Asian Crisis

Gregory Ruggiero
Independent Study
Professor Pantos
April 29, 1999

Abstract

In only three decades, Asia achieved a degree of economic transformation and improvement that in Europe and the United States took almost a century to achieve. Accompanying this, the East Asian “miracle”, as the World Bank described it, were several by-products, both positive and negative. The Asian emergence became an economic boom, with all the usual trappings that proliferate in such periods. A new doctrine, one concerning “Asian values,” was created to explain the rise of the East and the anticipated decline of the (decadent) West. Easy answers were sought and, as is usually the case, found. For a time, Asian markets and economies could only go up.

Nothing is ever that simple, however, or permanent, particularly in financial markets. For every boom, there is a bust; for every bubble, a crash. The markets, and thus real economies, are always in the state of flux. As Professor Pantos has pointed out in a quote by Heraclitus, “All is flux nothing stays still, nothing endures but change”. And yet, for a time, Asia broke – or rather, bent – the rules, experiencing year after year of unheard of growth. The story, the region, the economies were irresistible – until they were resisted by global market pressures and forces that seemed to explode onto the scene in July 1997 with the devaluation of the Thai baht, but that in reality had been building for several years.

The spectacular growth rates that Asia achieved in the 1980s and 1990s will be difficult, if not possible, to match in the future, but that is not a bad thing. It is vital to target and achieve sustainable, noninflationary, productivity – oriented growth for long-term health of an economy. Growth driven chiefly by temporary, cyclical factors such as easy credit, low-wage costs, and headline grabbing, large infrastructure projects is of necessity more vulnerable to a sharp slowdown or even a crash.

Several Asian countries will experience sharp slowdowns – a painful process, but better a slowdown than a crash. Thailand and Indonesia are the obvious exceptions. They are both on a course with similar economic and political systems that continues to hang on the very edge of a precipice from which it might not return.

This paper will touch upon the overall factors of the Asian financial crisis. It will also deal with, in detail, two countries in particular. Those countries being Japan and China. We will also touch upon the role played by banks in this crisis.

The Beginning Of The Crisis

The beginning of the Asian financial crisis can be traced back to July 2nd 1997. That was the day the Thai government announced a managed float of the Baht and called on the International Monetary Fund (IMF) for technical assistance. That day the Baht fell around 20 percent against the United States dollar. This became the trigger for the Asian currency crisis. Within the week the Philippines and Malaysian governments were heavily intervening to defend their currencies, while Indonesia intervened and also allowed the currency to move in a widened trading range, a sort of float but with a floor below which the monetary authority asked to defend the currency against further falls. By the end of the month there was a currency melt down during which the Malaysian Prime Minister Mahathir attacked rogue speculators and named the notorious speculator and hedge fund manager, George Soros, as being personally responsible for the fall in value of the ringgit. Soon other East Asian economies became involved, Taiwan, Hong Kong, Singapore and others to varying degrees. Stock and property markets were also feeling the pressure though the declines in stock prices tended to show a less volatile but nevertheless downward trend over most of 1997. By Oct. 27 the crisis had a worldwide impact, on that day provoking a massive response on Wall Street with the Dow Jones industrial average falling by 550.26 or 7.18 percent, its biggest point fall in history, causing stock exchange officials to suspend trading.

There is now fairly common agreement that the affected Asian currencies had been out of line with their economic fundamentals. For years, if not decades, many of the Asian economies had fixed their currencies against the United States dollar. In earlier years they had probably kept their values low as part of their export push. Virtually all of the Asian economies that have been mentioned in the context of the Asian financial crisis have based their economic strategies on export promotion. That certainly includes Japan, the second wave of economies, Korea and Taiwan, and the third wave of economies which followed the Japanese industrial policy model to varying degrees, especially Malaysia, Thailand, as well as Indonesian and the Philippines. Hong Kong has been different, relying on a laissez-faire economic policy. All but Japan had fixed exchange rates against the United States dollar, though some such as Singapore operated a loose link with the United States dollar. The appreciation of United States dollar against Japanese yen and third country currencies meant a decline in the competitiveness of these East Asian countries so long as they continued to fix their currencies against the United States dollar. It seemed to be the case that under these fixed exchange rates, countries continued to try to defend overvalued exchange rates for far too long, and long after everyone realized that the currency was overvalued.

In that way the monetary authorities concerned were offering everyone a good one way bet. If you bet against the currency the worst thing that can happen is nothing and you get your money back. However, the overwhelming odds are in favor of a win because the speculation itself becomes overwhelming. With that sort of game, it is no wonder why a country like Malaysia found a seemingly unlimited number of speculators willing to a bet against the ringgit.

