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• protected or illiquid sectors having low return and long gestation period
(real estate and petrochemicals in Indonesia, Thailand, Malaysia) causing
maturity mismatch between assets and liabilities of the financial
intermediaries,
• Sectors with high or excess capacity having low or negative returns (steel,
ships, semiconductors, automobiles in Korea),
• Non-tradables (such as land, office blocks and condominiums in Thailand)
that generate return in domestic currency and did not generate foreign
exchange;
• Directed lending by chaebols in Korea to maintain their market shares in
automobiles and electronics with inadequate attention to profitability, and
• Speculative and unproductive lending in share markets.
1
• The paper expresses personal views of the author and does not
necessarily reflect the views of the Ministry of Finance, Government of
India.
2
The whole system set the stage for a classic boom-bust cycle in asset
markets. Stock and property prices soared initially then plunged leading to
the currency and financial crisis. These prices plunged even more after the
crisis, and led to deep and wide spread economic crisis and social chaos. The
financial intermediaries, both banks and non-bank, were the creators of this
asset cycle. Liabilities of these financial intermediaries were perceived as
having an implicit government guarantee, but they were essentially
unregulated. They borrowed large amounts of international capital, much of
which was on short-term maturity, denominated in US dollars and not hedged
against currency risks. They lent money to highly leveraged speculative
investors, mostly in real estate.
The difficulties that the East Asian countries face are not primarily the
result of macroeconomic imbalances. Rather, they stem from weaknesses in
financial systems and, to a lesser extent, governance. Although private sector
expenditure and financing decisions led to the crisis, it was exacerbated by
governance issues, notably government involvement in the private sector
and lack of transparency in corporate and fiscal accounting and the provision
of financial and economic data. Thus, the build-up to the difficulties in East
Asia, which eventually lead to the present economic and financial crisis in
these economies and elsewhere, can be traced in four major factors:
3
• Various features of their external economic environment (such as
dependence on exports of automobiles and electronics), that at first were
favourable, turned sour in several respects in 1996 and 1997;
It may be observed from the Table-1 that there were serious macro-economic
imbalances on the eve of the crisis in all the crisis economies. They became
increasingly vulnerable in 1997 to external shocks for the following reasons:
• The current account deficit as a per centage of GDP ranged between 2 per
cent in Korea to 5.2 per cent in Philippines.
• External debt as a per centage of GDP ranged from 34 per cent in Korea to
76 per cent in Indonesia.
Banking sector was subject to high risk and vulnerability to adverse shocks
for the following reasons:
• Ratio of domestic credit to GDP rose to 165 per cent in Korea, 160 per cent
in Malaysia and 157 per cent in Thailand.
4
• Debt to equity ratio reached nearly 400 per cent in Korea compared with
85 per cent in Taiwan, 144 per cent in Germany, 160 per cent in Malaysia,
154 per cent in Sweden, 200 per cent in Japan and 150 per cent in USA.
• On the eve of the crisis, short-term interest rates rose to more than 16 per
cent in Korea and 22 per cent in Thailand.
World was astonished with the speed and extent to which the crisis spread
from Thailand to other countries in the region. The financial and exchange
rate crisis, that began in Thailand in mid 1997, spread to many countries of
East Asia, Russia, parts of Latin America and also affected the economic
health of major industrial economies like Japan, North America and Europe.
Contagion or the Wake up call effect and slipover effects through
intraregional trade and investment linkages have been felt by many
emerging market countries in other region in the form of declining stock
prices and intense pressures on exchange rates, It has adversely affected
their economic growth prospects in 1998 and outlook for future.
The crisis has led to dramatic depreciation of the nominal exchange rates
(Table-1). The sharp movement of the exchange rate has greatly complicated
the macroeconomic policy choices by raising the cost of repaying foreign
debt, weakening the financial and corporate sectors. Remarkably, the CPI
inflation rate since June 1997 has been in the range of 5-12 per cent with the
exception of Indonesia, where the current inflation is running around 80 per
cent. Mexico, by way of comparison, experienced a 40 per cent surge in
inflation during first ten months of its crisis in 1995. Despite large increases
in nominal interest rates in some countries, only Korea and Thailand have
been able to maintain real interest rates as significantly higher levels than
those before the crisis.
For the crisis-hit East Asian economies real GDP growth rates in 1998 are
predicted to be negative, ranging from -5 per cent and -6 per cent in some
5
countries like Thailand to -10 per cent to –15 per cent for Indonesia. These
countries continue to incur massive social and economic costs in terms of
loss of output, acceleration of inflation, rising unemployment, and growing
poverty.
