Charles W.L.Hill
University of Washington
(China parallel highlights )
Asian Contagion
Between June 1997 and January 1998 a financial crisis swept like a brush fire through the "tiger economies" of SE Asian. Over the previous decade the SE Asian states of Thailand, Malaysia, Singapore, Indonesia, Hong Kong, and South Korea, had registered some of the most impressive economic growth rates in the world. Their economies had expanded by 6% to 9% per annum compounded, as measured by Gross Domestic Product. This Asian miracle, however, appeared to come to an abrupt end in late 1997 when in one country after another, local stock markets and currency markets imploded. When the dust started to settle in January 1998 the stock markets in many of these states had lost over 70% of their value, their currencies had depreciated against the US dollar by a similar amount, and the once proud leaders of these nations had been forced to go cap in hand to the International Monetary Fund (IMF) to beg for a massive financial assistance. This section explains why this happen, and explores the possible consequences, both for the world economy, and for international businesses?
Background
The seeds of the 1997-98 Asian financial crisis were sown during the previous decade when these countries were experiencing unprecedented economic growth. Although there were and remain important differences between the individual countries, a number of elements were common too most. Exports had long been the engine of economic growth in these countries. A combination of inexpensive and relatively well educated labor, export oriented economies, falling barriers to international trade, and in some cases such as Malaysia, heavy inward investment by foreign companies, had combined during the previous quarter of a century to transform many Asian states into export powerhouses. Over the 1990-1996 period, for example, the value of exports from Malaysia had grown by 18% per year, Thai exports had grown by 16% per year, Singapore’s by 15% per year, Hong Kong’s by 14% per year, and those of South Korea and Indonesia by 12% per year. The nature of these exports had also shifted in recent years from basic materials and products such as textiles to complex and increasingly high technology products, such as automobiles, semi-conductors, and consumer electronics.
An Investment Boom. The wealth created by export led growth helped to fuel an investment boom in commercial and residential property, industrial assets, and infra-structure. The value of commercial and residential real estate in cities such as Hong Kong and Bangkok started to soar. In turn, this fed a building boom the likes of which had never been seen before in Asia. Office and apartment building were going up all over the region. Heavy borrowing from banks financed much of this construction, but so long as the value of property continued to rise, the banks were more than happy to lend. As for industrial assets, the continued success of Asian exporters encouraged them to make ever bolder investments in industrial capacity. This was exemplified most clearly by South Korea’s giant diversified conglomerates, or chaebol, many of which had ambitions to build up a major position in the global automobile and semi-conductor industries.
An added factor behind the investment boom in most SE Asian economies was the government. In many cases the government had embarked upon huge infra-structure projects. In Malaysia, for example, a new government administrative center was been constructed in Putrajaya for M$20 billion (US$8 billion at the pre July 1997 exchange rate), the government was funding the development of a massive high technology communications corridor, and the huge Bakun dam, which at a cost of M$13.6 billion was to be the most expensive power generation scheme in the country.
Throughout the region governments also encouraged private businesses to invest in certain sectors of the economy in accordance with "national goals" and "industrialization strategy". In South Korea, long a country where the government played a pro-active role in private sector investments, President Kim Young-Sam urged the chaebol to invest in new factories. Mr. Kim, a populist politician, took office in 1993 during a mild recession, and promised to boost economic growth by encouraging investment in export oriented industries. Korea did enjoyed an investment led economic boom in the 1994-95 period, but at a cost. The chaebol, always reliant on heavy borrowings, built up massive debts that were equivalent, on average, to four times their equity.
