Hearings on the Fifth Summit of the Asia Pacific Economic Cooperation Forum
by Marcus Noland, Peterson Institute for International Economics
Testimony before the Subcommittee on Asian and Pacific Affairs International Relations Committee
United States House of Representatives
November 6, 1997
It is an honor to be invited to submit testimony to this Subcommittee. Regrettably, I am unable to appear before the Subcommittee in person, and would respectfully like to submit this written testimony. In it, I will make three main points:
The Causes of Financial Instability in Asia
This year a number of countries in Asia have experienced significant nominal exchange rate depreciation and declines in asset prices. In Thailand the stockmarket has fallen by nearly half from its peak earlier in the year and the baht has depreciated more than 66 percent against the dollar since June. Other countries around the region have had similar experiences: in the Philippines the stock market is down by nearly half, and the currency 34 percent; in Malaysia the stock market is down 45 percent and the currency 33 percent; in Indonesia the stockmarket is down 33 percent and the currency 49 percent; and in South Korea, the stockmarket is down by more than 40 percent, and the won has depreciated 8 percent against the dollar. In China and Hong Kong the stock markets are down significantly, though their currencies have as yet remained firm against the dollar. Asset price declines have not been limited to the stockmarket: other asset prices (such as real estate prices) have fallen as well.
Although these results are disturbing, to some degree they are not wholly unexpected: developing countries (including those in Asia) exhibit more volatility in macroeconomic aggregates and financial market indicators than larger, more diversified, developed economies.1 Greater volatility in rates of inflation and economic growth can hamper risk assessment by developing country financial institutions. Developing countries tend to have more institutionally concentrated financial systems than developed countries (i.e. fewer banks account for a larger share of lending). Moreover, these institutions themselves tend to hold less diversified portfolios than their counterparts in developed countries. A higher share of assets tends to be denominated in the domestic currency, and assets tend to be more concentrated in terms of sectoral distribution. For example, loans to the domestic real estate sector or construction companies make up a large share of the loan portfolios of many developing country banks. This relative lack of portfolio diversification tends to make the financial sectors of developing countries more fragile than those of developed countries. Although developing country banks may meet the same nominal capital adequacy standards as developed country banks, on a risk-adjusted basis many are undercapitalized, creating vulnerability to economic downturns.2
In some cases financial fragility has been exacerbated by a mismatch of assets and liabilities by both financial sector and non-financial sector firms. For example, if domestic interest rates are high relative to foreign interest rates, banks may be tempted to finance long-term domestic lending through short-run foreign borrowing. This leaves them (and, by extension, domestic lending) vulnerable to either foreign interest rate spikes or domestic currency depreciation. This may be particularly problematic if the domestic currency is pegged to a foreign currency such as the dollar, and the peg is abandoned and the domestic currency depreciates.
Finally, domestic policy may contribute to financial fragility in at least two distinct ways. As noted earlier, developing country financial systems tend to be under-diversified. The presence of foreign financial institutions may effectively increase diversification and reduce fragility. For example, foreign banks tend to be less exposed to the host country's domestic economy, and thereby in a better position to maintain lending during downturns in which host country institutions may be far more negatively impacted. Lack of financial openness, therefore, can contribute to financial crises.
More fundamentally, domestic policy may contribute directly to financial crises by encouraging financial institutions to act in economically inefficient or irrational ways. For example, financial institutions may be encouraged to channel capital to politically connected or preferred borrowers to the detriment of the economy.3 Such practices may be sustainable as long as the rate of economic growth remains high, as financial institutions compensate for the low effective rate of return on loans to these preferred borrowers with high rates of return on other loans. However, if the rate of growth slows, the bad loan drag begins to inhibit the ability of banks and non-bank lending institutions to supply credit to the economy. This is what has transpired in a number of Asian economies this year as prices declined in some key exports (computer chips, autos, and some light manufactures where Chinese exports have emerged rapidly, to cite a few examples). With the slowdown in export revenue, growth prospects diminished. Equity prices began to fall followed by movement out of the domestic currency leading to exchange rate depreciation (in countries that float their currency), or alternatively, pressure on the exchange rate peg (in countries that peg to a foreign currency like the dollar). Parenthetically, the movement out of domestic assets is typically led by domestic residents (not foreign speculators) and the available evidence (on net stock market purchases, for example) suggests that this was likely the pattern in the recent events in Asia as well.
Gauging the extent of current distress is difficult due to unconventional and opaque accounting practices in a number of countries, but private sector estimates of the amount of non-performing loans to national income among the developing countries of the region range from less than 5 percent in the case of Singapore, to 20-25 percent in the cases of Thailand, Malaysia, and South Korea. Put another way, South Korea appears to be facing a banking crisis on the scale of our saving and loan debacle—but with an economy less than one tenth the size of ours, and without the cushion that a high level of per capita income provides.