In addition to the currency misalignment leading up to 1997, there were other factors that have been implicated in the Asian crisis. Prior to this, Asia had been the flavor of the month, as far as investors around the world had been concerned. Australia, for example, now has a number of listed companies that are basically investment funds that invest in Asia. The Australian stock exchange has been very active in the past, trying to get Asian companies to list in Australia and now quotes an Asian index, an index of all the listed companies in Australia whose business is chiefly their operations or investments in Asia.

There is nothing to suggest that the Asian shares listed in Australia were anything other than sound. However, that is not the case elsewhere. A lot of speculative money went into the real estate and property development. The speculative activity fed on itself and produced asset price inflation bubbles in countries like Thailand, Malaysia and the Philippines. Now of course the speculative bubble has burst, as is evident in reduced property values. In the second half of 1997, annual office occupancy costs fell by 56 per cent in Bangkok, 37 per cent in Manila, 36 per cent in Kuala Lumpur and 27 per cent in Hong Kong. Business Week claims that before the crisis there were white elephant construction projects, a bribe-based business ethic, and way too much capacity in too many industries.

Since the crisis broke there has been a lot of critical comment as to the issues such as corporate governance, accountability, transparency of the financial system, and the like. These issues have been addressed in the packages agreed with the IMF and have been pursued independently by countries such as Malaysia without IMF prompting. All of those accountability and transparency issues are important. However, the speculative activity in Asian assets leading up to July 1997 was unlikely to be influenced by more and better information on the underlying assets. It is in the nature of speculative booms that such rational considerations are ignored.

Since the events of 1997, an important body of opinion has developed, laying the blame for the Asian crisis on the interventionist policies pursued by the governments in the economies concerned. The head of the Australian Treasury, Mr. Ted Evan’s, has put the blame squarely on the government intervention in the relevant Asian economies:

Asian countries have repeated the mistakes of many of their western counterparts. The desire to give government preference to particular investments rather than to get the overall economic climate right is a hard habit to shake. Though many governments now see the problems in attempting to pick winners, they nevertheless lean towards policies, which seem more, designed to pick losers. The most obvious example of this is incentives given to investments on the basis that they would not otherwise occur.

While there may be no apparent fiscal problem in such circumstances, when the policies become unsustainable, there are inevitably pressures for the cost to be picked up in the fiscal accounts. If the mechanisms used to create the investment incentives include the direction of lending via the banking system, while that system remains under implicit or explicit government guarantee, the danger is extremely great, the more so because its magnitude is hidden until the crisis occurs.

It is true that there has been heavy government intervention in many of the Asian economies. However, it seems unfair to blame government intervention for the current financial problems without recognizing the role of government in producing the dramatic growth in economic activity and living standards in the Asian region in earlier periods.

The Asian crisis 1997-98 has several facets that fascinate observers. First, it is an economic and political crisis as well as a financial upset. Second, the most seriously impacted countries (MSIs)--Thailand, Indonesia, and Korea--were until recently being congratulated for their economic miracles. Can miracle makers turn into miscreants’ overnight? Third, there is a suspicion that the crisis has been mishandled by the International Monetary Fund (IMF), the government of Indonesia, and the monetary authorities of Thailand, Korea, and Taiwan. Misdeeds are always interesting to investigate. Finally, some observers believe that the crisis is more a consequence of the volatility of global financial markets than of the problems of individual countries.

It all happened so fast. By year's end, the crisis had spread throughout Southeast Asia and even affected the richer economies to the North, especially South Korea. The value of currencies across the region collapsed- not just the Thai baht but also the Indonesian rupiah and the Malaysian ringgit. Southeast Asian financial markets crashed as well. Plummeting stock prices and plunging currencies combined to slaughter three-quarters of the value of Indonesian and Thai financial assets. The miracle economies of Southeast Asia are in depression. Conditions vary from country to country. Recession prevails in Malaysia, and in Thailand the steep downturn will cost over two million workers their jobs by the end of 1998. In Indonesia,crippling stagflation threatens to double prices at the same time that it pushes nearly one half the population into poverty14.

The financial crisis in Asia differs in important ways from previous crisis in the developing world. The roots of the current turmoil are in private sector, not public sector borrowing. Most of the afflicted countries have run budget surpluses or minimal budget deficits in recent years. At the same time, private sector borrowing increased heavily, especially from abroad and especially short-term. For instance, loans to Thai corporations from international banks doubled from 1988 to 1994. By 1997, Thai foreign debt stood at $89 billion - four-fifths of which was owed by private corporations. But most disturbingly, one-half of the debt was short-term, falling due inside a year14.

