By Krishna Gidwani
In the early 1990s, while the United States lingered in a deep recession, the economic world marveled at the remarkable productivity levels being achieved by countries in the Far East. Like Japan before them, the "Asian Tigers" went from low-technology, agricultural economies to industrialized and sometimes high-tech economies in a surprisingly short period of time. Singapore, South Korea, Taiwan, and Hong Kong led the group with their high-tech industries while Indonesia, the Philippines, Malaysia and Thailand followed with their rapid industrialization. By the mid-1990s, however, the U.S. economy was healthier than ever (achieving rapid growth with low inflation) while the burgeoning Asian economies were showing signs of slowing. For some of these Asian countries, this slow-down was evidence of far more than a typical downturn in the business cycle. By the summer of 1997, fundamental cracks in the financial structures of these countries had manifested themselves through, among other things, investment panics and currency devaluations. The countries hardest hit by this "Asian Crisis" were Thailand, Indonesia, Malaysia and Korea.
An analysis of the Asian financial crisis will reveal that the events leading up to and facilitating the currency debacle often stemmed from poor macroeconomic fundamentals which in turn led to morally hazardous behavior. For instance, misaligned investment incentives stemming from implicit (and sometimes explicit) promises of government bail-outs to banks and other financial intermediaries in the event of insolvency were very problematic. Also, competitive devaluations played an important role in the unfolding of the massive currency crisis and its contagion across countries. Along with illuminating the causes and effects of the Asian crisis, I will specifically focus on the economic status of Korea during this period. Korea was one of the last countries hit by the financial disease, but did not escape some of the most severe economic damage. A close study of Korea will also exemplify the function of the International Monetary Fund (IMF) during major financial crises such as this.
What Triggered the Financial Downslide?
A number of theories have surfaced trying to explain why the crisis happened when it did. Most agree that it was at least partly caused by sector-specific shocks such as the fall in the demand for semiconductors in 1996. Adverse terms of trade fluctuations such as this caused a significant slowdown of export growth in several countries in the region between 1996 and 1997. More important than demand shocks, however, was the precarious condition of the largest economy in the region: the Japanese economy. (Krugman, 1998)
In 1996 it appeared that an economic recovery was returning in Japan after five years of zero growth, but the increase in the consumption tax in April 1997 pushed Japan into another recession; second and third quarter economic activity declined. This stagnation of the Japanese economy caused a significant decrease in the amount of exports of other Asian countries to Japan and resulted in current account deficits for those exporting countries. The depreciation of the yen relative to the U.S. dollar during this period exacerbated the terms of trade problem for these countries (it was now cheaper for the U.S. to buy Japanese exports). Unlike in the Mexican currency crisis of 1994-1995 when the major regional economic power, the United States, was in a strong cyclical upswing, the weakness of Japan in 1997 intensified the problems of the struggling Asian economies. (Roubini et al, 1998)
While most economists agree on what caused the crisis, they also agree that if these factors had not caused it, others would have. In order to understand why, it is imperative to look more closely at the economic systems of the affected countries, as well as those of countries that were only mildly hit (i.e. Singapore, Taiwan, etc.).
Banking and Moral Hazard
Moral hazard occurs when one party to a transaction is not fully accountable for the consequences of his actions. It is a problem that became readily apparent to Americans during the Savings and Loans crisis of the 1980s and that is very obvious to those studying the aftermath of the Asian financial crisis.
Government guarantees on bank deposits are standard practice throughout the world, but normally these guarantees come with strings attached. The owners of banks have to meet capital requirements (put a lot of their own money at risk), restrict themselves to sound investments, and so forth. In Asian countries, however, regulation of financial intermediaries was extremely poor. Loan classification and provisioning practices were very lax, state-owned banks paid little attention to the creditworthiness of borrowers, and capital requirements were often inadequate relative to the riskiness of a bank's ventures. (Goldstein, 1998) Yet, domestic and international creditors did not monitor the lending decisions of banks because of the implicit, and sometimes explicit, guarantees of a government bail-out if things went wrong.
