Explanations are about the only thing not in short supply in the Asian slump. For all their diversity, they can be collapsed into two meta interpretations that reflect deeper differences in beliefs about rationality and markets.
Those whose worldview emphasizes rationality, self-adjusting markets, and market failure as exceptional tend to see the crisis as the result of rational calculations in a situation of market-distorting government interventions and institutional weaknesses in Asian economies. Those whose worldview stresses nonrationality (or a different kind of rationality than that assumed by neoclassical theory), and who also stress routine failure of well-working markets and the need for government interventions to modify market outcomes, tend to see it as the result of nonrational calculations in underregulated financial markets, both national and international.
Thus the debate about the causes has been less a debate than a case of paradigms talking past each other. Some hard testing is needed. The problem is that even in one country several different explanations may contain truth and even reinforce each other. But even allowing for country and time differences, "There are not 18 good reasons for anything," as economist George Stigler once said. What follows aims, modestly, not at the necessary hypothesis formulation and testing but at an interpretive account. It gives prominence to the nonrational elements as an offset to the tendency of economists to be much more accepting of stories based on the assumption of rational calculation simply because that is more congruent with neoclassical theory. And unlike other accounts, it encompasses both the slump and the prolonged prior success.
Since July 1997, exchange rates and stock prices in East and Southeast Asia have plunged. South Korea, Thailand, and Indonesia have had the largest drops in exchange rates, ranging from 36 percent to 72 percent by the end of March 1998. However, Malaysia and the Philippines, generally regarded as having escaped lightly, have had exchange rate declines of not much less than Thailand and South Korea. Adding the fall in the stock market to the fall in the exchange rate to get a broader measure of impact, we have to put Malaysia with the group of worst affected countries, with the Philippines just behind. In short, the conventional understanding that only South Korea, Thailand, and Indonesia have been badly affected is not true by these measures. Malaysia and the Philippines have been hurt almost as much. Even Japan, Hong Kong, and Singapore have taken substantial hits. Taiwan and China look to be least affected.
The slump is still not in the clearing-after-the-storm stage. After a respite in early 1998, a second great wave of capital outflow occurred in May and June, and forecasters resumed chasing the economies downhill. It is not an exaggeration to liken the crisis in Asia to the Great Depression of the 1930s in terms of the scale of the falls in output and consumption and the increase in poverty and insecurity. Countries have been pushed back down the hierarchy of world income to where they were 10 years ago and more in terms of per capita income measured at current exchange rates. Meanwhile the international lenders have escaped with small losses, disproving once again the adage, "If you owe the bank $1 million you have a problem, if you owe the bank $1 billion the bank has a problem."
Most commentators agree that the sharp pullout of funds by investors across the region triggered the slump, and that the pullout was panicky. The whipsaw movement from capital inflows to capital outflows occurred on a scale that could not but tear apart the social fabric of countries subjected to it, especially where political structures were only weakly institutionalized. Net private flows to or from the five most affected Asian economies--Thailand, South Korea, Malaysia, Indonesia, and the Philippines--were plus $93 billion in 1996; they were negative $12 billion in 1997. The swing in one year of $105 billion (with most of the outflow concentrated in the last quarter of 1997) equals 11 percent of the combined GDP of the five countries. Asia's experience was worse even than Latin America's in the 1980s. The swing between 1981 inflows and 1982 outflows in the three largest debtors (Brazil, Mexico, and Argentina) amounted to 8 percent of their combined GDP.
Any interpretive account of the crisis must explain why the inflows and the outflows were so large, and why the contraction of economic activity has continued to be so sharp. It also has to link the banking crisis, the currency crisis, and the corporate crisis, and it must link the politics with the economics, all without becoming so luxuriant as to be obscure.
Large Asian firms have tended to finance a large proportion of their investment from bank borrowing, and to carry a large amount of debt relative to equity compared to Western or Latin American firms. High debt-to-equity ratios allowed them to invest much more than through retained earnings or equity finance alone, and high corporate investment helped to propel the region's fast economic development over several decades.
Corporate sectors with high levels of debt are vulnerable to shocks that cause a fall in cash flow or an increase in fixed payment obligations, especially systemic shocks such as a fall in aggregate demand, a rise in interest rates, or devaluation of the currency (when part of the debt is foreign).
This bank-based system of financial intermediation encourages close relations between bankers and corporate managers, and is sometimes called "relationship banking." The system often includes government incentives to direct lending to particular sectors or functions. And it includes a closed or partially closed capital account, which means that financial capital cannot move freely in and out of the country. The entire apparatus buffers highly leveraged corporate sectors from systemic shocks and from the prudential limits of Western banks, allowing businesses to sustain levels of investment well above what the risk preferences of equity holders would allow. Very high domestic savings permit most of the investment to be financed domestically.
