Financial Crisis and Recovery: Patterns of Adjustment in East Asia, 1996-99

Park, Yung Chul; Lee, Jong Wha Working Paper Financial Crisis and Recovery: Patterns of Adjustment in East Asia, 1996-99 ADBI Research Paper Series, No. 45 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Park, Yung Chul; Lee, Jong Wha (2002) : Financial Crisis and Recovery: Patterns of Adjustment in East Asia, 1996-99, ADBI Research Paper Series, No. 45, Asian Development Bank Institute (ADBI), Tokyo, https://hdl.handle.net/11540/4150 This Version is available at: https://hdl.handle.net/10419/111134 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. 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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/3.0/igo/ ADB INSTITUTE RESEARCH PAPER 45 Financial Crisis and Recovery:  Patterns of Adjustment in East Asia, 1996-99 Yung Chul Park and Jong Wha Lee October 2002 The contraction of real income in the East Asian countries that suffered the crisis which erupted in 1997 was much larger and the subsequent recovery of these countries has been much faster than could have been predicted from previous episodes of crisis elsewhere. According to this empirical examination of macroeconomic developments—including a V-type adjustment of real GDP growth—a large real depreciation, expansionary monetary and fiscal policy, and an improvement in the global economic environment have been responsible for the upturn of the crisis-hit countries. This study argues that the East Asian financial upheaval was in large measure a liquidity crisis caused by investor panic. Once the liquidity constraint was eased as it was during the first half of 1998, domestic demand surged again and the crisis countries have been able to move back toward the pre-crisis path of growth. adbi.org I ADB Institute Research Paper Series No. 45 October 2002 Financial Crisis and Recovery: Patterns of Adjustment in East Asia, 1996-99 Yung Chul Park and Jong Wha Lee II ADB INSTITUTE RESEARCH PAPER 45 Additional copies of the paper are available free from the Asian Development Bank Institute, 8t h Floor, Kasumigaseki Building, 3-2-5 Kasumigaseki, Chiyoda-ku, Tokyo 100-6008, Japan. Attention: Publications. Also online at www.adbi.org The Research Paper Series primarily disseminates selected work in progress to facilitate an exchange of ideas within the Institute’s constituencies and the wider academic and policy communities. The findings, interpretations, and conclusions are the author’s own and are not necessarily endorsed by the Asian Development Bank Institute. They should not be attributed to the Asian Development Bank, its Boards, or any of its member countries. They are published under the responsibility of the Dean of the ADB Institute. The Institute does not guarantee the accuracy or reasonableness of the contents herein and accepts no responsibility whatsoever for any consequences of its use. The term “country”, as used in the context of the ADB, refers to a member of the ADB and does not imply any view on the part of the Institute as to sovereignty or independent status. Names of countries or economies mentioned in this series are chosen by the authors, in the exercise of their academic freedom, and the Institute is in no way responsible for such usage. Copyright © 2002 Asian Development Bank Institute. All rights reserved. Produced by ADBI Publishing. ABOUT THE AUTHORS Yung Chul Park has been a Visiting Scholar to the ADB Institute since April 2000. For the I nstitute, Prof. Park has been preparing an important series of papers, of which this is the first, around the broad themes of development paradigms and future prospects for Asia. He is a Professor of Economics at Korea University, Seoul, and a leading commentator on Asian economics and development. Jong Wha Lee, also from Korea University, has been a Visiting Professor at Harvard University, where he received his Ph.D. in Economics. He is the co-author of a number of influential papers, frequently with Prof. Robert Barro. III PREFACE The ADB Institute aims to explore the most appropriate development paradigms for Asia composed of well-balanced combinations of the roles of markets, institutions, and governments in the post-crisis period. Under this broad research project on development paradigms, the ADB Institute Research Paper Series will contribute to disseminating works-in-progress as a building block of the project and will invite comments and questions. I trust that this series will provoke constructive discussions among policymakers as well as researchers about where Asian economies should go from the last crisis and recovery. Masaru Yoshitomi Dean ADB Institute IV ABSTRACT This paper analyzes the macroeconomic adjustment from the crisis in East Asia in a broad international perspective. The stylized pattern from the previous 160 currency crisis episodes over the period from 1970 to 1995 shows a V-type adjustment of real GDP growth in the years prior to and following a crisis. The adjustment shows a much sharper V-type in the crisis episodes with the IMF program, compared to those without. Cross-country regressions show that depreciation of real exchange rate, expansionary macroeconomic policies and favorable global environments are critical for the speedy post-crisis recovery. In this sense, the East Asian process of adjustment is not much different from the stylized pattern from the previous currency crisis episodes. However, the degree of initial contraction and following recovery has been far greater in East Asia than what the cross-country evidence predicts. This paper argues that the sharper adjustment pattern in East Asia is attributable to the severe liquidity crisis that was triggered by investor panic and then amplified by weak corporate and bank balance sheets. We find no evidence for a direct impact of a currency crisis on long-run growth. Korea has stood out as a better performer than the other crisis countries in managing recovery largely because it has been relatively more successful in restoring the soundness and stability of its financial system. V TABLE OF CONTENTS About the Authors II Preface III Abstract IV Table of Contents V 1. Introduction 1 2. Cross-Country Patterns of Adjustment to Currency Crisis 2 2.1. Data 2 2.2. Methodology to Evaluate the Currency Crisis and the IMF Program in a Cross-Country Framework 4 2.3. Macroeconomic Adjustment during the Currency Crisis 5 2.4. Determinants of the Post-Crisis Recovery 15 3. Assessments of the Recovery Process in East Asia 21 3.1. Macroeconomic Adjustments in East Asia 21 3.2. Factors behind the Speedy Adjustment in East Asia 29 3.2.1. Macroeconomic Factors 29 3.2.2. Panic and Balance Sheet Effect 32 3.3. Structural Reform and Recovery 37 3.4. Differences in Post-Crisis Performance among the Asian Countries 38 4. Prospects for Long-term Growth in East Asia 41 4.1. Impacts of a Currency Crisis on Long-Term Growth 41 4.2. Sustainability of East Asian Growth 43 5. Concluding Remarks 44 Tables and Figures (in body of text) Table 1. Incidence of Currency Crises and IMF Program Participation, over the Period, 1970-1997 4 Table 2. Determinants of the Pace of Recovery from the Currency Crises: A sample of 95 crisis episodes between 1970 and 1995 18 Table 3. Regressions for Investment Rate in the Post-Crisis Period 20 Table 4. Macroeconomic Adjustment in East Asia, 1993-2000 22 Table 5. Capital Flows to the Five Asian Economies 33 Table 6. Foreign Exchange Losses of the Korean Corporate Sector 35 VI Table 7. Ratio of Foreign Liabilities to Foreign Assets of the Banking Sector 35 Table 8. Foreign Assets and Liabilities Outstanding at Financial Institutions in Korea 36 Table 9. Long-run Impact of Currency Crisis on per Capita Growth Rate 42 Figure 1. Changes in GDP Growth Rates during the Currency