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Lessons From the Asian Financial Crisis
From: Cambridge University Press
| By:
Joseph Stiglitz |
EDITOR'S INTRODUCTION |
In the second half of 1997, the world's most rapidly growing and successful economies crashed, one after another. The Asian financial crisis took the world by surprise and prompted much fear of knock-on effects. Can similar crises now be avoided elsewhere? Former World Bank senior vice president and chief economist Joseph Stiglitz assesses the situation. |
 e cannot expect to eliminate all fluctuations or all crises. Even if we could eliminate all of the "problems" and "mistakes" in economic policy, it is unlikely that we could fully insulate economies against shocks, including events such as the OPEC oil price increases in the 1970s or changes in market sentiment, such as occurred in the East Asian crisis. Furthermore, although there is much more scope for policy reforms in developing countries, we should not delude ourselves into thinking that this can take place overnight. Building robust financial systems is a long and difficult process. In the meantime, we need to be realistic and recognise that developing countries (DCs) have less capacity for financial regulation and greater vulnerability to shocks. We need to take this into account in policy recommendations in all areas, especially in the timing and sequencing of opening up capital markets to the outside world and in the liberalisation of the financial sector. |
 We must bear in mind, too, in designing policy regimes (such as opening up capital markets) that we cannot assume that other aspects of economic policy, such as macroeconomic policy or exchange rates, will be flawlessly carried out. The policy regimes we adopt must be robust against at least a modicum of human fallibility. Airplanes are not designed to be flown just by ace pilots, and nuclear power plants have built into them a huge margin of safety for human error. |
Better information
One of the international reforms to have come out of the [1994] Mexican crisis was the almost universal call for better information, in terms of accuracy, scope and timeliness. The East Asian crisis has reinvigorated the calls for better information, as foreign investors have blamed the East Asian governments for not giving them enough information. Much of this has just been blame-shifting. Just as Mahatirs blame Soroses for their problems, so too do international investors blame the countries they invest in for not providing them with full information: if only they had been told the truth, they would not have got into the problems they did. But most of the supposed problems in East Asia, including the "lack of transparency," were not news, they were widely known prior to the crisis. Indeed, there is a serious question about whether or not all of the available information was even being used. There is no systematic evidence linking lack of transparency to economic crises--the last major banking-cum-currency crises were in Scandinavia--models of transparency. And even if there were, there is no evidence that corruption or transparency were significant problems in all of the East Asian countries affected by the crisis. According to a number of ratings of transparency and corruption, Indonesia was one of the worst middle-income countries. But Thailand and the Philippines were about average (and substantially above average compared to DCs as a whole). And Korea and Malaysia were consistently rated among the least corrupt and most transparent of any developing country. |
There is no doubt, however, that more information is usually better. In the case of East Asia, it is likely that the general lack of information made it difficult for investors to distinguish between firms and financial institutions that are healthy and those that are not. In response, investors shied away from all. With more credible information systems, firms that remain healthy would be able to retain access to credit. |
The standard macroeconomic data would not have been very helpful in predicting the East Asian crisis, which had to do with the composition and allocation of private/private capital flows. Unfortunately, getting information about private sector spending and borrowing is much more difficult than obtaining comparable information about public finances. This is especially the case when transparency is limited. In a world where private/private capital flows are increasingly important, we will need to recognise that monitoring and surveillance are going to be especially challenging. The growing use of derivatives is increasingly making the full disclosure of relevant information, or at least the full interpretation of the disclosed information, even more difficult. We should remember, too, that the great merit of a market economy is that dispersed information is aggregated through prices and the incentives they create for behaviour, without the need for any centralised collection of information or planning. There is a certain irony about praising a market economy for this decentralisation of information, and at the same time complaining about the lack of aggregate data necessary to assess systemic risks. |
Moreover, we should not be under the illusion that having improved data is sufficient for financial markets to function well. In East Asia much of the important information was available, but it had not been integrated into the assessment of the market. Furthermore, it is impossible to eliminate all uncertainty and asymmetries of information. Entrepreneurs will always know more about their investments than will the banks that lend to them, and managers will always know more about their actions than shareholders will. Without the correct incentives, even perfect aggregate information would not be sufficient for the efficient, or stable, functioning of markets. |
