THE FINANCIAL CRISIS IN EAST ASIA

1. To what extent does the financial crisis in East Asia differ from earlier crises?

This is perhaps the most serious financial crisis since the breakdown of the Bretton Woods system in the early 1970s, in terms of both its scope and its effects. Its impact is much more global than that of the financial crises we have seen in the past two or three decades, including those in Latin America. Today, global financial integration is much more pervasive, and the East Asian countries have a much higher share of world trade and production. For the first time, a financial crisis in the South has had a profound impact on capital markets in the North. It is also expected to cause a significant drop in global growth.

2. What are the roots of the crisis?

Although different influences have been at play in different countries in the region, a common feature is that the crisis has its origin in the private sector and has taken the form of a major market failure. One can describe it either as excessive borrowing abroad by the private sector, or as excessive lending by international financial markets. In any case, as pointed out by Alan Greenspan, Chairman of the US Federal Reserve Board, it is clear that more investment monies flowed into these economies than could be profitably employed at modest risk. Hence, there is a failure of free financial markets to produce an optimal global allocation of capital. There was a similar episode in the Southern Cone of Latin America in the late 1970s and early 1980s. The private sector was allowed unrestricted access to external finance in the belief that, for private firms, the difference between domestic and external debt was not significant, since they were expected to assess carefully the costs and benefits on which their survival depended. The result was private over-borrowing and a debt crisis, necessitating subsidized debt servicing via preferential exchange rates and eventually the nationalization of private external debt and a de facto socialization of the banking system.

3. What is the role of governments in the crisis?

Perhaps one could fault governments for failing to prevent market failure. But what they might have done is a complex question. According to one view, the problem is not liberalization as such but the absence of effective prudential regulation and supervision of the banking system. There can be little doubt that prudential limits on bank lending, capital adequacy requirements and currency matching conditions for assets and liabilities that are properly enforced can help prevent excessive risk-taking by banks, thus containing the adverse effects of widespread defaults. However, it is not easy to prevent domestic credit expansion when capital inflows lead to a rapid liquidity expansion. As long as capital inflows and liquidity expansion remain unchecked, lending will eventually spill over from the financing of safe and productive investments to risky and speculative assets. This in turn raises the collateral values of the assets financed by such lending, thereby encouraging belief in the appropriateness of these values. Such a process was experienced not only in Asia but also in Mexico in the early 1990s and in the US in the 1980s.

In this process, as the investment boom continues, growth remains strong and the external balance deteriorates. But eventually loans become non-performing and banks are weakened. Thus, deterioration of the external balance and weakening of the financial sector are two sides of the same process of excessive capital inflows. The basic problem is the absence of instruments to restrict capital inflows and contain their impact on macroeconomic and monetary conditions. It is difficult to check this process solely through prudential banking regulations. In any case, such regulations cannot prevent excessive non-bank private borrowing abroad. This is not always appreciated, even though in East Asia an important part of private borrowing from international banks is by non-bank firms: one-third in the Republic of Korea, around 60 per cent in Malaysia and Thailand, and even more in Indonesia. Nor do international financial markets impose the right kind of discipline over private borrowers in developing countries. All too often they manifest herd-like, pro-cyclical behaviour in both giving and cutting back loans. The global reverberations of this boom-bust character of finance are further enhanced by greater integration of markets and increased mobility of capital. This is why governments need to be prepared to use a broad range of policy instruments, including but not restricted to prudential regulations.

4. What is the role of external factors?

Quite apart from the overreaction of financial markets in lending and calling back loans, two external factors seem to have played a major role. First, the appreciation of the dollar led to the appreciation of the currencies in the region, as they were pegged to the dollar. The regional division of labour in East Asia (in the context of the so-called flying geese process) presupposes a stable pattern of exchange rates, and this may be an important reason why individual countries were not willing to devalue vis-à-vis the dollar and hence vis-à-vis each other. Second, a glut has emerged in markets for a number of manufactures produced in the region, such as electronics, leading to sharp declines in their prices. Attention has focused on over-investment in some areas, but such over-investment also reflects sluggish global demand - a phenomenon that UNCTAD has been constantly warning about in recent years in opposition to the widespread complacency regarding growth in the world economy. In any case, less than 10 years ago there was much talk about a shortage of savings in the global economy. Now, however, the refrain has changed, and the new culprit is excessive global investment at a time when unemployment in the North is on the rise and poverty in the South remains unabated.