With liberalization governments gave up their capacity to coordinate foreign private borrowing. The IMF, the World Bank, and the Organization for Economic Cooperation and Development (OECD) acknowledged the need for the concomitant strengthening of bank regulation and supervision, but did not constrain their push for liberalization, which outpaced regulatory strengthening on the ground.
Liberalizing the financial sector and opening the capital account is dangerous when banks have little experience in international financial markets and when nonbanks also borrow abroad. It is doubly dangerous in the context of a bank-based financial system and a high debt-to-equity corporate sector. It is triply dangerous when the exchange rate is pegged. And when the banks and nonbanks are essentially unsupervised, a banking-cum-currency crisis is just waiting to happen. In Asia, swift external financial liberalization with unsupervised banks and fixed exchange rates undermined the previous system of industrial and banking cooperation and exposed fragile debt structures to unbuffered shocks.
The growth also reflects the imbalance between savings and investment in Japan. For many years the Japanese, the fastest aging population in the world, have been saving hard for the approaching years of long retirement. The economy is mature, among the richest in the world, and not able to utilize productively enough investment to absorb the savings. The result is an excess of domestic savings over domestic investment that manifests itself in chronic current account surpluses matched by capital exports.
In the decade from 1985 to 1995, the yen appreciated enormously against the dollar, from about 238 to 80. East and Southeast Asian currencies, linked to the dollar, depreciated against the yen. At the depreciated exchange rates, East and Southeast Asia provided much more competitive production sites. Japanese capital flooded out to the rest of Asia, much of it for export-oriented production aimed at the United States. Capital from other core economies joined in. With such high rates of investment, largely for the production of tradeable goods, the economies grew at phenomenal speeds. Thailand itself had perhaps the highest growth rate in the world between 1985 and 1994.
Japan's imbalance between savings and investment also grew after the early 1990s because of the bursting of the property, stock market, and currency bubbles. Japanese banks found themselves with many bad loans. Banks near insolvency tend to take big risks unless they are recapitalized, merged, or forced into bankruptcy. Rather than force the banks to follow one or another of these solutions, the Japanese government decided to allow them to write off the bad loans gradually (to "trade through"), giving them extra profits by a variety of subsidies. Meanwhile, the voracious Japanese appetite for savings continued, the savings going mostly into the banks. The banks had to lend.
After the early 1990s, Japanese banks aggressively sought high returns from foreign lending, much of it in risky loans to Southeast Asia. They found themselves able to borrow both domestically and abroad at low rates. They lent short-term to Southeast Asian banks and firms at appreciably higher rates, confident that Southeast Asian currencies would remain pegged to the dollar. European banks also lent heavily, especially after the flight from Mexico in the wake of the Mexican financial crisis of 1994-1995.
On the demand side, banks and firms in South Korea and Southeast Asia rushed to borrow abroad. Borrowing abroad at roughly half the cost of borrowing domestically seemed to be a one-way bet: you could only win. The proviso was that the currency tie to the dollar be maintained, precluding exchange rate risk. (The higher credit-rated banks and enterprises of South Korea not only borrowed abroad and lent domestically, they also then lent to Southeast Asia.)
At the same time, capital flowed in to accommodate the excess of investment over savings. High-speed growth generated gross domestic investment demand even higher than gross domestic saving, itself about the highest in the world.
In short, the inflows were driven both by the need to accommodate the excess of investment over savings (manifested in current account deficits), and by the opportunity, thanks to capital account opening, for foreign creditors to get higher returns and domestic borrowers to borrow more cheaply. They were also driven by the image of "miracle Asia." Nobody was paying much attention to the growing imbalances in the banking systems or to other risk factors.
The inflows put upward pressure on the exchange rate. The attention of the monetary authorities and of speculators and investors was on the chances of preventing appreciation of the exchange rate. Nobody was thinking depreciation. Nobody was hedging against a currency sell-off.
Third, from the spring of 1995 onward the yen fell against the dollar (from a peak of 80 in 1995 to 147 in June 1998). Investments in Southeast Asia that had been competitive at the earlier exchange rate were now less competitive, as the local currencies rose with the dollar; much investment now looked to be "excessive." Fourth, the terms of trade (export prices over import prices) were trending downward, especially because of competition from China. And fifth, China gobbled up export markets in the United States and Japan during the 1990s.
But investment continued to surge throughout the region, much of it into a narrow range of sectors, and productivity and profits began to suffer. At the margin, companies put more and more investment into nontradeable speculative ventures, including property and land. Thailand, Malaysia, and Indonesia all experienced speculative property balloons inflated by foreign finance.
Moreover, the affected countries were highly integrated (roughly half of total trade was intraregional) and moving into the downside of the business cycle at the same time. Had they been less integrated or less synchronized, the regional multiplier effects would have been much smaller. (Taiwan has survived relatively unscathed partly because it already had its boom and bust in the early 1990s. By the time this crisis hit the region Taiwan's banks were in relatively good shape.) The third vital element in the regional picture, after integration and the wrong end of the business cycle, was the stagnation of Japan, whose GDP amounts to two-thirds of total East and Southeast Asian GDP.