Although our information about private capital flows is imperfect, and although even with vastly improved information I am not sanguine that we--or the market--would be able to predict or forestall all crises, I do think that the returns from improving our statistical bases are significant. My caution is only that we should not be misled into thinking that this will solve our problems. Better information--seemingly the most important improvement in the international financial architecture to come out of the last crisis--should not lull us into complacency. |
Regulation and restraint
The second set of widely endorsed policies is better financial regulation. Again, there is no doubt that better financial regulation would be a good thing: after all, how could anyone object to "better"? The more important question is, how much do we expect better financial regulation to accomplish, and what form should this regulation take? This is a huge topic that I have addressed elsewhere (J. E. Stiglitz and B. Greenwald, Quarterly Journal of Economics 108(1), 1993, pp. 77-114). In this context, however, I would like to focus on the role of financial regulation in crisis-prevention and contrast Basle-style financial regulation with mild financial restraints. |
We can examine the effects of financial regulation on crisis-prevention by conducting a thought experiment about whether better financial regulation, along the lines of the Basle accord, would have prevented East Asia's crisis. Although better financial regulation is clearly desirable--for both growth and stability--we should not over-estimate the ability of financial regulation to overcome the macroeconomic incentives. |
What would have happened if the government had maintained the same misguided foreign exchange policy, but had had a better regulated financial sector? In this case, regulators would have limited banks' ability to borrow short in foreign currency and lend long to buy non-tradeable assets. But the expected constancy of the exchange rate and the differential between foreign and domestic interest rates, which was increased by the attempts to sterilise the capital inflows, driving up the domestic rate, would still have created the same incentives to borrow short-term money from abroad. The result could have been that instead of banks, corporations or non-bank financial institutions would have accessed international markets directly. This is, of course, what happened in Indonesia where roughly two-thirds of the external debt was incurred by the non-bank private sector, among the highest fraction of any country in the world. No country can, does, or probably should regulate individual corporations at the level of detail that would be required to prevent the foreign exchange and maturity mismatches that arose. |
Furthermore, in contrast to its neighbours, Malaysia's central bank adopted much more prudent policies vis-à-vis short-term borrowing, and as a result its ratio of short-term debt to reserves in end-December 1996 was 0.54 compared to 1.74 for Thailand. (Other aspects of Malaysia's situation were comparable to that elsewhere in East Asia--for instance, their level of non-performing loans. But even this may be misleading, since Malaysia required larger reserves against losses, so that their banks were in better financial positions.) As a result, Malaysia did not suffer as much from the failure of foreign creditors to roll over short-term loans, and thus it did not face the imminent threat of a default that brought Korea and Indonesia to the brink. Despite this fact, Malaysia's crisis, measured by the depreciation of its exchange rate or its expected growth in 1998, has been just as severe as that of Korea or Thailand. Taiwan (China) had strong financial institutions, sound macroeconomic policies and an exchange rate that was widely believed to be reasonable. As a result, it saw its exchange rate gradually depreciate by only 20 per cent, which represented an almost equally substantial depreciation of its real exchange rate. |
Well designed bank regulations--such as risk-adjusted capital adequacy standards and risk-adjusted deposit premia--might have gone some way toward reducing financial market vulnerabilities. For instance, when lending to borrowers who have large uncovered foreign exchange exposures and very high debt equity ratios, banks would have charged higher interest rates to reflect this greater risk; and the threat of higher interest rates would have provided a disincentive for firms to have risky financial positions. |
To the degree that better financial regulation would have been helpful, three observations are in order: |
First, countries with more advanced institutions have found it difficult to develop a regulatory framework that insulates them from financial crises. Even banks in the supposedly well regulated advanced countries made loans not just to Korean banks, but also directly to its chaebol, with their high debt/equity ratios. As a practical matter, however, no government has imposed good systems of capital adequacy. One important lacuna is that although credit risk is typically recognised (though gauged imperfectly), market value risk associated with changes in interest rates or risk premia is not. Furthermore, regulations do not examine total portfolio risk, including the correlations among market risks and between market risk and credit risk. Even countries such as the US have deliberately shied away from fully transparent risk-adequacy standards based on modern risk analysis. Accordingly, it is unreasonable to expect such indirect control devices to work effectively in DCs.
