To make sense of the crisis that began in Asia in 1997, it is crucial to consider where the ravages of economic destabilization hit hardest and where they were felt much less severely. Why were such varied countries as Indonesia, South Korea, Thailand, and Malaysia badly damaged, while such equally varied cases as Singapore, Vietnam, the Philippines, Taiwan, and China punched and bruised but not knocked to the ground?
The answer lies in systemic changes in international capitalism: specifically, the control of capital flows to developing countries, and the growing prominence of highly mobile and volatile forms of capital and transactions. It is clear that the vulnerability of a country varies with the nature of its linkages and exposure to external capital flows, which can change course more rapidly than ever before and on a scale that can easily overwhelm all but a few economies. Like a huge electrical grid, as the current in the system grows more unstable and potentially dangerous, it matters first the degree to which one is plugged in and second, whether surge protectors are in place to dampen the effects of massive fluctuations.
No country in Asia has been untouched by the destabilizing economic impact of the crisis. All have seen exports hurt, stock market capitalizations reduced, rates of foreign investment slowed, and currency values eroded. But where the crisis began, which countries were pulled in quickly and deeply, and where the devastation has been greatest has depended on how exposed a country was to the external financial system.
The key considerations were the convertibility of currency; the existence, size, and international exposure of capital markets; the degree of private foreign borrowing by local corporations; the share of this borrowing that was short-term; and the ease with which currency traders could raise local credit to launch an attack on a national currency. These factors were more important than the economic fundamentals of the countries in question, their degree of crony capitalism, or even whether governments were resolute and skilled in adopting policies to dampen the crisis once it began to spread throughout the region--although policy responses have certainly had an impact over the medium term after the crisis moved through different phases.
There are three aspects of the crisis that are especially surprising. The first is that a region everyone believed was so strong could stumble and crumble so rapidly. The second is that so many countries could get swept simultaneously into a crisis. And the third is that the crisis has remained so deep and durable, despite domestic and international efforts to restore stability and confidence, including some $120 billion in rescue packages sponsored by the International Monetary Fund (IMF). Indeed, what began in Thailand, Malaysia, and Indonesia soon spread to South Korea, shook Hong Kong, and threatened China and Japan. These crises caused ripple effects that disrupted the capital markets of Europe and North America, with graphs of the daily fluctuations on the New York Stock Exchange resembling the brain waves of a patient caught in a nightmare.
"In nearly every economic crisis, the root cause is political, not economic," concluded Singapore's senior minister, Lee Kuan Yew, in an address to leading American businesspeople at the Fortune 500 Forum in Boston last year. Lee did not mean political in the same sense as Malaysian Prime Minister Mahathir Mohamad, who blamed the crisis on an international conspiracy of Jews who, he implied, were upset to see Muslims prosper economically (a view that is not only odious but odd, since the crisis began in Thailand). Lee meant that the behaviors of economic actors are a response to prior government decisions and policies. Governments oversee and enforce the context in which economic activity unfolds; their policies create the opportunities and set the rules. They can also produce the kind of time bomb that exploded in Southeast Asia at the beginning of July 1997. This is because the interaction between government and economy does not stop with the context created by governments. Economic actors react according to their own interests, and in the 1990s they do so in an increasingly connected transnational environment.
Thus, the Asian crisis is not just the result of government policies, but specifically how they interact in an international environment dominated by private controllers of capital who are willing and able to relocate massive resources away from perceived danger in a very short time frame--and are not necessarily willing to bring them back as quickly as they withdrew them. Significantly, once this process starts, it does not matter if the danger is real or perceived. This suggests important lessons regarding transparency and information.
When the stakes are high, information is crucial. Investors operate well with risk, by which probabilities of different outcomes can be calculated. They do not operate well with uncertainty, which means the absence of quality information on which to base investment decisions. Transparency transforms uncertainty into risk. In the world of Asian business, transparency means bringing into public view much more information about who is doing what; who owns what; who is borrowing, from where, how much, for what; and how well everyone is doing (including the government itself), as well as who is being bailed out, protected, and subsidized, and at whose expense.
