by Edwin M. Truman, Peterson Institute for International Economics
Remarks at the conference "Trends in Asian Financial Sectors," part of the conference and seminar series "The Asian Financial Crisis Revisited: Challenges Over the Next Decade," held at the Federal Reserve Bank of San Francisco
June 20, 2007
© Peterson Institute for International Economics, 2007.
It is ritualistic on occasions such as this to cite Santayana to remind policymakers and observers that unless they have learned the lessons of history they are likely to repeat them. In the case of the Asian financial crises, lesson learning is particularly challenging because of the breadth of contradictory interpretations of events a decade ago. At one extreme is the view that the Asian countries were innocent victims of the excesses of the global financial system that were aided and abetted by the International Monetary Fund, which did more harm than good. At the other extreme is the view that the macroeconomic and financial policy regimes of the Asian countries, circa the mid-1990s, were fundamentally flawed and that the crises experienced across Asia were entirely predictable on the basis of those shortcomings, which had been largely disguised.
My own view is closer to the latter than the former, but because of these differences, it is essential to look back briefly before we try to discern Asia’s economic outlook. In my view, the greatest risks to Asia’s prosperity in the future lie in the lack of consensus about its recent past and the failure to learn the right lessons.
The causes of the Asian financial crises are many and varied. They differed substantially across the affected economies. This is why I always use the plural in referring to the crises of this period. With that important qualification, the crises were the result of five factors. First, the vulnerabilities of the economic and financial systems were disguised by sustained economic expansion during a period of less-than-benign global economic and financial conditions. China was pulling out of a period of sub par growth occasioned by the need to control rapid inflation; Japan was in the middle of its lost decade; Europe had not yet recovered from its European exchange rate mechanism (ERM) crises or digested the economic and financial implications of the end of the Cold War; Latin America was still digging out from the Tequila crises of the mid-decade; and the global economy was flying on a single engine made in America.
Second, the macroeconomic frameworks of the Asian economies were excessively oriented toward growth. Depending on the country, internal and/or external macroeconomic imbalances were evident. All countries had adopted excessively rigid exchange rate policies.
Third, banking systems were weak and distorted by a high degree of official intervention and supervisory inattention, at best. Borrowers relied too heavily on short-term credit from banks. Banks operated within an opaque framework of implicit or explicit government guaranties. The degree of leverage in the economy shocked outside observers, when they learned about it.
Fourth, corporate governance and common notions of due diligence were essentially nonexistent, hidden under layers of implicit guaranties. Currency and other mismatches were substantial in the balance sheets of the financial and nonfinancial sector. In retrospect, the collapse of domestic investment that contributed substantially to the depth of the crises in Asia was not a surprise.
Fifth, given the prevailing culture that discouraged openness and transparency, the only real surprise was that there were fewer surprises than there were as the successive crises unfolded over the course of 1996, 1997, and 1998. (The Asian financial crises had their origins in 1996, when the imbalances in Thailand were clearly identified. Who is to say that if the Thai authorities had acted then, the other countries would have been unaffected?)
Over the ensuing decade, many of the major weaknesses in Asian economic policies and financial systems have been addressed. Economies, individually and collectively, are less vulnerable to internal or external shocks, in particular in a world that has been characterized by four years of remarkably benign economic and financial conditions and the general expectation that those conditions will extend through this year and into 2008 at a minimum. With no clouds on the horizon, why worry?
Macroeconomic frameworks are more robust with greater appreciation of the need to establish and nurture the ability to implement countercyclical policies. Foreign exchange regimes are less rigid, but remain a source of internal and external uncertainty and potential conflict, as I will discuss in a moment.
Banking systems are stronger and better capitalized. Capital markets are being developed with better infrastructures. In most countries, nonperforming loans have been substantially reduced. Regulatory regimes are more robust though in many countries procedures for the normalization and regularization of insolvencies are untested. The efficiency and profitability of many banking institutions have not reached international norms. The state continues to play a large explicit and implicit role in the allocation of credit.