The consequence of this shaky banking structure was immoderate domestic investment. Banks that perceived their operations as insured against adverse contingencies borrowed excessively from abroad and lent excessively domestically to finance risky investment projects. Since the interest rate at which domestic banks could borrow abroad and lend at home did not reflect appropriately the riskiness of the projects being financed, the banking system frequently channeled funds toward projects that were very marginal, if not outright unprofitable. This excessively risky lending created inflation of asset prices. The overpricing of assets was sustained in part by a circular process, in which the proliferation of risky lending drove up the prices of risky assets, making the financial condition of the intermediaries seem sounder than it was.
Ultimately, though, a wave of defaults in the corporate sectors signaled the low profitability of past investment projects and asset prices began to drop. Falling asset prices made the insolvency of financial intermediaries visible, forcing them to cease operations, which led to further asset deflation. As asset prices fell, it became increasingly doubtful whether governments would really stand behind the deposits and loans that remained. Foreign investors began pulling their money out of banks which caused asset prices to plunge further and local currencies to become devalued. Banks that had heavily relied on external borrowing were left with a large stock of short-term foreign debt that could not easily be repaid. (Roubini et al, 1998)
Short-term foreign debt was especially problematic for two reasons. First, the debt was short-term and had to be paid back relatively quickly. For many banks this was difficult because almost all that remained of their asset stocks were long-term loans. The second problem was that the debt was in foreign currencies. This is not always a bad thing; it depends on the going exchange rate. If your currency depreciates, the value of your debt (which stays constant in terms of foreign currency) increases in terms of local currency.
Beginning with Thailand in the summer of 1997, the Asian currencies underwent a series of harmful devaluations. In Thailand, weak financial sectors, coupled with poor banking supervision and declining quality of investment, caused many foreign investors to pull out of the country. Thai assets experienced decreasing demand and the currency (baht) depreciated accordingly. The situation in Thailand acted as a wake-up call for international investors to reassess the creditworthiness of other Asian countries (Goldstein). Investors found that several of these economies had weaknesses comparable to those in Thailand. Malaysia, Indonesia and the Philippines all underwent similar investment retractions and currency devaluations during the summer. Although a devalued currency is often harmful, one positive thing that does come out of it is an increase in competitiveness. As a country's currency depreciates, its exports become cheaper to outsiders and its current account gets a boost. But, just as this country's current account improves, those of the importing countries may become negative. So, in order to maintain competitiveness, these other countries must devalue their own currency through loose monetary policy. These games of competitive devaluations transmitted speculative pressures to one currency after the other. In July and August, the fall of the Thai baht spread to the Malaysian ringitt, the Indonesian rupiah and the Filipino peso. By September, the contagion had spread to Singapore and Taiwan and, within days, to Hong Kong.
As for Korea, between the end of 1996 and September 1997 the won had depreciated only by 8% against the dollar. In the same period, the Thai baht had depreciated by 42%, the Indonesian rupiah by 37%, the Malaysian ringitt by 26%, and the Philippines peso by 28%. This implied that by the end of September, the won had appreciated in nominal terms by 34%, 29%, 20% and 18%, relative to the currencies of Thailand, Indonesia, the Philippines and Malaysia respectively. (Roubini et al, 1998) In October, with six major currencies in the region having devalued by an average of 40%, the Korean won could not maintain its high-value position. By November, the won experienced a sharp depreciation, causing a significant relative appreciation in the other regional currencies. But, because of the shaky financial conditions of their economies, these other countries could not sustain a currency appreciation and further depreciation ensued. All currencies continued to fall in December on the heels of the won drop, with each depreciation round instigating the next series of depreciations.
The Korean won maintained its parity the longest, even longer than Singapore, Taiwan and Hong Kong, but this should not be attributed to the relative health of its economy. In reality, the Korean economy had been unhealthy for a long time and, when the dust had cleared, was one of the most devastated economies of the crisis.
