Bad Lending Leading to the East Asian Crisis In 1990s - Essay Example

?Bad Lending Leading to the East Asian Crisis In 1990s Table of Contents Introduction 3 Major Features of Asian Economic Crisis 4 Economic Explanation of the Problem 8 Conclusion 12 References 14 Introduction Prior to the recent global economic crisis of 2008, world financial markets had to witness the East Asian economic turmoil during the year 1997. The cycle of excessive lending practiced in East Asia, during the late 1990s, was exaggerated by implied or unambiguous agreements between lenders and debtors, along with weak administration of financial regulations and concerns among the banking sector The economic crisis in East Asia was escorted by bad lending practices which resulted in the devaluation of currencies, reduction of exports, loss of economic credibility and adverse economic growth. The East Asian economic crisis was later analysed as caused by several external and internal stimuli such as improper maintenance of financial market activities, inadequate foreign borrowing and absence of inducements towards risk management among others (Dullum & Kulkarni, 2005). Considering this aspects, this essay will describe how different activities resulted in high lending activities in East Asian economies causing a crisis situation. The objective of the essay is to analyse and describe the main economic problem that triggered the economic crisis in East Asian nations. Hence, the rationale for choosing this topic is to understand various facets which can lead to bad economic crisis with the aim to gain knowledge regarding measures which can be implemented to avoid such circumstances. Major Features of Asian Economic Crisis In the year 1997, when the financial crisis was identified, International Monetary Fund (IMF) reported that the situation was fundamentally caused due to the inefficiency of East Asian financial markets to manage its foreign debt as well as lending policies. As soon as this crisis hit, IMF assigned that it was the responsibility of East Asian capitalism. This occurrence was further observed to have created a significant impact upon the Asian financial markets including Indonesia, Korea, Thailand, Malaysia and Philippines. In these nations, bank lending dues on private organisations had increased remarkably before and during the crisis situation. For instance, in Philippines, credit to private organisations surpassed 40% growth from 1993 to 1996. The amount of liabilities also ascended from 8.8% of GDP in 1995 to 21% of GDP in 1997 in Philippines. In Korea, the amount of foreign liabilities of banks had been observed to gain growth in almost two-folds, i.e. from 4.5% of GDP in 1993 to 9.5% of GDP in 1997. Only in Indonesia, even though the credit growth was recorded at a modest level within the national financial structure, the private organisations were engaged in borrowing openly from foreign sources. The most risky circumstance was observed in Thailand where the aggregate amount of foreign liabilities of banks had increased rapidly to almost 28% of GDP in 1995 (Radelet & et. al., 1998). This huge amount of liabilities can further be observed as the result of weak regulatory measures taken by governments and poor financial structure of different East Asian nations. This huge amount of liabilities imposed a degree of negative impact on the economic performances of these East Asian nations, as most of the foreign creditors began extracting their capital from these countries as well as the other nations in the East Asian region. Due to deep capital outflow, the currency exchange rates came under strong burden. It can be observed that in 1997, the currency exchange rates of Indonesia, Malaysia, Philippines and Thailand had reduced by more than 20%. The collapse of economic conditions in these nations triggered the feeling among investors that other nations in the East Asian region will soon fall under economic crisis. The major rating organisations slowly demoted the nations in East Asian region, causing more capital extraction by the creditors. Furthermore, as exchange rate depreciated, foreign creditors become unenthusiastic to allow new loans and to overturn existing loans. On the other hand, the national debtors who had not hedged their foreign exchange made an attempt to close their stock position. These aspects resulted in the spread of crisis in several economies of the East Asian region (Radelet & et. al., 1998). Although there are several schools of thoughts related to the occurrence of East Asian crisis, there are certain features which had been described by most of the authors vis-a-vis the issue. It can be observed in this regard that the East Asian nations excluding Japan, Taiwan and China had four major weaknesses. Foremostly, East Asian nations pursued a varied extent of premature and indiscriminate economic liberalisation during 1990s, comprising both national financial market deregulation and open economy. Financial liberalisation comprised actions focussed to permit the entry of international banks, to raise the number of international financial institutions, to increase the scope of their functions and to authorise increased access of banks and other financial institutions to global capital markets. Furthermore, interest rate controls and limitations on commercial debt funding and international lending were raised during the period of 1990s. Additionally, the economic liberalisation was continued without a satisfactory provident administration and directive of financial activities of banks in East Asian region. Moreover, governments also instantaneously abandoned policy management of investment and borrowing activities. These weak regulations permitted banks to lend excessively to private organisations and to borrow substantially from overseas market (Bustelo, 2000). The other salient feature of East Asian crisis was the excessive debt in foreign liabilities, especially in relation to the short-term liabilities. The information of World Bank stated that in the year 1996, Indonesia recorded a foreign debt of 64% (against GNP), Thailand had foreign debt amounting to nearly 52% (against GNP), Malaysia had foreign debt of around 52% (against GNP) and Philippines operated through foreign debts amounting to nearly 51% (against GNP). It is worth mentioning in this regard that lending activities through banks to the private segment had significantly increased during the period