The Southeast Asian miracle economies got into trouble when their export boom came to a halt as these short-term loans were due. For instance, stymied by a decline in First World demand, especially from recession-ridden Japan, Thai exports grew not at all in 1996. Also, opening domestic markets to outside money brought a deluge of short term foreign investment and spurred heavy short-term borrowing from abroad, fueling a building boom. By the mid '90s, a speculative binge in everything from high-rise office towers to condos to golf courses accounted for nearly 40% of growth in Thailand. Now that the bubble has burst, the region endures a horrendous drying out process. Southeast Asian exports from autos to computer chips to steel to textiles now glut international markets all made worse by intensifying competition from Chinese exports. Foreign financial capital has fled. Domestic spending is collapsing. Banks fail at unprecedented rates. Unemployment mounts, and as more and more people across the region fall into poverty, the Southeast Asian financial crisis has become a story of tremendous human suffering17.

In the language of economists, the crisis is also a story of market failure. Southeast Asian capital markets failed in three critical ways. First, too much capital rushed in. Lured by the prospect of continued double digit growth and searching for new places to invest its overflowing coffers, financial capital continued to flow into the real estate sectors of these economies even when financial instability was widespread and obvious to all. Second, the capital markets and the banking system could not channel these funds into productive uses. Too much money went into real estate and too little went into productive investments likely to sustain the export boom. Third, too much capital rushed out, too quickly. The excessive inflow of capital reversed itself and fled with little regard for the actual strength of a particular economy.

On July 2, 1997 Thailand devalued its currency against the U.S. dollar, triggering a currency crisis that has led to devaluation’s first in Southeast Asia--with the worst effects in Indonesia--and later in other emerging markets, notably South Korea, South Africa and Russia. More than a year later, the wave of devaluation’s is not yet over. Brazil and Venezuela are the countries most likely to succumb next. By the time of wrapping up this paper, Brazil is already facing crisis.

The underlying economic trend that brought on the Southeast Asian currency crisis was competition from China and Japan. In low value-added goods, such as textiles, China is displacing the Southeast Asian countries. Because Southeast Asia had been so successful economically in the 30 years leading up to the crisis, people in the region were earning higher wages than before. As a result, makers of low value-added goods were relocating production from Southeast Asia to China or to other countries with low wages. In high value-added goods, such as automobiles, Southeast Asia faced renewed competition from Japan. Until the crisis, the Japanese yen had been depreciating against the U.S. dollar since mid-1995 (moving from about 80 per dollar to about 120 per dollar) whereas the Southeast Asian currencies had not been. In U.S. dollar terms, Japanese goods were becoming cheaper while Southeast Asian goods were not.

So, Southeast Asia was being squeezed between competition from China at the low end and competition from Japan at the high end. Southeast Asia would have to adjust to the change in competitiveness under any exchange-rate system. However, the pegged exchange rates that most Southeast Asian countries had at the start of the recent currency crisis have made adjustment more dramatic and painful. As speculative pressure has spread from Southeast Asia to other emerging markets, those with pegged exchange rates have been particularly affected.

Exchange rates can be unmanaged, as with clean floating and fixed exchange rates, or managed, as with pegged, crawling, fluctuating within a target zone, and dirty floating rates. (Clean rates involve no sterilized intervention; dirty rates involve sterilized intervention. Sterilized intervention occurs when the central bank tries to reduce the full effect of changes occurring in the foreign-exchange market from reaching domestic credit markets, or the reverse.) With a floating rate, whether clean, or dirty the central bank makes no promise to keep exchange rates within any particular range. A target related to the supply of money has priority. Today that target is usually the inflation rate.

With a truly fixed rate, the monetary authority gives the exchange rate priority over all other targets. It maintains a constant exchange rate with the anchor currency despite fluctuations in inflation or interest rates. Hong Kong and Panama are examples of countries with fixed exchange rates. Hong Kong has a currency board (though see below on its peculiar features); Panama uses the U.S. dollar and has no locally issued paper money.

With managed exchange rates, especially a rigidly pegged exchange rate, the central bank tries to target simultaneously the exchange rate and the supply of money. With a managed rate the central bank has two targets, whereas with a clean fixed rate or a floating rate there is only one target. Maintaining a highly managed rate implies struggling against market forces, and ultimately failing, whereas maintaining a fixed rate or a floating rate means working with market forces.

To understand why, recall that like any other good, money has a supply and a demand. Suppose that the national currency is the peso. The nominal supply of money--the number of pesos in circulation--is determined by the central bank. The real supply of money is the purchasing power of each peso times the nominal supply (the amount of pesos in existence). When the real supply of money does not match the real demand, the quickest, most efficient way for adjustment to occur is for the real supply to vary through changes in the exchange rate, if the exchange rate is floating, or changes in the nominal supply of money, if the exchange rate is fixed. A slower way for adjustment to occur is for the economy’s output of goods and services to change. If consumers do not want output to change, adjustment through output is less efficient than adjustment through the exchange rate or the nominal supply of money.