In Korea, there had already been a serious deterioration of the macroeconomic conditions in 1995 and 1996. Current account deficits had dramatically widened from 1991 to 1994, leading to an unprecedented accumulation of short-term foreign debt. Export growth had fallen sharply in 1996 as negative terms of trade shocks (the fall in demand for semiconductors) hit the economy. As a result of these maladies, industrial production growth rates had halved relative to 1995. Debt/equity ratios were very high and profitability very low among the chaebols. The financial conditions of the chaebols and the banks that had lent to them were increasingly shaky and the possibility of widespread bankruptcy was very realistic. In reflection of these weaknesses, the stock market had fallen sharply (by 36%) in 1995 and 1996 relative to its 1994 peak. (Bartholete, 1998)
As it were, the 1997 crisis was not triggered by the fall of the won that came under severe attack in October, nor by the investment panic that developed in November and December. It was instead triggered in early 1997 by a series of bankruptcies of large chaebols that had heavily borrowed in previous years to finance their investment projects. By mid-1997, eight of the top thirty chaebols were bankrupt. The string of bankruptcies started with Hanbo Steel in January, then Sammi Steel in March and the Jinro Group in April. In July, the Kia Group, the eighth largest chaebol, failed to pay $370 million worth of liabilities and was put under fiscal protection by the government. This string of corporate bankruptcies and financial difficulties in 1997 led to serious financial difficulties for the banks that had heavily borrowed abroad to finance the investment projects of the failed chaebols. A number of these financial institutions were effectively bankrupt by the spring of 1997. (Bartholete, 1998)
It was mentioned above that while the currency crisis was spreading throughout the region, the Korean won had been momentarily spared from the rapid collapse of the other currencies. Things changed in October for a number of reasons. First, by the end of October, the effective real appreciation of the won caused by the collapse of several currencies was quite large. The Thai baht had depreciated relative to the U.S. dollar by 55%, the Indonesian rupiah by 54%, the Malaysian ringitt by 34% and the Philippines peso by 33%. The Korean won had depreciated by only 14%, implying that the won had appreciated in nominal terms by 37%, 36%, 20% and 15% relative to the currencies of Thailand, Indonesia, Malaysia and the Philippines respectively. This relative appreciation substantially detracted from Korean export competitiveness. Secondly, by October, Singapore and Taiwan (who competed directly with Korea in a wide range of export products) had allowed their currencies to depreciate rather than defend their parities. This put Korea at an even more severe competitive disadvantage. (Roubini et al, 1998)
An independent factor in the worsening of the crisis and currency depreciation in 1997 related to a heavy increase in the liabilities of the banking system in the 1990s. The depreciation of the currency worsened the financial burden of banks and some of them went bankrupt. Since, at times, it was not clear which banks were solvent and which were not, foreign banks that had heavily lent to Korean banks began refusing to renew the loans that would have been automatically rolled-over in more stable times. The foreign banks' unwillingness to renew normal lines of credit in the face of high risks of bankruptcy made the prospect of loans defaulting more likely and led to a situation of financial panic. This panic was made worse by the prisoner-like dilemma facing international investors. In a non-cooperative equilibrium it was rational for each lender to try to get out of Korea before everyone else did to avoid massive losses. However, this simultaneous attempt to get out escalated the crisis, leading to further depreciation of the won, which worsened the financial positions of the Korean banks. The situation calmed down only at the end of December 1997 when, faced with the prospect of a default caused by a self-fulfilling unwillingness to renew short-term debts, the American, European and Japanese banks jointly agreed to negotiate an orderly renewal of such short-term loans. However, this agreement was largely induced by the creditor countries' expectations of reimbursement from the bail-out package approved by the IMF in early December. (Roubini, 1998)
A final factor that has contributed substantially to Korea's economic woes in late 1997 was the country's presidential elections. Political instability or mere uncertainty about the course of economic policy will have much the same consequences as banking sector instability. The threat of a change to a regime that is not committed to sound macroeconomic policies can reduce the willingness of the international financial community to provide financing for a current account deficit. In the midst of the crisis, the political front-runner (and eventually president elect), Kim Dae Jung, was sending confusing and sometimes contradictory policy signals. Given this uncertainty about the December elections, the implementation of the first IMF plan was seriously in doubt and international investors were increasingly wary.
