Speech for Asian Network of Economic Policy Research (ANEPR) 2003-2004,
16 January 2004, Tokyo, Japan
The subject of my remarks tonight is "Applying key lessons from the 1997-98 Asian Crisis to the current and near future Chinese economy."
Missing links between Miracle and Crisis
In 1993, the World Bank published "East Asian Miracle." Only several years later, the Asian financial crisis surprised everybody. What happened during such a short interval period? What was a link between the Miracle and the Crisis which everybody failed to capture and missed? By analyzing the missing links, we will be able better to identify both strengths of East Asian economies as revealed by the 30 years-sustained high growth and their weaknesses as revealed by the Crisis. Only when we can coherently analyze such two apparently contradictory phenomena, we could successfully design the post-crisis paradigms in Asia. Furthermore, we can apply such coherent analysis to the case of China in order for her to continue to achieve her sustained high growth without suffering from a serious financial crisis.
The basic characteristics of the Miracle performance during 1960-96 are well-known：(1) about 4 % annual growth of output per labor, (2) supported by high capital accumulation, both physical and human, (3) the growth of total factor productivity of above 1 % per annum which was higher than that of the average of OECD countries, suggesting East Asian economies were catching up with international technology frontier and (4) strong macroeconomic fundamentals such as largely balanced fiscal budget, 5~6 % inflation rates, and high domestic saving rates at around 35 % of GDP. Latin America, Africa and South East Asia had never shared these characteristics of the East Asian Miracle.
Immediately after the Crisis, it was argued that Asian crony capitalism was responsible for it. However, such argument is not be convincing without analyzing how the same cronism successfully achieved the Miracle performance which was not shared by other developing regions.
Two angles for analyzing the missing links
In my view, the missing links can be analyzed from two angles: first, international monetary macroeconomics combined with the balance-sheet approach, and second, an institutional evolution approach. For the former angle, I have developed the concept of a capital account crisis, to be distinguished from conventional current account crises. For the latter angle, I have developed the concept of institutional gaps which are apt to emerge between new risks induced by financial liberalization and deregulation, on the one hand and the capacity of the pre-existing institutional infrastructure which can not manage such new risks, on the other. The latter angle of institutional evolution and the concept of institutional gap can capture dynamic functional changes in the triangle relationships among government, family businesses and banks under both domestic financial and capital account liberalization.
Capital account crisis
Capital account crisis starts with capital inflows with two distinct macro- and microeconomic features. First, the volume of net capital inflows is "massive" in a sense that such inflows exceed the size of the underlying current account deficit, resulting in the overall balance of payment surplus. This overall surplus leads to either increases in the base money, bank credit and money supply and hence the expansion of domestic absorption under fixed exchange rate regime or leading to currency appreciation under flexible regime. Therefore, the actual current account deficit widens at any rate, driven by such massive capital inflows, not by poor macroeconomic fundamentals. The massive capital inflows were attracted by East Asia higher interest rates than dollar rates against the background of the Miracle performance, which also convinced marketeers of the maintenance of their fixed exchange rate regimes.
The second feature is microeconomic in nature, that is, the composition of the massive capital inflows is dominated by short-term, dollar-denominated bank loans, giving rise to both maturity and currency mismatch in the balance sheets of domestic borrowers, either banks or enterprises in host countries. Once capital flows reverse themselves, however, the overall balance of payments will turn into a deficit and hence declines in foreign reserves ie causing not only international liquidity crisis but also domestic banking crisis for two reasons. Firstly, bank loans can not be easily priced or sold in the marked due to information asymmetry between banks and potential buyers in the market regarding idiosyncratic characteristics of individual bank loans. Secondary, once external reserves are drained, currency depreciates, which in turn expands dollar-denominated liabilities in terms of domestic currency. Thus, twin crises are entailed.
But what triggers the reversal of capital flows? Some economists claim that the current account deficit became larger and un-sustainable before the crisis, but this was a symptom driven by massive capital inflows. The trigger was the turnaround of the conventional business cycle accompanied by asset price bubble in host countries, from an expansionary to a contractionary phase. The uniqueness of this domestic business cycle lay in the sheer fact that the expansionary phase and asset bubble in the 1990s were in their large proportions financed by the aforementioned capital inflows. Once the business cycle in a host country turned downturn, banks started to slow down the extension of loans as usual, but this time including massive foreign banks' loans. This process was exercabated by speculative capital movements. The result was the abovementioned twin crises, deepened by the downward spiral of the deterioration of the balance sheets of domestic banks and enterprises in host countries.