These questions strike at the heart of power relations across Asia. Failing to answer them satisfactorily over extended periods, which was the norm during the cold war, is no longer a viable option. Indeed, as hidden information about the economies of Southeast Asia seeped out in July 1997, it triggered an escape psychology among private capital controllers that by November had erased some $400 billion of value from the region's capital markets (measured from the beginning of 1997). All the economies in the region saw their growth slow in 1998, and several went into recessions and contractions that are projected to continue into 1999. Along the way, billions of dollars in production and hundreds of millions of jobs are being lost. According to estimates in October 1998, since the crisis began, $1 trillion in loans had gone bad, $2 trillion in equity capitalization for Asian stock markets had been vaporized, and $3 trillion in GDP growth had been lost.
It is also important to note that even if analysts or policymakers can successfully diagnose the superficial and deep causes of crises, it is not obvious what policies will create stability. Even the Mexico crisis of 1994 and 1995 provides few clear parallels and lessons for dealing with the disaster that has spread like wildfire across Asia. It appears that many policymakers in the region, together with powerful international institutions like the IMF, took actions that were tailored more to standard balance of payments difficulties than to the kind of crisis that hit Asia. As they groped for a policy combination that worked, their actions sometimes helped deepen and prolong the crisis.
Finally, any analysis of the crisis and the responses to it (including one that strongly emphasizes external factors, as I do here) must be linked analytically to the struggles over power within the governments of the region. For instance, one consequence of the close arrangement in Southeast Asia between the state and its clients in business and politics is that there is a built-in tendency for economic reformers in government, who are marginalized from power in normal times, to seize moments of crisis as a window of opportunity to ram through as many fundamental changes in the domestic political economy as possible. Some of these policies may help address the immediate crisis, but just as often they extend it. Far from being a rational, methodical, planned, phased, or integrated set of policies to stabilize the economy and set it on a more prosperous course, the actions of frustrated reformers are sometimes driven by a desire simply to make as many sweeping changes as possible before the window closes and power swings back to those who traditionally enjoy it during the interim between crises.
This is of interest for three reasons. First, it helps explain why seemingly useful and even crisis- averting policies are delayed so long, as well as why reforms tend to be introduced in wrenching packages that only make sense as acts of desperation. Second, it suggests a twisted relationship between economic crises and the power of economic reformers in clientelist Asian states: crises sharply increase the influence of reformers, but once solved, often result in an equally sharp decrease in reformers' influence. And third, it provides an important reminder that despite nationalist public statements and posturing, economic ministers often use the conditions imposed by international agencies like the IMF for maximum advantage in their intragovernmental and domestic struggles. This was especially true in Indonesia, where ministers responsible for the economy insisted on including many policy changes and reforms as conditions for the IMF bailout that the fund had not demanded but for which it was later criticized. Thus, those who would cast the conflict as pitting foreign versus domestic forces miss one of the most important political dimensions of the crisis.
The first public indication of problems in Southeast Asia came on July 2, 1997, when Thailand announced that its currency, the baht, would be floated. To the casual observer this was a curious development, but hardly worth more attention than the thousands of other facts filling the newspapers that day. But to individuals controlling huge pools of investment resources in Southeast Asia, this was a flashing red light signaling danger for the whole region. Within weeks, the Indonesian government also floated its currency, the rupiah--yet another stunning announcement for investors, both local and global, whose entire game plan for Southeast Asia was founded on stable exchange rates pegged to the United States dollar. It was in this moment that the liberalization of investment flows into and out of developing countries made its impact felt with a vengeance. It was also the moment when the latent vulnerabilities linked to high external exposure, especially to private and short-term bank debt, became explosive.
The already thin economic analysis by most capital controllers prior to these announcements was soon replaced by a pure psychology of escape. All controllers of liquid capital, including domestic actors, began behaving like spooked wildebeests on the Serengeti. Frustrated policymakers, economists, and even managers and analysts at major institutional investing firms tried desperately to break the grip of the escape syndrome by pointing out that, despite some obvious and even deep problems with the political economies of Southeast Asia, the region's economic fundamentals simply did not warrant such a mass exodus. But when the managers and analysts were done talking to reporters, most of them went back to their terminals and phones and rejoined those selling shares and local currency because they knew that words of assurance would not be enough to stop the stampede.