Leverage ratios have been dramatically reduced, and significant improvements in corporate governance have been made at least on paper. However, surveys of the investment climate in East Asian economies, as reported by the World Bank and Asian Development Bank, reveal widespread perceptions of deterioration or no change from climates that were mediocre in 1996. The Asian crises economies generally rank at or substantially below the 70th percentile of countries. These surveys focus on macroeconomic instability, economic and regulatory policy uncertainty, and the availability of credit, skilled labor, and other infrastructure dimensions; they also cover control of corruption, the rule of law, the quality of regulation, and voice and accountability.
These perceptions may merely be catching up with a reality that had been disguised by the strong economic performances of many of these economies since the mid-1980s, when many of them faced crises that were largely ignored by observers a decade later. However, the fact is that these negative conditions are currently viewed as damping rates of investment with the result that that growth rates are a couple of percentage points less than a decade ago.
The political and business culture of too many Asian economies remains defensive toward openness and transparency. As a group, their lack of transparency in terms of the release of Article IV documents and open participation in Fund/Bank financial sector assessment programs is only exceeded by economies in the Middle East. The retreat into regionalism is symptomatic of this defensiveness. Regionalism is not seen as a device to foster openness and change; rather regional integration is portrayed as a bulwark against a dangerous and unsympathetic outside world.
Against this qualified progress, what about the outlook for the Asian economies today? The opportunities are great, but the risks are substantial. And, again, circumstances differ substantially among the individual countries.
The Asian economies are less vulnerable to external or internal shocks than a decade ago. Their economic and financial systems are more resilient. The leaders and citizens of Asia can face the future with greater confidence than was justified in January 1997. In part this is because of the benign global economic and financial conditions that have prevailed for the past several years. However, note that my statements are couched in the relative terms of a cautious former central banker.
We know that at least a moderate global economic and financial correction is inevitable. In addition, an economic downturn —global growth of 2–2 ½ percent or less—cannot be ruled out before the end of this decade. The origins may be internal to Asia, for example, from a sharp slowdown in Chinese growth in the context of the collapse of a distorted and overheated economy; or they may be external to Asia, for example, from a substantial correction of the US external deficit associated with significant interest rate and exchange rate adjustments and a rebalancing of the global economy.
Whether the Asian economies will be able to weather a global correction, to say nothing of a global economic downturn, without experiencing substantial negative effects on their growth rates is questionable. Challenges in the form of low rates of investment, rising inequality, and adverse demographic trends suggest definite risks.
Banking and financial systems are better prepared, but far from robust. Banks and their customers are now exposed to sudden exchange rate appreciations rather than depreciations. In some cases, balance sheets remain excessively reliant on government obligations. Despite the improvements in corporate governance, the investment climate remains weak. Authorities responsible for the Asian economies are resistant to reforms in labor markets or their service sectors.
The governments in Asian economies generally have greater sophistication and capacity to use countercyclical monetary and fiscal policies to cushion any downturn than a decade ago. However, their exchange rate policies at best can be characterized as confused. Some continue to manage heavily their exchanger rates; others have been forced to abandon such policies, but only after building up unwanted and unneeded reserves; some have reverted to exchange controls that further damage their investment climates. The accumulation of a vast amount of reserves and other official cross-border investments is likely to be a major source of internal and external controversy and tension going forward.
Internally, the economic and financial challenge is to manage the domestic counterpart of these reserves without triggering a boom-bust cycle that would severely impact the domestic financial sector as well as the economy as a whole. In domestic political terms, the government’s management of its hoard of cross-border assets either in the form or reserves or in some type of sovereign wealth fund is likely to be a source of political controversy and frictions as the inevitable losses are recorded.
Externally, the lack of transparency and accountability governing these holdings poses risks to the global financial system. Although it is unlikely that portfolio reallocations across assets and currencies will be disruptive to financial markets, as long as government policies are opaque that risk remains. Uncertainty and a lack of information breed volatility and the potential for counterproductive actions.
