EUROPE

Autumn 2012

by Siriwan Chutikamolthan

What lessons for eurozone policymakers can Asia offer after the devastating financial crisis it experienced back in the late 1990s? At first glance, the causes of the Asian crisis were very different, but on closer examination, the similarities are worth pondering. As a start, it’s useful to recall the obvious differences between Europe today and Asia a decade and a half ago. Before its crisis, Asia was growing fast enough to have earned an international reputation as an “economic miracle”, while its workers were widely seen as hard-working, most national governments were prudent with their fiscal budgets and in general sovereign debt was low.

In Europe, by contrast, Greece has been characterised by low growth rates and declining labour and total factor productivity. Many of the eurozone governments in Mediterranean countries have been generous with public workers’ compensation and early retirement, and have run fiscal deficits leading to ever-increasing levels of government debt.

Another important difference in the causes of the crisis is that Asia’s difficulties in the mid-1990s began with a currency crisis, when national currencies were unable to hold their values and therefore were forced to devalue substantially. The depreciation threat triggered capital flight from ASEAN nations, followed by a tight credit squeeze eventually leading to bankruptcies of banks and corporations that no longer had access to funding. On the surface, troubled eurozone countries do not face the possibility of depreciating national currencies as they use the common Euro.
But there are more similarities in the causes of the two crises underneath the surface, so perhaps Europe should be studying Asia’s relatively quick rebound for some policy pointers. Both crises had their origins in national losses of competitiveness that affected their exports. Indonesia, Malaysia and Thailand had been suffering from rising production costs, while South Korea was facing tougher competition from Japan because it had devalued the yen. Their current accounts were consequently in deficit. Today we can again see a slump in competitiveness in the most troubled EU member states, although their problem is chronic while that of their Asian counterparts was for only the few years leading up to the crisis.

One of the main features of the Asian crisis was the fixed exchange rate regime, under which several Asian currencies were pegged to a basket of currencies, about 80% of the weight was the U.S. dollar. In the early to mid-1990s, the U.S. dollar was appreciating strongly, thus causing Asian currencies too to appreciate against other currencies. Adhering to the peg, Asian nations did not devalue their currencies to counter their rising production cost, so in effect they found themselves in a ‘common currency’. Some eurozone countries now find that their inability to devalue is central to their problems.

High levels of external debt also brought the crisis to Asia in 1997 just has it has to some eurozone members. In both cases, a large slice of this external debt was short-term, creating repayment difficulties when it became due with the prospects for rolling-over these debts much diminished. But the Asian debts were primarily borne by banks and non-bank companies, while the most troubled eurozone debt is sovereign and owed by governments.

The economic conditions that led to the Asian crisis in 1997 share many common elements with Portugal, Italy, Ireland, Greece and Spain – the so-called PIIGS. There was fast credit growth to fund consumption and investment, much of which went into speculative projects like real estate. A large portion of this credit was funded by foreign loans. In some respects, the Asian crisis shared more similarities with Spain and Ireland than with Greece, where the malaise stemmed from excess consumption by both government and households.

Another similarity became apparent in both regions once the crisis was well under way. Loan losses rose and a lack of transparency led to contagion through the banking system, and gave rise to the sour of panicky behaviour that could cause bank failures. And besides mass lay-offs in the financial sector, such as in South Korea in 1997, where one in three employees was laid off, any freezing of the credit system means that other sectors will be caught in the downward spiral because of the lack of liquidity.

In short, the Asian and the eurozone crises share the same root causes of over-leveraged positions despite dwindling competitiveness and the problems created by a fixed exchange rate system.

The IMF imposed austerity measures on Asian countries hit by the crisis, consisting of tight fiscal policies to cut government spending along with equally tight monetary policies, all in the hope that high interest rates would deter capital flight and prevent further currency devaluations. Asian countries followed these conditions for several months, but then realised that such austerity was creating rampant bankruptcy, lay-offs, unemployment and stock market collapses as well as social unrest evidenced in mass protests, but was failing to stem capital flights or deter devaluation. The high interest rates created credit crunches, and although commercial banks had liquidity, the uncertainty of the crisis meant they were reluctant to lend. Many companies that had not had problems until then became adversely affected by the lack of credit.

Malaysia did not accept the IMF package, although it implemented capital controls and IMF-type austerity. Thailand renegotiated to secure more lenient terms from the IMF, while others relaxed their monetary and fiscal policies. Indonesia resorted to an expansionary fiscal policy, incurring government debt that had to be paid off at a later date.

This is not to say that fiscal austerity is wrong. Anyone who has over-indulged and whose consumption was funded by borrowings will have to tighten his belt when the lenders withdraw their support. Greece, for instance, has over-consumed and under-produced for years, and on top of that its governments have been overly generous with social welfare but lax on tax collection. Greece clearly needs drastic improvements if it is to turn around. Given that, several economists argue that austerity may not be a suitable immediate response to a financial crisis. Even if crises are caused by a country’s fundamental economic problems, these should not be dealt with while the crisis is at its peak. The IMF was subsequently been criticised for imposing austerity on South Korea, Thailand and Indonesia. Noted Harvard economist Jeffrey Sachs commented: “Asia would have been better if the IMF had never set foot in these countries”.

The key to Asian nations’ responses to the crisis was the various structural reforms they implemented. Although measures varied from country to country, common reforms included restructuring of their banking sectors, capital market reforms, and reform programmes for companies, labour market rules, and, above all, policies concerning the public sector.

In the banking sector, besides closing down and nationalising weak financial institutions, many of the remaining ones were recapitalised with massive rights offerings. Foreign banks were allowed to enter to increase competition, more stringent bank supervision, accounting and auditing standards were imposed. On capital market reform, South Korea abolished the ceiling on foreign investment in equities and bonds in order to attract capital inflows. Other Asian countries liberalised trade and foreign investment and deepened their local bond and equity markets to reduce companies’ reliance on bank loans. On corporate sector reform, transparency and governance standards were raised by adopting international accounting standards, improving commercial, bankruptcy and securities exchange laws. Labour market reforms, notably in Korea, where wages had been rising faster than productivity, saw the legalisation of lay-offs and the outsourcing of services in spite of strong union protests. But workers’ basic rights also received better protection, and unemployment benefit and social safety nets were improved. Coupled with Asian-style performance bonuses, the overall result was greater labour market flexibility.

For public sector reform, several countries sold off state-owned enterprises to raise public funds, tax collection was streamlined and enforced, while government spending plans were made more transparent and economic data to monitor the economy was greatly improved.

These reform measures took time, and some are still on-going. While different countries have enjoyed varied degrees of success, the lesson they share is that a crisis caused by losing competitiveness requires more than short-term liquidity solutions. Structural reforms that address the root causes of the crisis are needed in the eurozone’s weaker countries, just as they were in Asia.

Siriwan Chutikamoltham is a Senior Teaching Fellow and Director of Banking and Finance at Nanyang Technological University in Singapore. Siriwan@ntu.edu.sg