II. Ten Years After the Crisis: How Much Stronger Is Asia?
- International Monetary Fund. Asia and Pacific Dept
- Published Date:
- October 2007
Ten years ago, the forced devaluation of the Thai baht set in motion a devastating external and financial crisis that engulfed much of emerging Asia and spread beyond the region’s borders. Through most of Asia, but most notably in Korea, Indonesia, Malaysia, the Philippines, and Thailand, output contracted, a number of financial and nonfinancial businesses went bankrupt, and unemployment and poverty increased significantly. In response to the crisis, most of the affected countries turned to the international community for large-scale financial assistance in the context of economic adjustment programs.
A decade later, the recovery from the crisis has on most accounts been impressive. It took some time to appreciate that this was a new type of crisis, one driven by financial rather than current account imbalances, and for confidence to be restored. Within a couple of years, however, supported by comprehensive structural reforms and nimbler macroeconomic policy frameworks, most of the crisis economies started to grow again, with attendant declines in unemployment and poverty. In the financial sector, nonperforming assets were dealt with, directed lending curtailed, and banking systems recapitalized and privatized. As a consequence, Asia is today, once again, the most dynamic region in the world, accounting for close to half of global growth.
Yet skepticism has emerged in various circles about the sustainability of Asia’s post-crisis growth model. Some prominent commentators and academics have questioned whether Asia has learned the right lessons from the crisis, and have warned about the possibility of a new crisis (Box 2.1). One of the main criticisms is that emerging Asia has failed to heed the need for flexible exchange rates, and is instead relying on large but only partially sterilized foreign exchange intervention to keep its currencies “competitive.” This growth strategy is argued to be making Asia highly vulnerable to external demand shocks, while feeding into large global imbalances and potentially stoking a protectionist backlash. Moreover, the run-up in liquidity resulting from reserve accumulation is thought to be leading to credit booms and asset market bubbles, putting the region at risk of a new deflationary bust triggered by sharp falls in investment and/or asset prices, declining confidence, and a buildup of nonperforming loans in banking systems. In addition, perceptions that emerging Asia’s financial systems remain insular and underdeveloped, and that its economies continue to be dogged by weak governance, are commonly cited fault lines. It is important to note that most of these commentators use the term “crisis” loosely, so that the quantitative scenario they have in mind when referring to a possible “crisis” in Asia is not always clear—in particular, whether what is being envisioned is a 1997-style meltdown, or a sharp, but less dramatic, slowdown along the lines experienced in the aftermath of the dot-com bust in 2001.
Box 2.1.A Selection of Recent Asia Critiques
“Indeed, the currency and financial policies in Asia today are risking planting the seeds of a new and different financial crisis in the region in the medium term … or even in the short term if global shocks such as a U.S. hard landing take place … So what are the problems with the current Asian economic, currency and financial model? The answer is, in brief, the effective return to fixed exchange rates in spite of the rhetoric of a move to floating rates. First, this new model is leading to excessive monetary and credit growth, asset bubbles in stock markets, housing markets and other financial markets that will eventually lead to a build up of financial vulnerabilities that could trigger a financial crisis different from that of 1997–98 but that could be potentially as severe. Second, excessive reliance on net exports and production of capacity for exports is dangerous for several reasons: it makes Asia now reliant on the U.S. for its growth [and] increases the risks of a protectionist backlash in the U.S. and Europe.” Nouriel Roubini (2007), New York University.
“Ten years after the 1997 crisis, Asia is booming again. It is still at significant risk but any new crisis will take a different form. The trigger would be a sharp drop in asset valuations. The obvious place for a problem to originate is China, given the rapid run-up in equity prices there and the highly imperfect nature of the information environment … But there are reasons to ask whether such a large increase in the capital stock, mobilized in short order, can de deployed safely. One can imagine a variety of economic, financial and political shocks that could transform investors’ positive views of this question. Asset valuations would fall sharply. Investment would fall sharply. China’s growth would fall sharply. These events could compound, and in turn be compounded by, problems in the banking and financial system How common are these problems to other Asian countries? Since Asian stock markets are highly correlated, major asset price drops in China would all but certainly be accompanied by major drops elsewhere in the region … Major recessionary implications would follow if the stability of the financial system, and particularly banks, is undermined.” Barry Eichengreen (2007), University of California at Berkeley.