The swing of capital movements from inflows to outflows amounted to about 15 % of GDP of the crisis-hit Asian countries on average in just one year or so, during which the value of currencies collapsed by 50 % or more and the twin crises caused domestic absorption to collapse, leading to a sharp decline in import demand by the crisis-hit Asian economies. Correspondingly, the current account turned from large deficits into even larger surpluses in the absolute amount in just one year or so, driven by the sudden reversal of massive capital flows.
The nutshell of the capital account crisis
In the nutshell, the capital account crisis is 180 degrees different in nature from the conventional current account crisis. The latter crisis is caused by poor macroeconomic fundamentals, whereas the capital account crisis is featured by massive capital inflows first attracted by the Miracle performance including good macroeconomic fundamentals, then followed by the sudden massive reversal of capital flows, causing the downward spiral of the balance sheets and hence the serious twin crises. Because of this nature of the capital account crisis, which has little to do with poor macroeconomic fundamentals including government budget, the Asian capital account crisis stands in sharp contrast to either the first or the second generation models of currency crises and hence very different from Russian, Brazil, and Turkey crises in recent years which are essentially the hybrid of the second generation model crisis and a capital account crisis. Despite the fact that the key difference lies in the pre-crisis government budget situation between the Asian and the other recent currency crises, the IMF has labeled all these recent crises as capital account crises. This labeling is misleading not only in analysis of the nature of crisis but also in providing policy prescription or conditionalities, as actually seen in the IMF conditionalities which, however, fit conventional current account crises caused by poor macroeconomic fundamentals, but does not fit the Asian capital account crisis.
How about the second angle of the analysis of the missing link between the Miracle and the Crisis? My conclusions are three-fold as follows.
The success of authoritarian states with growthmanship
First, the Asian authoritarian states with "growthmanship" succeeded in mobilizing both mass saving and investment conducted by family businesses through banks, which were accompanied by both export-promotion and foreign technology import policies, by abandoning one-sided import substitution only policies at the earlier stage of take-off.
Export-promotion policies provided family businesses not only with strong incentives to invest and produce for exports, encouraged by exemption for exporters from high tariffs and quotas on capital and intermediate goods imports, but also with microeconomic disciplines to family businesses by exposing their exportable products to international competition. As a result, microeconomic efficiency was enhanced, together with assimilatin efforts to effectively imitate imported foreign technology, supported by human capital formation. Rapid accumulation of both physical and human capital did not end up with lower and lower rate of return on capital because of the aforementioned reasonably high growth of total factor productivity, helped by foreign technology assimilation as well as managerial efficiency enhancement by family business through their exposure to international markets.
Domestic bailing-out policies
Second, the rapid physical accumulation through mobilizing massive bank loans occasionally ended up with the large amount of bad loans and potential bankruptcies of large family businesses, particularly at the time of recession of the domestic business cycle. So long as most of domestic investment was financed by domestic bank loans and so long as high growth supported by export promotion was maintained, the bailing-out policy of "top big to fail" was made possible, while moral hazard sneaked into the economic systems over time.
New risks entailed by financial liberalization
Third, this successful overall economic progress certainly invited financial liberalizations, first, domestic and then, the capital account. However, the miracle growth-induced-financial liberalization gave rise to two new risks. One is much more risk-taking behavior on the part of both lenders and borrowers, since liberalization alters their incentives. This phenomenon after financial liberalization is not unique to the Asian crisis but quite universal, as observed in S and L debacles in the U.S., Nordic countries' crises in the early 1990s, and Japanese asset bubble and burst in the 1980s and 1990s. In this sense, the Asian crisis is not attributable to unique Asian cronism associated with the triangle relation among governments, family businesses, and banks. In general, financial crises as universal phenomena can be attributed to the gaps between the aforementioned new risks arisen from financial liberalization and deregulation on the one hand and the capacity of the pre-existing institutional infrastructure (legal, regulatory, and informational) to manage such new risks. For instance, well-defined capital adequacy ratios were not covered by the pre-crisis existing regulatory institutions. This analytical framework can apply not only to the aforementioned crises but also the Enron crisis.