The governments of India, China, Thailand, Indonesia, Korea, and Malaysia control, on the basis of conservative estimates, at least 60 percent of their countries’ cross-border investments. The comparable figure for the United States is 2 percent, and even for Norway, with its huge sovereign wealth fund, the figure is only 33 percent, based on data on Norway's international investment position, but Norway is a leader in transparency about its external investments. These large cross-border holdings in official hands are at sharp variance with our conception of a market-based global economy and financial system in which decision making is largely driven by the profit-maximizing behavior of numerous private agents. Unless this threat to the fundamental nature of the global economic and financial system is dealt with via a quantum adjustment in transparency and accountability in the management of official, cross-border asset holdings, we risk a dramatic rise in financial protectionism around the world triggered by political forces in the industrial countries.
What does this mean for Asia? My fear is that the leaders of the Asian economies, having failed to learn the right lessons from the Asian crises a decade ago, have constructed a Maginot Line out of their huge holdings of external reserves and their commitment to a regional rather than a global framework of economic and financial cooperation.
The buildup of reserves is likely to produce internal and external economic and financial tensions and controversies as I have outlined. The actual reserves are likely to complicate the management of internal demand and to give rise to external vulnerabilities. The emphasis on regional solutions to perceived challenges has contributed to a profound ambivalence about financial openness.
Proponents of Asian regionalism often point to Europe as an example, but they fail to appreciate three aspects of the European experience. First, the Europeans, in their search for so-called monetary stability, have not been immune to external economic and financial developments outside their borders, most recently in the global downturn earlier in this decade. Second, the most serious disturbances affecting European economies over the past several decades have had internal roots; I am thinking of the banking crises in the early 1990s, economic disruptions of 1992–93, and the malaise that has affected the European economies for most of the past decade. Third, despite their 50-year history of economic and financial integration, at times of crises the authorities of European economies have turned their backs on common solutions, declined to provide extensive unconditional credit to their partners, and pursued policies dictated by prudence and narrow self interest.
Thus, Asia’s economic outlook has improved from a decade ago. However, the economic and financial policies and institutions of the countries in the region remain underdeveloped and untested. The accumulation of hoards of cross-border financial assets by Asian governments and the lack of transparence and accountability surrounding their management pose a risk to the stability of Asian economies and to the global economy and financial system. I fear that too much emphasis has been placed on closed, regional solutions to nonproblems to the detriment of the pursuit of open, global approaches with greater promise of economic health and vitality.
Policy Brief 13-21: Lehman Died, Bagehot Lives: Why Did the Fed and Treasury Let a Major Wall Street Bank Fail? September 2013
Op-ed: Misconceptions About Fed's Bond Buying September 2, 2013
Op-ed: A Dose of Reality for the Dismal Science April 19, 2013
Op-ed: Five Myths about the Euro Crisis September 7, 2012
Working Paper 12-7: Lessons from Reforms in Central and Eastern Europe in the Wake of the Global Financial Crisis April 2012
Article: Why the Euro Will Survive: Completing the Continent's Half-Built House August 22, 2012
Policy Brief 12-18: The Coming Resolution of the European Crisis: An Update June 2012
Policy Brief 12-20: Why a Breakup of the Euro Area Must Be Avoided: Lessons from Previous Breakups August 2012
Book: Sustaining China's Economic Growth after the Global Financial Crisis January 2012
Testimony: A New Regime for Regulating Large, Complex Financial Institutions December 7, 2011
Working Paper 11-2: Too Big to Fail: The Transatlantic Debate January 2011
Policy Brief 10-24: The Central Banker's Case for Doing More October 2010
Policy Brief 10-3: Confronting Asset Bubbles, Too Big to Fail, and Beggar-thy-Neighbor Exchange Rate Policies February 2010
Article: The Dollar and the Deficits: How Washington Can Prevent the Next Crisis November 2009
Speech: Rescuing and Rebuilding the US Economy: A Progress Report July 17, 2009
Testimony: Needed: A Global Response to the Global Economic and Financial Crisis March 12, 2009
Testimony: A Proven Framework to End the US Banking Crisis Including Some Temporary Nationalizations February 26, 2009
Speech: Financial Regulation in the Wake of the Crisis June 8, 2009
Paper: World Recession and Recovery: A V or an L? April 7, 2009
Op-ed: Stopping a Global Meltdown November 12, 2008
Book: Banking on Basel: The Future of International Financial Regulation September 2008