A central bank directly controls only the monetary base (M0). Monetary aggregates broader than the monetary base (M1, M2, M3), which mainly comprise various types of credit issued by commercial banks and other financial institutions, are determined by the profit-seeking behavior of those institutions, which in most respects is the same under any type of monetary system in a market economy. Typically, a bigger nominal monetary base allows commercial banks to expand the nominal credit they grant, while a smaller nominal monetary base induces them to reduce the nominal credit they grant.

What the central bank does to the monetary base is the key to the difference between central banking on the one hand and a currency board or dollarization on the other. The central bank can create either a persistent excess or a persistent deficiency in the real supply of money when it engages in sterilized intervention, a type of operation in which it allows neither the exchange rate nor the nominal monetary base to change when its foreign reserves change. Because central banks generally target exchange rates in terms of a currency whose purchasing power is relatively stable, such as the U.S. dollar, targeting the exchange rate indirectly targets the purchasing power of the local currency.

Sterilized intervention involves the central bank in targeting the real monetary base, and through it, broader measures of the real money supply, rather than letting market forces adjust the real supply to the real demand. Mistakes in targeting the real supply of money create opportunities for arbitrage in foreign-currency markets and elsewhere: the bigger the mistakes, the bigger the opportunities. Central banks that do not allow the real supply of money to fall when the real demand falls encourage speculative pressure on the currency, because they allow the monetary base to grow to a size that their foreign reserves cannot support at the current exchange rate. Pressure builds until devaluation and the resulting increases in the prices of many goods, especially foreign goods, reduce the real supply of money.

Sterilized intervention causes trouble. But of all the central banks in the world, only the Reserve Bank of New Zealand never engages in sterilized intervention; it has not intervened since 1985. The U.S. Federal Reserve System engages in sterilized intervention occasionally, but unlike many central banks it does not truly target the exchange rate. Instead, it concentrates its efforts on keeping inflation low by limiting the growth of the monetary base.

Orthodox currency boards and dollarized monetary systems do not engage in sterilized intervention because no central bank exists to loosen the link between foreign reserves and the monetary base. In a currency board system the monetary base is backed 100 percent or slightly more by foreign reserves. In a dollarized system the foreign reserves--typically U.S. dollar Reserves--are the monetary base. In both systems, a decrease in demand for the monetary base automatically decreases dollar reserves and sets in motion appropriate changes in capital flows, interest rates, and prices. The rules under which currency boards and dollarized monetary systems operate leave them no freedom to supply a different amount of the monetary base than the public demands. If anchor currency is one with relatively good performance (as the U.S. dollar has had), that means that currency board systems and dollarized systems import good performance without creating distortions. A central bank, however, has the freedom in the short term to supply a larger or smaller monetary base than the public demands. Accordingly, a central bank tends to hinder the real supply of money from adjusting to the real demand. (For more detail on this argument, see Schuler 1998a.) This is an inherent flaw of central banking, which results from institutional characteristics and cannot be cured merely by replacing bad officials with good officials.

So, orthodox currency boards and dollarization are superior to central banking from the standpoint of economic theory, as well from the standpoint of the historical record. The freedom of a central bank to manage the money supply and the exchange rate destabilizes rather than stabilizes the economy.21

Chronology of the Asian Financial Crisis:

Early May (1997) Japan hints that it might raise interest rates to defend the yen. The threat never materializes, but it shifts the perceptions of global investors who begin to sell Southeast Asian currencies and sets off a tumble both in currencies and local stock markets.

June 1997 Thailand orders 16 finance companies that have high levels of bad debt to merge with healthier ones.

July 2-After using $33 billion in foreign exchange, Thailand announces a managed float of the baht. Thailand is forced to abandon its fixed exchange rate for the baht against the US dollar. The baht plunges more than 20% immediately and continues to slide. At the end of the month, Thailand finally asks for help from the International Monetary Fund. The Philippines intervenes to defend its peso. The Philippine peso falls nearly 10% against the dollar, followed by the Malaysian ringgit and the Indonesian rupiah. Regional stock markets plunge. South Korea’s Kia Group, the country’s eight largest “chaebol” conglomerate, is put under the control of a government-organized alliance of banks. Kia is the fourth of South Korea’s top 30 chaebols to collapse, or nearly collapse, in 1997.

July 18-IMF approves an extension of credit to the Philippines of $1.1 billion.

July 24-Asian currencies fall dramatically. Malaysian Prime Minister Mahathir attacks rogue speculators and later points to financier George Soros.

August 13-14-The Indonesian rupiah comes under severe pressure. Indonesia abolishes its system of managing its exchange rate through the use of a band.

August 20-IMF announces $17.2 billion support package for Thailand with $3.9 billion from the IMF.

August 28-Asian stock markets plunge. Manila is down 9.3%, Jakarta 4.5%

September 4-The peso, Malaysian ringgit, and rupiah continue to fall.

September 21-George Soros says, “Dr. Mahathir is a menace to his own country”.