5. Could the crisis have been anticipated?

Financial instability has become a systemic feature of the global economy and has been occurring with considerable frequency since the beginning of the past decade. Accordingly, such instability is a recurring theme of our annual Trade and Development Report (TDR). In 1990 we argued that the hands-off approach to finance was putting serious strains on international debtor-creditor relations and on the international payments and exchange rate arrangements. We warned that although disruptions in financial markets had until then been contained, "as long as the international monetary and financial system remained structurally vulnerable, the potential for an extremely costly crisis would remain". Since then the world economy has witnessed further bouts of financial instability, including debt deflation in some major industrial countries, a currency crisis in Europe, a financial crisis in Latin America, and now the East Asian crisis. In the early 1990s, the UNCTAD secretariat was among the minority of forecasters that persistently expressed doubts as to the sustainability of Mexico´s external financial position. On South East Asia, the TDR 1996 sounded a clear warning, noting that growth in the region relied excessively on foreign resources, and that these economies could suffer from loss of competitiveness and were highly vulnerable to interruptions of capital inflows. We shall return to this theme in our TDR 1998, to be released in September, with a detailed analysis of the causes and effects of the crisis, the policy response and its global implications, and actions needed at the national and global levels to avert such crises.

6. How should the international policy response be assessed?

Handling a crisis of this kind poses a complex policy challenge. Indeed, a major disagreement has emerged among mainstream economists over the appropriateness of the standard policy package comprising, inter alia, fiscal austerity and tight money. A main concern is that these could drive the economies into deep recession. Confidence and stability in currency markets have so far proved difficult to restore. A way still has to be found to prevent the undermining of a positive response to recent shifts in exchange rates by the effects of high interest rates on the banking sectors and companies´ capacity to meet their financial obligations. The credit crunch seems to be so deep that, despite favourable exchange rates, firms are unable to export, as their access to trade credit has been curtailed. Thus, an important part of the improvement in the current account balances of the Republic of Korea and Thailand so far seems to have been due to import cuts rather than export expansion. Over a longer horizon, however, increased exports should account for a major share of the required external adjustment.

7. What is to be done?

A positive adjustment to the crisis should include a number of components. First, loans should be rolled over and rescheduled to allow the countries concerned to service them from future export earnings and not through increased external borrowing at penalizing rates. This should be combined with the provision of external liquidity to support the exchange rate and enable a more accommodating monetary policy to be pursued while restructuring of the financial sector is under way. In this respect, there are important lessons to be learned from the policy response of the US Federal Reserve Board to the debt deflation of the early 1990s - a response which played a major role in bringing about one of the country´s longest recoveries following one of its deepest post-war recessions. Finally, it is necessary to raise global growth to provide markets in which Asian countries can earn the foreign exchange needed to pay off their foreign currency debt. Thus, an important component of the solution is to remove the deflationary bias in the macroeconomic policies in those areas of the developed world running large trade surpluses. Until the surplus countries initiate domestic demand-led growth and reduce their external surpluses, the global economy will continue to be vulnerable to the risk of financial instability and recession, and the crisis in South East Asia will continue to contribute to the decline in global growth and to trade frictions.

8. Will the Asian financial crisis dampen world economic growth?

On the eve of the crisis, there was already a major imbalance in the world economy: virtually all major industrial countries except the US were expecting faster growth on the basis of increased exports. The surplus countries (Europe and Japan) were employing restrictive fiscal policies and attempting to increase their export surpluses to preserve growth. With the notable exceptions of China and Taiwan Province of China, the fast-growing economies of East Asia were major contributors to global demand, running large deficits financed by private capital inflows. Perhaps the single positive contribution of the East Asian crisis is that it has halted the tendency towards monetary restriction and higher interest rates in the US and Europe, and hence prevented the global deflationary gap from deepening further. It has eased the concern of central bankers over the risk of inflation, leading Alan Greenspan, Chairman of the US Federal Reserve Board, to talk of deflation. Japan has also been spurred to take steps to reflate its economy, while alleviating the drag on activity resulting from the weakness of its banking sector. However, the crisis in East Asia will still mean slower growth of global demand and output. This is recognized by the IMF and by the OECD, which have revised (downward) their growth estimates.