In the weeks and months that followed, several countries in Southeast Asia endured devaluations in their currencies averaging over 50 percent and declines in local stock markets that were even higher. Millions of workers and managers were fired from companies that either went bankrupt or had to scale back operations because economic growth rates were suddenly much lower, imported components were much more expensive, or major government projects were postponed or canceled. At the epicenter of the crisis were the region's ailing banking and property sectors, which only grew more unstable as the crisis deepened.
If it is true that there were serious underlying problems in the political economies of Southeast Asia, then why did the crisis not occur six, twelve, or even eighteen months earlier? All the problems confronting the region's economies--weak banks, wasteful and nonproductive investment, overbuilding in the property sector, excessive borrowing by private sector firms, and speculation in local stock markets with borrowed funds--had been chronic for years. Part of the answer is that it took time for these trends to mature and converge in the right (or wrong) mix. But part of the answer also concerns information (or the lack of it), a psychology among investors that inflates an economic bubble, and a triggering moment that causes the bubble to burst.
That moment came when currency traders, suspecting that Thailand's economic situation was much worse than investors thought, were proved correct. The day was July 2, when policymakers in the Thai government, who had spent a staggering $23 billion buying baht in a vain attempt to maintain the dollar peg, gave up their defensive effort because they realized that they would run out of foreign exchange reserves long before there would be any good economic news to report about the country's property and banking sector. Only an immediate, genuine, and reliable upturn in the health of the economy could have stopped the pressure from the currency traders (by causing them to lose large amounts of money for betting the news would be bad). And given the realities in the Thai economy, there would be no such upturn.
It would be incorrect to draw the simple conclusion that the big problem was the peg to the dollar. It was a smart thing to do and worked rather well as long as the dollar was weak. Pegged currencies gave Thai and other regional exporters a competitive edge, especially against producers based in Japan. This, in turn, generated high growth, which attracted capital and helped strengthen the belief--some would say hype--that the economies of Southeast Asia would sustain high growth rates indefinitely. Those who pointed to serious and growing problems in the region's economies were shouted down by others who responded that the countries would grow their way out of the bottlenecks they faced, be they national debt, balance of payments problems, insolvent banks, or oversupplies in office space and expensive residential property.1 Between 1990 and 1995, when the dollar was weak and exports were still booming, Thailand ran current account deficits of 7.7 percent of GDP, a level that normally signals serious problems to investors, rating agencies like Moody's Investors Service and Standard and Poor's, and such watchdog institutions as the World Bank and IMF. But no one seemed to care and no alarm bells were rung.
When the dollar appreciated in value, the peg went from being a blessing to a curse as Thailand's exports became relatively more expensive. At the same time, there was a global slowdown in key Southeast Asian exports, especially electronics. China's massive devaluation in 1994 played a central role in the slowdown, since Chinese exports undercut exports of similar products from Southeast Asia. By the first quarter of 1997 it was clear that private Thai companies, encouraged by the stable exchange rate, were running up their short-term debts even more aggressively by borrowing tens of billions of dollars from foreign commercial banks.
Currency traders were the first to notice the sharp rise in Thailand's current account deficit. And since most currency traders are based at commercial banks, they were also the first to notice the surge in Thai businesses' and financial institutions' borrowing of large amounts of dollars with relatively short maturities. The final blow came in the spring of 1997 when, against the advice of local and foreign economists who were already worried that Thailand was sitting on a bubble, five new banking licenses were issued to individuals with strong government connections. It was at this point that currency traders became convinced that Thailand was in trouble, and began to bet with their resources that they were right.
This story helps explain how Thailand got into trouble, and even how that trouble quickly pulled the country into a crisis. But why should a crisis in Thailand have triggered a chain reaction that not only pulled in other major countries in the region, but spread to distant and diverse areas of the globe? To understand this, the analysis must shift to an entirely different set of actors and forces.
The chain reaction was set in motion by currency traders and managers of large pools of portfolio capital who operate under intense competitive pressures. These pressures cause them to behave in a manner that is objectively irrational and destructive for the whole system (especially for the countries involved), but subjectively both rational and necessary for any hope of individual investor survival. Since an increasing proportion of private capital flowing to developing countries in the early 1990s was in the form of commercial loans and portfolio investments, meaning stocks, bonds, and other securities, countries across Southeast Asia moved rapidly to open up capital markets; selling shares is an important alternative to raising capital from commercial banks. But where does this capital originate and how does it reach the market?
