East
Asia, 1997: Avoidable or Inevitable?
Abstract
: In 1997
the nations of East Asia experienced the worst economic crisis in their
history. At the time scholars presented
a diverse array of possible explanations for the disaster, but found themselves
unable to agree upon any one cause. We
are now in a position to readdress this important question. This article thus reviews the existent scholarly
works on the Crisis, in an attempt to find a unifying theme in the diverse analyses. It discovers that though there is a great
diversity of opinions as to the most ‘fundamental’ cause, ranging from
accusations of cronyism and the failure of the developmental state to
indictments of the evils of liberalization, there seems to be a general
consensus that the ‘proximate’ cause of the crisis was the immense rapid
capital flight out of Asia. The article
thus begins with an investigation of these capital flows. It contends that whipsaw movement of capital
in and out of East Asia in 1997 was inherent to the structure of global
finance, showing that the over-liquidity of financial markets and the
psychology of investment both predispose financial markets to large, erratic,
and potentially dangerous surges. The
article concludes with a survey of measures that could protect developing
nations from such dangerous flows.
Having exhausted its foreign
reserves, the Thai government finally conceded that it could not maintain an
exchange rate pegged to the US dollar, and on July 2, 1997 it allowed the baht
to float freely. Fearful that the Thai
currency would depreciate, many investors responded by pulling their assets
rapidly out of the Thai economy.
Consequently, the baht and the stock market both plummeted, and the Thai
economy was thrown into a crisis from which it is still recovering.
This story was replayed time
and again throughout East Asian countries in the months to come. The Philippines spent US$2 billion of its
reserves before the peso was floated on July 11, 1997. In August Indonesia’s rupiah followed
suit. On October 17 the moorings of the
New Taiwan dollar were also cast off, and in December the outline was completed
as the South Korean won was allowed to float.
After floating their
currencies, other Asian economies generally suffered the same fate as Thailand
had, being forced to watch in horror as foreign investors fled and currencies
depreciated. This devaluation was often
drastic, as in the case of Indonesia where the rupiah lost 80 percent of its
value in the span of a few months (Robison and Beeson 4). On top of such painful depreciation, this
immense outflow of capital led to a credit crunch that spread the crisis from
the financial sector into the real economy.
As these economies contracted, many firms “were unable to obtain even
trade credit and went bankrupt even when they had full order books. Those firms that survived were forced to pay
extraordinarily high real interest rates for credit which led to very harsh
cutbacks in output and employment”(Nixson and Walters 500). Consequently,
between 1997 and 1998 the unemployment rates doubled in Hong Kong and
Singapore, and during the same time period the unemployment rates tripled in
Indonesia and South Korea (Nixson and Walters 513). In Malaysia the economic
growth rate fell from 7.2% in 1997 to –5.1% in 1998, while inflation doubled
(Robison and Beeson 5). Between July
1997 and July 1998 the interest rate in Indonesia skyrocketed from 18.25% to
65.0% (Robison and Beeson 5). Asian
economies crumbled, and it was with good reason that Bill Clinton described the
crisis “the greatest financial challenge facing the world in the last half
century”(quoted in Goldstein 170).
This paper seeks to
understand the cause of this economic disaster. Though there is a great diversity of opinions as to the most
‘fundamental’ cause, ranging from accusations of cronyism and the failure of
the developmental state to indictments of the evils of liberalization, there
seems to be a general consensus among scholars that the ‘proximate’ cause of
the crisis was the immense rapid capital flight out of Asia. The paper will thus begin by investigating
these capital flows, first noting the widespread agreement among political
economists about their causal role, and then demonstrating the wisdom in this
consensus through an examination of the size and volatility of these
flows. In the second section the paper
will then argue that the proximate cause of the crisis, this whipsaw movement
of capital, is inherent to the structure of global finance. Here it will examine the over-liquidity of
financial markets and the psychology of investment, showing that both
predispose financial markets to large, erratic, and potentially dangerous
surges. The paper will conclude with a
survey of measures that can be taken to protect developing nations from such
dangerous flows, asserting that capital controls should be imposed in Asia to
provide slower domestic reforms with time to mature.
