By Krishna Gidwani
In the early 1990s, while the United States lingered in a deep recession, the economic world marveled at the remarkable productivity levels being achieved by countries in the Far East. Like Japan before them, the "Asian Tigers" went from low-technology, agricultural economies to industrialized and sometimes high-tech economies in a surprisingly short period of time. Singapore, South Korea, Taiwan, and Hong Kong led the group with their high-tech industries while Indonesia, the Philippines, Malaysia and Thailand followed with their rapid industrialization. By the mid-1990s, however, the U.S. economy was healthier than ever (achieving rapid growth with low inflation) while the burgeoning Asian economies were showing signs of slowing. For some of these Asian countries, this slow-down was evidence of far more than a typical downturn in the business cycle. By the summer of 1997, fundamental cracks in the financial structures of these countries had manifested themselves through, among other things, investment panics and currency devaluations. The countries hardest hit by this "Asian Crisis" were Thailand, Indonesia, Malaysia and Korea.
An analysis of the Asian financial
crisis will reveal that the events leading up to and facilitating the currency
debacle often stemmed from poor macroeconomic fundamentals which in turn led to
morally hazardous behavior. For
instance, misaligned investment incentives stemming from implicit (and
sometimes explicit) promises of government bail-outs to banks and other
financial intermediaries in the event of insolvency were very problematic. Also, competitive devaluations played an
important role in the unfolding of the massive currency crisis and its
contagion across countries. Along with
illuminating the causes and effects of the Asian crisis, I will specifically
focus on the economic status of Korea during this period. Korea was one of the last countries hit by
the financial disease, but did not escape some of the most severe economic
damage. A close study of Korea will
also exemplify the function of the International Monetary Fund (IMF) during
major financial crises such as this.
What Triggered the
Financial Downslide?
A number of theories have surfaced trying
to explain why the crisis happened when it did. Most agree that it was at least partly caused by sector-specific
shocks such as the fall in the demand for semiconductors in 1996. Adverse terms of trade fluctuations such as
this caused a significant slowdown of export growth in several countries in the
region between 1996 and 1997. More
important than demand shocks, however, was the precarious condition of the
largest economy in the region: the Japanese economy. (Krugman, 1998)
In 1996 it appeared that an economic
recovery was returning in Japan after five years of zero growth, but the
increase in the consumption tax in April 1997 pushed Japan into another
recession; second and third quarter economic activity declined. This stagnation of the Japanese economy
caused a significant decrease in the amount of exports of other Asian countries
to Japan and resulted in current account[1]
deficits for those exporting countries.
The depreciation of the yen relative to the U.S. dollar during this
period exacerbated the terms of trade problem for these countries (it was now
cheaper for the U.S. to buy Japanese exports).
Unlike in the Mexican currency crisis of 1994-1995 when the major
regional economic power, the United States, was in a strong cyclical upswing,
the weakness of Japan in 1997 intensified the problems of the struggling Asian
economies. (Roubini et al, 1998)
While most economists agree on what
caused the crisis, they also agree that if these factors had not caused it, others would have. In order to understand why, it is imperative
to look more closely at the economic systems of the affected countries, as well as those of countries that were
only mildly hit (i.e. Singapore, Taiwan, etc.).
Banking and Moral Hazard
Moral hazard occurs when one party to a
transaction is not fully accountable for the consequences of his actions. It is a problem that became readily apparent
to Americans during the Savings and Loans crisis of the 1980s and that is very
obvious to those studying the aftermath of the Asian financial crisis.
Government guarantees on bank
deposits are standard practice throughout the world, but normally these guarantees
come with strings attached. The owners
of banks have to meet capital requirements (put a lot of their own money at
risk), restrict themselves to sound investments, and so forth. In Asian countries, however, regulation of
financial intermediaries was extremely poor.
Loan classification and provisioning practices were very lax,
state-owned banks paid little attention to the creditworthiness of borrowers,
and capital requirements were often inadequate relative to the riskiness of a
bank's ventures. (Goldstein, 1998) Yet, domestic and international creditors
did not monitor the lending decisions of banks because of the implicit, and
sometimes explicit, guarantees of a government bail-out if things went wrong.