Crises 6 Figure 2. Changes in GDP Expenditure Components during the Currency Crises 8 Figure 3. Macroeconomic Policy Indicators during the Currency Crises 12 Figure 4. Changes in Real Exchange Rate during the Currency Crises 14 Figure 5. Adjustment of Real GDP Growth in East Asia 21 Figure 6. Quarterly Changes of Real GDP Growth in East Asia 25 Figure 7. Quarterly Movements of GDP Components in East Asia 26 Figure 8. Real Effective Exchange Rate in East Asia 28 Figure 9. Policy Indicators in East Asia 30 References 45 1 Financial Crisis and Recovery: Patterns of Adjustment in East Asia, 1996-99† Yung Chul Park and Jong Wha Lee 1. Introduction Over the three-year period after the crisis broke out in 1997, the five Asian countries—Indonesia, Korea, Thailand, Malaysia, and Philippines—managed impressive recoveries. These recoveries were faster than anyone expected. The economies started to bottom out in the second half of 1998. The rebounding of growth rate in 1999 was no less drastic than its free-fall. In Korea, for example, the growth rates showed a turnaround from –6.7% in 1998 to 10.7% in 1999. The purpose of this paper is to make an assessment of this speedy adjustment from the crisis in East Asia. In particular, we analyze the macroeconomic adjustment process of the East Asian currency crisis in a broad international perspective. First, we assess the impacts of the crisis on GDP growth using a cross-country data set, which compiled all currency crisis episodes over the period from 1970 to 1995. From these cross-country data, we draw some stylized facts about the adjustment of key macroeconomic variables during the crisis. Then we investigate the critical factors that determine the adjustment process. Our analysis of cross-country patterns shows that GDP growth rates drop with the eruption of a crisis but then recover quickly to the pre-crisis level in two or three years, showing a V-pattern of adjustment. Thereafter, the GDP growth rates tend to rise slightly above the pre-crisis levels, but then subside back to a more sustainable level. We also compare the adjustment patterns of GDP growth rates between two subgroups of the currency crisis episodes—one with conditional financial assistance from the International Monetary Fund (IMF) and the other without. We find that the adjustment process was much sharper in the group of the crisis episodes with the IMF program, compared to those without. That is, in the IMF program countries, GDP growth rates start to fall precipitously even before the eruption of a crisis but then recover to its pre-crisis level more quickly in two years. The macroeconomic adjustment process in East Asia is in general consistent with these stylized patterns. However, the degree of initial contraction and following recovery has been far greater in East Asia than what the cross-country evidence predicts. This paper tries to make an evaluation of what factors contributed to the sharper contraction and the quicker recovery in East Asia compared with the cross-country patterns. As we will elaborate in section 3, we believe that a large number of internal and external factors are responsible for the deeper crisis and the quicker recovery in East Asia. The origin and the nature of the shock, initial conditions, the development of external environments, and the stabilization and structural adjustment policies taken must have a significant consequence on the adjustment path as they did in the eruption of the crisis. From cross-country regressions based on the sample of previous crisis episodes, we find that depreciation of exchange rate, expansionary macroeconomic policies and favorable global environments are the critical determinants of the post-crisis recovery. In the regression, the † We thank Robert Barro, Richard Portes and participants at the NBER Conference on Management of Currency Crises, Monterey, United States, March 2001 for their helpful comments on an earlier draft. Si-Yeon Lee and Do-Won Kwak provided able research assistance. 8 Figure 2. Changes in GDP Expenditure Components during the Currency Crises (a) Private Consumption in GDP 64.0 65.0 66.0 67.0 68.0 69.0 70.0 71.0 72.0 73.0 74.0 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Years Before/After Crisis Percent All Currency Crises Crisis with IMF Program Crisis without Program No Crisis (b) Investment Rate 15.0 16.0 17.0 18.0 19.0 20.0 21.0 22.0 23.0 24.0 25.0 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Years Before/After Crisis Percent All Currency Crises Crisis with IMF Program Crisis without Program No Crisis 9 (c) Real Export Growth Rate -5.0 -3.0 -1.0 1.0 3.0 5.0 7.0 9.0 11.0 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Years Before/After Crisis Percent All Currency Crises Crisis with IMF Program Crisis without Program No Crisis (d) Export Share in GDP 22.0 23.0 24.0 25.0 26.0 27.0 28.0 29.0 30.0 31.0 32.0 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Years Before/After Crisis Percent All Currency Crises Crisis with IMF Program Crisis without Program No Crisis 10 (e) Real Import Growth Rate -5.0 -3.0 -1.0 1.0 3.0 5.0 7.0 9.0 11.0 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Years Before/After Crisis Percent All Currency Crises Crisis with IMF Program Crisis without Program No Crisis (f) Import Share in GDP 27.0 28.0 29.0 30.0 31.0 32.0 33.0 34.0 35.0 36.0 37.0 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Years Before/After Crisis Percent All Currency Crises Crisis with IMF Program Crisis without Program No Crisis 11 In the crisis-hit countries, domestic expenditure or demand is either slowly recovering or remains permanently below the pre-crisis level. In contrast, export demand shows a quick recovery during the post-crisis period. Panel (c) shows that in the crisis-hit countries, real export growth rates jump from less than 1% in t-1, to 3.0% in the crisis year and to 5.9% in t+1, and then remain at over 5% through the post-crisis period. For both program and non-program countries, export growth during the post-crisis period is faster than that of the pre-crisis or tranquil period, and thus leads a strong recovery. Consequently, as shown in Panel (d) of Figure 2, after the currency crisis the export share increases permanently above the pre-crisis level. But, note that on average the export share in all crisis-hit countries is still lower than that of the non-crisis average. During the early post-crisis period the quick recovery of export growth is accompanied by a contraction of import demand. The pattern of import reduction is more conspicuous in the program countries where import growth rates are negative in the pre-crisis period as well as the crisis year. Panels (e) and (f) of Figure 2 show that although the growth rate of imports recovers to the pre-crisis and non-crisis average in two years following the crisis, its share in GDP remains below the non-crisis average of 35.5%. The growth of exports and imports shows that the current account to GDP ratio improves quickly after the crisis. Thus, net exports tend to lead the recovery in the crisis-hit countries. Macroeconomic Policy Indicators Public consumption is an indicator of fiscal policy. Panels (a) and (b) of Figure 3 show that public consumption growth rates tend to slow down slightly in the crisis year, and then recover to the pre-crisis as well as non-crisis average. But in the first year following the crisis, there is contrasting behavior between the program-countries and non-program countries. While the public consumption growth rate is over 5.0% for the non-program countries, it is –0.8% for the program countries in the year of t+1. This confirms that an agreement with the IMF introduces a contractionary fiscal policy in the program country. Reflecting this sharp contraction in public consumption expenditure, the ratio of public consumption to GDP declines quickly in t+1 with the IMF program. The ratio remains at a level lower than the pre-crisis or non-crisis average in both program and non-program countries even five years after a crisis. 