October 8-Rupiah hits a low; Indonesia says it will seek IMF assistance.

October 14-Thailand announces a package to strengthen its financial sector.

October 20-23-The Hong Kong dollar comes under speculative attack; Hong Kong aggressively defends its currency. The Hong Kong stock market drops, while Wall Street and other stock markets also take severe hits.

October 28-The value of the Korean won drops as investors sell Korean stocks.

November 5-The IMF announces a stabilization package of about $40 billion for Indonesia. The United States pledges a standby credit of $3 billion.

November 3-24-Japanese brokerage firm (Sanyo Securities), largest securities firm (Yamaichi Securities), and 10th largest bank (Hokkaido Takusshoku) collapse.

November 21-South Korea announces that it will seek IMF support.

November 25-At the APEC Summit, leaders of the 18 Asia Pacific economies endorse a framework to cope with financial crises.

December 5-Malaysia imposes tough reforms to reduce its balance of payments deficit.

December 3-Korea and IMF agree on $57 billion support package.

December 18-Koreans elect opposition leader Kim,Dae-Jung as new President.

December 25-IMF and others provide $10 billion in loans to South Korea.

January 6-1998 IMF and South Korea agree to a 90-day rollover of short-term debt.

January 12 1998-Peregrine Investments Holdings of Hong Kong collapses. Japan discloses that its banks carry about $580 billion in bad or questionable loans.

January 15-1998 IMF and Indonesia sign an agreement strengthening economic reforms.

January 29-1998 South Korea and 13 international banks agree to convert $24 billion in short-term debt, due in march 1998, into government backed loans.

January 31-1998 South Korea orders 10 of 14 ailing merchant banks to close.

February 2-1998 The sense of crisis in Asia ebbs. Stock markets continue recovery.

Causes of the Asian Crisis

The causes of financial problems in these countries are many and differ somewhat from economy to economy. In general, the Asian Tiger economies had been growing at rates of 5 to 10 percent per year for the past decade. They were opening their economies to foreign direct investments, foreign goods and services, capital flows, and were relying heavily on dollar markets, particularly the United States, to absorb their exports. In order to attract foreign investments and facilitate capital flows, their currency exchange rates were kept in fairly close alignment with the U.S. dollar or a basket of currencies dominated by the dollar.

The financial services sector in most of these newly industrialized economies had been developing rapidly and without sufficient regulation, oversight, and government controls. As capital markets were liberalized, banks in these countries could borrow abroad at relatively low rates of interest and re-lend the funds domestically. Over the past decade, foreign borrowing by these countries had shifted from a preponderance of government to private sector borrowing. Whereas in the 1970s, the government might have borrowed for infrastructure development from the World Bank or a consortium of international banks, in the 1990s, the local bank might borrow directly from a large New York money center bank. The financial crisis in Asia began in currency markets, but this exchange rate instability was caused primarily by problems in the banking sectors of the countries in question.

The causes and structural factors contributing to the financial crisis include:

Private sector debt problems and poor loan quality.

Rising external liabilities for borrowing countries.

The close alignment between the local currency and the U.S. dollar

Weakening economic performance and balance of payments difficulties.

Currency speculation.

Technological changes in financial markets, and

A lack of confidence in the ability of the governments in question to resolve their problems successful.

The financial difficulties in Asia stemmed primarily from the questionable borrowing and lending practices of banks and finance companies in the troubled Asian economies. Companies in Asia tend to rely more on bank borrowing to raise capital than issuing bonds or stock. Governments also have preferred developing financial systems with banks as key players. This is the Japanese model for channeling savings and other funds into production rather than consumption. With bank lending, the government is able to exert much more control over who has access to loans when funds are scarce. As part of their industrial policy, governments have directed funds toward favored industries at low rates of interest while consumers have had to pay higher rates for purchasing products that the government has considered to be undesirable. A weakness of this system is that the business culture in Asia relies heavily on personal relationships. The businesses, which are well connected, tend to have the best access to financing. This leads to excess lending to the companies that are well connected and who may have bought influence with government officials.

Korean banks and large businesses borrow in international markets at sovereign rates and re-lend the funds to domestic businesses. The government bureaucrats often can direct the lending to favored and well connected companies. The bureaucrats also write Law’s regulating businesses, receive approval from the Parliament, write the implementing regulations, and then enforce those regulations. They have had great authority in the Korean economic system. The politicians receive legal contributions from businesses. They approve legislation and use their influence with the bureaucrats to direct scarce capital toward favored companies.

International borrowing involves two other types of risks. The first is the maturity distribution of accounts. The other is whether the debt is private or sovereign. As for maturity distribution, many banks and businesses in the troubled Asian economies appear to have borrowed short-term for long-term projects. Many economists blame such loans for the Asian crisis. Some of this debt is to finance trade and is self extinguishing as the trade transactions are completed. Mostly, however, the short-term loans have come due before projects are operational or before they are generating enough profits to enable repayments to be made, particularly if they go into real estate development.

