Asias Banking Crisis by Shanker Satyanath - Book Report/Review Example

Globalization, Politics and Financial Turmoil: Asia’s Banking Crisis” by Shanker Satyanath – A Book Report 2008 Globalization essentially involves free movement of capital across national barriers. This, while bringing about productivity increases and economic growth, has also often resulted in financial crises. In the book, “Globalization, Politics and Financial Turmoil”, Shanker Satyanath describes the experience of East Asia during the financial crisis of 1997-98, when some of countries in this region was subject to a situation that has been equated to the Great Depression in America and Europe of the 1930s. Satyanath postulates that developing democracies experience such crises mainly because there is a breakdown in communication between the chief executive of the monetary authority and financial officers in such times, leading to insufficient banking regulations and eventually flight of capital out of the country, which then has a snowballing effect. For the purpose, Satyanath elaborates on three bodies of literature – 1) globalization of capital and the political scenario in which there are possibilities of miscommunication 2) the presence of ill-informed chief executive and 3) the existence of veto players, that is, those whose consent is necessary for any policy change. Prior to the 1980s, all developing countries had relatively stringent regulations on capital inflows and outflows. All foreign exchange transactions were strictly monitored and banks had limits on overseas borrowings. From the 1980s, the International Monetary Fund (IMF) began to put pressures on the developing countries to liberalize the financial sectors, justifying that the access to foreign capital would allow these countries to invest more than the domestic savings allowed them to. Besides, short-term cyclical recessions could be balanced with countercyclical capital inflows from overseas. Also, free mobility of capital would also allow domestic investors to invest abroad thus neutralizing domestic shocks while also allowing them to earn higher risk-adjusted returns. Lastly, the dismantling of the bureaucratic shackles would allow the financial sectors of the developing countries become more professional, the IMF argued. Consequently, many Asian countries liberalized the capital accounts as they did the trade accounts in the 1980s and 1990s, and the result was higher growth rates in Gross Domestic Product in the immediately succeeding years. However, by 1996, many of these same economies began to show signs of slower growth. Simultaneously, what disturbed the analysts were the growing current account deficits and increase in foreign borrowings. The current account deficits were the result of real currency depreciation, rising real wages, declining export markets and realignment of the dollar-yen ratio. The financial sector was beginning to be in the doldrums as the domestic credit market had expanded on the basis of foreign borrowings. The banks’ vulnerability also increased with rapidly rising defaults and non-performing assets. Gradually, rumors began to spread that the Thai baht was unsustainable and speculators began to attack the currency. On July 2, 1997, Thailand was forced to put a stop on the free exchange rate mechanism. Various alternative explanations of the Asian financial crisis has been forwarded. Satyanath puts forward a novel idea that a collapse of communication between the chief executive and the officials is at the root of the misunderstanding over the impending crisis and the lack of immediate regulatory actions that was the root of the problem. In essence, it is the political economy of the country that posits how stringent the regulatory system can be. Both authoritarian as well as democratic structures may lead to the failure of the financial systems. Satyanath develops a model in which the chief executive considers signals on bank defaults from the central bank governor and the finance minister as inconsequential when these messages deviate only slightly from his view on the robustness of the monetary system. As a result, even when the signals begin to differ by a wider margin, the chief executive considers this as a misperception and ignores these. At the same time, given their experience of previous reactions of the chief executive and anticipating that his signals will be ignored, the finance minister and the central bank governor disagrees with the chief executive on every signal and provides incorrect information. Typically, the disagreement occurs on the amount of buffer required over the defaults, which only the central bank governor is likely to be informed about through the information collected by his officers through site visits. Although the chief executive may have some inkling of the growing amount of default from the financial press but the latter usually has little quantitative information. The chief executive may appoint officials to report to him independently or have officials in the banks report to him directly. But this would break the banking hierarchy down and crony capitalism in the financial system would bear the risk of corruption all the same. In such situations, there is the risk of lax regulations and the signaling problem would lead to an incentive problem. At the same time, in a democratic structure, it is not as easy to appoint a trusted person as it is in an autocratic regime. As a result, there is a complete breakdown of communication between the chief executive and the financial officers in a democracy when a crisis begins to emerge. In an autocratic system, the communication could have been forced but in a democratic structure, the legislative would not allow the cronyistic situation. The best-case scenario would then be that there is a moderately robust financial system and the chief executive does not have a crony set-up but instead receives signals from the central governor. However, even in a moderately robust system, the situation may at times move slightly away. If the signaling system is not immediately attended to, and a democracy does not necessarily assure that this would automatically happen, a lax regulatory environment may result. To avoid this scenario, there is usually a long term commitment to have a stricter regulatory regime. Thus, even in the best-case scenario when the chief executive is in command over the financial system, there is an arms length relationship between the chief executive and the central bank governor without the interference of cronies and there is no breakdown of communication between the two, a strict regulatory regime is preferred to a lax regulatory one. Same is the case, according to Satyanath, when both the central bank governor and the finance minister are signaling agents. He develops a model in which the chief