Korea and the International Monetary Fund
The IMF exists as a security blanket for countries that experience major economic dilemmas. Yet, the need for an institution such as the IMF is often debated. The strongest argument in favor is that, without access to conditional financing, troubled countries are likely to respond to negative economic shocks with unsound macroeconomic policies (i.e. currency devaluations and trade controls such as tariffs and quotas). There would essentially be no other choice. However, the main argument against the IMF centers around the moral hazard problem it creates. Knowing that they will be bailed out of any major economic trouble, financially unstable countries, as well as developing countries, have incentive to undertake excessively risky behavior (predominantly in the banking sector) in an attempt to right their economic ship or develop at a faster rate. A close look at how the IMF dealt with Korea during its economic difficulties will reveal some of the costs and benefits of having this kind of protective institution. Whether the net effect of IMF policy on the Korean economy is good or bad, it is likely that the mere presence of the IMF helped induce the type of morally hazardous investment behavior that led up to the Asian financial crisis.
In late November 1997, following the dramatic plunge of the Korean won on the foreign exchange market, a team of IMF economists was rushed to Seoul to negotiate the terms of a massive bail-out package with the design of restoring health and stability to the Korean economy. In close consultation with IMF negotiators, the World Bank and the Asian Development Bank also sent their own teams of economists. A World Bank package with stringent conditionalities on financial governance was announced on December 18th. During the process, an important precedent was set. The IMF's standard measures of economic reform had been launched for the first time in an advanced industrialized economy. (External Relations Department, 1998)
The IMF put together a $60 billion bail-out package for Korea, but it is the structural provisions of the bail-out that are more interesting and important:
--increased flexibility of exchange rates
--a temporary tightening of monetary policy to stem balance of payment pressures
--structural reforms to remove features of the economy that had become
impediments to growth (such as monopolies, trade barriers, and nontransparent
--opening and maintaining lines of external financing
--the closure of unviable financial institutions (and close supervision of weak ones)
--the recapitalization of undercapitalized institutions
--increased foreign participation in domestic financial markets
(External Relations Department, 1998)
To support this reform of the financial systems measures have been designed to improve the efficiency of all markets:
--breaking of the close links between business and government (restructuring of the chaebol system)
--liberalization of capital markets
--increased transparency with regards to fiscal, corporate and banking sectors, as well as economic data
(External Relations Department, 1998)
These programs have been adapted and altered as economic conditions in Korea have evolved and continue to evolve over time. The crisis in Asia is still unfolding and new disturbances cannot be ruled out.
As things stand now, the IMF bail-out of Korea is showing signs of moderate success. The won has strengthened by over 30% since its low in mid-December. The Korean stock market is up 30% as well. More importantly, foreign direct investment and portfolio investment are beginning to flow back into the country again. Of course, forecasts for Korean GDP growth this year suggest a decline of about 1%, so all is far from well. Nevertheless, the Korean economy is finally, albeit slowly, moving away from the financial disaster that crippled it only a short time back. The IMF, at least in Korea's case, seems to have partially mitigated the morally hazardous behavior it may have, by the simple fact of its existence, provoked.
Bartholete, Jeffrey. "Is Korea Ready to Explode?" Newsweek 12 Jan. 1998: 42.
External Relations Department, IMF. "The IMF's Response to the Asian Crisis" April 1998. http://www.imf.org/External/np/exr/facts/asia.HTM
Goldstein, Morris. "The Asian Financial Crisis" January, 1998.
Hirsh, Michael. "It Only Gets Worse: Election-eve Pledges are complicating a bailout" Newsweek 22 Dec. 1997: 74.
Krugman, Paul. "What Happened to Asia?" January 1998
Krugman, Paul. "Asia: What Went Wrong?" March 2, 1998.
Roubini, Nouriel, Giancarlo Corsetti and Paolo Pesenti. "What Caused the Asian Currency and Financial Crisis?" March, 1998.
Rubin, Robert. "The Rubin Rescue" Time 12 Jan. 1998: 46-50.