Four main factors as indicated below are responsible for the current
recession:
6
(b) Lack of internal demand as a result of several factors such as:
(c) Problems on the supply side: The corporate sector face considerable
difficulties in responding to demand, mainly due to collapse of financial sector.
There is also the problem of trade finance and internal credit crunch due to
various factors such as:
(d) Political and social factors: Political and social events also played a
significant part in the crisis. While political changes in Thailand and Korea
assisted in stabilising of the exchange rate, with the establishment of a clearly
understood and supported reform programme, political uncertainty in
Indonesia played an important role in the opposite direction. There were signs
of social unrest almost everywhere, although by different degrees.
Unemployment rates are now 3 per cent in Malaysia, 6 per cent in Korea and
15 per cent in Indonesia. Poverty is therefore increasing at an alarming rate.
Indonesia, which had an impressive record of poverty reduction, is expected to
experience a rise in the poverty ratio from 11 per cent to about 16 per cent
within a year (World Bank 1998). The poor are being severely hurt during the
crisis as demand for their labour falls, prices of essential commodities rise,
social services are cut, and crop failures occur due to weather shocks. Social
areas, including ensuring food and medicine supplies, keeping children in
school, and protecting women’s health are key targets for interventions by the
government and multilateral funding agencies.
7
Indian economy remains relatively less affected by the recent economic
crisis in East Asia and elsewhere. After achieving an average growth rate of
about 7 per cent per annum during the Eighth Plan (1992-1997) and 7.7 per
cent per annum in 1994-1997, growth rate of real GDP declined sharply to 5
per cent in 1997-98. But, the deceleration of the overall growth rate in 1997-
98 was mainly attributed to domestic factors such as a decline in agricultural
value added by 1 per cent and sluggish growth in industrial value added at
5.9 per cent in 1997-98. External factors had only marginal impact on the
growth rate of India, as the dependence of GDP on external trade is very
limited. Overall growth rate of GDP is expected to improve to 5.8 per cent in
1998-99 supported by a growth rate of 4.7 per cent in industry, 5.3 per cent
in agriculture and 6.7 per cent in services.
8
• Limited convertibility of Indian Rupee on capital account,
• Firm control on short-term external borrowing and
• Lack of large exposure of Indian banks and financial institutions to
speculative and illiquid sectors such as real estate and share markets.
9
• Basic lesson from the crisis is that the sooner the problems are identified,
recognised and properly treated, the better the chances for being
successful, and the smaller the economic and social costs involved. The
problems are always worse than expected. This seems to be true for both
monetary policy and financial and banking reforms.
• The odds for the occurrence of a financial crisis can be reduced by better
macroeconomic fundamentals, complemented by appropriate legal,
regulatory and institutional set-up for effective prudential regulation,
monitoring, surveillance and supervision of the financial system and
improved corporate governance. These entail structural reforms with an
unavoidably long-time scale.
10
(b) Financial sector reforms
• The linchpin of the crisis is the weak banking and financial system, which
has constrained the monetary authority in conducting monetary policy
and banking supervision as well as facilitating payments system.
• A few lessons for the financial sector reforms are now evident. First, worst
time to reform a financial system is in the middle of a crisis. Second, when
currency turmoil is associated with financial difficulties, raising interest
rates over an extended period may simply worsen the situation by
bringing about widespread corporate and bank insolvency. Third,
currencies should not be left to sink while funds are used to bail out the
international creditors.
• Monetary policy in general is a short run issue, even though it has long-
term implications. Banking restructuring is, however, a long-term problem.
It deals with problems of efficiency, management, supervision, regulation,
law enforcement, banking ethics, etc., which are microeconomic issues.
These have to be considered carefully in designing and implementing
banking reform together with monetary policy.
11
its inflationary consequences and downward pressures on partner
countries’ currencies. For economies with large amounts of short-term
external debt, it is particularly important that monetary conditions provide
adequate incentives for the private sector to roll over short-term foreign
loans in the face of the increase in risk premium.
12
• Fiscal deficits were allowed to increase considerably in all crisis countries,
alleviating the effects of the crisis on real activity. This fiscal expansion
reflects accommodation of the deterioration in fiscal positions resulting
from the recession and exchange rate depreciation.
• Objections that no fiscal tightening was needed because the crises were
made by the private sector and not the result of “government profligacy”
are valid: even if fiscal policy was not part of the initial problem, it was a
useful part of the solution.
• Collaboration and consultation at the regional and bilateral level are also
capable of contributing to the prevention of financial crisis. Their potential
role is particularly important with respect to the prevention of currency
disorders and contagion effects.
13
flows, strong contagion effects of crisis, and increased moral hazard
in international financial markets.
