Asia Remains Cautious a Decade on From 1997 Crisis

It’s been a decade since the Asian financial crisis through the region into an economic nosedive. What has been learned? The answer is simple: the affected Asian countries have learned almost too much. The rest of the world has learned very little.

Here is a check list.

Thailand: In the country where the crisis started with a steep devaluation of the baht, the response to the collapse of asset prices and much of the banking system was too slow and the liquidation of failed companies took far too long due to political and other influences. But the cautious orthodoxy of the Democrat-led government in power at the time of the crisis achieved fiscal consolidation surprisingly quickly. The Thaksin government’s more ambitious goals enabled economic expansion to resume earlier than would otherwise have been the case and a flexible exchange rate and antipathy to currency controls enabled normalcy to return. Despite political turmoil and the pressures of excess capital inflows that led to short-term panic control measures, Thailand has avoided artificially low interest rates. Foreign exchange reserves are at comfortable, but not excessive, levels and asset prices, partly thanks to politics, remain modest, at least by current international standards.

Korea: The prime example of a tough, disciplined response to the crisis. Korea swallowed nasty IMF medicine and a lot of national pride, opened much of its economy and allowed at least the partial reform of the chaebol system of conglomerates. Reforms stemming from the crisis, plus an exchange rate which was highly favorable until recently, enabled a return to steady, if undramatic, export-led growth. For a long period, memories of the crisis resulted in an overly cautious fiscal policy and eagerness to accumulate reserves. However over the past two years Korea has been willing to keep interest rates at sensible levels and that in turn has resulted in a massive appreciation of the won while the yen and NT dollars have fallen against the US currency and the yuan has appreciated only. Willingness to accept this is a sign of maturity in Korean decision-making and the balance now struck between export and domestic demand. Despite this exchange rate flexibility, its accumulation of foreign assets has been extreme and partly explains the buoyancy of domestic asset prices.

Indonesia: Recovery was probably more rapid than anyone could have expected. Foreign debt write-offs were a big help and asset sales eventually brought in significant cash. But relative political stability after the demise of Suharto in 1998 enabled a very cautious fiscal policy which in turn was made easier by a recovery in the prices of many commodities. Gradually falling interest rates have become possible without resulting in an overly weak currency, which in turn has further improved the fiscal situation. However, economic growth remains below potential due to inadequate investment, a function less of availability of capital than of ineffective government decision-making. The external situation is strong, but Indonesia is more dependent on commodity prices now than in 1997.

Malaysia: Another example of how recovery from the crisis has not been followed by renewed rapid growth. Whether or not currency controls were necessary, they were most likely continued for far too long. Asset prices languished and with them the impetus for demand-driven growth. Malaysia is the most extreme example of post-crisis excess in terms of current account surplus, which has been in double digits as a percentage of GDP for several successive years. As the crisis-era bank rescues were far less costly than in Thailand or Indonesia, it has been able to maintain an expansionary fiscal policy which has partly offset generally weak private sector investment. However, private capital outflows have been very large at the same time as reserve accumulation has been rapid. Cautious appreciation of the ringgit over the past year has been beneficial but is still quite modest. Malaysia now has defensive strength, but is vulnerable to a turn-around in energy prices, including palm oil for bio-diesel.

What then of the lesser impacted Asian economies?

Japan’s problems were very different, but the Japanese choice of a weak exchange rate, massive foreign trade surplus and large capital outflows has proved little more beneficial than the opposite conditions did to Thailand and company. The absence of a real sense of crisis in Japan over the state of its financial intermediaries was partly a result of its strong overseas position. But it meant that for years the problem was inadequately addressed. Even now that the financial sector has been restored to health, the illusion persists that a weak exchange rate and very low interest will both stimulate domestic demand and buoy exports. In practice it does one, not the other. Taiwan suffers from a less-serious case of the same disease. Tokyo’s strong external position plus domestic politics mean that 15 years after its asset boom collapsed banking reform is still not complete, domestic demand is weak and capital outflow (not just to China) is high because of very low local interest rates.

Hong Kong also has not seen a strong and sustained recovery in domestic demand. The external surplus is massive, but the fixed exchange rate acts as a drag on real incomes. Political commitment to the US dollar peg was reinforced by the Asian crisis, and the authorities like to believe that the peg limited the damage. However, it is at least equally arguable that given Hong Kong’s strong reserve position a more flexible rate would have achieved economic stability without resort to the panicky 1998 government stock buying to counter an attack on the peg. Now appreciation of the yuan and the likelihood that most Asian currencies will sooner or later rise further against the US dollar again make the wisdom of the peg look questionable.

China, meanwhile, has for quite awhile been suffering the consequences of failure to recognize the merits of flexible exchange rates – one of the two most important lessons of the crisis. Runaway stock and property booms and massive overinvestment in unproductive assets are inevitable results of artificially low interest rates, a vastly undervalued currency and massive reserve accumulation.

Japan, China and Taiwan are all in differing ways mirror images of the Asian crisis countries of a decade ago. China and Japan’s trade surpluses now mirror much of the deficit of the US. Japan and Taiwan’s exports of capital resulting from low interest rates have created the multibillion dollar carry trade mirrored in debt-driven buyouts by private equity companies that have been driving share prices worldwide, but most of all in countries large current account deficits – the US, UK, Australia, New Zealand, Spain, Turkey etc.

This is all no more sustainable than the massive, sustained short-term foreign bank lending to Thailand, Indonesia, Korea etc which preceded the Asian crisis. So the coming crisis will not so much impact those hurt before. But it will hurt Japanese, Chinese and Taiwanese lenders as surely as western and Japanese banks were (deservedly) clobbered by the Asian crisis. And it will be the end of the high-flying hedge funds and leveraged buy-out firms that have been borrowing cheap yen to finance investments in expensive assets.

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