The other risk in East Asia arose from capital account liberalization in the 1990s, which, as mentioned earlier, financed the large portion of domestic investment during the prosperity phase of the business cycle of host countries. Such investment became excessive due partly to the hitherto built-in moral hazard. The result was that the traditional bailing out policy could no more easily apply to dollar-denominated debt ridden domestic banks and enterprises. This is simply because they were ridden with external dollar-denominated, not domestic currency-denominated, huge debt. This is yet another gap between the new risks arisen from financial liberalization and the capacity of the pre-existing institutional infrastructure which lacked, for example, prudential regulation on external debt exposure.
Applying key lessons to China
How can we apply these analyses and lessons about the missing links to the current Chinese economy? The most important lesson for China is to build institutional infrastructure as quickly as possible, so as to successfully manage new financial risks entailed by domestic liberalization and de facto capital account liberalization in the forthcoming several years.
Building institutional infrastracture
At the ADB Institute, we attempted to quantify the quality of institutional infrastructure required for well-functioning financial markets. The market-supporting institutional infrastructure covers legal (such as the rule of law and enforcement of rules), regulatory (such as prudential regulations and creditors' rights) and informational (such as accounting and auditing) institutions. The quantified quality of such institutional infrastructure provides the ranking of countries ranging from the full mark of 10 down to the mark of zero. The mark for the crisis-hit Asian economies was 4.6 on average in 1998, as compared with which, the mark for China was only 1.6, whereas the average mark for Singapore, Hong Kong, Taipei China, Chile were 7.5. Furthermore, through quantifying both the quality of institutional infrastructure and the degree of capital account openness, we found no correlation between the two indicators, suggesting that capital account liberalization was badly advised and pre-matually implemented for emerging market economies, regardless of the development stage of their market-supportive institutional infrastructure.
Financial services liberalization promised by the WTO accession will lead China to de facto capital account opening in several years during which China's high growth will be maintained as in the case of the pre-crisis East Asia in the 1990s. Unless China meets the challenge of quickly improving the quality of institutional infrastructure by competing with the quick clock of approaching de facto capital account liberalization, we can not rule out the possibility of a type of capital account crisis in China. It goes without saying that the first priority should be placed on the serious problems unique to current China such as the resolution of huge non-performing loans (NPLs), through capital injection to state-owned banks. The weak incentives on the part of management and the resultant feeble corporate governance are all deeply rooted in the state ownership of large banks and enterprises. Managerial incentives and corporate governance can be improved through their decisive privatization, by capitalizing on the success of the pragmatic two tracks development strategy, as indicated by the accumulation of capital and the development of entrepreneurship unlike the case of Russian privatization.
New global imbalances and renminbi
What further complicates institutional reforms in China is the emergence of new global imbalances, featured by a large U.S. current account deficit at 5 % of GDP, the counterpart of which is current account surpluses of all East Asian economies including Japan. This time, the counterpart of the U.S. external deficit is shared more or less equally by Japan and East Asian emerging economies, standing in sharp contrast to the 1980s when Japan's surplus was essencially the major counterpart of the U.S. deficit at 3.5 % of GDP.
Therefore, the issue of renminbi is bound to be discussed in this Pan-Pacific context as well as in a consistent manner with ongoing essentially market-based economic integration in Asia. The renminbi issue is two-fold: (1) its "level," regarding whether renminbi is undervalued or not, and (2) its exchange rate "regime," regarding whether it should float or remain fixed.
Two macroeconomic criteria for renminbi adjustments
For the former issue, there are two macroeconomic criteria for judging whether renminbi should appreciate or not. First, if China's current account surplus/GDP ratio has been rising over time, appreciating of renminbi will be required for containing such increasing imbalances. Whether China should register a deficit on her current account as an equilibrium since China is a developing county is a different issue. The settlement on this issue depends upon the rate of return on capital given extremely high investment and saving/GDP ratios in China as well as the U.S. equilibrium current account imbalance as an advanced country. The second macroeconomic criterion is whether foreign reserves accumulation is causing high domestic inflation through the expansion of the base money. In China, CPI inflation rate was minus 0.8 % in 2002 and probably around 1 % in 2003.