In short, the vulnerability of the real economy in Asia did increase in the few years before the crisis. Price and investment trends led to growing current account deficits. Also, at least in Thailand and South Korea, new civilian democratic regimes altered the central policymaking technocracy and lost focus on national economic policies. Government-bank-firm collaboration came to be steered more by the narrow and short-term interests of shifting coalitions. Their experience is bad news for the proposition that more competitive politics yield better policies.
Also, we know that bankers and money managers tend to exhibit herd-like behavior, since any individual banker or bank will be faulted by management or shareholders for missing out on business that others are getting, but will not be faulted for creating losses when everyone else is also generating them. The effect is compounded by information cascade, such that the entry or exit of one prominent actor is interpreted by other actors to signal that the situation is better or worse than they thought. They then enter or exit for reasons related not to their own independent assessment of risk and reward but to their presumption that the first actor knows something they do not.
Decreasing export growth and rising current account deficits by 1995 and 1996 made for mild concern among international banks and money managers, especially in relation to Thailand. But doubts were held at bay by the continuing fast growth and the image of miracle Asia. Then the outlook for speculators and investors in the European and United States markets improved in 1997. Interest rates looked set to rise, presenting lenders with opportunities for higher risk-adjusted returns than they had had before. Equity markets soared. In Japan, on the other hand, the outlook turned for the worse in the second quarter of 1997. In early May 1997, Japanese officials, concerned about the decline of the yen, hinted that they might raise interest rates. The threat never materialized. But the prospect of a rise in Japanese interest rates in order to defend the yen, plus the worries that were circulating about Thailand's currency, plus the brighter opportunities in the United States and Europe, raised fears among commercial bankers, investment bankers, and others about the safety of big investment positions throughout the region that were predicated on currency stability.
The Asia crisis proper began in Thailand in July 1997. Earlier, in 1996-1997, the Thai property and stock market bubbles had burst. Later the foreign banks realized they had large short-term foreign exchange loans to Thai borrowers that were unhedged and uncovered by Thai reserves.1 Knowing that the profitability of their loans depended on the currency peg, they raced for the exits at the first signs that the peg might not hold. As they sold holdings in Thai baht, the country's foreign exchange reserves ran out. The baht was floated in early July 1997, and sank. The IMF entered Thailand in August 1997 with a support package and conditionality measures that included the freezing of many finance companies. This was the start of what Harvard professor Jeffrey Sachs has called the IMF's screaming fire in the theater.2 The freezing of finance companies sent uninsured depositors into a panic. Later the IMF imposed the closure of some domestic banks in Indonesia with the same result (inevitable where deposits are uninsured).
Taiwan's small (12 percent) devaluation in October, despite its towering foreign exchange reserves, acted as a firebridge from Southeast to East Asia. After Taiwan's unexpected devaluation the Hong Kong dollar and the South Korean won suddenly looked set for devaluation also. As holders of these currencies, too, tried to pull out, the crisis grew from a "Southeast Asian" crisis to an "Asian" crisis. From October to December, Japanese, American, and European bankers demanded full repayment of interest and principal from their South Korean borrowers as short-term loans came due, leaving the Korean government with no option but to turn to the IMF. The IMF and South Korea signed a $57 billion rescue package in early December. In mid-December the Koreans revealed that their short-term debt was nearly double what they had said just the previous week, or $95 billion. The gap between $95 billion and $57 billion left scarcely a dry pair of pants in the official community on either side of the Pacific.
A large rescue package at this point could have stopped the crisis from spreading. Better information about bank and corporate balance sheets might also have checked the panic by enabling investors to discriminate between good and bad assets. Instead, the perception shifted from miracle Asia to "Asian crony state capitalism" almost overnight. "Crony capitalism," a label originally coined by activists in the anti-Marcos struggle in the Philippines, was now appropriated to convey a "told you so" moral about the dangers of government intervention.
Once floated, the region's currencies fell in vicious iteration with domestic bankruptcies. As foreign banks that had been routinely rolling over their short-term loans began to demand repayment of not only the interest but also the entire principal, highly leveraged firms found their cash flow insufficient to cover their now much higher payment obligations. A fast rising number of often well-managed and profitable firms were cut off at the knees. They started to reduce their cash outflows by delaying payments to suppliers, cutting back on expenditures, and firing employees, and also raised cash by selling inventories at cut-rate prices and selling assets at whatever they could fetch.
The process fed through from firms to banks as banks wrote off loans and wrote down assets. Their calling in of loans put pressure on their borrowers, and banks that went bankrupt put pressure on their depositors. The financial economy and the real economy dragged each other down.
