Bad Lending Leading to East Asia Crisis in the 1990s - Essay Example

? Bad Lending Leading to East Asia Crisis in 1990s Introduction The crisis in East Asian is among the most critical events in the recent past. The crisis did not only affect East Asia alone, but it impacted the worldwide crisis in 1990s, among them being like Russia in 1998, Brazil in 1998-1999, and Mexico in 1995. Immediately after the crisis, the international monetary fund assigned the primary responsibility of the crisis to East Asian capitalism, particularly its financial markets. The primary strategy by IMF for the countries hit hardest like Korea, Indonesia and Thailand overhauled the financial system in East Asia (Hopkins 2006, p. 347). The basic diagnosis attributed the crisis to the financial chaos caused by the financial systems riddled by the insider dealings, weak corporate governance, and corruption that caused inefficient spending investment. This weakened stability in the banking system. The economies in East Asia were successful for generations, and the crisis in1997 was unanticipated despite Yung Chul Park (1996) warning against impending crisis. Many foreign investors invested a lot of funds even at the onset of the crisis (Choe and Chinmay 2007, p. 232-255). This paper investigates on the bad lending that led to the financial crisis in East Asia in 1990s. This is because of the success of economies in East Asia that led to massive financial inflows in years leading to crisis, with few warning signs. Background to financial crisis Central to the full understanding of the cause of East Asian crisis is multifaceted evidence on the structure of the incentives used by financial and corporate sectors, which operated in the area. The moral problem magnified the financial vulnerability during the liberalization of the market in 1990s. This exposed fragility concerning the macroeconomic and the financial shocks that occurred between 1995 and 1997. This problem exhibited the three different, yet interrelated dimensions at corporate, the financial and the international level (Choe and Chinmay 2007, p. 232-255). The political pressures at the corporate level maintained high economic growth rates that guaranteed the private projects under government control. Even in the absence of the explicit bail-out promises, strategies and production plans of the corporate sector overlooked the riskiness and the costs of the investment projects. The industrial and financial policy enmeshed in the widespread business sector of political and personal favouritism and markets operated under the impression of their investment returns being insured from the adverse shocks. This represented underpinnings of the sustained process of accumulation of capital leading to account deficits. The investment rate remained high because of the fall in interest rates of neighbouring countries like Japan. As a result, banks borrowed excessively from abroad as well as lending excessively at home (Ichikawa 1998, p. 155-179). Extensive liberalization of the capital markets consistently provided large supply of funds at minimized costs to the domestic, corporate sector and national financial institutions. This motivated the exchange rate policies that reduced volatility of domestic currency in US dollars lowering the risk premium on the dollar-denominated debt. Internationally, moral hazard hinged on behaviour of the international banks. Over the period that led to crisis, international bands rented a lot of funds to the domestic intermediaries in the region neglecting the risk assessment standards. They presumed the direct government guarantee to the short-term interbank liabilities through bailout using the IMF support programs (Ichikawa 1998, p. 155-179). The stagnation of economy in Japan in 1990s lowered the exports from Asian countries. Few months before the crisis in East Asia, economy of Japan declined significantly, thus shattering the recovery process. The fall in ‘semi-conductors’ demand in 1996, and the adverse fluctuations in trade worsened the trade balances between 1996 and 1997. The appreciation of US dollar relative to European currencies and Japanese yen since mid-1995 enhanced deterioration of cost-competitiveness (Iida 2000, p. 423-464). These financial imbalances increased the vulnerability of the Asian countries to financial crisis driven by the deteriorating expectations and sudden switches in sentiment and confidence of the market. In 1997, real estates and the stock market failed drastically, leading to huge losses, as well as outright defaults, within the corporate and the financial sectors. From the summer of 1997 onwards, prompt reversals in financial capitals inflow accelerated the collapse of the regional currencies