The majority of capital invested in Southeast Asia's capital markets is owned and managed by local actors. But a substantial portion comes from many millions of private citizens from around the world. This money is gathered together in a variety of institutional forms, such as pension funds and mutual funds, which have management teams that decide where to invest the capital and how much to allocate.
It is through these large institutional investors that, collectively, tens of billions of dollars in portfolio capital get invested in the capital markets of developing countries. But there is still another stage in the system before the money reaches capital markets in areas such as Southeast Asia. Often even the largest institutional investors lack the staff and expertise to invest intelligently in emerging markets. To solve this problem, specialized mutual funds have arisen that are designed to invest in emerging markets. At the head of these funds are emerging market fund managers (EMFMS). It is the EMFMS who make the micro-level decisions about which countries and companies in emerging markets will receive the investments as purchases of shares in capital markets around the world. This structure for channeling investment capital produces what political economist Mary Ann Haley calls a precarious "funnel" effect. Hundreds of millions of independent investors and savers entrust their money to a much smaller number of institutional investors, who then entrust a portion of their capital to an even smaller number of EMFMS. The disturbing result is that most of the portfolio capital supplied to developing countries ends up in the hands of just 100 extremely important EMFMS.
Of course, EMFMS are paid handsomely for serving this specialized role as the eyes, ears, and decision makers for millions of people and their money. Justified or not, these individual investors (plus a range of institutional investors) expect that EMFMS will act prudently and responsibly with the capital under their control.2 Yet even when they are behaving at their analytical best, there are still two major problems for EMFMS: the intense pressure they are under in a highly competitive environment to outperform all the other EMFMS, and the poor quality of information about the world's emerging markets.
It is the combination of these three elements--the funnel effect, intense competitive pressures, and bad information--along with currency traders and high short-term bank debt, that produced the explosive volatility and the chain reaction that has rocked Asia. Having severe problems in one's political economy is a necessary precondition for being vulnerable to the forces of this chain reaction. But it is not sufficient. China and Vietnam shared many of the same political economic pathologies of their Asian neighbors, and should have been swept into the crisis and felt its full disruptive force. But because neither country had a convertible currency and Vietnam lacked a capital market, the behavior of currency traders and EMFMS had a delayed and muted effect. Elsewhere, however, currency traders lost confidence, started betting local currencies would go down in value, and unloaded them en masse, thus commencing a self-fulfilling downward spiral that is exceedingly difficult for government officials with limited reserves and a convertible currency to counter. Meanwhile, EMFMS started selling shares across the region, and then beyond it. Entire banking and corporate sectors that had borrowed heavily in yen- and dollar-denominated currencies sank into immediate insolvency.
With profit-seeking and risk-averse private investors now in charge of most capital flows, displacing bureaucratically and politically motivated actors controlling official flows, the psychology, motivations, and volatility of these investors take on great significance. One of the least understood aspects of investments channeled through capital markets--or, indeed, bank deposits--is that the decision to invest, to keep the capital where it is, or to withdraw it is only partly based on the direct information the individual investor has about the quality, safety, and stability of the investment, whether it is in a country's capital market, a bank, or in an individual company. It is also based on what the investor believes other investors will do.
And so there is a paradox: even if there is no good reason to panic, the more individual controllers of money and capital act to protect themselves in times of uncertainty, the more genuine reason there is to panic. And the logic of the syndrome applies equally to foreign and domestic capital controllers. The chain reaction starts because once a major triggering event like the float of the Thai baht occurs, EMFMS realize that the positive (buy/bullish) psychology regarding other similar emerging markets--which is a very delicate bubble because it is rarely based on solid data and information--can burst and cause tremendous financial losses. A trigger like that seen in Thailand also causes EMFMS to ask tougher questions, look much more closely at the data on the economies in which they are invested, and demand better answers and immediate policy actions to prevent a loss of confidence. If the answers and policies are late or never come, the chain reaction continues and deepens as it widens. Once a crisis starts, it also has the effect of exposing weaknesses in an economy that had previously been well hidden, such as high debt levels, poor sales or export performance, problem loans in the banking sector, or dangerous interlocking relationships between capital markets, banks, and the property sector. As this happens, what begins narrowly as a financial crisis enters a vicious cycle that quickly turns it into a full-scale economic crisis.