12 Figure 3. Macroeconomic Policy Indicators during the Currency Crises (b) Public Consumption in GDP 13.0 13.5 14.0 14.5 15.0 15.5 16.0 16.5 17.0 17.5 18.0 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Years Before/After Crisis Percent All Currency Crises Crisis with IMF Program Crisis without Program No Crisis (a) Real Public Consumption Growth Rate -8.0 -6.0 -4.0 -2.0 0.0 2.0 4.0 6.0 8.0 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Years Before/After Crisis Percent All Currency Crises Crisis with IMF Program Crisis without Program No Crisis 13 (c) Real Money Supply (M2) Growth Rate -5.0 -3.0 -1.0 1.0 3.0 5.0 7.0 9.0 11.0 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Years Before/After Crisis Percent All Currency Crises Crisis with IMF Program Crisis without Program No Crisis (d) Real Bank Credit Growth Rate -12.0 -7.0 -2.0 3.0 8.0 13.0 18.0 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Years Before/After Crisis Percent All Currency Crises Crisis with IMF Program Crisis without Program No Crisis 14 Like fiscal policy, monetary policy of the program countries contrasts sharply with that of the non-program countries. Panel (c) of Figure 3 shows that the real money supply growth rate remains positive throughout the years following the crisis and increases over time to return to the pre-crisis level in five years after the crisis in the non-program countries. In contrast, in the sample of the crisis-hit countries with IMF program participation, money supply growth is negative. Thereafter it returns to the pre-crisis average growth rate. The sharp reduction in money supply in the program countries implies that, as in fiscal policy, participation in an IMF program brings in tight monetary policy in the crisis-hit economy. It is claimed that a currency crisis often develops into a banking crisis. As international lending declines suddenly, a weak banking sector is unable to play a proper intermediation role. Banks reduce the supply of credit to the private sector. Panel (d) shows that credit supply growth indeed slows down in the crisis-hit countries. For four to five years prior to the crisis, the real credit growth rate is 7.4%. Thereafter credit growth rates decline over time, reaching –1.6% in the crisis year. Even five years after the crisis, credit growth does not return to the level of the pre-crisis or tranquil period. The slow-down of real credit growth is more pronounced in the IMF program countries. The supply of real credit declines by more than 8% in the year following the crisis and thereafter continues to slow-down throughout the post-crisis period. The robust growth of net exports during the post-crisis period is likely to be related to the real exchange depreciation associated with (or caused by) the currency crisis. Figure 4 shows that a currency crisis causes a sharp real depreciation of the exchange rate by about 15% in the crisis year. The real exchange rate also depreciates by 5.3% in the year following the crisis. Thereafter, it appreciates about 2% per year. Hence, the real exchange rate remains depreciated after the crisis. The pattern of adjustment in the real exchange rate is similar in both the program and non-program countries. Figure 4. Changes in Real Exchange Rate during the Currency Crises -20.0 -15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Years Before/After Crisis Percent All Currency Crises Crisis with IMF Program Crisis without Program No Crisis 15 2.4. Determinants of the Post-Crisis Recovery We believe there are a large number of factors that determine the stylized pattern of adjustment in real output growth in the crisis-hit countries. Broadly speaking, there are four major factors that influence the adjustment pattern; (i) the origin and nature of the shock, (ii) initial conditions, (iii) domestic policies, and (iv) external environments. Origin and Nature of the Shock The origin and nature of the shock that has provoked a crisis can influence the evolution of the crisis. Many currency crises can be attributed to macroeconomic mismanagementlarge budget deficits and consequent monetary expansion in a fixed exchange rate regimeas the Latin America debt crisis in the early 1980s was. In this case, real depreciation of the currency and contraction of domestic absorption help to restore internal and external balance, leading to improvement in the economy. Investors’ panic can intensify the effects of speculative attacks on currency. In particular, when the capital account is liberalized, a bad expectation by foreign investors can easily lead to a sudden reversal of foreign lending, thereby causing a significant contraction of the domestic economy. In particular, the adverse impact will be magnified if domestic corporations and financial institutions are heavily leveraged by large, unhedged, and short-term foreign currency debts. When a sharp and unexpected depreciation wreaks havoc with highly-leveraged corporate and bank balance sheets, a sudden reversal of capital flows exacerbates the downturn in investment and the economy (Krugman, 1999, Aghion, Bacchetta, and Banerjee, 2000). But, once the investors’ panic calms down and foreign capital resumes to flow in, the economy can rebound quickly back to its long-term trend. Initial Conditions Differences in initial conditions could result in different patterns of adjustment. For example, structural variables such as per capita output and openness could be important in determining the pattern of post-crisis recovery. The level of initial per capita GDP can influence the growth rate in the post-crisis period. In growth theory, a country with a lower initial per capita GDP is in a more favorable position for future growth. The fundamental idea is that the gap in existing capital and technology between the current and steady-state levels offers a chance for rapid “catching up,” via high rates of capital accumulation as well as the diffusion of technology from more technically advanced economies. In addition, when a currency crisis leads an economy to a lower level of per capita income relative to that of its own trend, the subsequent growth rate of the economy that rebounds to its potential growth would be higher. Openness can also influence the speed and extent of the post-crisis recovery. When the economy is more export oriented, a quicker improvement in the current account follows a currency devaluation. Lee and Rhee (2000) argue that the quick recovery of the Korean economy may have been possible because of its openness and export orientation. An export oriented economy benefits more from devaluation after the crisis, and a subsequent improvement in the current account could in turn help restore foreign investors’ confidence and hence stability in the foreign exchange market. 16 Several studies also point out that the behavior of macroeconomic variables prior to the crisis can influence the degree of real output contraction. For example, a rapid expansion of bank credit or lending boom during the pre-crisis periods is critical to the post-crisis recovery (Sachs, Tornell, and Velasco, 1996, and Hong and Tornell, 1999). Gupta et al.