amidst international and domestic panic (Iida 2000, p. 423-464). The Economic Problem The IMF and other international establishments attributed the crisis in East Asia to financial institutions and banks, as well as the over-speculation of the share market and the real estate. Furthermore, they blamed the government’s collusion with businesses, and the bad policy of fixed exchange rates with high deficits in the current account. They studiously eluded blaming financial markets, the currency speculation, and behaviour by huge institutional investors on crisis (Kochlar, Prakash and Mark 1998, p. 31). The economic fundamentals in the region experienced fatal flaws despite the appraisals few weeks before the eruption of the crisis. The development in global financial system comprising of financial liberalization and deregulation, increasing interconnections of the market and the transaction speed using the computer technology, as well as development of huge financial players like investment banks contributed to crisis in East Asia. This shifted capital blocks across the borders to high and quick returns of US$2 trillion a day. Any efforts towards financial liberalisation by developing country before preparation of the knowledge base expose it to tremendous shocks in financial inflows and outflows (Kochlar, Prakash and Mark 1998, p. 32). A total of US$184 billion entered the Asian countries as the net private capital 1994 to 1996. In 1996, the US$94 billion entered Asian countries while in the first half of the 1997, an entry of $70 billion resulted. The onset of crisis resulted to flow out of $102 billion, and subsequent massive outflow continued (Kochlar, Prakash and Mark 1998, p. 34). Some currencies in East Asia were over-valued, and over-reaction of the market decreased the value of the currency beyond justifiable fundamentals. The hedge funds in Thailand triggered the crisis when Thai government spent over US$20 billion of the foreign reserves in speculator’s attack. Hedge fund made average net profit of 10.3 percent between January to June and jumped to 19.1 percent in July 1997. The profits almost doubled when July was included leading to profit windfall (Kui-Wai and Ming-Lok 2009, p. 172-182). The Description of Major Features Evidence on the imbalances in East Asia in 1990s is described first through the assessment of the current account. The current account deficit resulted to the disruptive tensions in financial markets. This standard reflects the collapse of currencies in many countries, in Asia. The below tables show current account measure expressed as GDP share based on data on balance of payments and national income account (Kui-Wai and Ming-Lok 2009, p. 172-82). Table 1: The national income account (NIA) definition of Current Account (% GDP) Table 2: The Balance of Payment definition of Current Account (% GDP) Based on data from the two tables, Malaysia and Thailand experienced most severe current account imbalances, experiencing a deficit over a decade. From the NIA data, current account in Thailand experienced over 6% GDP almost in every year, and this approached 9% between 1990 and 1996. Malaysia experienced high deficit of over 10% GDP in 1993, and this fell gradually to 3.7% in 1996. Philippines experienced long-term imbalances with a deficit of over 5% for four years, and lasted highly in subsequent years. At the beginning of the decade, Indonesia started with a huge imbalance of over 4%, which shrank between 1992 and 1993 (Kui-Wai and Ming-Lok 2009, P. 172-182). The gap widened thereafter reaching 3-4% between 1995 and 1996. Korea experienced low deficit in early 1990s, which was negligible in 1993. After this, imbalance increased significantly reaching 5% in 1996 Table 3: The Balance of Payment definition of Trade Balance (% of GDP) The data in table 3 reflects the current account imbalances from the large trade deficits. The net factor payments were relatively low. From the countries remaining, Hong Kong started with high surplus that averaged over 7% GDP in 1990-1993, after which the surplus shrank to 2% in 1994, resulting to over 2% deficit between 1995 and 1996. Singapore experienced surplus of 10% GDP between 1990 and 1993 reaching 16% between 1994 and 1996. China had a surplus of 1.5% GDP between 1990 and 1992, and 2% deficit in 1993. Taiwan experienced consistent surplus in 1990s, with a large surplus of more than 4.5% GDP. The data on current account gives preliminary evidence of the currency crisis associated with the external competitiveness. The countries with the highest current account deficits experienced severe attacks in 1997. The depreciation in countries with smaller deficits reduced dramatically. Economic Explanation The assessment of the