• As mentioned earlier, in all the East Asian crisis economies, weaknesses in financial systems
as a result of weak regulation and supervision and a long tradition of a heavy government role
in credit allocation led to misallocation of credits and inflated asset prices. Another vital
weakness of all countries was associated with large unhedged private short-term foreign
currency debt in a setting where the private corporate sector was highly leveraged.
• Short-term foreign currency denominated debt created two kinds of vulnerabilities in these
economies. First, if some creditors pulled out their money, each individual creditor had an
incentive to join the queue. As a result, even a debtor that had been fully solvent before the
crisis could be plunged into insolvency. Second, such debts also created vulnerabilities
associated with the exchange rate depreciation. Exchange risk was either borne directly by
the financial institutions or passed on to the corporations as the funds was on lent (thereby
converting exchange risk into credit risk). These factors were further complicated by the
interaction of exchange rate and credit risks. Currency depreciation led to wide spread
insolvency and created additional counter-party risk, which in turn added momentum to the
exit of foreign capital.
• The management of debt crisis being faced by the East Asian countries is not without
precedence. Following the inception of the Latin American debt crisis in 1982, and on the
presumption that the debt problem was one of liquidity and not solvency, the initial debt
management strategy aimed at normalising the relationship between the debtors and creditors
through a combination of economic adjustment by debtor countries and negotiations on
financial relief. The financing modalities provided debtor countries with some financial relief
through interest rate spreads, reduced fees, extension of maturities and provision of some new
finances. The negotiations conducted on a case-by-case approach for debtor countries were
co-ordinated by the private bank steering committees in consultation with the IMF, World
Bank and governments of the creditor banks’ home countries (Islam 1998).
• In the context of the current Asian crisis, countries have been succeeded in striking a
reasonably comprehensive debt-rescheduling strategy with creditor banks. The
implementation of the deal is voluntary and all creditors have not joined the scheme. So long
as free movement of international capital is allowed, there is no guarantee that the debt crisis
will not recur in future. Whenever such a financial crisis occurs in future, it is necessary to
formulate an international debt management strategy on the basis of negotiations among
international private lenders, investors and borrowers for sharing the responsibility for debt
relief, for rescheduling or for delaying claims on repayment.
• In the case of the present East Asian crisis, considerable thought is being given to
mechanisms that involve private sector to forestall and resolve crisis in a more timely and
14
systematic way. A range of options are available in this respect, viz. (a) to contract credit and
swap facilities with groups of foreign banks, to be activised in the event of liquidity
pressures, such as those contracted by Argentina and Mexico; (b) embedding call options in
certain short-term credit instruments to provide for an automatic extension of maturities in
times of crises; (c) feasible modifications of terms of sovereign bond contracts to include
sharing clauses; and (d) a possible role for creditor councils for discussion between debtors
and creditors. However, these are complex issues and need to be designed carefully so that
there are no perverse incentives, which may encourage private creditors to bail themselves
out at the first sight of difficulty, rather than providing net new financing in the event of a
crisis.
• All countries need to monitor very carefully short-term debt, long-term debt by residual
maturity, all guarantees and all contractual contingent liabilities arising out of both debt and
non-debt creating financial flows.
• A more comprehensive approach is needed when trying to deal with excessive private
borrowing and risk taking in the presence of large capital inflows and weak financial
systems. This often means applying more flexible exchange rates, tighter fiscal policy and
improved financial system. Domestic financial sector liberalisation should also proceed
carefully and in step with tighter financial regulation and supervision, and internationally
recognised prudential norms for capital adequacy and provisioning for non-performing
assets by commercial banks and financial institutions.
• We can conclude with the following observations made by the World Bank in their Report on
Global Economic Prospects and the Developing Countries (1999):
“The most pressing issue is to develop better mechanisms to facilitate private-to-private debt
workouts, including standstills on external debt under some conditions, and to restore capital
flows and increased international liquidity to countries in crisis. Although there are some
compelling arguments for a lender of the last resort, difficult issues arise for appropriate burden
sharing, the rules for intervention, and the avoidance of moral hazard. Improved regulation by
creditor country authorities and better risk management of bank lending to emerging markets
should also help reduce probability of crisis. More timely and reliable information is desirable,
but complete transparency and better information alone will not prevent a crisis”.
“The main lessons of the crisis are that countries need to build and strengthen regulatory and
institutional capacities to ensure the safety and stability of financial systems, especially at the
interfaces with international financial markets; and that the international architecture to prevent
crises and deal with them needs to be strengthened more effectively”.