The consequence of this shaky
banking structure was immoderate domestic investment. Banks that perceived their operations as
insured against adverse contingencies borrowed excessively from abroad and lent
excessively domestically to finance risky investment projects. Since the interest rate at which domestic
banks could borrow abroad and lend at home did not reflect appropriately the
riskiness of the projects being financed, the banking system frequently
channeled funds toward projects that were very marginal, if not outright
unprofitable. This excessively risky
lending created inflation of asset prices.
The overpricing of assets was sustained in part by a circular process,
in which the proliferation of risky lending drove up the prices of risky assets,
making the financial condition of the intermediaries seem sounder than it
was.
Ultimately, though, a wave of
defaults in the corporate sectors signaled the low profitability of past
investment projects and asset prices began to drop. Falling asset prices made the insolvency of financial intermediaries
visible, forcing them to cease operations, which led to further asset
deflation. As asset prices fell, it
became increasingly doubtful whether governments would really stand behind the
deposits and loans that remained.
Foreign investors began pulling their money out of banks which caused
asset prices to plunge further and local currencies to become devalued. Banks that had heavily relied on external
borrowing were left with a large stock of short-term foreign debt that could
not easily be repaid. (Roubini et al,
1998)
Currency Devaluation
Short-term foreign debt was especially
problematic for two reasons. First, the
debt was short-term and had to be paid back relatively quickly. For many banks this was difficult because
almost all that remained of their asset stocks were long-term loans. The second problem was that the debt was in
foreign currencies. This is not always
a bad thing; it depends on the going exchange rate. If your currency
depreciates, the value of your debt (which stays constant in terms of foreign
currency) increases in terms of local currency.
Beginning with Thailand in the
summer of 1997, the Asian currencies underwent a series of harmful
devaluations. In Thailand, weak
financial sectors, coupled with poor banking supervision and declining quality
of investment, caused many foreign investors to pull out of the country. Thai assets experienced decreasing demand
and the currency (baht) depreciated accordingly. The situation in Thailand acted as a wake-up call for international
investors to reassess the creditworthiness of other Asian countries
(Goldstein). Investors found that
several of these economies had weaknesses comparable to those in Thailand. Malaysia, Indonesia and the Philippines all
underwent similar investment retractions and currency devaluations during the
summer. Although a devalued currency is
often harmful, one positive thing that does come out of it is an increase in
competitiveness. As a country's
currency depreciates, its exports become cheaper to outsiders and its current
account gets a boost. But, just as this
country's current account improves, those of the importing countries may become
negative. So, in order to maintain
competitiveness, these other countries must devalue their own currency through
loose monetary policy. These games of
competitive devaluations transmitted speculative pressures to one currency
after the other. In July and August,
the fall of the Thai baht spread to the Malaysian ringitt, the Indonesian
rupiah and the Filipino peso. By
September, the contagion had spread to Singapore and Taiwan and, within days,
to Hong Kong.[2]
As for Korea, between the end of 1996 and September 1997 the
won had depreciated only by 8% against the dollar. In the same period, the Thai baht had depreciated by 42%, the
Indonesian rupiah by 37%, the Malaysian ringitt by 26%, and the Philippines
peso by 28%. This implied that by the
end of September, the won had appreciated in nominal terms by 34%, 29%, 20% and
18%, relative to the currencies of Thailand, Indonesia, the Philippines and
Malaysia respectively. (Roubini et al,
1998) In October, with six major
currencies in the region having devalued by an average of 40%, the Korean won
could not maintain its high-value position.
By November, the won experienced a sharp depreciation, causing a
significant relative appreciation in the other regional currencies. But, because of the shaky financial
conditions of their economies, these other countries could not sustain a
currency appreciation and further depreciation ensued. All currencies continued to fall in December
on the heels of the won drop, with each depreciation round instigating the next
series of depreciations.
(Goldstein,
1998)
The Korean won maintained its parity
the longest, even longer than Singapore, Taiwan and Hong Kong, but this should
not be attributed to the relative health of its economy. In reality, the Korean economy had been
unhealthy for a long time and, when the dust had cleared, was one of the most
devastated economies of the crisis.
Korea's Crisis
In Korea, there had already been a
serious deterioration of the macroeconomic conditions in 1995 and 1996. Current account deficits had dramatically
widened from 1991 to 1994, leading to an unprecedented accumulation of short-term
foreign debt. Export growth had fallen
sharply in 1996 as negative terms of trade shocks (the fall in demand for
semiconductors) hit the economy. As a
result of these maladies, industrial production growth rates had halved
relative to 1995. Debt/equity ratios
were very high and profitability very low among the chaebols.[3] The financial conditions of the chaebols and
the banks that had lent to them were increasingly shaky and the possibility of
widespread bankruptcy was very realistic.