“The Asian financial crisis of 10 years ago taught two contrasting lessons: the one the majority of western economists thought the Asians should learn; and the one Asians did learn. The western economists concluded that emerging economies should adopt flexible exchange rates and modern, well-regulated and competitive financial markets. The Asians decided to choose competitive exchange rates, export-led growth and huge accumulations of foreign currency reserves … One instrument they have used has been sterilization of the monetary consequences of reserve accumulations, to prevent the normal expansion of money and credit, overheating, inflation and so loss of external competitiveness … The post-crisis policy system has proved more durable than many expected. At its heart, however, is China. Though not affected directly by the crisis, it was one of the countries that learnt its lessons in the Asian way. I do not believe these astonishing trends are desirable or sustainable.” Martin Wolf (2007),Financial Times.
“Asia’s economic outlook has improved from a decade ago. However, the economic and financial policies and institutions of the countries in the region remain underdeveloped and untested. Banking and financial systems are better prepared, but far from robust. Banks and their customers are now exposed to sudden exchange rate appreciations rather than depreciations. In some cases, balance sheets remain excessively reliant on government obligations. Despite the improvements in corporate governance, the investment climate remains weak.” Edwin Truman (2007), Peterson Institute for International Economics.
“It is therefore important to try to identify sources of new risks to economic stability … In the case of Thailand, … [the] first issue has to do with political interference in financial institutions. The main targets for political interference are the state-owned commercial banks and the specialized public financial institutions.” Sussangkarn and Vichyanond (2007), Thailand Development Research Institute.
It should be noted that other prominent academics have held much more positive views about the sustainability of current policies in Asia. For instance:
“Indeed, the academic literature and financial press are now littered with discarded, once-authoritative opinions on how the system would soon end from its own weight … When this failed to happen, they produced long lists of reasons of why it might collapse at any moment: saving exporting countries would overheat, [and/or] official sectors in either savings exporting or importing countries would react to the negative effects on their economies… The idea that the system we describe is inherently unstable is logically flawed, in our view, and in any case has not been supported by the last seven years’ events.” Dooley, Garber, and Folkerts-Landau (2007), UC Santa Cruz and Deutsche Bank.
This chapter argues that emerging Asia has made much progress in tackling the financial and structural imbalances that led to the 1997 crisis, and that while new vulnerabilities have emerged, they are in most cases manageable since the region is much more resilient than 10 years ago.12 Indeed, Asia’s comfortable external positions and large stocks of external reserves should act as an important buffer in the face of any severe shock.
Key Lessons from the Asian Crisis
At the outset, it is important to highlight one wrong conclusion that Asian countries fortunately did not draw from the crisis—namely, that it was safest to withdraw from globalization. Despite the crisis, Asia did not turn its back on the outward-looking orientation that propelled its spectacular rise on the world’s economic stage. Asia’s share of global export markets has increased significantly since the crisis, as has its integration with international financial markets. Significantly, no country concluded that permanent capital controls were desirable—even Malaysia, the one country that did impose such controls during the crisis has been steadily dismantling them over the last decade. Instead, the reforms undertaken in the region over the past decade have been geared to equip it to benefit more from globalization and to cope with its attendant risks.
More directly, the main lesson of the Asian crisis was that financial imbalances can wreak havoc on an economy, even one with seemingly sound macroeconomic fundamentals. The specifics of the crisis differed from country to country, with banking and real estate imbalances being a more prominent story here, and corporate imbalances, there. However, there was a common theme running across most of the affected economies: these countries had accumulated large unhedged foreign exchange liabilities, as domestic interest rates were higher than international rates and very tightly managed fixed exchange rates had conveyed a false impression of no exchange rate risk. This run-up in foreign currency liabilities was used to support excessively leveraged positions, seen for example in high corporate debt-to-equity ratios across the region. In addition, implicit state guarantees and lax supervision prevented risk from being priced efficiently. Currency devaluations, once they occurred, dramatically eroded leveraged balance sheets loaded with such liabilities, and led to large contractions in domestic demand. In some countries, the devaluation was triggered by international investors’ concerns of overappreciated real exchange rates and widening current account deficits; in others, maturity mismatches precipitated the fall when loans were not rolled over. A general lack of transparency about the true level of external debt and usable reserves compounded investors’ fears and contributed to the abrupt withdrawal of international capital.
