Liberalisation that Triggered the Asian Crisis and the Apparent Insulation of China and India - Essay Example

Liberalisation that Triggered the Asian Crisis and the Apparent Insulation of China and India As the world embarked in globalisation of business and trade, a spectre of inherent and structural failure to adapt to rapidly changing environments and financial liberalisation almost toppled East Asian economies in 1997. As many developing countries in Asia undertook significant liberalisation programs during the 1980s and 1990s, these programs have been regularly promoted by the International Monetary Fund (IMF) and their success during recent years must be attributed to a larger social acceptance of the potential benefits of necessary austerity measures. Least expected is that, in a very short period of time, a financial crisis sprouted in Thailand and spread like epidemic to the neighbouring countries of Southeast Asia and eventually triggered serious turmoil in the currency and financial markets of Japan and South Korea. While the extent of crisis differed from country to country, the Asian economies were brought face to face with serious difficulties that came from over-reliance on short-term foreign capital, speculative investments, and poor supervision by financial authorities. Even the resilient economies of Singapore, Taiwan, and Hong Kong have shown related problems, slowly being eroded by the persistent weaknesses of their neighbouring economies (Robison, Beeson, Jayasuriya, & Kim, 2000, p. 100). What may have gone wrong that spelled the unfortunate events to take place? Why did some countries in the region, like China and India, have been unaffected by the crisis? What measures did these affected countries do to thwart the eventual downfall of their economies? What did policies did India and China foster in order to insulate them from the said crisis? As this paper explored answers to these questions, further recommendations by experts will also be tackled in order to prevent the same crisis from ever happening again. Liberalisation Liberalisation is termed as a programme of changes in the direction of moving towards a free-market economy. This normally includes the reduction of direct controls on both internal and international transactions, and a shift towards relying on the price mechanism to co-ordinate economic activities. In such a programme less use is made of licences, permits and price controls, and there is more reliance on prices to clear markets. It also involves a shift away from exchange controls and multiple exchange rates, towards a convertible currency (Black, 2002). Long before U.S. Treasury Secretary James Baker, and thereafter everyone else, began to speak of “liberalisation” in late 1985, Helleiner (1992) informed that it was the developing countries that originated the logic of “growth-oriented adjustment” to solve balance of payments and debt difficulties. But when they spoke of the need for growth, they, unlike Baker and the World Bank, attached no controversial excess “liberalisation” baggage to it. The World Bank, through the IMF, typically recommend the earliest and fullest possible import liberalization, beginning with the replacement of quantitative import restrictions by tariffs, thereby creating both government revenue and greater transparency of incentives, and thereafter reduction in the levels and dispersion of tariffs. Gradualist approaches have generally been favoured by the more pragmatically oriented in the liberal camp and many have noted the importance of favourable macroeconomic conditions (capital inflow, terms of trade, weather, etc.) in the timing of successful major policy changes (Helleiner, 1992). The World Bank itself has recently argued: The more ambitious and long-lasting liberalizations—in Portugal, Greece, Spain, Israel, Chile and Turkey—all started with macroeconomic stabilization. The countries which have tried to liberalize trade in the midst of macroeconomic crisis have failed (World Bank, WDR, 1987, p. 109). More importantly, it is important to note that the main purpose of the IMF in imposing liberalisation has been to encourage free payments between the peoples of different nations. As a condition of granting credit to countries in financial trouble, it typically requires governments to ease restrictions on international payments. These programs have two standard elements--trade liberalisation, including the elimination of import quotas and the reduction of tariffs; and financial liberalization. Although usually centred on the removal of exchange controls, financial liberalization may also require local and inefficient financial markets to abandon their small-minded and restrictive ways of doing business; they must instead integrate with the international banking system and accept competition from large multinational groups. One study has shown that the IMFs Structural Adjustment Program helped improve the economic efficiency of both domestic and foreign companies. The benefits of liberalisation extend beyond the borders of the countries involved. For instance, the liberalisation in Mexico, where the privatisation of the state telephone company (TelMex), led to large investments by Southwestern Bell (Frankel & Romer, 1999). With the crisis in check, this required IMF loans to help the shattered economies of Indonesia, Thailand, and South Korea stabilize their currencies. In addition, although they did not stabilize their currencies. In addition, although they did not request IMF loans, the economies of Japan, Malaysia, Singapore, and the Philippines were also hurt by the crisis. As the volume of investments ballooned during the 1990s, often at the bequest of national governments, the quality of many of these investments declined significantly. The investments often were made on the basis of unrealistic projections about future demand conditions. The