The medium-run impact of these financial problems obviously differs from country to country around the region depending on the underlying economic fundamentals of each country, policy responses, and spillover effects. It would be beyond the scope of this testimony to analyze the economic circumstances of each country in the region. However, it should be noted that markets respond to government policies and policy differences will affect outcomes.
If government policies have contributed to the crises as argued above, then markets will respond to changes in policy. In particular, markets will reward policy clarity and punish obfuscation. Similarly, markets will punish poor, and reward good, performances by individual firms. Policies that fuzz this distinction, for example by making strong firms bear the burden of weak performance by inefficient firms, blunt the market mechanism and impede recovery.
It is fair to say that most observers have been disappointed in the response of the Thai authorities to their mounting problems. Likewise, recent moves by the South Korean government to nationalize some failing banks and industrial firms appear to be socializing risk by in effect forcing efficient South Korean firms to bear the costs of bailing out their rivals, regardless of their own capacity or culpability. In contrast, Indonesia's recent agreement with the International Monetary Fund, if implemented (and this is a big caveat) would represent a significant step towards righting Indonesian economic policy.
In this context, it is notable that among major developing countries, Thailand exhibits the largest interest rate spread between its own government bonds and US Treasury benchmark issues. And over the past year, the two countries for which the spreads have most widened are Thailand and South Korea. In other words, the markets have been signalling their displeasure with the direction of Thai and Korean policies for the past year by demanding higher and higher rates of return on Thai and Korean sovereign debt. Indeed, last week Standard and Poor's downgraded its rating of Korean sovereign debt. (Likewise, both Moody's and Standard and Poor's have downgraded the debt ratings of a number of private banks around the region in recent weeks.)
Finally, it should be added that there may be significant spillover (as distinct from contagion) effects on other countries in the region. Trade and capital flows are the most obvious channels for the transmission of economic changes in one country to its partners. But there may be more subtle effects as well. The recent currency depreciations and credit crunches in Southeast Asia could adversely affect Vietnam, for example, by reducing its attractiveness as a host for foreign direct investment — why build a new factory in Vietnam when one can buy (a suddenly more competitive) existing factory in Thailand for firesale prices?
Implications for the United States
Recent events in Asia can effect the US in a variety of ways. The most obvious has been the transmission of instability in Asian financial markets to financial markets elsewhere around the globe, including those in the United States. As the events of the past two weeks have shown, however, if the economic fundamentals are strong it is unlikely that such contagion effects could adversely effect the performance of the real economy, though the financial markets may be subject to temporary instability.
Effects on US economic performance is more likely to come through a slowdown in exports to Asia as regional growth slows. In aggregate terms, however, exports to the affected economies do not account for a significant share of US national income: taken together, exports to the developing countries of Asia account for less than 2 percent of percent of US national income, with South Korea accounting for the largest single share (around one-third of a percent of GDP). The currency devaluations will make these economies relatively more competitive in the US market. This could translate into lower prices for some imported products which could benefit US consumers, but also put pressure on domestic import-competing producers in sectors where the US continues to maintain significant domestic production. (In products such as toys, in which the US already imports nearly all of domestic consumption, the effect will be virtually a pure consumer gain.)
The recent developments in Asia also pose some challenges for US policy. It is clear that many of these economies need to significantly reform and restructure their financial systems. Deregulation does not mean no regulation, however. It would be imprudent to allow anyone with a drivers license to pilot a commercial jetliner. The financial regulators of a number of these economies are the regulatory equivalents of Sunday afternoon drivers, and soon they may be expected to fly jets. Effective regulation of modernized financial systems will require extensive (re-)training, new computers and software etc. There is enormous scope for federal, state, and private sector technical support as these countries go through their processes of reform. In the long-run, liberalization without sufficient attention to prudential regulation could prove disastrous.
At the same time, the US may also be called upon to provide financial support for reform efforts as in the recent package negotiated with Indonesia. As I argued earlier, some of the financial problems experienced in Asia are caused by politically motivated misuse of the financial system. Ending this pattern of abuse may require going well beyond narrowly conceived technical changes and addressing fundamental issues of political reform. Governments in the region will exhibit differing degrees of capacity and willingness to undertake politically painful reforms, as confirmed by the events of recent weeks. Successful outcomes are by no means assured and as a consequence, it would be advisable to evaluate requests for financial support carefully. In this regard APEC may prove to be a useful instrument to bring peer pressure to bear on governments in the region.
1. For evidence on this point, see Morris Goldstein and Philip Turner, "Banking Crises in Emerging Economies: Origins and Policy Options," BIS Economic Papers, No. 49, Basle: Bank for International Settlements, October 1996, Table 1.
2. See Goldstein and Turner op. cit. Table 4.
3. For a more detailed development of these ideas in the Korean context, see Marcus Noland, "Restructuring Korea's Financial System for Greater Competitiveness," Working Paper Series, 96-14, Washington: Institute for International Economics.