sustainability of the current account imbalances does not reflect the determination of the current account deficits in speculative outflows and devaluation of the financial crisis. Standard theoretical criterion used to assess the imbalances in the current account is solvency notion. A country remains solvent when discounted value of expected stock of the foreign debt is non-positive in infinitely future. A country accumulating foreign debt at a faster rate than the real cost of borrowing is not expected to be so forever (Kui-Wai and Ming-Lok 2009, P. 172-182). Practically, solvency criterion is not stringent since the inter-temporal constraint budget in a country imposes little restrictions regarding evolution of the foreign debt and current account by a country. The path by the current account towards presenting of discounted value for current and future surpluses in trade is equal to the position in current external debt inconsistency with solvency. Countries run very huge and persistent deficits in the current account and still remain solvent on condition that they generate the trade surpluses in future (Minqi 2007, p. 449-471). Theoretically, solvency notion is loose and is used by analysts as a policy in resorting to more criteria. The non-increasing foreign debt to the GDP ratio practically tests solvency. Under the realistic assumption of interest rate exceeding the growth rate of the output, a stable ratio of debt to GDP is the sufficient condition for existence of solvency. From this condition, solvency may be made operational through calculation of the ‘resource balance gap’ from a country with an increasing debt to GDP ratio. The gap represents the difference between current trade balance and trade surplus required in stabilizing the long-term debt to GDP ratio. Countries with large ratios of deficit to GDP, and debt to GDP, or large difference between real interest and growth rates of the economy experience a very large gap (Minqi 2007, p. 449-471). The calculation of resource balance gap requires assumptions about long-run differentials between real interest rate and growth rate of the economy. Arguments by theoretical and the empirical levels compels a positive differential in steady state irrespective of the observed negative values in short-run. One percent differential between real interest rates and the output growth is conservative but a realistic assumption. Based on these assumptions, adjustment of trade balance required in stabilizing the ratio of foreign debt to GDP is presented as below. Table 4: The Trade Balance; Resource Gap The table 4 above represents the large resource gaps in 1996. This predicts larger figures when the calculation is carried out at the end of 1996. This enhances determination of the resource gap to enhance pre-assessment of the post-crisis scenario. The figure in 1996 does not significantly reflect the induced devaluation to increase the external burden among countries. A recent assessment of current account deficits focuses on sustaining the external imbalances. This is specified through running current account deficit and accumulating the foreign debt in relation to the GDP. Solvency requires running of the trade surpluses by a country in the future. This is through consideration of the foreign debt and current account deficits accumulation. The reversal in the trade balance is consistent with the solvency so as to materialize with sharp change in the current policies and external crisis (Minqi 2007, p. 449-471). Sustainability notion raises complex macroeconomic and issues in analysing the political economy in analyzing the external imbalances. For instance, sustainability can be related to the willingness to pay by country, and the willingness to lend by the creditors. Willingness to pay may be difficult for a potentially solvent country, but not feasible politically to divert the output from the domestic to the external use. The willingness to lend by the creditors in the current terms maintains the assumption in theoretical solvency, and the presumption might not be realistic (Tran 2000, p. 56). Foreign creditors believe that a country fails regarding its liabilities using this presumption that require high default premiums and quit lending. Instead of provision of unified theoretical framework when studying the external imbalances, the sustainability notion approach focuses on empirical analysis of the macroeconomic performances in the crisis episodes aimed at determining the conditions necessary for existence of balance reversals in sharp trade. Using this information, the imbalances in the current account can be assessed in the context of overview of the macroeconomic fundamentals in East Asia region. This includes the growth