In reflection of these weaknesses, the stock market had fallen sharply
(by 36%) in 1995 and 1996 relative to its 1994 peak. (Bartholete, 1998)
As it were, the 1997 crisis was not
triggered by the fall of the won that came under severe attack in October, nor
by the investment panic that developed in November and December. It was instead triggered in early 1997 by a
series of bankruptcies of large chaebols that had heavily borrowed in previous
years to finance their investment projects.
By mid-1997, eight of the top thirty chaebols were bankrupt. The string of bankruptcies started with
Hanbo Steel in January, then Sammi Steel in March and the Jinro Group in
April. In July, the Kia Group, the
eighth largest chaebol, failed to pay $370 million worth of liabilities and was
put under fiscal protection by the government.
This string of corporate bankruptcies and financial difficulties in 1997
led to serious financial difficulties for the banks that had heavily borrowed
abroad to finance the investment projects of the failed chaebols. A number of these financial institutions
were effectively bankrupt by the spring of 1997. (Bartholete, 1998)
It was mentioned above that while
the currency crisis was spreading throughout the region, the Korean won had
been momentarily spared from the rapid collapse of the other currencies. Things changed in October for a number of
reasons. First, by the end of October,
the effective real appreciation of the won caused by the collapse of several
currencies was quite large. The Thai baht
had depreciated relative to the U.S. dollar by 55%, the Indonesian rupiah by
54%, the Malaysian ringitt by 34% and the Philippines peso by 33%. The Korean won had depreciated by only 14%,
implying that the won had appreciated in nominal terms by 37%, 36%, 20% and 15%
relative to the currencies of Thailand, Indonesia, Malaysia and the Philippines
respectively. This relative
appreciation substantially detracted from Korean export competitiveness. Secondly, by October, Singapore and Taiwan
(who competed directly with Korea in a wide range of export products) had
allowed their currencies to depreciate rather than defend their parities. This put Korea at an even more severe
competitive disadvantage. (Roubini et al, 1998)
An independent factor in the worsening
of the crisis and currency depreciation in 1997 related to a heavy increase in
the liabilities of the banking system in the 1990s. The depreciation of the currency worsened the financial burden of
banks and some of them went bankrupt.
Since, at times, it was not clear which banks were solvent and which
were not, foreign banks that had heavily lent to Korean banks began refusing to
renew the loans that would have been automatically rolled-over in more stable
times. The foreign banks' unwillingness
to renew normal lines of credit in the face of high risks of bankruptcy made
the prospect of loans defaulting more likely and led to a situation of
financial panic. This panic was made
worse by the prisoner-like dilemma facing international investors. In a non-cooperative equilibrium it was
rational for each lender to try to get out of Korea before everyone else did to
avoid massive losses. However, this
simultaneous attempt to get out escalated the crisis, leading to further
depreciation of the won, which worsened the financial positions of the Korean
banks. The situation calmed down only
at the end of December 1997 when, faced with the prospect of a default caused
by a self-fulfilling unwillingness to renew short-term debts, the American,
European and Japanese banks jointly agreed to negotiate an orderly renewal of
such short-term loans. However, this
agreement was largely induced by the creditor countries' expectations of
reimbursement from the bail-out package approved by the IMF in early December.
(Roubini, 1998)
A final factor that has contributed
substantially to Korea's economic woes in late 1997 was the country's
presidential elections. Political
instability or mere uncertainty about the course of economic policy will have
much the same consequences as banking sector instability. The threat of a change to a regime that is
not committed to sound macroeconomic policies can reduce the willingness of the
international financial community to provide financing for a current account
deficit. In the midst of the crisis,
the political front-runner (and eventually president elect), Kim Dae Jung, was
sending confusing and sometimes contradictory policy signals. Given this uncertainty about the December
elections, the implementation of the first IMF plan was seriously in doubt and
international investors were increasingly wary.