(2000) find that the higher the size of short-term external debt and the amount of private capital flows are in the years prior to the crisis, the more severe is the contraction of output during the crisis-period. Policy Factors Macroeconomic and structural reform policies implemented by the government for crisis management can play a key role in the post-crisis adjustment of real output. Fiscal policy has a direct impact on domestic demand. Monetary policy plays a critical role in determining domestic consumption and investment. In addition to the macroeconomic stabilization policies, structural reform programs can have significant effects on the adjustment path. It is often argued that structural reforms introduced by the IMF plays a catalytic role in resuming foreign trade and private capital inflows and thus contributes to the fast recovery of a crisis-hit economy as the commitment to the reform program improves foreign investors’ confidence in the economy. The critics of the IMF program, however, argue that the implementation of financial restructuring in conjunction with contractionary macroeconomic policies can make a credit crunch more severe than otherwise after the crisis. For external demand, a larger depreciation of exchange rate is expected to increase export earnings while cutting down import demand to improve the current account. External Environments A global economic environment is also critical in the post-crisis adjustment of crisis-hit countries. Business fluctuations of the world economy can influence post-crisis growth as they have a substantial impact on the terms of trade and export earnings of the crisis-hit country. To the extent that the relevant data are available, we carry out an empirical assessment of the factors determining the pattern of post-crisis recovery. The explanatory variables that we consider to explain the speed and the extent of post-crisis recovery include per capita real GDP in the crisis year, world economic growth, which is an average of per capita GDP growth rates of a crisis-hit country’s trading partners weighted by its trade share, an interactive term of the real exchange depreciation rate with openness (trade-GDP ratio), real public consumption growth, and real money supply growth. We also include an investment rate.5 The regression also includes a dummy variable for the IMF program countries to see if participation in an IMF program had any impact on the recovery process. Upon entering an agreement with the IMF, a member government subscribes to the IMF conditionality which typically entails fiscal austerity, tight monetary policy, and currency devaluation. Since we 5 Investment ratio can be considered an endogenous variable. The regression results do not change qualitatively when we exclude investment ratio in the regressions. Note that investment includes public investment in addition to private investment. The regressions for investment rate are presented in Table 4. 17 include macroeconomic policies variables separately in the regression, the dummy variable may be able to capture the effect of the IMF program participation in post-crisis recovery. We also control the differences in country-specific factors that may influence the potential growth path, by including the average growth rate for three to five years prior to the crisis. However, we do not include the pre-crisis macroeconomic policy variables in the regressions, for the impact of these variables on the post-crisis recovery are extensively discussed in Hong and Tornell (1999) and Gupta et al. (2000). Also, we cannot incorporate any variables that measure structural vulnerabilities of the corporate and financial sectors due to the lack of broad cross-country data. The dependent variable in the regression is the average growth rate of real GDP during the post-crisis period over k years.6 (1) ,,...,1),ln(ln 1 1, 1 ,, NiGDPGDP k yjti k j jtikti =−= −+ =++ ∑ where GDPi t+j is real GDP for country i in the j years after the crisis year (t) and N is the number of crisis episodes in our sample. Then, yi,t+k represents the real GDP growth rate, averaged over the post-crisis period of k years. Because we are mostly interested in short-term recovery, we choose k from 1 to 5. In the previous literature, k was often chosen arbitrarily, and thus cross-section data in which each country had only one observation was used for empirical investigation. Our framework differs significantly in that we use panel data. Thus, we utilize both cross-section and time dimension information. Our regression specification is as follows. (2) .5,...,1,,...,1 ,,,, ==+ ′ =+++ kNixy ktiktikti εβ where x denotes the vector of the explanatory variables. Note that some independent variables such as real GDP in the crisis year, pre-crisis average growth rate, and an IMF program dummy are identical across all five equations. Fiscal policy variable is included as an average over the period from the crisis year t to the post-crisis year t+k, while monetary growth and real exchange depreciation variables are included as an average over the period from the crisis year t to the post-crisis t+k-1. We estimate this system of the five equations by a seemingly unrelated regression (SUR) technique that corrects for heteroskedasticity in each equation and correlation of the errors across the equations. 6 We have also estimated another specification by using the reversal of GDP growth rate between the crisis-hit (that is, t-1 and t) and the post-crisis period, instead of post-crisis GDP growth, for the dependent variable in the regressions. We find the results do not change much. 24 d. Philippines 1993 1994 1995 1996 1997 1998 1999 2000 GDP Growth Rate (%) 2.13 4.39 4.67 5.85 5.19 -0.59 3.32 4.0 Expenditure on GDP Private Consumption Growth Rate 3.05 3.72 3.82 4.62 4.99 3.45 2.64 3.5 (share in GDP, %) 78.8 78.3 77.7 76.8 76.6 79.7 79.2 70.7 Government Consumption Growth Rate 6.15 6.13 5.62 4.10 4.67 -1.95 5.41 -1.1 (share in GDP, %) 8.0 8.1 8.2 8.1 8.0 7.9 8.1 12.8 Gross Domestic Investment Growth Rate 8.00 7.14 4.94 9.94 9.77 -9.00 -0.11 2.3 (share in GDP, %) 22.7 23.6 23.3 24.8 26.3 22.2 21.1 17.8 Exports of Goods and Services Growth Rate 6.26 19.77 12.04 15.40 17.15 -21.04 3.65 8.7 (share in GDP, %) 34.9 40.1 42.9 46.8 52.1 41.4 41.5 -- Imports of Goods and Services Growth Rate 11.48 14.51 16.03 16.73 13.49 -14.71 -2.79 2.1 (share in GDP, %) 43.9 48.2 53.4 58.9 63.6 54.5 51.3 -- Policy Indicators Government Capital Expenditure as % of Inv. 15.0 13.7 13.4 8.1 8.0 8.0 11.0 -- Growth Rate of Real M2 20.2 16.0 16.2 14.2 20.2 -1.2 9.4 -- Annual Real Bank Credit Growth Rate 30.7 19.2 31.8 38.8 20.2 -15.4 -6.3 -- Real Effective Exchange Rate -- -- 100.0 110.4 111.0 94.0 100.8 69.0 e. Thailand 1993 1994 1995 1996 1997 1998 1999 2000 GDP Growth Rate (%) 8.38 8.95 8.90 5.93 -1.68 -10.17 4.16 4.4 Expenditure on GDP Private Consumption Growth Rate 8.43 7.87 7.55 6.83 -1.05 -12.33 3.49 4.6 (share in GDP, %) 55.8 55.2 54.6 55.0 55.4 54.0 53.7 56.4 Government Consumption Growth Rate 5.11 8.19 5.37 11.91 -3.03 1.94 2.82 6.5 (share in GDP, %) 8.3 8.2 7.9 8.4 8.3 9.4 9.3 11.5 Gross Domestic Investment Growth Rate 8.55 10.83 10.04 8.08 -18.59 -35.17 -1.72 11.8 (share in GDP, %) 40.9 41.6 42.7 43.0 33.7 19.0 20.5 22.7 Exports of Goods and Services Growth Rate 12.74 14.25 15.50 -5.53 8.41 6.72 8.86 19.5 (share in GDP, %) 42.4 44.4 47.1 42.0 46.3 55.1 57.5 -- Imports of Goods and Services Growth Rate 11.78 15.75 19.87 -0.52 -11.38 -22.28 20.24 24.6 (share in GDP, %) 44.9 47.7 52.5 49.3 44.4 38.4 44.4 -- Policy Indicators Government Capital Expenditure as % of Inv. 12.9 13.4 12.0 16.6 23.4 29.3 23.1 17.7 Growth Rate of Real M2 15.1 7.7 11.3 6.8 10.9 1.6 5.1 -0.9 Annual Real Bank Credit Growth Rate 18.6 24.6 15.1 9.4 13.6 -11.3 -6.0 -17.3 Real Effective Exchange Rate -- -- 100.0 109.2 102.4 90.0 93.5 73.6 Source: Asian Development Bank on-line country data (http://www.adb.org/Statistics/country.asp) Note: The share of expenditure components in GDP is constructed based on data in constant prices. 