This is "debt deflation," akin to that seen in the Great Depression. Debt deflation is a downward pressure on prices of both products and assets at a time when investment demand is falling, resulting in a rising real value of debt. It is given a strong twist in Asia by the devaluation-induced rise in the price of imports, including intermediate goods and medicines. Asia is now caught in the slow, painful unfolding of debt deflation with import inflation. It is all the worse because of Asia's high debt-to-equity ratios; any increase in interest rates, fall in cash flow, or devaluation impart a bigger contractionary effect than where debt-to-equity ratios are lower. This is how, in the chaos theory metaphor, the butterfly that flapped its wings in Thailand caused a hurricane across Asia.
This was the theory. In practice the increase in real interest rates, combined with other elements of the austerity package (tax increases, cuts in government expenditure), only depressed firms' cash flow and raised their fixed payment obligations, tipping more and more of them into insolvency, accelerating the capital outflows and reducing the inflows. In making the return of capital flows the priority, the fund forgot that private capital flows are cyclical rather than countercyclical. When an entire economy is sinking and instability abounds, foreign capital will not return, whatever the interest rate. Certainly the high real interest rates did not have the effect of reversing the currency falls in Asia. And the wider statistical evidence shows no clear relationship between the level of real interest rates and changes in the exchange rate.
A sharp dose of austerity may make sense for a Latin American-style excessive consumption crisis. But the Asian crisis was related to excessive investment (much of it in nontradeables), not excessive consumption. IMF demand compression has worsened already existing problems of excessive production capacity.
Similarly, being required to undertake fundamental structural reforms at the height of the crisis worsened confidence, reinforcing the "cronyism" image. Requiring a sharp rise in bank capital adequacy standards in the midst of the crisis caused a cut in credit, a rise in nonperforming loans, and further bankruptcies. The Asian experience confirms that the middle of a liquidity crisis is a bad time to make radical financial reforms.
The fund also required governments to guarantee the foreign debts of local firms and banks. Protected from default, foreign creditors hung back on rescheduling or rolling over the debt. This worsened the hard currency squeeze on local debtors, pushing them to buy foreign exchange to cover their increased dollar needs and adding to the exchange rate collapse.
These various policy mistakes help to explain why the slump has been so protracted. Their effects are compounded by the high debt-to-equity ratios of the corporate and financial systems, by the relatively high level of regional integration, by the synchronous movement of all the regional economies except Taiwan, and by Japan's stagnation. Mexico in 1994 recovered relatively quickly by exporting to the giant to the north, whose political structure was sufficiently institutionalized to accommodate a $20 billion swing in trade balances in one year. Had Japan been expanding it might have played a similar role as the United States had for Mexico. Fears of further falls in the Japanese yen (even after the steep fall of June 1998 to 147 yen to the dollar) add to the continuing reluctance to invest and raise fears of competitive devaluations, notably in China and Hong Kong.
Until recently, most Asian governments generally acquiesced to the IMF's strategy--in part because they needed the IMF's money and approval, and in part because they believed in it. Now that the cost of this option has become apparent a policy backlash has begun. It constitutes what the September 4, 1998, Wall Street Journal calls "the most serious challenge yet to the free-market orthodoxy that the globe has embraced since the end of the Cold War."
In the face of steep losses of output and the threat of social unrest, and with huge current account surpluses to cushion the need for Western short-term capital, Asian governments are lowering interest rates and promoting a Keynesian fiscal expansion. Indeed, they are becoming more interventionist across the board in order to regain control of their economies. Some have described their actions as a rejection of Anglo-American capitalism, and look to China as a model since it has escaped relatively unscathed. Their turning away from the United States and toward China may have important long-term implications. And the mood is spreading well beyond Asia. "The 'free market' path of development--from developing to emerging to a developed nation--has failed to live up to the expectations of the people of the South," said South African Deputy President Thabo Mbeki recently.
In particular, Asian governments and policy analysts are urgently discussing whether they should continue to allow financial capital to flow freely across their borders, as the IMF and the United States have insisted. They realize that whatever the balance between the "real" and "financial" causes of the crisis, the capital account opening that they undertook in the 1990s is centrally implicated. Capital account liberalization first allowed large and uncoordinated inflows and then torrential outflows in the second half of 1997 and on into 1998. Recall that the switch in flows between 1996 and 1997 amounted to some 11 percent of the combined GDP of the five crisis-affected countries. China has escaped the direct impact of the crisis in large part because its currency is nonconvertible, preventing both inflows and outflows of hot money (but not preventing foreign direct investment, of which China has enjoyed a great deal). Much the same applies to India.
Malaysia, which had been among the most open economies on the capital account, has gone furthest in reintroducing capital controls--explicitly following China. Indeed, the new special functions minister, Diam Zainuddin, announced that "Malaysia's new currency controls are based on China's model."