As long as an economy is growing and not facing particular financial difficulties, rolling over these loans may not be particularly difficult. Competition among banks is intense. In the Asian case, as U.S. banks begin to restrict lending to certain Asian countries in 1996 and 1997, European banks took up much of the slack. When a financial crisis hits, loans suddenly become more difficult to procure, and lenders may decline to refinance debts. Private sector financing virtually evaporates for a time.

To show this phenomenon here is a breakdown of six Asian countries that shows the amount borrowed and the distribution of the maturities on those accounts. For these six Asian countries shown, all have relied heavily on debt with a maturity of one year or less. At the end of 1996, the proportion of loans with maturities of one year or less was 62 percent for Indonesia, 68 percent for South Korea, 50 percent for the Philippines, 65 percent for Thailand, and 84 percent for Taiwan.

A structural change in the nature of the borrowing by these Asian countries is that the type of borrowing has shifted away from the government and banks borrowing from international financial institutions or receiving development assistance funds through foreign aid programs to borrowing by private corporations.

Until capital markets were liberalized in the newly industrialized countries of Asia, most of the outside funds flowing into these economies was borrowed by the governments. Now major banks and nonbank private sector account for most of the borrowing.

A problem with private sector borrowing in developing market economies is that while individual borrowers may have viable projects, when all borrowing is aggregated and demands for foreign exchange and repayment or tallied, the country can face difficulties. Even if each individual loan is financially viable, the total of all loans may not be so because the nation may be short of the foreign exchange necessary to meet the repayment schedules.

Although Japan is not considered to be one of the Asian economies experiencing a currency crisis, it has been experiencing many of the same problems that are confronting its Asian neighbors. Japan’s banking sector, for example, carries an estimated 600 billion in questionable and nonperforming loans despite aggressive write-offs in recent years. When world attention began to be focused on Japan’s problem of nonperforming bad loans, it’s government first announced in 1994 that the total amount of such loans was about 136 billion. A year later, it admitted that the total was more like 400 billion or about 9 percent of gross national product. Private analyst, however, put the figure at roughly double that amount. Since 1992, the top 20 Japanese banks have written off approximately 35 trillion yen in bad loans. Still, the combination of the week Japanese stock market, weak real estate values, and sluggish economy continues to threaten Japan'’ banks as well as securities companies.

Although the current crisis has not affected mainland China’s renminbi to a large extent, China still has the potential of experiencing a major financial crisis. The problem began in 1981 when the government changed the banking system from one in which banks financed investments and provided funds to enterprises as part of the governments central plan to one based more on banking principles. Banks were to provide funds only as loans rather than as investments and were to charge interest and require repayments. Suddenly, the flow of funds from the banks to state-owned enterprises became liabilities that had to be repaid.

China’s four state-owned specialty banks do 75 percent of the nation’s deposit and loan business. Data on the condition of these banks is sketchy, but in late 1994, the four banks reported over 570 billion yuan in bad loans or about 20 percent of all the loans they had issued. Overdue loans were 11.3 percent, idle loans 7.7 percent and uncollectible loans 1.3 percent. These accounted for 90 percent of the officially recognized bad loans in the banking system. These figures, however, are likely to be understated because the state-owned banks have been lending to state-owned enterprises, and only about 30 percent of those enterprises are profitable, 20 percent have been losing money for years and are beyond salvaging, and the remaining 50 percent are somewhere in between.

The state-owned banks, therefore, have accumulated a huge portfolio of bad debts that have little prospect of being repaid. As was pointed out at a conference in Beijing in January1997, China’s national economy is being threatened by a latent monetary credit crisis. Furthermore, even though loans now are supposed to be allocated according to sound banking principles, in practice a large amount of monetary assets is still being allocated inefficiently through administrative and planned economic channels. State-owned banks have been required to provide loans to support enterprises which are running at low profit rates or at a loss. The resultant depletion of assets of state-owned banks has become an important factor threatening their own survival.

It’s no secret that the economic meltdown in Asia has mercilessly hammered that regions once robust and thriving economies. The Asian meltdown has put so much pressure on South Korea, for example, that blue-chip stocks on the Korean bourse have plummeted to just one-third of their U.S. dollar value two years ago. Down the coast in Thailand government officials have their own tales of woe. After watching their GDP roar along for more than a decade at growth rates that regularly exceeded 8 percent, the Thai economy is now battling recession. Though the worst seems to be over in Thailand and South Korea, the situation in Indonesia is harder to predict. Indonesian rupiah went into a free fall in financial markets plunging from 2,370 to the U.S. dollar in early 1997 to a low of 14, 500 in December, a move that earned the rupiah the hollow distinction as the worlds worst performing currency. In January, the rupiah went on to drop even further, to 17,500.