25 While domestic demand was sluggish, a large increase in net export paved the way for the initial recovery of the Asian economies. Import demand declined in all of the crisis-hit countries in 1998 by a substantial amount, ranging from 22% in Korea and Thailand and 5.3% in Indonesia, while exports continued to grow or remained unchanged in all countries except the Philippines. It is therefore clear that net exports led the recovery in East Asia. Figure 6 and 7 based on quarterly data demonstrate the pattern of adjustment in more detail. A close examination of the quarterly rates of GDP growth shows that both Korea and Thailand reached the trough as early as in the second quarter of 1998, and Indonesia, Malaysia and the Philippines two quarters later (see Figure 6). -20.0 -15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 97Q1 97Q2 97Q3 97Q4 98Q1 98Q2 98Q3 98Q4 99Q1 99Q2 99Q3 99Q4 00Q1 00Q2 00Q3 Indonesia Korea Malaysia Philippines Thailand Figure 6. Quarterly Changes of Real GDP Growth in East Asia (y-o-y, %) 26 Figure 7. Quarterly Movements of GDP Components in East Asia (a) Private Consumption in GDP 0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0 80.0 90.0 96Q4 97Q1 97Q2 97Q3 97Q4 98Q1 98Q2 98Q3 98Q4 99Q1 99Q2 99Q3 99Q4 00Q1 00Q2 00Q3 00Q4 01Q1 Indonesia Korea Malaysia Philippines Thailand (b) Investment Rate 0.0 10.0 20.0 30.0 40.0 50.0 60.0 96Q4 97Q1 97Q2 97Q3 97Q4 98Q1 98Q2 98Q3 98Q4 99Q1 99Q2 99Q3 99Q4 00Q1 00Q2 00Q3 00Q4 01Q1 Indonesia Korea Malaysia Philippines Thailand 27 (d) Real Import Growth Rate -60.0 -40.0 -20.0 0.0 20.0 40.0 60.0 96Q4 97Q1 97Q2 97Q3 97Q4 98Q1 98Q2 98Q3 98Q4 99Q1 99Q2 99Q3 99Q4 00Q1 00Q2 00Q3 00Q4 01Q1 Indonesia Korea Malaysia Philippines Thailand (c) Real Export Growth Rate -60.0 -40.0 -20.0 0.0 20.0 40.0 60.0 80.0 97Q1 97Q2 97Q3 97Q4 98Q1 98Q2 98Q3 98Q4 99Q1 99Q2 99Q3 99Q4 00Q1 00Q2 00Q3 00Q4 01Q1 Indonesia Korea Malaysia Philippines Thailand 28 Overall, the recession in East Asia bottomed out in the second half of 1998, less than a year after the crisis had broken out. As shown in Figure 7, the subsequent recovery in 1999 was led mostly by a surge in net exports. Over the post-crisis period private consumption to GDP ratio has remained stable in all countries except for Indonesia. In Indonesia, private consumption expenditure rose in 1998. In Korea and Malaysia, the investment rate started to increase from the latter half of 1998, whereas in the other countries the investment ratio has declined. An increase in public investment appears to have contributed to the resurgence of total investment expenditure in Korea and Malaysia. Table 4 shows that in both countries the fraction of government capital expenditure in total investment jumped from 11% in 1997 to over 21% in 1998. The large depreciation of currency has backed up the quick surge of net exports since 1998. Table 4 and Figure 8 show that the level of real effective exchange rates in the five crisis-hit East Asian countries depreciated by 22% on average, ranging from 12% in Thailand to 50% in Indonesia in 1998. Figure 8. Real Effective Exchange Rate in East Asia (1997Q2=100) 0 20 40 60 80 100 120 96 Q1 96 Q2 96 Q3 96 Q4 97 Q1 97 Q2 97 Q3 97 Q4 98 Q1 98 Q2 98 Q3 98 Q4 99 Q1 99 Q2 99 Q3 99 Q4 00 Q1 00 Q2 00 Q3 00 Q4 01 Q1 Indonesia Korea Malaysia Philippines Thailand 29 3.2. Factors behind the Speedy Adjustment in East Asia A large number of internal and external factors are likely to have contributed to the pattern of macroeconomic adjustment to the crisis in East Asia. On the basis of the cross-country evidence and available information on the pattern of macroeconomic adjustment in East Asia, we attempt to identify some of the factors that have engineered the post-crisis recovery. 3.2.1. Macroeconomic Factors According to the empirical examination of the stylized pattern of adjustments from the previous 160 currency crisis episodes over the period from 1970 to 1995, which show a V-type adjustment of real GDP growth, a large real depreciation, expansionary monetary and fiscal policy, and an improvement in the global economic environment have been responsible for the upturn of the crisis-hit countries. In this sense, the East Asian process of adjustment is not much different from the stylized pattern. The same factors contributed to the quick post-crisis recovery of the East Asian economies. Exchange Rate Depreciation and Openness An important structural factor driving the speedy adjustment in East Asia may have been the region’s higher level of openness. With a relatively large trade sector and export-orientation, these economies benefited from a large depreciation of the real exchange rate. The level of openness in terms of the share of export and import in GDP ranges from 200% in Malaysia to 60% in Indonesia. Thus, compared to other crisis-hit economies before, the depreciation is likely to have had a bigger impact on the more open East Asian economies. Note that the size of real exchange depreciation in the East Asian countries was comparable to the average depreciation rate in the previous crisis episodes. One special feature of the East Asia crisis is that compared to the cross-country evidence, the impact of depreciation on real output showed up as early as one year after the crisis. The large real exchange depreciation therefore restored external balance without much delay in East Asia. The flexibility in the labor market may have facilitated this swift adjustment, since the shift of resources from the non-tradeables to the tradeables sector elicited by the massive real exchange rate depreciation requires a flexible factor market. Favorable External Environment The quick improvement in East Asian exports has been supported by favorable external developments. The global economy was strong in 1999. The U.S. economy has been able to absorb a large amount of exports of the East Asian economies. The U.S. per capita GDP growth rates were 3.3-3.4% in 1998 and 1999, and jumped to 4.4% in 2000, which by far exceeded the average growth rate of 2.0% over the period from 1970 to 1995. As we saw from the cross-country regressions in section 2, global economic growth has a strong impact on the post-crisis recovery, in particular in the early years following the crisis. The deterioration in terms of trade that precipitated the crisis reversed in 1999. In particular, the increase in the prices of semiconductors helped to boost Korean, Malaysian, and Thai exports. 30 Macroeconomic Policy Adjustment Concerning macroeconomic policy management, the swift change in policy stance toward expansion has supported a quick recovery of the crisis-hit economies. In Korea relaxation of monetary and fiscal policy began around April of 1998. A comparison of the turning points in the adjustment process measured by growth rates of the quarterly GDP with the timing of policy changes, broadly speaking, confirms that easing of monetary and fiscal policy has quickened the pace of recovery in both Thailand and Malaysia (Figure 9). Thailand shifted to a modest relaxation of macroeconomic policy in June 1998, and its economy took off in the fourth quarter of the same year after zero growth in the preceding quarter. In particular, public consumption expenditure increased significantly in the latter half of 1998. It was not until the third quarterthe end of Augustof 1998 when a relaxation of monetary and fiscal policy was announced in Malaysia, and its economy moved out of the trough a quarter later. In Indonesia, on the contrary, because of the continuing weakness of the rupiah, monetary policy remained contractionary until the second quarter of 1999. But, public consumption increased sharply in the third quarter of 1999. This expansion boosted output growth in 1999. In the Philippines, monetary policy was slightly contractionary over the post-crisis period, while public consumption expenditure has been growing since the first quarter of 1999. Figure 9. Policy Indicators in East Asia (a) Real Public Consumption Growth -25 -20 -15 -10 -5 