result was significant excess capacity (Hill, 2004). As exemplified, Asian countries are not the first to liberalise their financial systems and link them to world markets. Some succeeded but many others failed -- an experience that offers several lessons. According to Bosworth (1998), we could delineate three lessons from it: First, pursuing capital mobility before establishing a sound domestic financial system is dangerous. That is particularly true if domestic interest rates far exceed those in global markets, tempting domestic banks to borrow abroad and lend at home without the requisite skills and markets to manage currency risks. It is even more true if government commitments to fixed exchange rates lead participants to underestimate the currency risks. Second, financial liberalization often outpaces improvements in the domestic regulatory system. Financial liberalization requires a profound change in the behaviour of both banks and regulators. In a repressed market, government often uses banks as a tool of industrial policy. After liberalization, it must develop a supervisory function directed more toward discouraging excessive risk taking and rent-seeking behaviour. In the short run, financial liberalization often has the perverse effect of raising domestic interest rates, and liberalization and increased competition push some firms and institutions toward bankruptcy. Without strong regulatory supervision, troubled banks will raise deposit rates and borrow to bet on one last roll of the dice. The deposit rate competition, in turn, draws in otherwise healthy banks. Once a bank is seriously impaired by its customers losses, it compounds the problem by rolling old bad loans over into new loans to hide its own insolvency. Matters are even worse in countries that allow interlocking ownership of banks and business enterprises. Third, regulators cannot be the only line of defence. Stronger accounting and public reporting requirements, together with standards for internal governance, are also essential to promote effective risk evaluation and management control by private individuals and markets. The Asian crisis of 1997 arose out of a situation in which the currencies of Southeast Asia were pegged to the dollar and, thus, had appreciated along with the dollar. Given large current account deficits and relatively small supplies of international reserves, the currencies became overvalued. In addition, the countries were enjoying significant capital inflows and had large short-term loans denominated in U.S. dollars. Fact is that an IMF study concluded that countries with pegged exchange rates had an average annual inflation rate of 8 percent, compared with 14 percent for intermediate regimes and 16 percent for floating regimes. It can be very difficult for a smaller country to maintain a peg against another currency if capital is flowing out of the country and foreign exchange traders are speculating against the currency (IMF, 1998). In 1997, when a combination of adverse capital flows and currency speculation forced several Asian countries, including Thailand and Malaysia, initialised to abandon pegs against the U.S. dollar and let their currencies float freely. Malaysia and Thailand would not have been in this position had they dealt with a number of problems that began to arise in their economies during the 1990s, including excessive private-sector debt and expanding current account trade deficits. According to Wade and Veneroso (1998), financial liberalisation in Asia was an inappropriate policy that only weakened a system that had served the regions economies well. As they see it, those economies had a unique financial system that was successful in mobilizing large amounts of savings and channelling them into productive investments. It was a system based on long-term financial relations, which some now call crony capitalism, between firms and banks, with the government standing ready to support both of them in the event of a systemic shock. What financial liberalization had done in these economies was, they argue, to weaken this unique financial system by attempting to restructure it in the fashion of the Anglo-American system. China and India It was Alan Greenspan, chairman of the US Federal Reserve, who stated that “the relative stability of China and India, countries whose restrictions on international financial flows have insulated them to some extent from the current maelstrom, has led some to conclude that the relatively free flow of capital is detrimental to economic growth and standards of living. Such conclusions, in my judgment, are decidedly mistaken.” Given the apparent collapse of many of the Asian economies in 1997 and 1998, Chinas continued strong growth performance is striking. Why China has performed so well? On analysing the aspects of Chinas financial system, it may have helped insulate it from the crisis so far. The Asian crisis have earned lessons that it is dangerous for a country to have weak, poorly regulated banks making policy loans to inefficient, over-leveraged state enterprises (IMF Staff, 1998). Although some commentators argue that Chinas financial system looks at least as bad as those of other regional economies, Chinas strong balance of payments position and substantial foreign reserves, it is unlikely that external pressure on the currency and thus saved them from the crisis. Another indicator of Chinas stability amidst the Asian crisis is the strength of its currency, the RMB. Chinas nominal exchange rate against the U.S. dollar has been virtually unchanged since early 1995. The stability of the nominal dollar rate contrasts with the sharp appreciation of Chinas trade-weighted real exchange rate. Chinas large foreign exchange reserves have helped insulate it from the worst effects of the crisis (Business Week, 16 March 1998). The rise in total foreign reserves (less