Andrew MacIntyre asserts,
“Ultimately, Asia’s economic crisis was about a sudden and profound loss of
confidence on the part of local and foreign investors”(143). Though many scholars would caution that the
loss of investor confidence cannot serve as a comprehensive explanation of
Asia’s difficulties, most would nonetheless agree that this loss of confidence
and the resultant capital flight were the factors that most immediately
precipitated the crisis. This
observation led Gary Hamilton to term the “currency fluctuation, followed this time
by an all-out panic” and capital flight as the “proximate” cause of the Asian
crisis (59). Robert Wade echoed this
conclusion using the same phrasing (698), while Gabriel Palma echoed the same
sentiment when she claimed that the East Asian crisis was “mainly the result
of… a sudden collapse of confidence and a withdrawal of finance”(799). Jeffrey Winter agrees that the capital flows
governed by currency traders were the “spark” of the crisis (82) and Jaymin Lee
concludes that crisis was primarily “precipitated by exposure to short-term
international capital movement”(152).
Joseph Lim goes so far as to assert that opening up to such short-term
foreign flows was “root cause of the crisis”(443).
Such agreement among
scholars, an unusual phenomenon in the study of political economy, can be
understood through an examination of the great size and volatility of capital
flows. In the early 1990s, Asian
economies began to liberalize, opening their doors to foreign investment. Money
flowed into Asia from around the globe at an unprecedented speed. In South
Korea foreign debt rose from US$43.9 billion in 1993 to US$157.0 billion in
1997. From 1992 to 1997, foreign debt
more than doubled in both Thailand and Malaysia, peaking in 1997 at US$95.8
billion and US$42.9 billion, respectively (Winters 82). In the five economies
most effected by the crisis - South Korea, Indonesia, Thailand, Malaysia and
the Philippines – external debt was equal to approximately 40 percent of their
aggregate GDP (Nixson and Walters 498, Winters 82). Foreign capital was extremely large and powerful in Asia.
Perhaps more important than its size is the
fact that this investment was highly volatile. The net private capital flows
for these five nations had risen from US$37.9 billion in 1994 to US$97.1
billion in 1996 (Nixson and Walters 498).
By the end of 1996, however, private short-term capital inflows
constituted 80 percent of the total private capital flows into the
aforementioned Asian economies (Nixson and Walters 503). This allowed these
enormous flows to rapidly reverse. By
the end of 1997, these five nations experienced a net outflow of US$11.9
billion, representing turnaround of US$109 billion, “equal approximately to 10
percent of the pre-crisis GDP of the Asian five” (Nixson and Walters 498). A quarter by quarter examination of private
bank flows into Asia illustrates this volatility even more clearly. In the first quarter of 1997 Asia received
US$21.2 billion from foreign investors, and in the second quarter it saw
another US$15.8 billion. But by the
third quarter the flows had reversed and Asia lost US$2.0 billion, and in the
fourth quarter another US$33.8 billion fled Asia (Winters 81). Investment in Asia was extremely mobile.
In the light of such enormous and volatile capital flows
it becomes easy to understand political economists’ agreement that capital
movement was the proximate cause of the crisis. The immediate
disappearance of immense amounts of
money led to the depreciation of Asian currencies, the collapse of Asian stock
markets, and the disappearance of credit.
The loss of credit produced contractions in the real economy, as the
inability to refinance loans or to borrow funds needed for the continuation of
regular production drove thousands of firms into bankruptcy. Over 10 million people lost their jobs at
the same time that failing currencies raised the effective prices of goods
(Pempel 78). The whipsaw motion of
capital decimated Asia.
As this motion of capital first into and then out of Asia
is widely agreed to be the proximate cause of the crisis, the next task becomes
an inquiry into the roots of these devastating capital flows. Richard Robison and Mark Beeson note that
one of capitalism’s most prominent historical characteristics has been a
repeated pattern of cyclical ‘booms’ and ‘busts’ (8). It is this cycle of booms, when increasing confidence leads to
manic investment, followed by busts, when investors’ panic leads to capital
flight, that has led to the greatest economic disasters for the developing
world in the past two decades: the 1982 debt crisis, the 1994 Mexican crisis,
and the 1997 Asian crisis (Palma 789). Thus it appears that the roots of
devastating capital flows must lie somewhere outside of the Asian context.
In “The Political Economy of East Asia at a Time of
Crisis,” Beeson observes that “the way the global economy is currently
configured encourages the movement of massive, often speculative and short-term
flows of capital with potentially deeply destabilizing effects on individual
countries”(357). The whipsaw motion of
capital thus emerges from the structure of global finance; dangerous capital
flows are inherent, or “endogenous”(Palma 790), to the current economic system.