9. Will the Asian crisis affect the launching of the European Monetary Union (EMU)?

The East Asian crisis may pose an additional challenge for the EMU. It has been pointed out by several observers that desynchronization of cycles among the participating countries, together with restrictions on individual countries´ budgetary policies and the absence of a strong fiscal centre à la US, can cause frictions regarding common interest rate and exchange rate policies, particularly since initial conditions with respect to external payments and labour markets differ widely. Such frictions are also possible when the EMU community receives asymmetric external shocks which require different monetary policy response for the different participants. In that respect, the coincidence of the Asian crisis with the launching of the EMU could be a major cause for concern.

10. How will the crisis affect other developing regions?

There are three channels of influence. First, contagion and capital flight: we have not seen much of it so far, but it cannot be ruled out. Second, the crisis is expected to influence policies in other developing countries with large external deficits. They may be inclined to cut their imports and external deficits to reduce their vulnerability to an interruption of capital flows. This happened after the Mexican crisis when, for instance, Brazil tried to reduce its external deficits despite continuing capital inflows. This would certainly be deflationary for the countries concerned and for the global economy. Finally, other developing regions will be adversely affected by changes in exchange rates. Given their sensitivity to inflationary pressures, Latin American and Central and Eastern European countries may not be able to adjust their exchange rates to restore their competitiveness in world markets.

11. Is there a danger of competitive devaluations?

This was a major concern for the architects of the Bretton Woods system, and that concern increased after the collapse of the system in the early 1970s. However, it receded when inflation became a major problem. Because of the implications for price stability, countries were unwilling to use their exchange rates to export unemployment. The threat of competitive devaluations is much more serious now than at any time since then, because the danger now is deflation, not inflation, as we already pointed out in TDR 1995. There were some signs of it during the currency crisis in Europe a few years ago when some countries pulled out of the EMS and devalued to import some demand. If the crisis deepens global deflation, there may be more action of this kind. This is why it is important to have expansionary policies in the countries with external surpluses.

12. Is this a situation which might tempt industrialized countries to protect their markets?

UNCTAD has always maintained that international monetary and financial instability is the principal enemy of free trade. Certainly, increased trade imbalances and reduced growth will provide humus to protectionist sentiments and such pressures may intensify, as much in countries with slow growth and high unemployment as in those with large trade deficits. Moreover, these pressures could succeed in attaining their goals if surplus countries do not pursue expansionary macroeconomic policies as developing countries start cutting their trade deficits.

13. Is the crisis a setback for the process of globalization?

There are some positive sides to it. It has long been maintained by many observers that it is not possible to speak of a "system" of international money and finance in the way we refer to the trading system. There is indeed a vacuum regarding global governance of finance. The East Asian financial crisis has increased awareness of the need for greater management of international money and finance so as to prevent the recurrence of similar crises. Indeed, the international community will undoubtedly be forced to think about whether or not existing arrangements regarding international payments and finance are compatible with stability and growth.

14. What are the issues?

The main problem is that, even though financial markets are much more integrated than product markets and capital is much more mobile than other factors of production, there is no global governance of international financial transactions analogous to that found in the area of trade. Moreover, the present international arrangements are not only inadequate but also asymmetrical; they are designed to discipline borrowers rather than regulate lenders. This stands in sharp contrast with the way national financial systems are designed. Moreover, international arrangements are designed to manage rather than to prevent crises. And the measures to stave off international banking crises tend to be at the expense of living standards, stability and development in debtor developing countries.

Second, with greater financial integration, the global impact of interest- and exchange-rate policies has become much more important. This is true not only for the major industrial countries but also for many developing countries where policies are seen to have had serious regional or global repercussions. There is no effective surveillance in these areas and there is no way of preventing "beggar thy neighbour" policies affecting key monetary and financial variables. Moreover, there is no mechanism for dispute settlement regarding macroeconomic and financial policies, such as exists for trade policies. If a country puts up its tariffs on imports of cars from its neighbour, the latter can go to the WTO and complain, but no forum exists where a country can make analogous representations about a rise in a major country´s interest rates and a consequent increase in its debt burden, or about a devaluation which has the same effect on its exports as higher tariffs.

Third, there are no effective, rule-based and adequately funded arrangements for the provision of liquidity by an international lender of last resort.

Finally, there is a need for a system of orderly work-outs based on rules and bankruptcy procedures governing international debtor-creditor relations. Several proposals to fill these gaps are worth considering. The international community needs to turn its attention to these issues as part of efforts to improve the governance of international finance.