in GDP, the public and private savings, the inflation, and the extent of openness (Tran 2000, p. 57). Conclusion In view of the East Asian economy, the financial crisis in 1997 and 1998 reflected the distortions in policy and financial structures despite the over-reaction in the market plunging the exchange rates, the asset prices and economic activities causing more severity than the warranted economic conditions. The liberalization of the finances converted the foreign exchange to local currency for the autonomous inflow and outflow of capital. The depreciation of currencies and crisis in debts transformed the crisis in Thailand, South Korea and Indonesia into sudden depreciation of currencies coupled with reduced foreign reserves in the anti-speculation attempts. The depreciation of currency increased the debt servicing burden in terms of the amount of local currency required in repaying the loans. The short-term loans were problematic where foreign funds pulled out sharply causing a fall in the reserves. The countries in East Asia sought the intervention of the IMF when the reserves fell beyond the level that could sustain the obligations of the foreign debts. The control of the external debts serviced the burden in terms of the local currency, and ringgit depreciation worsened the situation further. The financial liberalization was to be limited in extent of the foreign debts and lowering the level of these debts. The boom and bust of the local asset and the squeeze in liquidity saw increased inflows of the foreign funds in the stock markets and loans to the banking system. As the currencies depreciated, there was economic slowdown and loss of the foreign funds. This led to a further decrease in the share prices. The share market declined due to the heavy debts on the local banks, government and the companies that took loans from the foreign investors. Fall in share value pledged as collateral for the loans by the companies, and the fall in the value of the land led to a lot of financial difficulties among the borrowers. Individuals and companies were faced by problems when servicing the loans increasing the degree of non-performing loans. This weakened financial positions of the banks (Hopkins 2006, p. 356). The increased inflation resulted to rise in the prices of imports, and the reduction of the current account deficit reduced budget expenditure in the affected countries. This induced reduction in the current account deficit and added recessionary pressures due to high interest rates. The fall in output was transformed to full-blown recession in real economic production. The turnaround in the current account and the balance of payments acted as the bright spot, and the improvement was priced heavily. The fall in imports caused a trade surplus than the rise in exports in real terms. Improvement in the current account meant the outflow of the short-term funds by locals or foreigners. The easing of the monetary policy and the fiscal power in response to the recessionary conditions would have reduced the recessionary pressures (Tran 2000, p. 57). The crisis in East Asia forms the most crucial economic event within the region, beyond which no unanimity of the root causes and solutions. The crisis transformed into full-blown depression, with the forecasts of the growth of GNP and unemployment being more rampart. The depreciation threats spread from East Asia to South Africa, South America, and Eastern Europe and in Russia (Tran 2000, p. 58). References List Choe, S., & Chinmay, P. (2007). The Transformation of Korean Business Groups after the Asian Crisis. Journal of Contemporary Asia 37(2). pp. 232-255. Hopkins, S. (2006). Economic Stability and Health Status: Evidence from East Asia before and after the 1990s Economic Crisis. Health Policy 75(3). pp. 347-357. Ichikawa, N. (1998). The Financial Crisis in East Asia. Asia-Pacific Review 5(1). pp. 155-179. Iida, Y. (2000). Between the Technique of Living an Endless Routine and the Madness of Absolute Degree Zero: Japanese Identity and the Crisis of Modernity in the 1990s. Positions: East Asia Cultures Critique 8(2). pp. 423-464. Kochlar, K., Prakash, L., & Mark, R. (1998). The East Asia Crisis: Macroeconomic Development and Policy Lessons, Washington, D.C., International Monetary Fund, Asia and Pacific Department. pp. 30-34. Kui-Wai, L., & Ming-Lok, K. (2009). Output Volatility of Five Crisis-affected East Asia Economies. Japan and the World Economy 21(2). pp. 172-82. Minqi, L. (2007). Peak Oil, the Rise of China and India, and the Global Energy Crisis. Journal of Contemporary Asia 37(4). pp. 449-71. Tran, V. (2000). The Asia Crisis: The Cures, Their Effectiveness and the Prospects after. New York: St. Martin's. pp. 56-59. Read More