This section will develop this claim, demonstrating that both over-liquidity
and the psychological nature of investment promote the rapid and often erratic
movement of capital. Thus, the proximate cause of the Asian crisis will be
shown to be embedded in the structure of global finance.
Financial markets function well when they are “sellers’
markets”(Palma 790). When there is a
limited amount of funds relative to the number of willing borrowers, those
individuals who are lending money have the upper hand. They can afford to pick and choose among the
possible borrowers, and so they lend only to those who appear to be the safest
investments. Thus the firms that are
allocated money are those that are the strongest and most promising, while
risky investments are denied funds.
This not only leads to a sound economy, but it also ensures the safety
and continued health of the financial sector.
However, Palma cautions, when “international historical
liquidity grows to such an extent that financial markets become buyers’
markets, competitive pressures to recycle funds impair international financial
operators’ capacity to assess and price risks properly and to allocate
resources effectively”(790). When the
amount of money available to be lent becomes too large relative to the number
of willing borrowers, lenders are no longer able to be as selective. In such a case of over-liquidity, funds will
be directed towards riskier investments.
Whereas in a seller’s market money had gone only to those who did not
need to borrow, in a buyers’ market money is put into the hands of those who
will not be able to pay.
Today’s global economy,
Palma contends, is suffering from such a bout of over-liquidity. It is because of this surplus of liquid
capital that “international financial institutions ‘over-lent’ to developing
countries (LDCs), and the government, corporations, financial institutions
and/or households of these countries ‘over-borrowed’”(789-790), leading to each
of the great economic crises in the last two decades.
This indictment of
over-liquidity is supported by a look at the burgeoning amount of international
capital racing about the globe today.
Annual capital flows have now become 70 times greater than the annual
volume of world trade (Wade 696). A
glimpse at the money pouring through foreign exchange markets reveals the same
picture. In 1973, the average daily
turn over in foreign exchange markets was US$15 billion. By 1989 it had climbed to US$590 billion,
and by 1998 it reached US$1.5 trillion.
The daily turnover in foreign exchange markets now equals approximately
85 percent of the reserves of all the central banks in the world (Winters
83). And not only is the amount of
international capital rapidly increasing, but it is becoming more liquid and
mobile as well – 80 percent of net foreign exchange now has a maturity of one
week or less (Wade 696). Today’s global
economy certainly fits Palma’s description.
In Asia in the 1990s, such over-liquidity combined with
an insatiable economic appetite, resulting in a massive flow of capital towards
the east. As this investment rushed in,
these economies experienced a jump-start and began to record remarkable rates
of growth. The apparent success of
initial investors inspired western lending institutions to pour even more money
into Asia, and an enormous surplus of capital soon developed.
This over-liquidity led to
risky investments. As Chalmers Johnson
testifies, “Given a globalized financial system overloaded with money and a
lack of elementary prudence on the part of borrowers… [Asian countries]
borrowed hundreds of millions of dollars from foreign lenders. They invested these funds in sometimes
foolish projects, such as fancy apartment and office buildings, or in export
industries that were soon crippled by overcapacity”(657). This investment pattern, coupled with the
heightened mobility of capital, provided the groundwork for the panic in 1997
by increasing the chance of “a sudden collapse of confidence”(Palma 800). Thus the over-liquidity that characterizes
the current global economy led to risky investments and set the preconditions
for the sudden loss of investor confidence that decimated Asia. Thus, the
proximate cause of the crisis is seen to be embedded in the excess of money
sloshing about international financial markets.
As Winters observes, “All of
the difficulties experienced by the economies of the region … had been chronic
for years”(89). The soundness of Asian economies did not suddenly dissolve in
the summer of 1997 – the economic fundamentals were much the same as they had
been in the spring of that year, and in the spring of the year before
that. The mass exodus of capital from
Asia, he argues, had more to do with the psychology of investment than with any
hard economic realities.
Wade echoes this
assessment. After asking himself,
“Granted that the whipsaw movement of capital inflows and outflows is the main
proximate cause of the crisis, could it have happened without serious
vulnerabilities in the real economy?” he answers, “Almost certainly,
yes”(698). The psychological nature of
investment and the herd-mentality that it instills, he explains, make
unwarranted capital flight almost inevitable.