0 5 10 15 20 25 30 96Q4 97Q1 97Q2 97Q3 97Q4 98Q1 98Q2 98Q3 98Q4 99Q1 99Q2 99Q3 99Q4 00Q1 00Q2 00Q3 00Q4 01Q1 Indonesia Korea Malaysia Philippines Thailand 31 (b) Real Money Supply Growth -20.0 -10.0 0.0 10.0 20.0 30.0 40.0 97 Q1 97 Q2 97 Q3 97 Q4 98 Q1 98 Q2 98 Q3 98 Q4 99 Q1 99 Q2 99 Q3 99 Q4 00 Q1 00 Q2 00 Q3 00 Q4 01 Q1 Korea Malaysia Philippines Thailand Indonesia (c) Real Credit (1997, Q2=100) 0 20 40 60 80 100 120 140 160 180 97 Q1 97 Q2 97 Q3 97 Q4 98 Q1 98 Q2 98 Q3 98 Q4 99 Q1 99 Q2 99 Q3 99 Q4 00 Q1 00 Q2 00 Q3 00 Q4 01 Q1 Indonesia Korea Malaysia Philippines Thailand The positive role of expansionary macroeconomic polices in post-crisis recovery raises the question of whether the initial tightening of monetary and fiscal policy was too harsh, maintained for too long and as a consequence deepened the crisis. In order to deal with the crisis itselfstopping bank runs, protecting the payment system, and stemming capital outflows, the IMF prescribed tight monetary policy together with fiscal austerity, which initially led to a sharp increase in interest rates. The contractionary monetary and fiscal policy has been criticized by many, including Radelet and Sachs (1998) and Feldstein (1999), as having been unnecessary because these countries were suffering from a liquidity problem. 32 They imply that the traditional IMF prescriptions may have done more harm than good as they drove many highly leveraged but viable firms out of business, thereby deepening the downturn of the economy. The contribution of initial austerity IMF programs remains still in controversy. On the other hand, it is quite clear that the swift change of macroeconomic policy stance toward an expansionary one helped these economies recover quickly. Fiscal policy had become contractionary immediately after the crisis, but was reversed quickly to be expansionary. Change in monetary policy stance then followed. Once the depreciation of the currency was arrested and stability returned to the foreign exchange market, the authorities of the crisis countries were able to adjust gradually the interest rates downward and expand money supply. 3.2.2. Panic and Balance Sheet Effect The contraction of real income in the East Asian countries that suffered the crisis was much larger and the subsequent recovery of these countries has been much faster than what can be predicted from the previous episodes of crisis elsewhere. There must be additional factors that have contributed to the deeper contraction and the quicker recovery in East Asia. We consider that the East Asian crisis has an aspect of a severe liquidity crisis caused by investors’ panic. This nature of the crisis must have an important role in the macroeconomic adjustment during the crisis. Panic and Spread of the Crisis There is general agreement that a fixed peg to a currency basket dominated by the U.S. dollar when the current account was piling up deficits was one aspect of policy mismanagement that triggered the crisis in Thailand. Williamson (2000) shows that had it been implementing a BBC (Basket, Band, and Crawl) rule, Thailand might have staved off its crisis, because the country was suffering from a balance-of-payment crisis. However, the Thai crisis was contagious as shown by Park and Song (2001a and 2001b), and even a good exchange rate management using the BBC rule could not have saved other crisis victims like Indonesia and Korea from the contagion. Although macroeconomic policies and economic fundamentals of Korea and Indonesia were regarded as sound and credible, many foreign investors simply moved out of East Asian financial markets when they realized that most East Asian countries would suffer from similar macroeconomic and structural problems that were driving Thailand to the brink of debt default. With the withdrawal of foreign lenders and investors from the region, other East Asian countries experienced a sharp liquidity crisis and balance sheet problems associated with a large currency depreciation, causing a region-wide crisis explicable by a second and third generation model of crisis. That is, the contagion of the Thai crisis set in motion a crisis characterized by self-fulfilling prophecy and balance sheet deterioration in other East Asian countries, which did not have a serious balance-of-payment problem. Once hit by contagion, the BBC system was simply unable to stave off the crisis because the band could not be maintained. Why did foreign portfolio investors panic so much and exhibit herd behavior? They initially moved into East Asia with large sums of money to be invested in all types of local securities and real assets in the mistaken notion that rapid growth in the region would be sustained or that their investments would be protected by government guarantees. Most of the 33 foreign investors paid attention to the structural problems of the financial and corporate sections that began to haunt East Asia before moving in. When these problems came to light in the midst of currency depreciation and interest rate increases, they were startled. The ensuing fear of losing their investments then drove them to a state of panic, and every investor was scrambling for the exit. Thus, one critical factor that could explain both the initial sharper contraction and faster recovery is related to changes in the expectations of foreign investors and both domestic households and firms on economic prospects of the crisis countries. When foreign investors began to lose confidence in East Asian economies, capital flows abruptly reversed. As shown in Table 5, in 1997 private net capital flows reversed by $115 billion (from $120 billion inflow in 1996 to 5 billion outflow). It is no wonder that this large-scale shift in financial inflows provoked deep contractions, huge depreciation and financial embarrassment. And the argument goes that once investors’ panic calms down and foreign capital resumes to inflow the economy rebounds to its long-term trend. Table 5. Capital Flows to the Five Asian Economies (Unit: Billion US dollars) 1996 1997 1998 1999 2000e External financing, net (A+B) 118.6 39.5 -15.2 -4.9 -1.2 A: Private flows, net 119.5 4.9 -38.7 -5.2 -3.8 Equity investment 16.8 5.2 16.8 30.1 15.6 Direct equity 4.8 6.8 12.3 14.6 9.5 Portfolio equity 12.0 -1.7 4.5 15.4 6.1 Private creditors 102.7 -0.3 -55.5 -35.3 -19.3 Commercial banks 69.6 -17.4 -48.8 -29.3 -15.3 Non-bank private creditors 33.2 17.2 -6.7 -6.0 -4.1 B: Official flows, net -0.9 34.6 23.5 0.2 2.6 International financial inst. -1.9 22.7 19.7 -4.6 2.5 Bilateral Creditors 1.0 11.9 3.8 4.9 0.1 eestimate Note: The five countries include Korea, Indonesia, Thailand, Malaysia, and the Philippines. Source: IIF, January 2001. Immediately after the crisis, there was rampant speculation that the crisis countries might not be able to avoid foreign debt default and hence might have to declare a debt moratorium. The international financial community including international financial institutions also did not hesitate to lay the blame on the East Asian countries for the crisis. 