Accordingly, we focus on four dimensions—exchange rate flexibility, deleveraging, shifting away from unhedged foreign currency borrowing, and improvements in transparency and governance—to assess the extent to which Asia has reduced the vulnerabilities that triggered the crisis. Starting with the first, while most Asian economies have intervened heavily in foreign exchange markets and built up large international reserves, many have also allowed for increasing exchange rate flexibility, with considerable appreciations taking place.13 Limiting our analysis to the countries most affected by the crisis, Korea and Indonesia’s real effective exchange rates have appreciated by some 30 percent since early 2002, Thailand’s by more than 20 percent, and the Philippines’ by some 15 percent. To put these appreciations in international perspective, only seven non-Asian emerging countries have experienced real effective appreciations larger than 20 percent over the same period. China and Malaysia have been exceptions to this trend, yet since 2005 the renminbi and the ringgit have appreciated gradually against the U.S. dollar. However, as the IMF has repeatedly argued, there is room for further flexibility, which would benefit these countries first and foremost.
Figure 2.1.Crisis-Affected Countries: Nominal Exchange Rates, 1994 – 97
(U.S. dollars per national currency; January 1994=100)
Source: Bloomberg LP.
Figure 2.2.Crisis-Affected Countries: Nominal Exchange Rates, 1999 – 2007
(U.S. dollars per national currency; January 1999=100)
Source: Bloomberg LP.
On-balance-sheet leverage has also declined substantially since the crisis. Corporate debt-toe-quity ratios, for instance, have fallen sharply throughout the region. While corporate deleveraging has been a global phenomenon in recent years, no region in the world has seen declines as pronounced as those in Asia, partly because none suffered as much from the consequences of excessive corporate leverage. Not surprisingly, corporate deleveraging has been accompanied and aided by increases in corporate profitability. An examination of households’ leverage is also warranted: after all, crises never repeat themselves, and lower corporate leverage is no guarantee of stability if leverage has been transferred to another sector of the economy. Limited flow of funds data show that, in most countries, household debt has not increased much relative to GDP or to disposable personal income, and increases in household assets have often more than compensated.14 This being said, stable or rising asset-to-liability ratios may mask important vulnerabilities caused by rapid increases in specific segments of household debt, as witnessed by the sharp economic slowdowns caused by the credit card crises in Korea and Taiwan Province of China.
Figure 2.3.Crisis-Affected Countries: Corporate Debt-Equity Ratio1
Source: IMF, Corporate Vulnerability Utility database.
1 Nonfinancials. Simple average of Indonesia, Korea, Malaysia, Philippines, and Thailand.
Figure 2.4.Selected Asia: Household Assets-Liabilities Ratio
1Financial assets only.
The share of borrowing done in foreign currency has fallen sharply in the region. This is particularly true in Thailand, where foreign currency loans to firms operating in nontradable sectors, such as real estate, were quite prevalent before the crisis. Moreover, most countries have imposed much tighter foreign exchange exposure limits on banks since the crisis, and derivatives markets have become broader and deeper, allowing for more hedging of the existing stock of foreign exchange liabilities.
Figure 2.5.Foreign Currency Loans
(12-month percent change)
Sources: CEIC Data Company Ltd; and IMF country desks.
1July 2007 for Malaysia.
Financial sectors have recovered markedly from the consequences of the crisis, but there are lingering weaknesses. Bank recapitalizations and privatizations, changes aimed at curtailing distorted lending, improvements in supervisory and regulatory standards, and the opening of the sector to foreign capital have led to marked declines in nonperforming loans, significant improvements in capital ratios and profitability, and financial innovation more generally. At the same time, nonperforming loan ratios remain relatively elevated in all the crisis countries except Korea, suggesting some scope for further strengthening of banking sectors. Looking forward, it is worth noting that current regulatory and supervisory practices in the region could be strongly tested by the rise in complex, off-balance-sheet financial flows, as appears to be the case now in other regions of the world. Early indications that Asia has a limited direct exposure to U.S. subprime assets (Chapter I) should not lull the region into complacency, as evidence points to substantial increases in both the sophistication and the embedded risk in crossborder financial flows in Asia (Box 1.2).
Figure 2.6.Nonperforming Loans Ratio
Sources: CEIC Data Company Ltd; the World Bank; and IMF country desks.
1World Bank estimate for Korea for 1998.
There have also been some improvements in transparency and governance. Asian authorities now routinely publish more high-frequency information, including about their external debt and reserves. Also, many of the region’s central banks have moved to inflation targeting frameworks, so statements about monetary conditions and policy developments are now published regularly. At the same time, Asian countries have undertaken important efforts to improve corporate governance by limiting cross-shareholding, raising accounting standards, and strengthening shareholder rights. However, more remains to be done, particularly in the public sector: along five of six important dimensions—voice and accountability, political stability, government effectiveness, regulatory quality, rule of law, and control of corruption—emerging Asia ranked lower in 2006 than in 1996.
