Governments no doubt draw lessons from financial crises and adopt measures to prevent their recurrence. However, these often address the causes of the last crisis but not the next one. More importantly, they can actually become the new sources of instability and crisis. This appears to be the case in Asia where the lessons drawn from the 1997 crisis and the measures implemented thereupon may be inadequate and even counterproductive in crisis prevention today because they entail deeper global financial integration.
An immediate step taken was to abandon currency pegs and move to flexible exchange rates in order to prevent one-way bets for speculators. However, under free capital mobility no regime can guarantee stable rates and crises can also occur under flexible rates. Floating at times of strong inflows can cause nominal appreciations and attract even more speculative inflows as seen in recent years.
Second, equity markets have been opened on the grounds that equity liabilities are less risky and more stable than external debt. Consequently non-resident holdings as a percent of market capitalization have reached unprecedented levels, ranging between 20 and 50 compared to 15% in the US. This has made them highly susceptible to instability in mature markets, particularly since most emerging markets lack a strong local investor base.
Third, they have sought to address currency mismatches and exchange rate risks by opening domestic bond markets to foreigners and borrowing in their own currencies. Consequently sovereign debt in many emerging economies is now internationalized to a greater extent than that in reserve-currency countries. Whereas about one-third of US treasuries are held by non-residents, this proportion is higher in many Asian economies. Unlike US treasuries this debt is not in the hands of foreign central banks but in the portfolios of fickle investors. A consequence is significant loss of autonomy over domestic bond rates and exposure to interest rate shocks from the US.
Fourth, corporations have been encouraged to become global players by borrowing and investing abroad, resulting in a massive accumulation of dollar debt since 2008, directly or through their foreign subsidiaries. Hence the reduction in currency mismatches is largely limited to the sovereign while corporations carry significant exchange rate risks.
Fifth, limits on the acquisition of foreign securities, real estate and deposits by residents have been raised or abolished. A main motive was to relieve upward pressures on currencies from the surge in capital inflows. Thus, liberalization of resident outflows was used as a substitute to restrictions over non-resident inflows. Although this has led to accumulation of private assets abroad, these would not be readily available at times of capital flight.
Sixth, banking regulations have been improved. However, banks now play a much less prominent role in the intermediation of international capital flows than in the 1990s compared to international bond issues and portfolio inflows to securities markets.
These steps have failed to prevent credit bubbles. Since 2007 corporate debt increased by 15-20 percentage points of GDP in Korea and Malaysia. At 90% of GDP Malaysia has the highest household debt in the developing world. In Korea the ratio of household debt to GDP is higher than that in the US.
Asian economies are commended for improving their external balances and building self-insurance by accumulating large amounts of reserves. However, whether these would be sufficient to provide adequate protection against a reversal of capital flows is contentious. After the Asian crisis external vulnerability came to be assessed in terms of adequacy of reserves to meet short-term external dollar debt. However, short-term debt is not always the most important source of drain on reserves. Currencies can come under stress if there is a significant foreign presence in domestic markets and the capital account is open for residents. A rapid exit could create significant turbulence even though losses from declines in assets and currencies fall on foreign investors and mitigate the drain of reserves.
In all four Asian countries directly hit by the 1997 crisis, international reserves now meet short-term external dollar debt. But they do not always leave much room to accommodate a sizeable and sustained exit of foreigners from domestic markets and capital flight by residents. This is particularly the case in Malaysia. The ringgit has been under constant pressure since mid-2014 due to flight from domestic securities. It is now below the lows seen during the turmoil in early 1998. In Indonesia the margin is large, but foreign holdings of securities are also substantial and the current account is in deficit. It was included among the Fragile 5 in 2013 for being too dependent on unreliable foreign investment to finance growth.
All emerging economies with strong international reserves and investment positions, including China, have been hit by external shocks on several occasions since 2007. The Lehman impact in 2008 was strong but short-lived because of the ultra-easy monetary policy introduced by the US. Subsequently they came under pressure again during the ‘taper tantrum’ in May 2013 and in October 2014 and late 2015 due to concerns, inter alia, about the hike in US interest rates. These bouts of instability did not inflict severe damage because they were temporary disturbances caused by shifts in market sentiments without any fundamental departure from the policy of easy money. But they give warnings for the kind of turmoil emerging economies could face in the event of a fundamental reversal of the US monetary policy.
Should self-insurance built-up prove inadequate, there are two options – seek assistance from the IMF or engineer an unorthodox response, bailing in international creditors and investors by introducing, inter alia, exchange restrictions and temporary debt standstills, and using selective controls in trade and finance to safeguard jobs. Asian countries, like many others, are determined not to go to the IMF again. But, serious obstacles may be encountered in implementing unilateral heterodox measures, including creditor litigation and sanctions by advanced economies. Deepening integration into the inherently unstable international financial system before attaining economic and financial maturity and without securing multilateral mechanisms for orderly and equitable resolution of external liquidity and debt crises could thus prove to be highly costly.
Featured image credit: Hong Kong Skyline by Skeeze. Public domain via Pixabay.