Although strictly speaking it was not the poor condition of the Southeast Asian economies that caused the crisis, the political economies of the region were not completely healthy on the eve of the crisis. For years Asia's corporate and political leaders had borrowed more money than they could invest productively. Believing growth rates would remain strong indefinitely, they built hundreds of office towers, thousands of luxury condominiums (whereas the real shortage was in low-cost housing), and scores of resorts, and also used borrowed funds to speculate in the capital markets. According to one estimate, Asian (excluding Japanese) companies had borrowed at least $700 billion from the rest of the world just since 1992. Japanese banks lent Asians $263 billion, European banks lent them $155 billion, and American banks $55 billion. Conservative estimates were that by mid-1997, Indonesia, Malaysia, Thailand, Singapore, and the Philippines had accumulated bad bank loans that totaled $73 billion, or 13 percent of these countries' combined GDPs. That makes Southeast Asia's banking mess larger in relative terms than the savings and loan crisis in the United States in the 1980s and the bursting of the Japanese bubble in the 1990s.
A highly damaging downward spiral was triggered by initial pressures on the region's currencies and capital markets. In Indonesia, when the economic ministers raised interest rates to try to pull rupiah liquidity out of the market and defend the currency, they unwittingly deepened the crisis by increasing investors' alarm about how serious circumstances were; this tempted them to shift their money out of the potentially volatile Jakarta Stock Exchange and into the banking system, especially the large state banks. In Malaysia, Prime Minister Mahathir played to domestic nationalist and religious sentiment by lashing out at currency speculators and others who he felt had turned against the Malaysian economy for no good reason. Mahathir's statements, along with other signs that his government would not produce any serious policy responses to the spreading crisis, caused the pressure on Malaysia to increase. In Thailand, the crisis provoked infighting among coalition partners in the government, leading to the resignation of Prime Minister Chavalit Yongchaiyudh and the formation of a new government. The Chavalit government's initial response had been fragmented and contradictory, causing investor confidence in the country and the economy to drop to unprecedented levels.
The blame for the crisis spreads in several directions. The IMF and the World Bank are supposed to be watchdogs that alert governments and capital controllers to serious trouble on the horizon. But these institutions did not perform their jobs. The IMF failed to anticipate the Mexican peso fiasco. After that record bailout, a new "early warning system" to provide more extensive and timely information to policymakers and market actors was created. But the IMF provided no warnings in the weeks and months before July 2, 1997. In May the IMF had issued its annual World Economic Outlook, but it contained no clear signals indicating that Thailand or the other countries of Southeast Asia were in serious trouble. In response to these criticisms, the IMF claimed that it had known there were problems and that it had the internal documents to prove it. But as one observer asked pointedly, "Is secrecy the hallmark of an early warning system?"
Rating agencies like Standard and Poor's and Moody's have special access to corporate ledgers and boardrooms, yet businesses and banks that they had rated highly were crumbling under the weight of the region's financial crisis. Executives from these rating firms defended themselves by saying that as early as two years before the crisis they had already sent clear signals of problems, but that these concerns did not appear in their credit ratings. Why? Because, according to a top manager at Moody's, such signals are not supposed to appear in the ratings. "An institution run by a bunch of bureaucrats who couldn't run a corner candy store is not necessarily a bad credit risk," the manager pointed out. What matters is the willingness of governments to intervene and bail out management teams that the man from Moody's admits may in fact be "dumbos." A high credit rating does not mean that a company or bank is well managed. It means that despite "bad management, lax regulations, corrupt lending practices, and all other maladies," creditors will be paid because governments can be expected to provide public funds as backing. It happens that these rating agencies provide another measure, called financial ratings, and it is these that reflect what the agency thinks of a company's or bank's actual management and operation. But investors do not appear to consult these ratings.
The United States has also been criticized for the actions it took, or failed to take, that contributed to the crisis. One example was the almost reflexive response against the idea of setting up a regional monetary authority dominated by the Japanese. Especially when comparing the far more engaged United States response to the Mexican crisis, it is important to realize that the mostly counterproductive role of the United States government was more by neglect and distraction than by design. Because Mexico shares a long, porous border with the United States, and because immigration from Mexico is a sensitive political issue in Washington, the crisis that broke out late in 1994 received immediate and generous attention. The massive exposure of United States investors and bankers in Mexico also played an important role in the response from the Clinton administration. There were no parallel economic and political concerns regarding Asia. The crisis that began in Thailand and appeared to be spreading did not set off alarm bells in Washington.