Figure 2.7.Emerging Asia:
Corporate Governance Ratings1
Source: Asian Corporate Governance Association.
1 Ratings range from 0 (lowest) to 10 (highest).
Figure 2.8.Emerging Asia: Governance Indicators1
(12-month percent change)
Source: World Bank, Governance Indicators database.
1 Excludes China.
In short, most countries in the region have in the past decade achieved greater exchange rate flexibility, lower leverage with less recourse to unhedged foreign currency borrowing, more resilient financial sectors, and some improvements in transparency and governance standards. In so doing, and coupled with comfortable current account positions, relatively low levels of short-term external debt, and ample reserves, they have removed significant sources of potential vulnerability.
Yet, as noted earlier, some prominent commentators fear that Asia’s export-oriented strategy is sowing the seeds of a new type of crisis, one triggered by shocks to external demand or the bursting of credit and asset bubbles propped up by the large accumulation of reserves needed to sustain competitive exchange rates. We examine these concerns below.
The Challenges Ahead
It is true that the region is dependent on external demand. Emerging Asia remains reliant on exports as a source of growth, although to varying degrees. This reflects several factors: large real depreciations coupled with collapsing domestic demand in the immediate aftermath of the crisis (in emerging Asia excluding China, investment rates never completely recovered from pre-crisis levels, for reasons not fully understood; see IMF, 2006); strong productivity gains in tradable sectors that have led the region to gain market share in global export markets; and, in a number of countries, a policy mix that has tended to favor the export sector. Moreover, growing intraregional trade does not necessarily provide a strong buffer against shocks to external demand. This is because in Asia it is by and large dominated by trade in intermediate goods, in a vertically integrated system of regional supply chains geared toward the rest of the world, notably the United States and the European Union, with China playing a key platform role (see Chapter IV).
Figure 2.9.Emerging Asia Excluding India: Real GDP and Real Export Growth
(Year-on-year percent change)
Source: IMF, WEO database.
Shocks to external demand have in the recent past caused sharp slowdowns in the region, although there are grounds to be guardedly optimistic for Asia if growth in the United States were to falter. In 2001–02, a roughly 4 percentage point decline in U.S. growth led to a 3½ percentage point fall in emerging Asian growth, excluding China. However, several factors contributed to this large effect: growth in Europe and Japan was strongly affected by the dot-com bust, and hence these areas were unable to provide a buffer for Asia; the shock to global demand was concentrated in electronics, a key component of Asian exports; and, finally, domestic demand in the region was barely starting to recover from the Asian crisis. A stronger global economy than in 2001 and healthier domestic demand in Asia should help the region better confront a possible sharp U.S. slowdown this time around, but talks of decoupling remain premature given Asia’s strong dependence on exports and the growing importance of international financial linkages, which are particularly relevant now.
Figure 2.10.Real GDP and Electronics Exports Growth
(Year-on-year percent change)
Sources: CEIC Data Company Ltd; and IMF, WEO database.
The claim that partially sterilized reserve accumulation is fueling large increases in liquidity and credit does not characterize the region as a whole. Only in China and, particularly, India and Vietnam have money and credit aggregates been running substantially faster than nominal GDP, even though there are signs that credit growth in India is cooling. Moreover, in the case of India these trends may have been supported by rapid financial deepening from a relatively low level of development. (In the case of China and Vietnam, in contrast, the strong growth of money and credit aggregates reflects rapid but only partially sterilized reserve accumulation.) In the rest of the region, broad money and credit growth have remained relatively subdued despite rapid growth within specific segments, such as mortgage and small and medium-sized enterprise lending in Korea, or automobile and credit card lending in the Philippines. Concentrated run-ups in lending have in the recent past been enough to cause significant economic slowdowns as witnessed by the previously noted credit card crises in Korea and Taiwan Province of China, and call for tight supervision.
Figure 2.11.Credit to Private Sector
(Year-on-year percent change)
Sources: CEIC Data Company Ltd; and IMF, International Financial Statistics
The evidence that housing markets in the region are in the midst of a bubble is also mixed. IMF (2007a) finds that, by and large, housing prices in Asia have not risen much relative to overall prices, rents, or incomes. Only Australia, India, and New Zealand have shown particularly rapid house price appreciations at the national level, although in Australia real prices have fallen in recent years in some key cities, and in India housing markets are reportedly cooling.15 In some other countries there have been pockets of rapidly rising housing prices, including Beijing and Shanghai in China—where the pace of appreciation has slowed—as well as highend housing in Seoul, Hong Kong SAR, and, more recently, Singapore. As IMF (2007a) argues, there may be valid structural reasons for these localized booms, although it is impossible to dismiss the claim that some of the price appreciation has been driven by speculative dynamics. And in some cases, the localized boom accounts for a significant share of the national housing stock.