In Malaysia, the government had encouraged strategic investments in the semi-conductor and automobile industries, "in accordance with the Korean model". One result of this was the national automobile manufacturer, Perusahaan Otomobil Nasional Bhd, which was established in 1984. Protected by a 200% import tariff and with few other competitors, the Proton, as the car was dubbed, sold well in its captive market. By 1989 Perusahaan Otomobil Nasional Bhd was selling 72,000 cars out of a total market of 117,000. By 1995 it had a 62% share of a market which had grown to 225,000 cars annually. Whether this company could succeed in a competitive marketplace, however, was another question. Skeptical analysis note that in 1987 an average 1,600cc Proton cost about three times per capita income in Malaysia; by 1996 a 1,6000cc Proton costs 5.5 times per capita income – hardly what one would expect from an efficient enterprise.
In Indonesia, President Suharato has long supported investments in a network of an estimated 300 businesses that are owned by his family and friends in a system known as "crony capitalism". Many of these businesses have been granted lucrative monopolies by the President. For example, in 1990 one the President’s youngest son, Mr Hutomo, was granted a monopoly on the sale of cloves, which are mixed with tobacco in the cigarettes preferred by 9 out of 10 smokers in Indonesia. In another example, in 1995 Suharato announced that he had decided to build a national car, and that the car would be built by a company owned by Mr Hutomo, in association with Kia motors of South Korea. To support the venture, a consortium of Indonesian banks was "ordered" by the Government to offer almost $700 million in start-up loans to the company.
In sum, by the mid 1990s SE Asia was in the grips of an unprecedented investment boom, much of it financed with borrowed money. Between 1990 and 1995 gross domestic investment grew by 16.3% per annum in Indonesia, 16% per annum in Malaysia, 15.3% in Thailand, and 7.2% per annum in South Korea. By comparison, investment grew by 4.1% per annum over the same period in the US, and 0.8% per annum in all high income economies. Moreover, the rate of investment accelerated in 1996. In Malaysia, for example, spending on investment accounted for a remarkable 43% of GDP in 1996.
Excess Capacity. As might be expected, as the volume of investments ballooned during the 1990s, often at the bequest of national governments, so the quality of many of these investments declined significantly. All too often, the investments were made on the basis of projections about future demand conditions that were unrealistic. The result was the emergence of significant excess capacity.
A case in point were investments made by Korean chaebol in semi-conductor factories. Investments in such facilities surged in 1994 and 1995 when a temporary global shortage of Dynamic Random Access Memory chips (DRAMs) led to sharp price increases for this product. However, by 1996 supply shortages had disappeared and excess capacity was beginning to make itself felt, just as the Koreans started to bring new DRAM factories on stream. The results were predictable; prices for DRAMs plunged through the floor and the earnings of Korean DRAM manufacturers fell by 90%, which meant it was extremely difficult for them to make scheduled payments on the debt they had taken on to build the extra capacity in the first place.
In another example, a building boom in Thailand resulted in the emergence of excess capacity in residential and commercial property. By early 1997 it was estimated that there were 365,000 apartment units unoccupied in Bangkok. With another 100,000 units scheduled to be completed in 1997, it was clear that years of excess demand in the Thai property market had been replaced by excess supply. By one estimate, by 1997 Bangkok’s building boom had produced enough excess space to meet its residential and commercial need for at least five years.
The Debt Bomb. By early 1997 what was happening in the Korean semi-conductor industry and the Bangkok property market was being played out elsewhere in the region. Massive investments in industrial assets and property had created a situation of excess capacity and plunging prices, while leaving the companies that had made the investments groaning under huge debt burdens that they were now finding difficult to service.
To make matters worse, much of the borrowing to fund these investments had been in US dollars, as opposed to local currencies. At the time this had seemed like a smart move. Throughout the region local currencies were pegged to the dollar, and interest rates on dollar borrowings were generally lower than rates on borrowings in domestic currency. Thus, it often made economic sense to borrow in dollars if the option was available. However, if the governments in the region could not maintain the dollar peg and their currencies started to depreciate against the dollar, this would increase the size of the debt burden that local companies would have to service, when measured in the local currency. Currency depreciation, in other words, would raise borrowing costs and could result in companies defaulting on their debt payments.