Policymakers in the United States clearly misread the dimensions of the crisis, and certainly were very late in appreciating the negative impact it could have on the United States stock market and economy. By the time the Clinton administration began to engage the crisis more directly, it had a difficult time selling a deeper commitment to and intervention in Asia to the people and to Congress.
It is evident that the reemergence of global finance on a scale last seen at the end of the nineteenth century, in combination with late-twentieth-century technology and communications, is a volatile mix that wrenches governments and populations alike. United States Federal Reserve chairman Alan Greenspan noted in early 1998 that "these virulent episodes" seen in the Mexican and Asian crises may be "a defining characteristic of the new high-tech financial system." Greenspan admitted that no one fully understands the workings of that system. "At one point, the economic system appears stable," he said, while "the next it behaves as though a dam has reached a breaking point, and water--confidence--evacuates its reservoir." Hinting at a crack in the dam known as neoclassical economic theory, Greenspan concluded: "We have observed that global financial markets, as currently organized, do not always achieve an appropriate equilibrium."
The political question is whether people want their fates to be determined so thoroughly, randomly, suddenly, and irrationally by the controllers of mobile capital. Although it will be a difficult struggle, with capital controllers putting up a fight, decisions can be taken to severely limit the power and influence of hot money and those who wield it. Many people around the globe feel immobilized by abstractions like "globalization." Yet it is not technology but the policies of states that confer power to those controlling and moving investment resources around the globe. In September 1998, Malaysia's Mahathir decided to pull the plug, impose capital controls, and try a strong dose of Keynesian stimulation in an effort to regain some semblance of control over the domestic economy. Where this bold move will take Malaysia is unclear, but supporters and opponents of free markets are watching closely.
On the question of political participation, arguments about the wonders of authoritarianism for rapid economic development have been floating around government, business, and academic circles for several decades. It is striking, however, that Thailand and South Korea handled their crises better than Indonesia, and that both managed peaceful changes in government leadership at the peak of economic disruption--and did so without violence and bloodshed. In Indonesia, the country faced a political impasse for months as President Suharto clung to power despite his age, poor health, and role in making the country vulnerable to the crisis in the first place. Suharto was finally deposed at the cost of more than 1,000 Indonesian lives. The relatively more participatory political systems in Thailand and South Korea allowed discredited leaders to be eased out and new leaders to take the reins and push through painful reforms with a legitimacy that was utterly lacking in the halfhearted efforts of Suharto's New Order regime and the B. J. Habibie government that followed.
It is not yet clear how this crisis will affect Asian countries or international capitalism. For the present, controllers of mobile capital are in charge. Either through the direct signals of their capital investments and withdrawals or through the spins and policy reforms pushed by organizations like the IMF or individuals like Alan Greenspan, the capital controllers are able to punish and reward countries they dislike or favor. Of course, along the way jobs and goods get created. But over time, and with successive crises, especially in finance, it becomes apparent that the motives of these investors have little to do with jobs and production. These are by-products of the profit-making drive, not its central concern or goal. Neoclassical economists consider this to be the genius of market systems. You do not have to want to create employment or develop a society: it happens as if by magic.
But it does not happen automatically or magically. Nor does it happen without a good dose of coercion, conflict, and now the constant threat of tremendous economic upheaval. Private investors are choosy. Some 80 percent of total private capital flowing to developing countries goes to just a dozen countries. This means that until major changes are made in how capital is controlled, countries will face intense pressures to be responsive to the demands of capital controllers. This is going to yield reforms in the short and medium term that could undermine much of what has long defined business-government relations across many parts of Asia. But even as these crises produce reforms favoring mobile capital, they could also strengthen the resolve of governments and their citizens over the medium and long term to gain more control over how capital is controlled.
JEFFREY WINTERS a Current History contributing editor, is an associate professor in the department of politics at Northwestern University. He is the author of Power Motion: Capital Mobility and the Indonesian State (Ithaca, N.Y.: Cornell University Press, 1996).