The exchange controls put into place at the end of August in effect withdraw the Malaysian ringgit from the international currency trading system. Exporters are now required to sell their foreign exchange to the central bank at a fixed rate; that currency is then sold for approved payments to foreigners, mainly for imports and debt service. This system makes the ringgit convertible on the current account, as before, but not on the capital account. It thus prevents the buying of foreign exchange for speculative purposes. Residents cannot transfer ringgits to foreign bank accounts, and can take only a limited amount of foreign exchange for purposes of foreign travel. Nonresidents can convert ringgits into foreign currency only with the approval of the central bank. And sellers of Malaysian securities can only convert their ringgits into foreign exchange once they have held the security for 12 months. Holders of offshore ringgit accounts had from September 1 to October 1 to repatriate their ringgits, after which repatriation became illegal. With this last move the government ensured that the imposition of exchange controls, far from generating the always threatened punishment, capital flight, yielded a short-term, debt-free capital inflow.
Malaysia has not turned away from all forms of foreign capital. The controls are aimed specifically at short-term flows. They do not extend to foreign direct investment or the repatriation of interest, dividends, and profits. Current account transactions remain convertible; Malaysia remains committed to free trade.
Prime Minister Mahathir Mohamad accompanied this move with a stinging indictment of free markets. "The free market system has failed and failed disastrously." He added, "We have asked the International Monetary Fund to have some regulation on currency trading but it looks like they are not interested." He proceeded to sack Anwar Ibrahim, the deputy prime minister and finance minister and his heir apparent. Anwar had reassured international investors with his orthodox free market views and willingness to impose austerity measures. Although Malaysia had not taken IMF money and therefore had not come under a formal IMF program, Anwar had followed the IMF both in its broad strategy and in its specific advice to Malaysia.
The IMF's managing director, Michel Camdessus, said Malaysia's exchange controls were "dangerous and indeed harmful." United States Treasury Secretary Robert Rubin said that dramatic economic policy shifts by Malaysia were of concern to the United States and were "not the path that we think best lends itself to economic growth and stability over time."
Western financiers chorused disapproval. Salomon Brothers described Mahathir's measures as "regressive" and "ultimately destined to failure." Credit Lyonnais Securities (Asia) said that capital controls would turn Malaysia into "an equity black hole" for foreign investors. Indosuez W. I. Carr said the measures make "Malaysia virtually uninvestable." The underlying and doubtful assumption is that Malaysia, notwithstanding one of the highest savings rates in the world (37 percent of GDP in 1995), needs Western finance not only for immediate refinancing purposes but also in the longer term.
Mahathir has been voicing antimarket sentiments for some time, earning himself the reputation for being what might politely be called a lone voice. But even in economies that had been celebrated as exemplars of free market capitalism, policies are being implemented that make free market economists throw up their hands in horror.
Hong Kong is the most dramatic case. GDP is expected to contract by over 4 percent in 1998. Throughout the summer of 1998 it faced intense attacks by hedge funds against the Hong Kong dollar (pegged to the United States dollar in a quasi-currency board arrangement). The hedge funds calculated that when competitor countries had devalued by 30 to 40 percent or more against the United States dollar, the Hong Kong dollar would have to be devalued as well.
In response the government has been intervening to restrict various forms of trading on the stock market so as to ease the pressure on the Hong Kong dollar. And it has bought about 6 percent of the stock market, acquiring a national stake in the private sector. The aim was to hit the speculators by intervening to keep the price of stocks high, to show them that shorting stocks was not a one-way bet. It worked. The hedge funds took big losses and backed off.
Even Taiwan, which has weathered the crisis better than many of its neighbors, has seen a 7 percent fall in its export earnings in the first half of 1998 compared with the first half of 1997; it has also experienced a 20 percent stock market fall between March and August 1998. Notwithstanding its huge foreign exchange reserves, it too faces intense speculative pressure against its currency.
The policy response has been to insulate the New Taiwan dollar from the region's currency decline and bar foreign short-term investors while encouraging local investors. The government has been intensifying existing controls since May. The central bank virtually shut down trade in futures instruments used to pressure the local currency. Inflows of funds destined for the stock market are subject to central bank approval, allowing the authorities to influence demand for the currency. The offshore market in New Taiwan dollars has been closed. At the end of August the central bank issued a sharp warning that foreign currency speculators such as George Soros would be given "no quarter" to operate in domestic currency markets.
South Korea has all along kept in place some capital account restrictions on the convertibility of the won. And although the Korean government has not moved to impose Malaysian-type exchange controls it has become much more interventionist--and much more authoritarian. Many labor leaders are in jail, and riot police are deployed in force during strikes and demonstrations against the government. In the financial sector, the government is moving quickly (unlike Japan) to buy up bad loans from the banks and force small banks to merge with larger ones, putting the banking sector on the route to recovery--although many firms are still finding credit difficult to obtain because banks continue to try to meet the Basel standards of capital adequacy, as they are obliged to do by OECD membership (under the standards formulated by the Basel Committee of Bank Supervisors, a bank operating internationally is required to maintain capital reserves equal to at least 8 percent of its outstanding loans). The big question now is whether the government will take the banks off the Basel standards, which might greatly alarm international financial markets.