There are plenty of suggestions that the Asian crisis was the worst economic instability to strike the global economy since the Second World War. What few could agree on, however, was the cause of the crisis and whether the world community should take active measures to prevent such volatility in the future. The crisis has not only spread throughout the region, but some experts said there is a chance it could jump into emerging markets such as Russia, Central Europe and Brazil.

As distinct from a purely domestic financial problem, an international financial and economic crisis occurs only when both domestic and foreign investors lose confidence in the foreign exchange value of a currency. That loss of confidence then exacerbates structural economic weaknesses--something fundamental in the economy has gone badly wrong. The origin of a crisis matters, especially in the political dynamics that it sets off. The economic and political crisis was set off by an international financial debacle that has its own characteristics. Historically, such crises have usually occurred after an inflationary period in which the prices in one country's economy persistently exceed those in other countries, particularly those with whom it has close trading relations and with whom it competes. Indeed, hyperinflation is the variable that dominates all others in its ability to set off a currency crisis. It should be noted, however, that this was clearly not the case with the Asian financial crisis. Inflation in the economies of East Asia was under reasonably good control. Certainly the MSIs were not standout problems in this regard12.

Instead, one must look to a combination of factors to explain the Asian financial crisis. It may well be that four factors were involved, and all must be present for a crisis to be triggered. There must be simultaneously a technical condition, an external debt condition, a financial fragility condition, and a political uncertainty condition. Once a crisis is triggered, contagion takes over and becomes the most important factor in the threat to similarly situated countries. Thailand was the country with all four conditions present before the Asian financial crisis; the others only "qualified" after contagion hit them.

Technical Condition

The first factor that contributes to a financial crisis is that a currency is significantly overvalued. This can only happen if the monetary authorities are unwilling to let the currency depreciate in a timely and orderly manner. Determining overvaluation is not simple to calculate and requires much subjective judgment. Thus if only a relatively slight amount of overvaluation is suspected--say less than 10 percent--market players are unlikely to make a run on the currency because the risk/reward ratio is unattractive. It is a different story, however, if the overvaluation is believed to be 20 percent or more8.

Corsetti, Pesenti, and Roubini rely on indices of real effective exchange rates published by J. P. Morgan in making their determination of significant overvaluation. If market participants decide that overvaluation is present and begin to sell the questioned currency for foreign currency and the monetary authorities choose to resist the pressure, then the monetary authorities must intervene in the foreign exchange market. If the market is convinced that the currency is seriously overvalued and continues to sell it, then eventually the central bank will run out of its owned reserves and all the foreign currency it is willing or able to borrow. When the currency plug is finally pulled and the currency is free to float, it usually overshoots on the downside because the price decline itself attracts momentum speculators and panics unsophisticated investors. The crisis continues until the undervaluation attracts investors and speculators on the other side.

External Debt Condition

The second factor that is needed for a crisis is a rapid and substantial build-up of short-term foreign debt. If a current account deficit is entirely financed with, or results directly from, an inflow of real long-term capital such as foreign direct investment (FDI), then the soundness of a currency is rarely questioned. This is because the foreign capital results in an investment that in time can provide a flow of foreign currency returns sufficient to service the foreign debt8.

In contrast, as it was addressed by Lawrence Krause, if short-term borrowing is relied upon to finance a current account deficit, then serious concerns are raised as to whether the debt can be repaid. These-short-term debts can be either those of the public sector, the private financial sector, or even the private nonfinancial sector. Short-term debts are constantly being reviewed and can reverse direction quickly. Thus if short-term capital is being relied upon and access to additional amounts begins to be problematic, then the conditions for a reverse flow are created that can initiate a currency crisis. It often happens that either the government or the private sector takes on much short-term debt in the months immediately before a crisis, which aggravates the situation tremendously. The crisis will only end when foreign bankers are convinced that financial stability has returned and that the government or private sector will be able to repay the foreign debt despite and because of its lower-valued currency.

Financial Fragility Condition

The third factor is disarray of public finances, or the existence of fragile private domestic financial institutions. In the Asian MSIs, the private finance companies and banks were fragile, and their condition combined with weak prudential oversight by their governments. These are really two sides of the same coin because banks cannot become overextended if the regulatory authorities are doing their job properly.

One of the distinguishing characteristics of the so-called Asian model of development is close and cooperative relationship between the government and private business. A danger arises if the relationship becomes too close and prevents effective competition in markets from developing. Such distortions are particularly damaging to an economy when the financial sector gets so involved that prudent oversight is undermined.