of 1990 to 1996. The debt structure revealed high proportion of liabilities of East Asian organisations in Japanese and US currencies at a comparatively low level of interest. Besides, most of the debt risks were not hedged because of underdevelopment of national hedging instruments. Thus, East Asian economies highlighted an increased exposure towards liquidity issues and balance of payment crunch (Bustelo, 2000). The third weakness of East Asian nations was identified in terms of over investment, particularly in manufacturing segments with excess capability which exaggerated real estate and increased the indexes of stock markets in the long-run scenario. During the mid-1990s, the investment rate with respect to GDP was almost 40% in both Thailand and Malaysia and about 35% in both Indonesia and South Korea. However, the Incremental Capital Output Ratio (ICOR) demonstrated a rising tendency in the beginning of 1990s in nations such as South Korea, Thailand and Malaysia. This represented a procedure of deteriorating investment effectiveness and decreasing capital productivity. On the other hand, increased percentage of bank lending was focussed towards investments in real estates, equities and other financial assets, making the banks highly vulnerable towards liquidity crisis (Bustelo, 2000). Last, but not the least; the herding behaviour in the international economic market (such as anxiety of investors) encouraged enormous currency devaluation and remarkable drop in stock market indexes. The report of Institute of International Finance stated that net funds rendered to the five East Asia nations namely Malaysia, Philippines, Thailand, Indonesia and South Korea facing most vulnerable situations had been augmented from US$ 37.9 billion in 1994 to US$ 102.3 billion in 1996;. The effect of this setback amount further created an impact on the lending of commercial banks and performance of portfolio investments. Furthermore, due to unwillingness deciphered by the domestic residents to hold credits in national currencies, the foreign creditors became less enthusiastic to rollover their credits which resulted in liquidity squeeze within the East Asian nations. Meanwhile, manufacturing organisations demonstrated a high financial leverage ratio, where several banks became undercapitalised, owning insufficient liquid assets and high level of collateralised loaning (Bustelo, 2000). Economic Explanation of the Problem The major reason for the financial crisis of 1997 is believed to be the ineffective incentive structure and lack of proper regulatory framework of the East Asian countries. During the 1990s, the issue of morality in Asia had exaggerated the economic vulnerability of the region through the procedure of financial market liberalisation, revealing its instability in terms of economic shocks witnessed in between the period of 1995 to 1997. The problem of the East Asian crisis demonstrated three different, yet strictly consistent dimensions at the commercial, economic and global level (Corsetti & et. al., 1999). At the commercial level, political stress for upholding high rate of economic growth had resulted in long tradition of support from governments for executing private investment projects. Several private investment projects were therefore effectively commenced under the control of governments, being directly funded and supported by providing credit facilities to the growth of industries. Even with lack of clear assurances of ‘bail-out’, the manufacturing plans and policies of commercial sectors continued ignoring the risks of such investment projects with respect to low rate of returns and high level debt among others. During this period, economic and industrial policies were observed as involved within extensive commercial network of personal and political partiality. Hence, with the enthusiasm of governments to support the backward organisations in particular industries, market started to operate under the belief that the return on such investment projects was comparatively more insured against negative shocks (Corsetti & et. al., 1999). Such beliefs signified the underneath of constant process of capital accretion resulting into insistent and substantial current account shortfalls. Contextually, the evidences related to the performances of the Asian nations during 1990s highlight that the productivity of the new investment projects had been quite low during the period. For example, In Korea, 20 out of 30 corporations displayed return on investment below the amount of its cost of capital in 1996. In 1997, before the Asian crisis stroked, several large-sized multinationals had already become vulnerable towards bankruptcy (Corsetti & et. al., 1999). Investment rates and capital influxes in Asia remained high even after adverse indications shown by low effectiveness of investment. To a certain extent, the crisis situation can be observed to have occurred fundamentally due to the fall in interest rates in highly industrialised nations such as Japan. The implemented low interest rates later reduced the cost of capital for organisations and encouraged large financial movements into Asian nations. Nevertheless, the crucial factor for the constant high investment rates was also due to moral threat issues witnessed in Asian markets, motivating national banks to borrow exclusively from foreign financial markets, especially from the western countries and to lend extremely in the real-estate market. The financial intermediation played vital part in directing funds towards investment projects that were marginally less beneficial or weak from social viewpoints (Corsetti & et. al., 1999). Several structural misrepresentations such as slack administration, poor regulation, low capital competency ratios, inadequate knowledge of regulatory bodies, one-sided inducements for investment project selections and irrational lending practices underlined semi-monopolistic association between banks and organisations. These factors were further observed as highly supportive towards the accumulation of severe weaknesses in the Asian economic system, with the most visible indications of increasing amount of non-performing loans (Corsetti & et. al., 1999). The negative impacts of the above described distortions were critically exaggerated by the quick procedure of liberalisation and financial market deregulation in Asia throughout 1990s which further played a major influencing role to increase