Second, given these limitations there are arguments for a whole variety of lending restrictions--not only sectoral limits, but also speed limits, as well as restrictions on the liability structures of the firms to which the banks lend. Greater financial sector restraints, rather than the weaker restraints that were adopted in practice, might have gone some way toward changing the composition of capital inflows (by raising the cost of short-term borrowing) and their use (by restricting investment in non-tradeables). Further restraints on international capital flows, justified by the externality imposed by international capital flows, could potentially have complemented these policies, further lengthening the duration, and reducing the risk, of capital inflows.
Third, the problems of designing an appropriate regulatory structure are becoming more difficult with derivatives and off-balance sheet items, and are more difficult for DCs, both because they are likely to face a shortage of good regulators and because they face greater risks. These problems are highlighted by the fact that both in Indonesia and Korea, some firms and banks thought they had covered positions, but bankruptcy of the party providing the hedge left them in an exposed position (Dooley, 1998). For a regulator to ferret out these problems would require it to assess the credit risk of innumerable firms. That is why regulators in more developed countries are switching to an evaluation of the risk-management systems, rather than monitoring individual transactions or even portfolio positions. It is likely to be some time before DC financial institutions can put in place risk-management systems that evaluate accurately portfolio risks taking into account both credit and market risks and the correlations within and between these risk categories. There is some concern that the Basle standards, by setting up a regulatory framework that does not deal adequately with these broader (and more relevant) aspects of risk may give banks (and their depositors and investors) comfort when they should not, and may actually lead to excessive risk in the relevant sense. |
The thrust of the Basle standards--setting up a "level playing field" so that banks throughout the world face similar standards--has itself come into question, as the differences in circumstances may in fact necessitate different standards for countries in different positions. Even when adopting the Basle standards is understood as a minimal recommendation, the more prudent policies are measured by, for instance, higher capital-adequacy requirements, not changes in the regulatory objectives or structure. Similarly, the thrust of financial market liberalisation has been to replace quantitative and other ad hoc constraints (for example, on lending to real estate) with broad-based capital adequacy and risk management standards. But given the deficiencies in those, which may have particularly severe consequences for DCs, this strategy clearly has its problems. Indeed, I have argued that this misguided strategy shares a considerable part of the blame for the problems in Thailand, which prior to financial market liberalisation actually had a relatively sound financial system. |
Controlling capital flows
A consensus is beginning to form that governments, and possibly the international system, need to do more to restrain the movements of capital, especially of short-term "hot money." Although better information and better regulation are important first steps they are, as I have argued, far from sufficient. Instead, I have argued that there is a theoretical rationale for policies that bring private risks into line with the social risks. |
Specifically, these policies aim to influence both the pattern and timing of capital flows. Currently, 75 per cent of private capital flows to only a dozen countries, and most low-income countries have little access to private capital relative to the size of their economies. Procyclicality is another undesirable feature of international capital flows. Countries seem to get the most private capital when they are growing strongly and need it least, and they have a relatively difficult time accessing capital in hard times when they need it most; as a result capital flows do relatively little to smooth the business cycle and may even amplify it. Accomplishing this objective, however, may be very difficult. |