executive’s idea of robustness of defaults lies in between those of the finance minister and the governor. If the default level rises to the finance minister’s ideal level that is above the chief executive’s but the latter has no information about it, the finance minister would hide the information since he would not like the chief executive to react to the situation and raise the robustness by increasing capital flows. On the other hand, the central bank governor, who has ideal level below that of the chief executive, has incentives to increase the robustness since the level of defaults is above his ideal level. So, while the governor has incentives to inform the chief executive about the rise in the default level, the finance minister does not have. The chief executive, as a result, is in a dilemma over whom to trust. Such divergence of preferences among his advisors color the chief executive’s decisions on many areas. There are uncertainties over whether the jump in defaults has happened or not as there are regarding the extent of the jump. In an authoritarian system, the chief executive is not constrained by the legislature, which is toothless, to appoint a close relative or any other trusted person to provide him with the information superceding the finance officials. Satyanath calls such steps “unorthodox solutions” to the signaling problem since it does not require any financial innovations. The chief executive can then provide reasonable commitments to respond to default jumps either way and assure adequate capital flows across sectors. Then, the banking system would then be less than moderately robust at all times. On the other hand, in a non-crony type of authoritarian regime in which the chief executive has arm’s length relationship with his officials, the regulatory regime is likely to be more robust. Satyanath then analyses the gridlock logic of democracies in which the chief executive is constrained to implement policies he would like by institutional barriers. Bank capital may fail to adjust to default changes since the legislature may not readily agree to such changes. The chief executive’s decisions may fall flat in the face of veto players that may be many. However, such situations are less likely when political powers lie with the chief executive. But in normal situations, the gridlock makes democratic institutions vulnerable to lax financial regulations. Satyanath says that the chief executive’s decisions face such problems regarding most financial variables, including bank capital, liquidity, and so on. The regulatory regime also encompasses other aspects like transparency of financial decisions, corruption and the vulnerability of financial regulatory to lawsuits brought about by banks. In an authoritarian regime, the chief executive has the powers to bring about stringent regulations. Hence, he is more relaxed in allowing his cronies to engage in less transparent deals and banks to operate with less liquid since he knows that he has the leeway to pull the brake when the need arises. Same is the case when the chief executive has arm’s length relationship with officers, there are no cronies but an authoritarian regime. Then, he would be relatively less constrained to enforce high liquidity with banks or insist on transparency. On the other hand, in a democracy with no cronies, the chief executive’s decision may be blocked by veto players hence he would be more cautious. In such situations, there is the propensity to have lax regulations at all times. Through empirical analyses of democratic countries in East Asia, Satyanath found that non-crony chief executives realized the need for stringent regulations but did not communicate the same to the veto players, knowing that the exercise would be futile in convincing the latter. At the same time, chief executives often had insufficient information and suffered from signaling problems. Satyanath justifies the variations in financial regulation across countries in east Asia by differences in bureaucratic powers. In Singapore and Hong Kong, where financial regulation was stringent, bureaucratic powers were also high. He, however, also concedes to the fact that the stringency of regulations depends also on the amount of “hot money” that the country receives. Countries that have stringent banking regulations are also likely to have limits on the inflow of “hot money” that is short-term capital inflows. However, even in countries like Malaysia and the Philippines, where there were little limits imposed on short-term debt, regulations were not stringent. Satyanath puts across his argument over the signaling preference and the associated problems with empirical analysis of the democracies of Thailand, South Korea and the Philippines, where the chief executives failed to find solutions to the signaling problem, resulting in the financial crisis of 1997-98 even in the authoritarian regimes of Chuan Leekpai, Kin Young Sam and Corazino Aquino respectively. After discussing the failure of the orthodox solutions, Satyanath goes on to discuss unorthodox solutions to the signaling problem with empirical analyses of Indonesia and Malaysia. Finally, Satyanath discusses the orthodox solutions that succeeded in Singapore and Hong Kong. Satyanath finds that there is relatively less support for free movement of capital as there is for trade. For example, Jagdish Bhagwati, a proponent of free trade, is more skeptical over the success of free movement of capital, Satyanath notes. Bhagwati cites the examples of China and Japan, both countries having achieved remarkable growth without capital convertibility. On the other hand, countries that have current account convertibility have less leeway over the exchange rate and interest rates, thereby affecting trade. In the present times of globalization, it has become all the more problematic to regulate the financial sector. In an increasingly inter-linked global economy, it is no longer possible for policy makers to manage their individual economies exclusive of what is happening elsewhere. The macroeconomic indicators of individual countries are greatly influenced by the global economic scenario. With sharing of production capabilities across national boundaries, capital flows are not only related to short-term speculative activities but hinge on actual productions. Therefore, a financial crisis is more likely to trigger a global recession than it did in the 1990s. In particular, with a situation that the United States is the recipient of most of trade flows while Asia more capital flows, the global imbalances in both trade and capital flows bring about the need for even more stringent financial regulations than what Satyanth perceived. Work Cited Satyanath, Shanker, Globalization, Politics and Financial Turmoil: Asia’s Banking Crisis, Cambridge University Press, 2006 Read More