gold) since 1994 was triggered by Chinas central bank accumulated foreign exchange to offset pressure for a nominal appreciation. At the end of 1998, China had about $149 billion in total reserves less gold, including about $145 billion in foreign exchange (Goldstein, 1998). However, risk still remain because China’s growth could slow sharply, perhaps reflecting continued declines in exports and non-state investment, an overhang of inventories, and widespread consumer unwillingness to spend. Foreign investors could become less willing to invest in and lend to China because of rising uncertainty about the economy and about the viability of Chinese financial institutions -- reducing investment further (Chen, Dietrich, & Fang, 2000, p. 55). In the case of India, although it had made numerous attempts to reform the financial system and open the capital account since 1991, the country obtained a little progress. Ironically, this lack of progress in capital account opening that helped India escape from the Asian crisis with relatively little damage to its economy (Lee, 2003, p. 17). During the time of the crisis, banks in India are all burdened with nonperforming loans: about 18.7 per cent of their loans is classified as substandard, doubtful or a loss in 1996. This high ratio of nonperforming loans is a result of social control imposed on state-owned banks in the years preceding 1991. It is too early yet to tell whether financial liberalization has improved the efficiency of banks and the quality of their loans. The public ownership of banks has created the appearance of their invulnerability to shocks, but as the fiscal health of the government deteriorates, its ability to bail out banks has come into question (Furman & Stiglitz, 1998). Another factor that has impeded financial liberalization in India is the extremely powerful labor unions, which have successfully thwarted many moves toward the privatization of banks. The few cases of privatization that the government was able to carry through were done as piecemeal disinvestment of a small portion of government shareholdings. The sole objective of disinvestment appears to have been that of generating revenues for a cash-starved government. Consequently, privatization in India has had no significant effect on the basic character of public sector firms (Lee, 2003, p. 19). However, banks are the weakest link in Indias financial sector. The large number of nonperforming loans can put the entire economy under an enormous strain if the banks are faced with a crisis. Such a strain will arise if the government is forced to render budgetary support to weak banks with funds diverted from social welfare programs in health and education. Such a reallocation of resources will result in a severe social problem in a poverty-stricken economy like India (Vaidya, 2003, p. 205). Conclusion An important lesson drawn from the Asian financial crisis is that the IMF’s “one-size-fits-all” approach to macroeconomic policy is inappropriate for many countries. In the case of the Asian crisis, critics demonstrated that the tight macroeconomic policies imposed by the IMF are not well-suited to countries that are suffering not from excessive government spending and inflation, but from a private-sector debt crisis with deflationary undertones (Sachs, 11 December 1997). Despite this, some expert criticised the IMF for insisting on applying the policies that it applies to countries suffering from high inflation. Several years after the IMF’s intervention, the economies of Asia recovered to some extent. Certainly, they could have averted the kind of crisis that might have occurred had the IMF not stepped in, and although some countries still faced considerable problems, it is not clear that the IMF should take much blame for this. Thus, the IMF should not force countries to adopt the policies required to correct economic mismanagement. For if IMF decides to withhold money, it might trigger another financial collapse in the future and emerging economies, like those in Asia, might not be able to surpass it.. References Black, J. (2002). Liberalization. A Dictionary of Economics. London: Oxford University Press. Bosworth, B. (1998, Summer). The Asian Financial Crisis: What Happened and What We Can Learn from It. Brookings Review, 16, 6. Business Week. (1998, March 16). Can China Avert a Crisis? Chen, B., Dietrich, J. K., & Fang, Y. (Eds.). (2000). Financial Market Reform in China: Progress, Problems, and Prospects. Boulder, CO: Westview Press. Frankel, J.A. and Romer, D. (1999). Does Trade Cause Growth? American Economic Review 89.3: 379–99. Furman, J., and Stiglitz, J.E. (1998) Economic Crisis: Evidence and Insights from East Asia, Brookings Papers on Economic Activity 2: 1-135. Goldstein, M. (1998). The Asian Financial Crisis: Causes, Cures, and Systemic Implications. Washington: Institute for International Economics. Helleiner, G.K. (1992). Conventional foolishness and overall ignorance: current approaches to global transformations and development. In Wilber, C.; Jameson, K., ed., The Political Economy of Development and Underdevelopment (5th ed.). NY: McGraw-Hill Companies, pp. 55–80. Hill, C.W.L. (2005). Global Business Today, (4th ed.), NY: McGraw-Hill Companies. IMF Staff. (1998, June 2). "The Asian Crisis: Causes and Cures." Finance and Development 35 International Monetary Fund. (1998). World Economic Outlook. Lee, C. H. (Ed.). (2003). Financial Liberalization and the Economic Crisis in Asia. New York: Routledge. Robison, R., Beeson, M., Jayasuriya, K., & Kim, H. (Eds.). (2000). Politics and Markets in the Wake of the Asian Crisis. London: Routledge. Sachs, J. (1997, December 11). Power unto Itself, Financial Times, p. 11. Vaidya, R. R. (2003). 8 Financial Liberalization in India. In Financial Liberalization and the Economic Crisis in Asia, Lee, C. H. (Ed.) (pp. 205-225). New York: Routledge. Read More