17). 66 Korea was able to re-enter international capital markets as early as May 1998. 67 Kwan S. Kim (2001, 40), notes that “the rapid rise in unemployment in the first half of 1998 was largely attributable to the bankruptcies of small and mediumsized firms which were hit disproportionately severely by the IMF’s high interest rate policy.” 68 As the economic recession grew worse and corporate bankruptcy multiplied, the IMF, it seems, finally realized its mistake, and in May 1998 granted permission to the Korean authorities to lower interest rates and to ease the money supply. However, the damage was done. 69 Even with the end of the IMF-supported program, the IMF will continue to have close relations with Korea. Regular consultations under Article IV of the IMF Articles of Agreement will continue to be held on an annual basis. IMF staff missions will also visit Korea because of the annual consultation discussions to maintain a close policy dialogue, and Korea will be subject to the IMF’s new policy on post-program monitoring. 70 The quotation is from Sunhyuk Kim (2000, 167). Also Beck (1998, 1030) notes that: “shortly after taking office, President Kim told one reporter, ‘if the chaebols reform, they will be given incentives; if they don’t, they will be at a disadvantage.’” 71 Oh (1999, 231) notes that if Rhee had not split the ruling camp, Lee would probably have been the winner. 72 Faizul M. Islam (2000, 136) asks “how did the South Korean economy recover so quickly? It was due primarily to the newly elected President Kim Dae Jung in December 1997 who introduced and implemented the reforms from the outset. Korea: crisis, reform and recovery 251 Chaebol and the labor unions who vehemently opposed those changes are surely but slowly yielding to President Jung’s reform plans.” 73 Mathews (2001, 166) notes that the top five have generally been responsible in their behavior. 74 More specifically, under the “big deals” it was hoped that each of the major chaebols would concentrate on only three or four core businesses, swapping other businesses with each other in order to achieve industrial rationalization. 75 Based on an exchange rate of 1,200 won per dollar. 76 Daewoo narrowly averted a default after its domestic creditor banks agreed to restructure its short-term debt. 77 The council was composed of eleven members (two from labor, two from business, two from government, four from political parties and the chairperson). 78 Despite this, Yong Cheol Kim and Moon (2000, 66) note that “the economic crisis penalized every sector of Korean society, but the hardest hit were the workers.” [Document text truncated for crawler view.]