Korea and the International
Monetary Fund
The IMF exists as a security blanket for
countries that experience major economic dilemmas. Yet, the need for an institution such as the IMF is often
debated. The strongest argument in
favor is that, without access to conditional financing, troubled countries are
likely to respond to negative economic shocks with unsound macroeconomic
policies (i.e. currency devaluations and trade controls such as tariffs and
quotas). There would essentially be no
other choice. However, the main
argument against the IMF centers around the moral hazard problem it creates. Knowing that they will be bailed out of any
major economic trouble, financially unstable countries, as well as developing
countries, have incentive to undertake excessively risky behavior
(predominantly in the banking sector) in an attempt to right their economic
ship or develop at a faster rate. A
close look at how the IMF dealt with Korea during its economic difficulties
will reveal some of the costs and benefits of having this kind of protective
institution. Whether the net effect of
IMF policy on the Korean economy is good or bad, it is likely that the mere
presence of the IMF helped induce the type of morally hazardous investment
behavior that led up to the Asian financial crisis.
In late November 1997, following the
dramatic plunge of the Korean won on the foreign exchange market, a team of IMF
economists was rushed to Seoul to negotiate the terms of a massive bail-out
package with the design of restoring health and stability to the Korean
economy. In close consultation with IMF
negotiators, the World Bank and the Asian Development Bank also sent their own
teams of economists. A World Bank
package with stringent conditionalities on financial governance was announced
on December 18th. During the process,
an important precedent was set. The
IMF's standard measures of economic reform had been launched for the first time
in an advanced industrialized economy. (External Relations Department, 1998)
The IMF put together a $60 billion
bail-out package for Korea, but it is the structural provisions of the bail-out
that are more interesting and important:
--increased flexibility of exchange
rates
--a temporary tightening of monetary
policy to stem balance of payment pressures
--structural reforms to remove
features of the economy that had become
impediments to growth (such as monopolies, trade barriers, and
nontransparent
corporate practices)
--opening and maintaining lines of
external financing
--the closure of unviable financial institutions (and close supervision of weak ones)
--the recapitalization of
undercapitalized institutions
--increased foreign participation in
domestic financial markets
(External Relations Department,
1998)
To
support this reform of the financial systems measures have been designed to
improve the efficiency of all markets:
--breaking of the close links between business and government (restructuring of the chaebol system)
--liberalization of capital markets
--increased transparency with
regards to fiscal, corporate and banking sectors, as well as economic data
(External Relations Department,
1998)
These
programs have been adapted and altered as economic conditions in Korea have
evolved and continue to evolve over time.
The crisis in Asia is still unfolding and new disturbances cannot be
ruled out.
As things stand now, the IMF
bail-out of Korea is showing signs of moderate success. The won has strengthened by over 30% since
its low in mid-December. The Korean
stock market is up 30% as well. More
importantly, foreign direct investment and portfolio investment are beginning
to flow back into the country again. Of
course, forecasts for Korean GDP growth this year suggest a decline of about
1%, so all is far from well.
Nevertheless, the Korean economy is finally, albeit slowly, moving away
from the financial disaster that crippled it only a short time back. The IMF, at least in Korea's case, seems to
have partially mitigated the morally hazardous behavior it may have, by the
simple fact of its existence, provoked.
Bartholete,
Jeffrey. "Is Korea Ready to
Explode?" Newsweek 12 Jan.
1998: 42.
External
Relations Department, IMF. "The
IMF's Response to the Asian Crisis"
April 1998.
http://www.imf.org/External/np/exr/facts/asia.HTM
Goldstein,
Morris. "The Asian Financial
Crisis" January, 1998.
http.//www.iit.com/news98-1.htm
Hirsh,
Michael. "It Only Gets Worse:
Election-eve Pledges are complicating a bailout" Newsweek
22 Dec. 1997: 74.
Krugman,
Paul. "What Happened to
Asia?" January 1998
http://web.mit.edu/krugman/www/DISINTER.html
Krugman,
Paul. "Asia: What Went
Wrong?" March 2, 1998.
http://www.pathfinder.com/fortune/1998/980302/fst8.html
Roubini,
Nouriel, Giancarlo Corsetti and Paolo Pesenti.
"What Caused the Asian Currency
and Financial Crisis?" March,
1998.
http://www.stern.nyu.edu/~nroubini/asia/AsianCrisis.pdf
Rubin,
Robert. "The Rubin
Rescue" Time 12 Jan. 1998:
46-50.