In another example, a building boom in Thailand resulted in the emergence of excess capacity in residential and commercial property. By early 1997 it was estimated that there were 365,000 apartment units unoccupied in Bangkok. With another 100,000 units scheduled to be completed in 1997, it was clear that years of excess demand in the Thai property market had been replaced by excess supply. By one estimate, by 1997 Bangkok’s building boom had produced enough excess space to meet its residential and commercial need for at least five years.
The Debt Bomb. By early 1997 what was happening in the Korean semi-conductor industry and the Bangkok property market was being played out elsewhere in the region. Massive investments in industrial assets and property had created a situation of excess capacity and plunging prices, while leaving the companies that had made the investments groaning under huge debt burdens that they were now finding difficult to service.
To make matters worse, much of the borrowing to fund these investments had been in US dollars, as opposed to local currencies. At the time this had seemed like a smart move. Throughout the region local currencies were pegged to the dollar, and interest rates on dollar borrowings were generally lower than rates on borrowings in domestic currency. Thus, it often made economic sense to borrow in dollars if the option was available. However, if the governments in the region could not maintain the dollar peg and their currencies started to depreciate against the dollar, this would increase the size of the debt burden that local companies would have to service, when measured in the local currency. Currency depreciation, in other words, would raise borrowing costs and could result in companies defaulting on their debt payments.
In this regard, a final complicating factor was that by the mid 1990s although exports were still expanding across the region, so were imports. The investments in infrastructure, industrial capacity, and commercial real estate were sucking in foreign goods at unprecedented rates. To build infra-structure, factories, and office buildings, SE Asian countries were purchasing capital equipment and materials from America, Europe, and Japan. Boeing and Airbus were crowing about the number of commercial jet aircraft they were selling to Asian airlines. Semi-conductor equipment companies such as Applied Materials and Lam Materials were boasting about the huge orders they were receiving from Asia. Motorola, Nokia, and Ericsson were falling over themselves to sell wireless telecommunications equipment to Asian nations. And companies selling electric power generation equipment such as ABB and General Electric were booking record orders across the region.
Reflecting growing imports, many SE Asian states saw the current account of their Balance of Payments shift strongly into the red during the mid 1990s. By 1995 Indonesia was running a current account deficit that was equivalent to 3.5% of its Gross Domestic Product (GDP), Malaysia’s was 5.9%, and Thailand’s was 8.1%. With deficits like these starting to pile up, it was becoming increasingly difficult for the governments of these countries to maintain the peg of their currencies against the US dollar. If that peg could not be held, the local currency value of dollar dominated debt would increase, raising the specter of large scale default on debt service payments. The scene was now set for a potentially rapid economic meltdown.
Reflecting growing imports, many SE Asian states saw the current account of their Balance of Payments shift strongly into the red during the mid 1990s. By 1995 Indonesia was running a current account deficit that was equivalent to 3.5% of its Gross Domestic Product (GDP), Malaysia’s was 5.9%, and Thailand’s was 8.1%. With deficits like these starting to pile up, it was becoming increasingly difficult for the governments of these countries to maintain the peg of their currencies against the US dollar. If that peg could not be held, the local currency value of dollar dominated debt would increase, raising the specter of large scale default on debt service payments. The scene was now set for a potentially rapid economic meltdown.
Meltdown in Thailand
The Asian meltdown began on February 5th, 1997 in Thailand. That was the date that Somprasong Land, a Thai property developer, announced that it had failed to make a scheduled $3.1 million interest payment on an $80 billion eurobond loan, effectively entering into defaulting. Somprasong Land was the first victim of speculative overbuilding in the Bangkok property market. The Thai stock market had already declined by 45% since its high in early 1996, primarily on concerns that several property companies might be forced into bankruptcy. Now one had been. The stock market fell another 2.7% on the news, but it was only the beginning.