Another objective concerns the composition of capital flows. There is now broad agreement about the value of foreign direct investment (FDI), which brings not just capital but also technology and training. Preliminary evidence from East Asia also shows that consistent with past experience, FDI is relatively stable, and certainly far more stable than other forms of capital flows. Unlike FDI, short-term capital does not bring with it ancillary benefits. In the form of trade credits it provides an important, and relatively inexpensive, source of international liquidity without which no economy, especially an export-oriented economy, can run. In addition to providing liquidity, short-term capital, along with other forms of flows, allows a country to invest more than it saves. When this money is invested productively, the benefits to the economy are large. But when the saving rate is already high, and when the money is misallocated, the additional capital flows just increase the vulnerability of the economy. Moreover, given their volatility, what well managed economy would risk basing long-term investments on short-term flows? More generally, it is not considered prudent to hold international reserves equal to or greater than short-term foreign debt, a policy that amounts to DCs borrowing from industrial-country banks at high interest rates only to relend the money to industrial-country treasuries at low interest rates. Perhaps for these reasons, several systematic empirical studies have failed to find any relationship between capital account liberalisation and growth or investment (see D. Rodrik, in Essays in International Finance, 207, May 1998, pp. 55-65). |
The large benefits of FDI, and the costs and benefits of short-term capital flows, have led many people to investigate ways to encourage long-term investments while discouraging rapid round trips of short-term money. There are many components of such a strategy: |
First, we need to eliminate the tax, regulatory and policy distortions that may, in the past, have stimulated short-term capital flows. Examples of such distortions are evident in the case of Thailand where the tax advantages for the Bangkok International Banking Facility (BIBF) encouraged short-term external borrowing, but subtle examples exist almost everywhere. Without risk-based capital requirements for banks, for instance, incentives for holding certain assets and liabilities will be distorted. |
Second, several countries have imposed prudential bank regulations to limit the currency exposure of their institutions. |
Third, these measures may not go far enough, especially once it is recalled that corporate exposure may itself give rise to vulnerabilities. And the systemic risks to which such exposure can give rise provide ample justification for taking further measures. Among the ideas currently under discussion are inhibitions on capital inflows. In thinking about how to accomplish this, we should look to the lessons of the Chilean experience. Chile has imposed a reserve requirement on all short-term capital inflows--essentially a tax on short-maturity loans. The overall efficacy of these controls is the subject of much discussion, but even most critics of the Chilean system acknowledge that the reserve requirement has significantly lengthened the maturity composition of capital inflows to Chile without having adverse effects on valuable long-term capital. |
Still other measures employ tax policies--for example, limiting the extent of tax deductibility for interest in debt denominated or linked to foreign currencies. The problems of implementing these policies may in fact be less than those associated with the Chilean system. |
In evaluating these proposals, we must be clear what the objectives of the interventions are. Two seem uncontroversial: reducing (though not eliminating) the volatility of flows and reducing (though not eliminating) the discrepancy between private and social returns. |
Conclusion
The prevention of crises has important domestic and international dimensions. We should not over-estimate the ability of purely domestic policies, such as greater transparency and better financial regulation, in averting crises. Although these are important, they must be supplemented by additional policies to restrain overly volatile short-term capital flows. |
This raises another question: who will implement these policies? The most important and feasible (especially in the near term) actions toward international capital flows are all at the national level--carried out either by developed countries or DCs. But there is also a currently very active dialogue at the international level. At a minimum, international groups and institutions can play an important role in encouraging the adoption of sound policies, and especially by persuading investors that the adoption of some restraints on capital flows is not necessarily a sign that a country is unfriendly to investment, but simply that it wants to insulate itself against some risk.
This is an extract from pages 392-399 of "Must financial crises be this frequent and this painful?," by Joseph Stiglitz, in The Asian Financial Crisis, edited by Pierre-Richard Agénor, Marcus Miller, David Vines and Axel Weber, published by Cambridge University Press. Copyright Pierre-Richard Agénor, Marcus Miller, David Vines and Axel Weber, 1999. |
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