In order to understand this
claim, the character of investors must be explored. A large amount of the money flowing into Asia comes from private
citizens around the world. These
individuals invest in banks or market funds, which in turn transfers these
aggregate pools of money into the hands of a select few investment specialists
and fund managers. Through this ‘funnel
effect’ a relatively small amount of people is entrusted with the control of
enormous amounts of capital (Winters 91).
These individuals face a
distinctive set of expectations. If any
single manager or banker makes a loss that the other investment brokers do not
make, or misses out on gains that other investors are making, she will be held
at fault by her management or shareholders, and may well face severe repercussions. However, if she makes losses that other
investors are also making, she will not be faulted. This set of expectations fosters a herd-mentality among bankers
and money managers, for the safest course of action is always to follow the
crowd (Wade 698).
Herd-like behavior is
further compounded by a lack of reliable information. In the absence of clear economic indicators, investment managers
are never able to be certain about the reliability of their investments. This perpetual lack of confidence leads
investors to continually eye one another, searching for signs of danger. Thus when a small number of investors happen
to pull out of a particular company or nation, other investors are likely to
infer that those who are leaving know something important. Fearful of making a loss that their peers
are avoiding, other investors will follow the lead of those who exited
first. In this way the lack of
information further exacerbates the herd-mentality of investors (Wade 699).
In Asia, this psychological
dimension of investment played a prominent role in the movement of
capital. The herd-like behavior
provides an explanation for the unprecedented influx of capital in Asian in the
early 1990s, the “manic” spree of investment that characterized the early part of
the decade (Palma 789). Similarly, the
psychology of investment explains the mass exodus of capital in 1997. The floating of Asian currencies was seen by
investors as a “red light signaling danger for the whole region”, and it thus
birthed a “pure psychology of escape.
All controllers of liquid capital, including domestic actors, began
behaving like spooked wildebeest on the Serengeti”(Winters 89). Despite the
lack of tangible change in Asian economies, from the perspective of investors
“escape is the only course of action that makes sense, even if, objectively,
rushing out of a market is unwarranted”(Winters 92). Thus as Johnson noted, the herd-mentality led to capital being
pulled out “from both poorly managed and completely healthy enterprises”(657). The psychology of investment thus led the
whipsaw motion of capital that decimated Asia.
The proximate cause of the crisis is again seen to be embedded in the
structure of global finance.
As it becomes apparent that large, rapid changes in
capital flow are embedded in the current structure of the global economy, the
next task becomes to search for measures that can be taken to protect domestic
economies. After a lengthy
investigation into the Asian crisis, The Council on Foreign Affairs Task Force
on the Future of the International Financial Architecture concluded that
“banking, currency, and debt crises cannot be eliminated entirely, but it would
be a counsel of despair to argue that little can be done to make them less
frequent and less severe”(Goldstein 170).
Similarly, Winters argues that while fluctuations in the “huge
electrical grid” of international finance are inevitable, countries are able
both to create mechanisms dampen these shocks, and to disconnect their
economies from the grid (79). The
global financial market is a dangerous force, but steps can be taken to protect
oneself from its vagaries.
The reform of the political economies of Asian nation is
an important and necessary step, but it will take some time to implement it
effectively. Some valuable domestic
reforms proposed by the Task Force include
discouraging liabilities of
the public and private sectors from getting way ahead of their liquid assets
and avoiding the buildup of large currency mismatches…. maintaining a strong
and well-regulated banking and financial system that extends loans on the basis
of their expected profitability and of the credit-worthiness of the borrower…
shunning heavy reliance on short-term borrowing and on longer-term debt
contracts with options that allow the credit to demand accelerated repayment if
conditions worsen… [and] holding enough international reserves and arranging
contingent credit lines so that there is enough liquidity on hand to cushion
against unexpected adverse shocks. (Goldstein 173)
Though it seems likely that
all these reforms will strengthen Asian economies, it seems unlikely that they
can be executed immediately. Domestic
reform takes time, especially when many powerful actors within a society have a
vested interest in maintaining the status quo.
South Korea provides a perfect example of this
point. In the early 1980s the Korean
government recognized a need for economic reform, and so throughout the next
two decades it took steps to liberalize its economy. “The official position of the government, and the consensus among
the majority of economists in Korea” emphasized the importance of the proper
sequencing of liberalization (Lee 152).