40 bailout, the banks and non-bank financial institutions were required to observe tougher banking regulations pertaining to risk management, loan-loss provisioning, and loan classification. Most of all, they were, after receiving government support for recapitalization, mandated to maintain their capital adequacy ratio over 10 percent which was deemed acceptable to foreign lenders and investors and at the same time to raise the return on equity to a market average in advanced economics. These institutional reform measures, though they were overdue, also shrank further the lending capacities of many financial institutions, in particular banks, because they had to be extremely risk averse in lending if they were going to meet the requirements for capital adequacy, return to equity, and the volume of non performing loans as a proportion of total assets. To complicate matters further, many of the recapitalized financial institutions became state enterprises. Managers and senior officials of these institutions were afflicted by the moral hazard syndrome whereby they were content with the status quo rather than searching for new promising borrowers or restoring long-term relationships with their existing bank loan customers. Of the five countries, Korea has been most aggressive and also achieved a great deal more compared to other countries in financial restructuring. Korea’s financial system regained much of its precrisis soundness and stability within a relatively short period of time after the crisis. Partly for this reason, the banking sector in Korea has been more expeditious in supplying bank credit than in other countries. After the crisis, the supply of bank credit in real terms continued to decrease in Indonesia, Thailand, and the Philippines (see panel (b) and (c) of Figure 9). In fact more than three years after the crisis, the real credit supply remained below the precrisis level despite the fact that the policy authorities in these countries were pursuing relatively easy monetary policies during the three-year period. Only in Korea, the supply of real credit has been growing and so has investment demand. This piece of evidence therefore suggests that investment and output expansion has been closely associated with bank lending in the five countries. A third reason for the relatively superior performance of the Korean economy in the recovery process is that Korea was able to restore much of the market’s confidence in its economy much earlier than the other countries. Toward the end of February of 1998, the Korean government was able to reschedule the bulk of its foreign debts with foreign creditor banks. After the rescheduling, Korean banking institutions were able to restore trade-related credit facilities and to borrow albeit at higher interest rates than before, from international financial markets. With the improvement of access of Korean banks and corporations to international capital markets, the nominal exchange rate began to appreciate, thereby allowing policy authorities to ease the tight stand of monetary and fiscal policy they had maintained before. Similar events that marked turning points in the recovery process took place much later in other countries. Finally, one could argue that Korea has stood out as a better performer among the five crisis countries, partly because it had a relatively more effective bureaucracy and greater institutional capacity to manage the crisis than other countries. Korea was also fortunate in that the new government that came to power early in 1998 was able to disassociate itself from the past policy mistakes and had a political mandate to carry out the drastic economic restructuring imposed by the IMF. Realizing that economic restructuring would help speed up recovery, the populace was prepared to support financial and corporate restructuring together with institutional reform covering both the private and public sector. In other crisis countries, 41 it is not clear whether similar public support for economic reform existed at the earlier stage of the crisis. 4. Prospects for Long-term Growth in East Asia As the recovery continues in East Asia, there is a growing hope that these economies will be able to return to their pre-crisis levels of robust growth. In this section, we make an assessment of the long-term growth prospects for East Asia. 4.1. Impacts of a Currency Crisis on Long-term Growth In this section we investigate the impact of a currency crisis on long-run growth based on a cross-country regression framework. We control all important growth determinants and then examine whether a currency crisis has had any independent impact on GDP growth in the long-run. A wide variety of external environment and policy variables will affect growth prospects by changing the long-run potential income and the rate of productivity growth. Based on the results from previous empirical research, we consider the following variables as the important determinants of long-run per capita income growth: (1) initial income, (2) human resources, (3) investment rate, (4) exogenous shock (terms of trade changes), and (4) institutions and policy variables (government consumption, rule of law, and openness).14 For the measure of human capital stock, we use the average years of secondary and higher schooling for population aged 15 and over, available from Barro and Lee (2000). The rule of law index is a measure for the quality of institutions, which is based on the evaluation by international consulting firms that give advice to international investors. The openness measure is based on Sachs and Warner (1995). This index is calculated as the fraction of years during the period that the country was considered to be open to trade and thus sufficiently integrated with the global economy. The evaluation of the country's openness is made on the basis of four dimensions of trade policy: average tariff rates, quotas and licensing, export taxes, and black market exchange rate premium. Table 9 presents the results of regression for per capita real GDP growth rate using the explanatory variables just described. The data is a panel set of cross-country data over the two decades, 1975-85 and 1985-95. The system of two equations is estimated by a seemingly-unrelated-regression (SUR) technique, which allows for the correlation of the errors across the equations. The regressions show that most of the controlling variables are the significant determinants of long-term growth. For instance, the coefficient on the log value of initial GDP is highly significant. Thus it provides strong evidence for conditional convergence: that is, a poor country with a lower initial income level grows faster, when the variables influencing the steady-state level of income are controlled. Specifically, the coefficient in column 1 of Table 9 implies that a country at the half of income level of another country grows by 1.4 percentage points (=2.0%*ln(2) ) faster than the richer country. 14 Our specification closely follows Barro (1997) in selecting the explanatory variables. 42 Table 9. Long-run Impact of Currency Crisis on per Capita Growth Rate Independent variable (1) (2) Estimation Method Seemingly-unrelated Regression Initial GDP per Capita (log) -1.965 (0.360) -1.975 (0.365) Years of Schooling 0.350 (0.246) 0.357 (0.247) Investment Rate 0.084 (0.033) 0.085 (0.032) Terms of Trade Change (% per annum) 0.084 (0.036) 0.086 (0.037) Government Consumption (Percentage in GDP) -0.139 (0.032) -0.140 (0.032) Rule of Law Index 1.212 (0.830) 1.195 (0.829) Openness (1= most open) 2.726 (0.482) 2.708 (0.485) Currency Crisis (no. of crises in previous decade) 0.043 (0.033) 0.211 (0.436) Currency Crisis with IMF Program (no. of crises in previous decade) -0.386 (0.670) R2 .54, .37 .54, .37 Number of Observations 84, 82 84, 82 Notes: The system has two equations, where the dependent variables are the growth rate of real per capita GDP for each of the two periods: 1975-85 and 1985-95. The estimations use the SUR (seemingly-unrelated) estimation technique, which allows the error term to be correlated across the two periods and to have a different variance in each period. Each equation is allowed to have a different constant term (not reported). Standard errors are shown in parentheses. The R2 values and the number of observations apply to each period separately. 