East Asia, 1997: Avoidable or Inevitable?

 

Shane Walton

US-Canada Fulbright Program

 

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.

 

 

Introduction

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.

 

The Proximate Cause: Capital Flows

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.

 

Capital Flows: Inherent in the Structure of Global Finance

            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.

 

Over-liquidity

            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.

 

Psychological Nature of Investment

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.  

 

The Danger is Inherent to Global Finance: So what can be done?

            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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