In the aftermath of Somprasong’s default it became clear that not only were several other property developers teetering on the brink on default; so where many of the country’s financial institutions including Finance One, the country’s largest financial institution. Finance One had pioneered a practice that had become widespread among Thai institutions --- issuing eurobonds denominated in US dollars and using the proceeds to finance lending to the country’s booming property developers. In theory, this practice made sense because Finance One was able to exploit the interest rate differential between dollar denominated debt and Thai debt (i.e. Finance One borrowed in US dollars at a low interest rate, and leant in Thai Bhat at high interest rates). The only problem with this financing strategy was that when the Thai property market began to unravel in 1996 and 1997, the property developers could no longer payback the cash that they had borrowed from Finance One. In turn, this made it difficult for Finance One to pay back its creditors. As the effects of over-building became evident in 1996, Finance One’s non-performing loans doubled, then doubled again in the first quarter of 1997.
………………In the aftermath of Somprasong’s default it became clear that not only were several other property developers teetering on the brink on default; so where many of the country’s financial institutions including Finance One, the country’s largest financial institution. Finance One had pioneered a practice that had become widespread among Thai institutions --- issuing eurobonds denominated in US dollars and using the proceeds to finance lending to the country’s booming property developers. In theory, this practice made sense because Finance One was able to exploit the interest rate differential between dollar denominated debt and Thai debt (i.e. Finance One borrowed in US dollars at a low interest rate, and leant in Thai Bhat at high interest rates). The only problem with this financing strategy was that when the Thai property market began to unravel in 1996 and 1997, the property developers could no longer payback the cash that they had borrowed from Finance One. In turn, this made it difficult for Finance One to pay back its creditors. As the effects of over-building became evident in 1996, Finance One’s non-performing loans doubled, then doubled again in the first quarter of 1997.
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The Asian Economic Model. Back in the late 1980s and early 1990s a number of authors were penning articles about the superiority of the Asian Economic Model or Asian Capitalism. According to its advocates, the countries of the Asian Pacific region, as exemplified by Japan and South Korea, had put together the institutions of capitalism in a more effective way than either the United States or Western European nations. The so called Asian Model of state directed capitalism seemed to combine the dynamism of a market economy with the advantages of centralized government planning (see Chapter 2 for details). It was argued that close cooperation between government and business to formulate industrial policy led to the kind of long-term planning and investment that was not possible in the West. Informal lending practices were credited with giving Asian firms more flexibility than allowed for by the rigorous disclosure rules imposed on similar transactions in the United States. And Western admirers praised government policies designed to encourage exports and protect domestic producers from imports.
However, economists have argued for some time that the Asian economic miracle had nothing to do with cooperation between government and business. Instead, it was the result of high savings rates, good education systems, and rapid growth in the labor force. Many warned that the Asian proclivity for government directed investment and poorly regulated financial systems was a dangerous mix that could lead to over investment, excessive debt, and financial crises. Despite the occurrence of just such a crisis in Japan in 1989, advocates of the Asian Way, including many leading politicians in Asia, steadfastly ignored the risks inherent in an interventionist economic model. Instead, they continued to sing the praises of business-government cooperation and "Confucian values", right up to the explosion of the debt bomb and the collapse of their stock markets and currencies in late 1997.
Now that the crash has occurred, momentum in Asia is starting to shift away from the "Asian Way" and towards the Western economic model. Pushed in part by the IMF, but also by shifting opinion among some politicians and business leaders within the region, Asia’s troubled economies seem to be embarking on a long overdue restructuring. Governments are pulling back from close cooperation with businesses, financial disclosure regulations are being tightened, troubled banks and companies have been allowed to fail, and markets are being deregulated to allow for greater competition and foreign direct investment. As a consequence, it seems reasonable predict that many Asian economies will come to resemble, more closely, the free market system championed by the United States than the Asian model exemplified by the Japan of the 1980s.
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