From these two criteria, there has been no immediate reasons for renminbi appreciation. A major source of increasing foreign reserves in China is massive net inflows of FDI, which account for above 4 % of GDP compared with 1.5~2 % current account surplus/GDP ratios. Therefore, it is desirable to finance some portion of FDI by issuing bonds denominated in renminbi.
Against the background of the large U.S. current account deficit, already accounting for 5 % of GDP in 2003, there will be high possibility that the U.S. deficit will be too large to be sustainable, so that a large depreciation of the U.S. dollar will be inevitable in 2005 or so. By then, the aforementioned two criteria may turn to justify renminbi appreciation. Therefore, that the new global imbalances will be simultaneously addressed by exchange rate adjustments of both U.S. dollar and Asian currencies including renminbi.
What are appropriate exchange rate regimes―how to resolve the trilemma?
Additional two issues will arise. One is what kind of exchange rate regime will be more appropriate for renminbi and other Asian currencies. The other is how the adjustment "burden" of currency appreciations and domestic absorption policies should be shared and designed for Asia and on the basic of what criteria.
The choice of exchange rate regimes, in my view, depends on two basic factors. One is how to resolve the so-called trilemma discussed in international monetary economics. That is, three policy goals of (1) fixing exchange rates, (2) free capital movements, and (3) independent monetary policy aimed at low inflation and high employment can not be simultaneously resolved. In other words, one of the three goals has to be sacrificed. For example, a sacrificed goal is, under the gold standard or currency boards, is independent monetary policy, under the Bretton Woods system, free capital movements and under float regime since 1973, fixing exchange rates. However, many emerging market economies are fearful of free float. This fear of float reflects the shallowness and the narrowness of their domestic financial markets which are responsible for volatility of floating exchange rates. Underdeveloped forward and swap instruments can not efficiently hedge spot exchange rate fluctuations and such risks, which in turn adversely affect external trade development of Asian emerging economies whose aggregated exports and imports often account for 50 to more than 100 % of GDP, unlike the case of G3. Furthermore, currency misalignments in the medium-run caused by continued capital flows substantially disturb the resource allocation between tradables and non-tradables. Therefore, crawling band systems can be recommended for emerging economies in Asia. The band can be widened in correspondence to the development of domestic financial markets.
In order to protect the upper band as well as to mitigate the aforementioned double mismatch, the Chilean type of capital controls on short-term capital inflows could be introduced. Chile utilized unremunerated reserve requirements (URR) and minimum holding periods (MHP) on all and any types of capital inflows.
Furthermore, in order protect the lower band, the regional lender of last resort facility should be established, by pooling a portion, say 10 %, of huge foreign reserves accumulated by individual East Asian countries. This facility will not only economize too much accumulated foreign reserves with low rates of return, but also protect the lower band of the crawling exchange rate regimes in case of a capital account crisis which requires the far larger amount of international liquidity beyond member countries' quotes as well as its quick delivery at the extremely good timing. These financial arrangements are very different from the rescue operation for the case of conventional current account crises. Only conventional crises can be managed by traditional stand-by arrangements and macroeconomic stabilization policies by the IMF. For geopolitical reasons, the United States, that is, either its congress or IMF strongly influenced by the U.S. can not function as international lender of last resort, particularly when American tax payers may have to bear the burden in case of defaults of borrowing countries from the lender of last resort facility.
Adjustment burden sharing in resolving the new global imbalances and economic integration in Asia
The issue of adjustment burden sharing in the resolving process of the new global imbalances between U.S. and Asia as a whole should be considered as a catalyst for further advance in economic integration in Asia through more intensive policy dialogues, particularly about economic relationship among currency adjustments, their impact on FTAs and FDI-based global production networks in Asia, appropriate exchange rate regimes, including the determinant of reference rates, and macroeconomic policy coordination .Only through such policy dialogues, we can pave a long way toward Asian common currency and monetary integration in Asia, going beyond trade, FDI and financial integrations.
- YOSHITOMI Masaru, "The Reality of Asian Economies－Miracle, Crisis, and Evolution of Institutions－" , September 2003, Toyokeizai (in Japanese)
- YOSHITOMI Masaru and ADB Institute Staff, "Post-Crisis Development Paradigms in Asia," ADB Institute, May 2003
Applying key lessons from the Asian Crisis to the Chinese economy
吉冨 勝 (国際協力銀行開発金融研究所客員研究員/前アジア開発銀行研究 (ADBI) 所長)