Figure 2.12.Real House Prices and Real Income, 1999–2007 1
(Average annual percentage growth)
Sources: CEIC Data Company Ltd; and IMF staff calculations.
1 June 2007 or latest available data.
2Japan house prices proxied by Tokyo Metropolitan Area.
Stock markets in Asia have seen substantial appreciations, reflecting the boom in global liquidity. Emerging Asia indices have tripled since the start of the global bull market in 2003, but the run-up substantially trails those in other emerging markets. While the price-earnings ratios do not appear grossly out of line with historical averages, they are higher than in other emerging markets and many mature markets. This is particularly true in China, where current price-earnings ratios can only be rationalized under very optimistic beliefs about future corporate profitability. Given still-limited share ownership in the country, the macroeconomic impact of a stock market correction through wealth effects would, a priori, be contained, but confidence effects could be larger.
Figure 2.13.Stock Market Indices
Source: Bloomberg LP.
1MSCI U.S. dollar basis.
Figure 2.14.Price-Earnings Ratio
Sources: CEIC Data Company Ltd; and Datastream.
1 Based on MSCI country index.
Overall, therefore, evidence of significant credit and asset booms seems concentrated in a few countries but does not seem to characterize emerging Asia as a whole. Yet even in economies where significant challenges are not evident, the situation will need to be monitored closely by policymakers, and policies geared toward preserving stability. A particular challenge is likely to be coping with continuous capital inflows, including through exchange rate flexibility and steps to further liberalize outflows. In India and, in particular, China, which is the focus of many Asia-skeptics’ attention, the evidence of a credit and asset boom seems stronger than elsewhere. However, while the medium-term challenges in these countries are real, the short-term vulnerabilities should not be overstated.
In China, rapid money, credit, and asset price growth are the financial counterparts to an unbalanced growth path. The consumption-to-GDP ratio is one of the lowest in the world at such levels of income and has been falling rapidly, while investment has been growing at an unprecedented pace aided by artificially low costs of capital, land, and energy, as well as an undervalued exchange rate. It is in China’s interest, therefore, to progressively rebalance the economy away from inefficient investment in tradables and toward consumption and efficient investment. Yet while these imbalances, if unchecked, will carry with them a rising probability of a large correction, the short-term risk of such an outcome appears limited: the external and fiscal positions are very strong, and foreign exchange reserves, now at $1.4 trillion, are the highest in the world. Moreover, much progress has been made in recent years in improving the health of the banking sector, and hence its ability to absorb losses.
In India, credit and asset price growth remain rapid despite some cooling in recent months, but these developments should be set in the context of balanced macroeconomic growth benefiting a broad range of sectors and components of demand, perhaps reflecting widespread productivity improvements. Moreover, the current account deficit remains small for a country growing at close to 9 percent a year, and the deficit remains readily financed by private flows—indeed, overfinancing of the deficit in recent years has led to a large accumulation of foreign exchange reserves.
Figure 2.15.(In percent of GDP)
Source: IMF, WEO database.
On balance, Asia has learned many of the key lessons from the crisis, and, while vulnerabilities exist within countries, the region is far more resilient to shocks today. By and large, Asia has come a long way over the past decade, as a result of major financial and corporate sector reform and significant improvements in macroeconomic policy frameworks. More flexible exchange rate regimes have cushioned external shocks and an impressive war chest of official reserves has been built up; short-term external debt has been reduced significantly; inflation targeting has provided a monetary anchor in many cases; and fiscal policies have taken on a longer-term perspective to safeguard debt sustainability. At the same time, the level of risk awareness among policymakers and private sector agents across Asia has also increased markedly. These improvements militate against systemic risks to the region’s economies, although a slowdown cannot be ruled out, particularly under current global conditions. In the near term, therefore, Asia’s economies appear to be on a less precarious footing than sometimes imagined. This, however, should not mask important challenges facing the region. Asia remains too dependent on exports as an engine of growth, and a concomitant rebalancing appears more needed than ever, not least through higher exchange rate flexibility. Financial sectors, while in stronger shape than in the past, will need to be developed further if the region is to cope successfully with increasingly complex and volatile capital flows. Policymakers in the region are acutely aware of these challenges and the need to guard against complacency, as crises seldom repeat themselves but rather tend to emerge from previously underappreciated sources of vulnerability.