Thailand has not introduced exchange controls, because it has no reserves left to defend and because it is entirely dependent on the IMF standby facility. But reaction in Bangkok recognizes that Mahathir, in Malaysia's situation, is not crazy.
Potentially the most dramatic development of all may come from the current discussion within Japan of reintroducing capital controls. Finance Minister Kiichi Miyazawa, at a press conference in early September before flying to San Francisco to meet Treasury Secretary Rubin and Federal Reserve chairman Alan Greenspan, was asked whether Japan was studying the option of erecting capital controls to protect against speculative attacks. In the words of the September 4, 1998, Reuters report of the conference, "He said it was too early to discuss that at the government level but added he had asked Toyo Gyohten, a special adviser to Prime Minister Keizo Obuchi, to study the issue." For the finance minister of the world's second-largest economy to say this just before meeting the two most powerful financial officials in the world, who are passionate opponents of capital controls, is remarkable.
MIT economist Paul Krugman argues that Asian countries should introduce controls on outflows as a short-term emergency measure. But, with the important exception of Japan, there is a stronger case for semipermanent controls on inflows. Countries such as South Korea and Thailand, which are accumulating huge trade surpluses accompanied by foreign exchange inflows, can probably lower domestic interest rates and generate monetary expansion without appreciably weakening their currencies. Most of the hot money that went into emerging Asia over the 1990s has now left, so controls are not needed to prevent further outflows of institutional funds.4
Exchange controls or other forms of capital control are nevertheless needed for two reasons. One is to protect against excessive inflows. Here we need to distinguish between three types of inflows: first, short-term capital to refinance foreign loans until current account surpluses grow to the point where the loans can be paid back from the surpluses; second, foreign additions to domestic savings available for investment (including foreign portfolio investment); and third, foreign investment that goes along with technology, capital equipment, and management and marketing expertise. The Asian economies do need immediate help in refinancing their top-heavy foreign debt, and they do need technology, capital equipment, and some kinds of foreign expertise. But they do not need the huge inflows that they had been receiving of short-term financial capital. They have the highest savings rates in the world, and account for over half of world savings (East Asia and the Pacific saved an average of 38 percent of GDP in 1995, compared to South Asia's 20 percent, Latin America's 19 percent, and the high-income countries' 21 percent).
As was noted earlier, these countries overinvested in some manufacturing sectors and in essentially speculative ventures in real estate, infrastructure, and equities, resulting in inefficient investment, asset bubbles, credit excesses, and exchange rate overvaluation--the ills that led to the current crisis. They have not been able productively to absorb even domestic savings, let alone extra foreign savings. It is ironic that most of the critics who point to excessive, crony-steered investment as the root of the crisis insist that Asia will suffer if it limits inflows of short-term financial capital.
Capital controls are needed, second, to make these fairly small, fairly open economies less vulnerable to the whims and stampedes of portfolio and hedge fund managers, and more generally to reestablish stable growth. This is especially so in economies with high corporate debt-to-equity ratios. South Korea is a classic example of how free capital movements in the context of high domestic and foreign debt can destabilize an economy with good "fundamentals." But the Hong Kong case shows how the same thing can happen in a small, open economy with low debt, large exchange reserves, and a current account surplus once short-selling speculators wielding vast financial resources make it the target of an attack.
Although he does not make the distinction between Japan and the rest, Krugman's argument for controls on outflows does hold for Japan. Japanese nominal interest rates are below foreign rates. An aggressive monetary policy sufficient to jump-start demand requires negative real interest rates, which requires nominal rates much lower than foreign rates. At some point the disincentive of keeping savings at home will outweigh the risks of a Wall Street crash and a dollar crash. There is now a large potential for savings exports to occur. Until as recently as April 1998, such financial exports were restricted. In April they were allowed as part of the first stage of "Big Bang" financial liberalization. The financial outflows since then have contributed to yen weakness. More aggressive monetary expansion would likely cause more outflows and further yen depreciation, which could destabilize other currencies in the region.
In short, Asia is moving strongly in the direction of capital controls, and there are good policy reasons why it should. Yet it would be quite wrong to conclude that the movement to capital controls is robust. The shift on the ground in Asia has already encountered vehement opposition from the United States, Britain, and the IMF.