43 We add to the regression a variable that measures the occurrence of currency crises. The variable is constructed with the number of currency crises that each country experienced during the past decade. We have used the number of crises over the period of 1970-75 for the first equation and over the period of 1975-85 for the second equation. Thus we test if an experience of a currency crisis can have an impact on growth in the next decade. The estimated coefficient turns out to be statistically insignificant, implying that there is no direct impact of currency crises on growth in the long-run. In the column (2) of the regression, we add another variable that represents the number of currency crises with IMF program participation. We also found no significance for this variable. Although there is no direct impact of a currency crisis on long-run growth, it would be possible that a currency crisis or IMF program can have an indirect impact on long-run growth by influencing the controlling variables. For instance, if the investment ratio becomes permanently lower by the post-crisis stabilization program in the crisis-hit countries, it would have a negative impact on growth in the long-run. On the contrary, if the IMF structural reform improves the quality of institutions, then a currency crisis with IMF program participation can have a positive impact on growth. 4.2. Sustainability of East Asian Growth The quick turnaround of the Asian economy from the 1997 crisis has brightened the region’s economic prospects. Despite the impressive record of the recovery, however, not everyone is sanguine about East Asia’s future prospects. The World Bank and IMF, for example, are not optimistic about the prospects of these countries sustaining the ongoing recovery, largely because weaknesses of financial institutions and balance sheet problems of corporations still remain unresolved in the region. The macroeconomic performance of the crisis countries will provide important clues to the question of whether these countries will be able to return to the pre-crisis trend rate of growth. Up to 2000, the pattern of recovery in East Asia has been quite similar to that of Mexico after its crisis in 1994. Although the financial crisis of 1997 abruptly brought a halt to Asia’s period of robust growth, there was little in Asia’s fundamentals that inevitably led to the crisis. The key to the Asian crisis was too much short-term capital flowing into weak and under-supervised financial systems. This suggests that with better financial management and a return to the core policies that resulted in rapid growth, the East Asian economies can again return to sustained growth (Radelet, Sachs and Lee, 2001). The major factors that have brought the relatively high growth in East Asia were high rates of saving, good human resources, trade openness, and maintenance of good institutions. In terms of these fundamentals, East Asia still keeps strong potential for a sustained growth. But, in the long-term, the growth rate will be lower than the previous pre-crisis average of 7%. The convergence factor, which was found to be quite strong in the cross-country growth regression in the last section, implies that the faster growth in the last decades for itself will force the East Asian economies to grow at a slower pace in the next decade. That is, the East Asian countries now have a much smaller gap in reproducible (physical and human) capital and technical efficiency from their long-run potential levels than they had in the last decades. Hence, the East Asian economies will face a smaller chance for rapid “catching up,” via high rates of capital accumulation as well as the diffusion of 44 technology from more technically advanced economies in the next decade, and inevitably become adjusted to a lower growth path. The coefficient in the cross-country growth regressions implies that the convergence factors alone makes the Asian economies grow by about 1.5 percentage points slower over the next decade, compared to the last decades in which they had started with less than a half of the current income. Hence, unless the economies could achieve substantial improvements in other fundamental factors, such as quality of institutions, they would grow at the range of 5% per year in GDP. 5. Concluding Remarks The contraction of real income in the East Asian countries that suffered the crisis which erupted in 1997 was much larger and the subsequent recovery of these countries has been much faster than could have been predicted from the previous episodes of crisis elsewhere. The purpose of this paper has been to identify some of the factors that may explain the severity of and rapid recovery from the crisis. According to this empirical examination of macroeconomic developments following the crisis in East Asia, including a V-type adjustment of real GDP growtha large real depreciation, expansionary monetary and fiscal policy, and an improvement in the global economic environment have been responsible for the upturn of the crisis-hit countries. In this sense, the East Asian process of adjustment is not much different from the stylized pattern observed from the previous 176 currency crisis episodes over the period from 1970 to 1995. However, the stylized pattern of adjustment cannot explain why the crisis was severe and the recovery has been much faster than what was expected from the previous experiences of crisis. This study argues that the East Asian financial upheaval was in a large measure a liquidity crisis caused by investors’ panic. Once the liquidity constraint was eased as it was during the first half of 1998, domestic demand has since surged again and the crisis countries have been able to move toward the pre-crisis path of growth. Among the five crisis countries, Korea has experienced relatively more robust and sustained recovery. One of the most important reasons for differences in the performance of the five countries can be found in the differences in the speed with which banks and other financial institutions were able to resume their normal lending operations. Korea has been most aggressive and effective in restructuring its financial sector. 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Asian Development Bank Institute Kasumigaseki Building 8F 3-2-5 Kasumigaseki, Chiyoda-ku, Tokyo 100-6008 Japan Tel: +81 (03) 3593-5500 Fax: +81 (03) 3593-5571 E-mail: [email protected]g www.adbi.org Papers are also available online at the ADBI Internet site: http://www.adbi.org/publications/ RESEARCH PAPER SERIES ADB INSTITUTE RESEARCH PAPER 45 A New Approach to Modeling the Impacts of Financial Crises on Income Distribution and Poverty March 2002 Code: 35-2002 by Iwan J. Azis Increasing Incomes for the Poor and Economic Growth: Toward a Simple Taxonomy for Policies April 2002 Code: 36-2002 by Jere R. Behrman The Role of the Global Economy in Financing Old Age: The Case of Singapore May 2002 Code: 37-2002 by Mukul G. Asher Have India’s Financial Market Reforms Changed Firms’ Corporate Financing Patterns? June 2002 Code: 38-2002 by Sayuri Shirai Measuring the Extent and Implications of Director Interlocking  in the Pre-war Japanese Banking Industry July 2002 Code: 39-2002 by Tetsuji Okazaki and Kazuki Yokoyama Exchange Rate Co-movements and Business Cycle Synchronization  between Japan and Korea August 2002 Code: 40-2002by Sammo Kang, Yunjong Wang and Deok Ryong Yoon Is the Equity Market Really Developed in the People’s Republic of China? September 2002 Code: 41-2002by Sayuri Shirai Taipei,China’s Banking Problems: Lessons from the Japanese Experience September 2002 Code: 42-2002by Heather Montgomery Banks’ Lending Behavior and Firms’ Corporate Financing Pattern  in the People’s Republic of China September 2002 Code: 43-2002by Sayuri Shirai An Overview of PRC’s Emergence and East Asian Trade Patterns to 2020 October 2002 Code: 44-2002 by David Roland-Holst Financial Crisis and Recovery: Patterns of Adjustment in East Asia, 1996-99 October 2002 Code: 45-2002 by Yung Chul Park and Jong Wha Lee