the supply elasticity of money from abroad. The widespread liberalisation of financial market was dependable on the policy objectives of lending large supply of funds to national banks and national commercial segments. This aspect had also encouraged the exchange rate strategies which were designed to minimise the instability of national currency with respect to the US dollar, hence lowering the risk premium on dollar based debt. The underlying belief of such over lending attitude was due to the presumption of short-term interbank liabilities under which governments would interfere in support of financial borrowers and provide assistance for bail-outs through IMF support programs (Corsetti & et. al., 1999). During the economic crisis it was observed that negative shock of investment created meagre influence on financial intermediaries to become more vigilant while lending. Rather, it was apparent that despite of negative circumstances of risky investments, the expectations of future bail-outs created a strong inducement on investors to undertake even more risks. In this context, several country specific and international shocks contributed towards worsening the overall economic position within the Asian region, and simultaneously intensifying the then existing economic misrepresentations. Furthermore, sector based shocks such as reduction in the demand of semi-conductors along with negative trade instabilities also supported to the deteriorating of trade balances in Asian region during 1996 to 1997 (Corsetti & et. al., 1999). Contextually, it can be observed that during 1995, severe appreciation of US dollar against Japanese Yen and other currencies of European nations resulted in significant deterioration of cost competitiveness in numerous Asian nations whose exchanges were effectually attached with respect to the US dollar. It can be observed that although several Asian currencies appreciated during the period of 1990s, the extent of real appreciation was not as significant as in the historical affairs of currency downfalls. Besides, the dynamics of real exchange rate was also irregular across different nations of Asia. For instance, in 1997, the level of real appreciations of currency was apparent in Malaysia and Philippines, but the actual appreciation rate of currency had not shifted considerably in nations such as South Korea, Thailand and Indonesia. On the whole, competitive stresses were increased by the growing power of China with respect to total export from the Asian region (Corsetti & et. al., 1999). As a consequence of collective impacts of several financial disproportions described above, Asian nations were observed as highly exposed towards economic crisis, either from unexpected changes in market assurance and soppiness of people, or by corrosion of prospects regarding weak conditions of the practiced financial structures. In the year 1997, collapse of real estate and stock market resulted in the rise of wide losses and absolute defaults in commercial and financial segments. Additionally, policy ambiguity, arriving from the absence of commitment to structural improvements by national authorities, deteriorated the entire economic climate of Asian region. From 1997 ahead, rapid reverses of financial capital influxes also resulted in the downfall of regional currencies, causing anxiety amongst national and international investors (Corsetti & et. al., 1999). Conclusion The East Asian crisis demonstrated significant lessons for investors, organisations and governments around the world. Reviewing the occurrence of East Asian crisis, it can be affirmed that the weakness of Asian financial system in terms of foreign debt and lending policies was the core reason for the crisis. These weaknesses resulted in absence of incentives among organisations, investors and governments to manage the investment risks effectively within the national as well as in the international contexts. One of the major reasons for the market analysts to fail identifying the crisis situation effectively was owing to the fact that the weaknesses of financial segment in East Asian nations were covered by rapid economic growth and huge amount of capital inflows. Most of the East Asian nations had enjoyed performing in an international atmosphere with low limitations on financial activities, resulted in high investment rates. However, after 1990s, series of external shocks such as depreciation of Chinese and Japanese currencies and decline of semi-conductor demand among others had negatively impacted on the performance of East Asian economies. Furthermore, the stress of foreign exchange and collapse of economy of certain East Asian nations prompted investors to reconsider the strengths of their financial systems (Moreno, 1998). The obvious consequence was rapid currency depreciation and stock index decline, initially in the South Asian region, and correspondingly in the entire East Asian region. From the above facts, it can be stated that it is prudent for governments in East Asia to reform the economic and trade policies and to strengthen the financial system to avoid further similar crisis situations. However, the occurrence of the international economic crisis in the year 2008, also owing to the lending policy related weaknesses of the Western countries, illustrates that learning lessons from previous faults and implementing the concerned strategies differ extensively in the practical scenario. References Bustelo, P., 2000. The Impact of the Financial Crises on East Asian Regionalism. University of Madrid. [Online] Available at: http://www.ucm.es/info/eid/pb/Bustelo00Region.pdf [Accessed January 01, 2013]. Corsetti, G. & et. al., 1999. What Caused the Asian Currency and Financial Crisis? Japan and the World Economy, Vol. 11, pp. 305-373. Dullum, A. & Kulkarni, K. G., 2005. Comparison of 1980s Latin American and 1990s East Asian Financial Crises. University of Denver. [Online] Available at: http://www.kulkarnibooks.com/assets/downloads/kishore_papers/paper_with_Annie_dullum_on_financial_crise_comparison.pdf [Accessed January 01, 2013]. Moreno, R., 1998. What Caused East Asia's Financial Crisis? Economic Research and Data. [Online] Available at: http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-24.html [Accessed January 01, 2013]. Radelet, S. & et. al., 1998. The East Asian Financial Crisis: Diagnosis, Remedies, Prospects. Brookings Papers on Economic Activity, No. 1, pp. 1-90. Read More