15
Table-1: Major macro-economic variables in India and East Asian countries in 1997
(In per centage, unless mentioned otherwise)
16
Table-2: Basic Indicators of the Indian Economy 1991-1998
(In per cent)
Variables 1990- 1991- 1992- 1993- 1994- 1995- 1996- 1997- 1998-
91 92 93 94 95 96 97 98 99*
GDP growth rate 5.4 0.8 5.3 6.2 7.8 7.6 7.8 5.0 5.8
Agricultural growth 3.7 -2.0 4.1 3.8 5.4 0.2 9.4 -1.0 5.3
Industrial growth 8.2 0.6 2.3 6.0 9.3 12.2 6.0 5.9 4.7
rate
Infrastructure 4.8 6.1 2.5 5.0 9.1 7.9 2.6 4.8 2.5
growth rate
Savings/GDP ratio 22.3 21.0 20.3 21.8 24.2 24.1 24.1 23.1 23.5
Investment/GDP 25.5 21.5 22.1 22.4 25.4 25.8 25.7 24.8 25.0
ratio
Fiscal deficit/GDP 7.7 5.4 5.2 6.9 5.6 4.9 4.7 5.5 6.0
ratio (Central govt)
Internal debt/GDP 48.6 47.4 46.8 49.1 47.0 45.6 44.1 45.9 45.8
ratio (Central govt.)
CPI inflation rate 11.6 13.5 9.6 7.3 10.3 10.0 9.4 6.8 10.0
Market cap (Rs.bn) 1103 3541 1771 3983 4331 4710 4639 4910 5000
Exports growth rate 9.2 -1.1 3.3 20.2 18.4 20.3 5.6 2.1 0.5
Current A/C as % of -2.9 -0.3 -1.7 -0.4 -1.0 -1.6 -1.1 -1.6 -1.4
GDP
Forex currency 2.2 5.6 6.4 15.1 20.8 17.0 22.4 26.5 26.8
assets ($ bn)
FER cover (no. Of 2.5 5.3 4.9 8.6 8.4 6.0 6.5 6.9 7.0
months)
External debt/GDP 27.3 37.7 36.6 33.1 30.0 26.3 23.8 23.8 23.5
ratio
Non-debt capital as 1.2 2.9 13.2 42.9 60.0 155.4 56.6 48.2 21
ratio total cap. flow
Debt-service ratio 35.2 30.2 27.5 25.6 26.2 24.3 21.2 19.5 18.5
Short-term debt as % 10.2 8.3 7.0 3.9 4.3 5.4 7.2 5.4 3.7
of total external debt
Short-term debt as % 147 77 65 19 17 23 25 17 12
of FE assets
Foreign invest ($ bn) 0.1 0.1 0.6 4.2 4.8 4.6 5.8 5.0 2.0
Foreign direct inv. 0.1 0.1 0.3 0.6 1.2 1.9 2.5 3.2 2.2
Portfolio investment 0 0 0.3 3.6 3.6 2.7 3.3 1.8 -0.2
17
Selected Bibliography
_______ (1998c) How has the Asian crisis affected other regions?,
Finance and Development, Volume 35, Number 3, September 1998,
Washington D.C.
_______ (1998d) Mitigating the social costs of the Asian crisis, Finance
and Development, Volume 35, Number 3, September 1998,
Washington D.C.
Islam, Azizul (1998) The dynamics of the Asian economic crisis and
selected policy implications, paper presented at the Expert Group
Meeting on “What have we learned one year into the emerging market
countries financial crisis?” 21-23 July 1998, United Nations, New York.
18
Kochhar, Kalpana; Loungani, Prakash, and Stone, Mark R. (1998) The
East Asian Crisis: macroeconomic developments and policy lessons,
IMF Working Paper.WP/98/128, August 1998, International Monetary
Fund, Washington, D.C.
Lissakers, Karin (1998) The IMF and reforming the global financial
architecture, Economic Perspectives (Electronic Journal), September
1998, United States Information Service, New Delhi.
Neiss, Hubert (1999) IMF in Asian monetary crisis: current and future,
pp.1-17, in Asian Economic Crisis: In Search of Higher Competitiveness
in Global Markets, Asian Productivity Organisation, Tokyo, 1999.
Sadli, M (1999) The Asian crisis and the way to recovery, pp.25-35, in
Asian Economic Crisis: In Search of Higher Competitiveness in Global
Markets, Asian Productivity Organisation, Tokyo, 1999.
Stiglitz, J.E. (1998) South Asia beyond 2000: lessons from East Asia and
elsewhere, Keynote Address to South Asia Beyond 2000, Colombo, Sri
Lanka, 19 March 1998.
World Bank (1998a) Social Consequences of the East Asian Crisis, September
30, 1998, Washington D.C.
World Bank (1999) Global Economic Prospects and the Developing Countries,
December 1998, Washington D.C.
19