Consider the hyperbole with which Alan Greenspan, Undersecretary of the Treasury Lawrence Summers, and other American officials have denounced the moves in Asia. Greenspan's testimony to the House Banking Committee is particularly striking. He normally testifies blandly and ambiguously, and about many subjects all at once. On September 16, he spoke passionately, clearly, and about only one subject: the perils of capital controls. He equated the sort of exchange controls introduced by Malaysia with "closing the economy to foreign investment," which in turn amounted to depriving the economy of "the benefits of new technologies," causing it to be "mired at a suboptimal standard of living." This is the voice of panic in the face of a threat to years of success in opening developing countries more completely to both trade and finance. He and other United States financial officials see it as imperative to make sure that the troubles in Asia are blamed on the Asians and that free capital markets are seen as key to world economic recovery and advance; the idea that international capital markets are themselves the source of speculative disequilibria and retrogression must not be allowed to take root.
Capital controls themselves are only the tip of the iceberg. The American and British governments wish to ensure that the current troubles do not derail the construction of a new international financial architecture built on the premise that free capital movements are the key to worldwide prosperity. They wish to remake other countries' financial systems in their own image. For the low-saving United States economy there is no more important foreign economic policy issue than this.
These endowments could easily provide the basis for an Asia Financial Facility. The facility would help member countries replenish reserves as soon as signs of distress became obvious, reducing the chance of speculative attacks and investor pullout. It is one thing to speculate against a currency backed by $30 billion of national reserves, and quite another to speculate against a currency backed by $300 billion of regional reserves. The facility would quickly disburse funds and its conditionality would be limited to stabilization rather than extended to structural reform. Even the first moves might shift perception from "failure" to "recovery" and send Western capital cartwheeling to take positions before prices rise--especially when Western stock markets fall from current valuations that are, in the United States case, twice the previous historic highs.
The main obstacle is political. Japan's proposal for an Asia Fund, made in mid-1997, was shot down by the United States Treasury, which wanted the IMF to have control of the rescue. Japan came back with a more modest proposal for a $30 billion regional fund on October 1, but the country's leadership remains paralyzed by the power struggle between big manufacturing, wanting a weak yen, and banks, wanting a strong yen. China has shown a moderate amount of leadership, and emerges from the crisis with its reputation enhanced relative to Japan's. But it is the United States Treasury under Secretary Rubin and Undersecretary Summers that has been shaping the overall strategy, both directly and indirectly by way of the IMF. The United States emerges from the crisis with much greater power in the region than it had before. And the United States does not want an Asian initiative that would exclude it from a central role. Nor does China want a Japanese-led fund.
Until Asian governments adopt expansionary policies, take control of short-term capital movements, and cooperate regionally, the crisis is likely to drag on and on, like water torture, bringing poverty and insecurity to hundreds of millions of people and turning parts of Asia into a dependency of the IMF and its number one shareholder. Recent policy changes suggest that this lesson is slowly being learned.
The capital inflows to Asia were a function of capital account opening, fixed exchange rates, lack of bank supervision adequate for an internationalized system, depreciation of domestic currencies against the yen (because linked to the falling dollar before 1995), and higher returns to financial assets in Asia than in the United States and Europe. The outflows were a function of capital account opening, appreciation of domestic currencies against the yen after the spring of 1995 (because linked to the rising dollar), falling export growth, and rising current account deficits, the combination of the last two giving rise to fears of devaluation.
The causation also has another strand, relating to herding behavior and information cascades and the like, that links individual rationality with collective nonrationality or suboptimal behavior. What is striking about the Asia crisis is the abrupt shift of confidence from miracle Asia to crony Asia--a "gestalt shift," in the language of cognitive psychology. In the famous drawing of a vase or a pair of inwardly turned faces, we see either one or the other, not some of one and some of the other, and the shift takes place instantaneously, not by degrees. This is a long way from the idea of the rational calculation of risks and rewards.
The notion of gestalt shift lends support to the panic story--that the crisis was caused in large part by speculator and investor pullout from economies that but for the pullout would have remained viable enough to generate returns within the normal range. The panic, in other words, was not simply the "trigger" or messenger of a crisis: the panic was a primary cause. The change in perceptions and behavior was much bigger than the change in real factors could warrant.
This line of argument suggests that had the massive outflow not occurred in Thailand or had it been reversed in a matter of a couple of months, the Asia crisis would not have happened. One can see several turning points where things might have gone differently. Had the Japanese government not made a colossal macroeconomic error in the spring of 1997 by raising taxes as the economy was slowing, the Japanese economy might still have been expanding. Had Japan in August 1997 matched its pledge to play a large role in promoting financial stability in the region with a contribution to the Thai bailout of $10 billion rather than $4 billion, confidence may have been restored. Ditto had the United States Treasury not shot down Japan's Asia Fund proposal. Ditto had the United States Congress not declined to provide more funds to the IMF in November 1997 because of a dispute about an abortion-related amendment to the country's foreign aid program. It took an unlikely conjuncture of these and several other events to produce a crisis on anything like this scale.