All parties agreed that “domestic liberalization should precede external
market opening… [and] long-term capital movement should be liberalized before
short-term capital movement”(Lee 152).
Despite this consensus, the proper sequencing of liberalization was not
achieved in Korea. The relationship
between political and economic elites is so deeply embedded in Korean society
that it cannot be easily removed. As
Jaymin Lee explains, “The superiority of the state over the private sector in
Korea was not newly introduced by the developmental state in the 1960s: it is
deeply rooted in Korea’s history of bureaucratic society, and cannot be
corrected overnight”(155). Furthermore,
Korean officials are indebted to the chaebols
for political contributions, and hence cannot implement certain domestic
reforms without endangering their own political careers (Lee 150). The government’s perception of the need to
liberalize the economy according to a certain sequence was of no importance,
for embedded practices and the power of actors with an interest in maintaining
the status quo effectively tied the government’s hands.
As this examination of the South Korean experience
indicates, domestic reform in Asia cannot be accomplished overnight. Though Winter’s surge protectors and the recommendations
of the Task Force are both to be pursued, they will inevitably require a
certain amount of time to mature. It
will take a while to gain endorsement for the removal of government support for
private corporations, as well as requiring a bit of time to establish strong
regulatory bodies able to adequately oversee banking and finance. During this period of maturation, Asian
nations ought to protect themselves by partially disconnecting their economies
from the dangerous electrical grid of international finance.
The best method for disconnecting is the imposition of
capital controls. This prescription still offers governments a wide variety of
policy options, allowing individual nations to customize capital control
packages to fit their unique situations.
The Task Force, for instance, proposes a Chilean style tax on capital
that is withdrawn too rapidly. In its
search for a way “to moderate the boom-bust cycle in private capital flows and
tilt the composition of such flows toward longer-term, less crisis-prone
components (such as foreign direct investment) while preserving most of the
benefits associated with greater market access”, it concludes that despite the
possible costs associated with the Chilean capital tax regulations, “if the
alternative is a boom-bust cycle followed by a costly financial crisis, the
choice seems clear” (Goldstein 175).
Chalmers Johnson echoes this suggestion, and then builds
upon it. He agrees with the Task Force
that the goal “is to end the volatility of hot money,” and consequently
recommends a “tax on short-term loans of 2%-3%”(660). He then proposes that “government regulations could also favor
direct foreign investment over purchases of shares of stock”(660). Through preferential regulation, the
government could thus increase the amount of FDI, which cannot exit swiftly,
while decreasing the amount of foreign investment in the stock market, which is
a very volatile.
Robert Wade and Frank
Veneroso favor a more radical approach.
After noting that the non-convertibility of the Chinese and Indian
currencies allowed these nations to emerge from the crisis relatively
unscathed, Wade and Veneroso take a detailed inventory of the capital controls
recently imposed by Malaysia, Hong Kong, and Taiwan, as well as examining the
capital controls that Japan considered.
This investigation led them to distinguish between two main forms of
capital controls: controls on outflows and controls on inflows. They argue that
“by and large, controls on outflows are more difficult to make effective,
especially in the midst of crises”(30) because there are numerous ways in which
investors can hide from government policing.
Inflows, they contend, “are much easier to control”(30). To further support their case for controls
on incoming capital, Wade and Veneroso point to the immense amount of domestic
savings that Asian nations have. East
Asian countries, they observe, “have the highest rate of savings in the world,
and account for over half of the world’s savings” (31). As Asian nations already save more than they
can productively invest, there is no need to open the doors to dangerous
foreign money. Thus, Wade and Veneroso conclude, placing controls on the inflow
of capital is the wisest choice.
It has been shown that enormous and highly volatile capital flows were the proximate cause of the Asian crisis, and that these flows are inherent to an over-liquid global financial market that fosters herd-like investment behavior. Thus ‘plugging-in’ to global finance always entails some danger, and governments should take appropriate actions to protect their national economies. As domestic reforms will often take a good deal of time to mature, due to both the embedded nature of economic patterns and the presence of powerful actors interested in maintaining the status quo, these nations ought to implement some form of capital controls in the meantime. Whether a particular nation places restrictions on outgoing or incoming capital, what is imperative is that the governments of developing nations take the necessary measures to disconnect their economies from a dangerous global financial market during the period of maturation.
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