This view also throws doubt on the popular moral hazard argument for why the inflows were so big. The moral hazard argument says that lenders lent appreciably more than otherwise because they believed they would be covered by implicit government or IMF guarantees. But the hypothesis is advanced without evidence that, for example, lenders lent more to companies, banks, sectors, and countries where there was a stronger prior presumption of bailout. It is equally plausible that lenders were paying no attention to downside risks, being carried along by the gestalt of miracle Asia and the incentives for herd behavior.
Much the same point applies to the popular "lack of transparency" hypothesis about the size of the inflows: that lenders lent more than they would have had they been better informed about balance sheets, foreign exchange reserves, and foreign debts. In fact, a large amount of relevant information was publicly available; for example, the Bank for International Settlements' commentaries from early 1995 onward stressed the buildup of short-term foreign debt. But investors were not paying attention until after the crisis hit, at which point they refocused from macro indicators to the micro indicators of debt maturity structures and the like that they could have been tracking all the while had they a mind to. On the other hand, lack of transparency may have a significant role in explaining the magnitude of the panic, and hence the size of the outflows, since creditors and investors came to believe they had no reliable basis to discriminate between good and bad assets.
The IMF argues that its far-reaching conditions for austerity and institutional reform boosted confidence as investors saw governments taking firm action to repair underlying vulnerabilities. The gestalt shift argument says, in contrast, that the news that the IMF was demanding a whole series of fundamental structural changes aggravated the loss of confidence, prompting a bigger rush for the exits.
The latter argument raises an interesting question of causality. IMF critics have pointed out that no sizable changes occurred in national institutional structures in the last year or two before the crisis, and go on to ask how, given this, institutional factors could be assigned a large role. But weaknesses such as lack of bankruptcy codes and creditor rights may exist for years without causing difficulties, provided growth remains high. Once growth falters these same constant weaknesses may help to bring on a crisis and hinder the resumption of growth. The question remains, however, whether the fund should have insisted on reforms in such areas in the midst of a liquidity crisis.
However the explanation is parsed, capital account opening is central. It exposed domestic financial structures--which had been strong enough to allocate huge domestic savings to generally productive and profitable investments over many years--to unbearable strain. Yet the IMF, the United States, and Britain now insist that the crisis demonstrates the importance of liberalizing the capital account even more, although in an "orderly" fashion. Orderly means with a proper regulatory and supervisory regime in place. The way to create that regime, they say, is to bring in foreign banks and financial services firms to operate in the domestic market. They will demand an effective regime and help supply the skills with which to operate it. In return, they will require freedom to enter and exit as they wish, and national treatment (parity with domestic firms, or better).
Even with a sizable sector of foreign financial firms, developing an effective regime will take many years. And duration aside, regulation according to whose norms? The norms of a capital-market-based Anglo-American system are very different from those of a bank-based Asian system. The latter reflect the functioning of a system that allows firms to carry much higher levels of debt than consistent with Anglo-American prudential limits. The system has powerful developmental advantages as well as higher risks of financial instability. And it also seems to be a response to very high levels of household savings that are deposited in banks. A regulatory regime based on Anglo-American norms of prudent debt-to-equity ratios will probably not work in these conditions.
The idea that the way to avoid more Asian-style crises is to integrate national economies even more fully into world capital markets is implausible. As Harvard economist Dani Rodrik remarks, "Thailand and Indonesia would have been far better off restricting borrowing from abroad instead of encouraging it. Korea might just have avoided a run on its reserves if controls on short-term borrowing had kept its short-term exposure to foreign banks, say, at 30 percent rather than 70 percent of its liabilities. On the other hand, which of the recent blowups in international financial markets could the absence of capital controls conceivably have prevented?" As Rodrik, World Bank economist Joseph Stiglitz, and Columbia University economist Jagdish Bhagwati have argued, there is little empirical evidence that capital account opening improves economic performance.
Rodrik notes that the greatest concern about capital account convertibility, however, is that it brings economic policy in developing countries even more under the influence of international capital markets--the influence of a small number of country analysts and fund managers in New York, London, Frankfurt, and Tokyo. Even if it were the case that free capital movements led to efficiency in the allocation of capital and thereby maximized the returns to capital worldwide, governments have much more than the interests of the owners of capital in view--or ought to have. They want to maximize the returns to labor, to entrepreneurship, to technical progress, and to maximize them within their own territory rather than somewhere else; they want to provide public goods that contribute to the good life. Only blind faith in the virtues of capital markets could lead one to think that maximizing the returns to capital and promoting development goals generally coincide.
ROBERT WADE is a professor of political science and international political econonmy at Brown University. He is the author of Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization (Princeton, N.J.: Princeton University Press, 1990). This article draws on: From 'Miracle' to 'Cronyism': Explaining the Great Asian Slump," in the November 1998 issue of the Cambridge Journal of Economics, and "The Gathering World Slump and the Battle over Capital Controls," New Left Review, September-October 1998.
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