Banking is a deceptively complex business, and it along with other financial services is changing rapidly. Overlending by banks is matched by overborrowing by nonfinancial firms. Persistently high real-growth rates of an economy reward firms that are highly leveraged and encourage overborrowing by firms in the fastest growing industries. If for any reason interest rates should rise dramatically, then financial distress is bound to ensue. If a domestic financial sector is protected from foreign competition, it is most likely that domestic firms will not be aware of the full risk they carry in their lending activity. If liberalization of regulations permits domestic financial institutions to gain access to foreign markets before adequate prudential oversight is in place, then the economy is really asking for trouble. Weak banks will face a liquidity squeeze when interest rates rise sharply; this is an inevitable consequence of a run on the currency. The run can turn into a panic if domestic financial institutions are forced to close. Foreign banks will quickly pull lines of credit and demand repayment of maturing loans11.

Political Uncertainty Condition

Political uncertainty is often recognized by financial analysts but rarely appreciated as a necessary condition for the triggering of a financial and economic crisis. Markets clearly do reflect political variables. Evaluating the political scene is a necessary step in a foreign investment decision. No due diligence report would be complete without evaluating the prospects for future economic policy and the wisdom and power of policymakers. When politics change, markets react. Thus politics and political uncertainty can be elements in triggering a financial crisis. Indeed, it may well be a necessary condition for a crisis, and it differentiates those countries with worrisome economic indicators that suffer a crisis from those with the same indicators that escape it. Political uncertainty means that private participants in the economy can no longer anticipate what economic policies are likely to follow. This may result from an absence of trust and confidence in the government, from a belief that the existing political regime may not last, or from other factors.

Government failures cannot be hidden from financial markets. Investors and speculators will become uncertain when they cannot anticipate the economic policy that will be implemented. Uncertainty will have an impact on reasonably cautious investors by dissuading them from making commitments in the questioned currency. Similarly, speculators will be attracted by possible gains and will be tempted to short the currency. If there is an event that focuses the market on government weakness, then the crisis can be rather sudden. The crisis can only end when the uncertainty over economic policy is resolved.

Derivatives, Did This Exasperate The Crisis?

There are four factors involved in the current financial crisis in Asia that have caused surprise. Since the Latin American debt crisis was thought to have been aggravated by the dominance of syndicated private bank lending, borrowers were encouraged to increase private direct investment flows. The stability of capital flows to Asia was used as an example. Yet, the Asian crisis appears to have been precipitated by the reversal of short-term private bank lending.

Second, the flows of capital to Asia have been used as an example of the benefits of free international capital markets in directing resources to the most productive uses. In the aftermath of the crisis it appears that total returns on equity investments in Asia have in fact been lower than most other regions throughout the 1990s.

Third, it appears that in a number of Asian countries, the majority of the international lending was between foreign and domestic banks. It has been suggested that the major causes of the crisis are unsafe lending practices by the Asian banks permitted by inadequate national supervision. Yet, these economies were the most advanced on the road to market liberalization. One of the cardinal principles of financial liberalization, formed in the aftermath of the Chilean crisis, is that the creation of institutional structures ensuring the stability of the financial system should precede financial market liberalization. Indeed, many countries were following this advice. It is interesting to note that the lending banks were generally large, global banks who employ highly sophisticated risk assessment procedures. Yet, they appear to have continued lending well after the increased risks in the region were generally apparent. This suggests that even the most sophisticated operators in global financial markets have difficulties in assessing risk, and that their regulators were no more successful in imposing prudent limits.

Finally, private portfolio and direct investment flows were considered to be preferable to syndicated bank lending because they were thought to segregate the problem of foreign exchange instability from asset market instability. Syndicated lending was dominated in the currency of the lending bank, and the exchange rate risk was borne by the borrower; but direct equity investors purchase foreign financial assets denominated in foreign currency and thus bears the currency risk. It was suggested that in a crisis the foreign investor would suffer first from a fall in asset prices, and second from a decline in the exchange rate, which would discourage him from liquidating the investment and reduce selling pressure in the foreign exchange market. Yet, the linkage between the collapse in exchange rates and equity markets appears to have been even closer in Asia than in other experiences of financial crisis.

One explanation of the crisis in foreign exchange markets is that a large portion of foreign borrowing by corporations and banks was unhedged because of prevailing expectations of stable exchange rates. When these expectations were disappointed, the scramble to repay these foreign currency loans created a massive market imbalance and a collapse of the foreign exchanges. This absence of generalized hedging of foreign borrowing has been interpreted to mean that financial derivative contracts played little or no role in the crisis. This position has been reinforced by the repeated references to an IMF study, which suggests the global hedge funds were not active catalysts in the Asian crisis. However, the recent quarterly reports of U.S. money center banks reflecting this initial impact of the Asian crisis on their lending to the area suggest that most of their losses have been related to derivative based credit swap contracts. Thus, at least in the case of U.S. banks, certain types of derivative contracts appear to have played some role in the flows of funds to Asia and thus in the instability of these flows. While bank derivatives are, tailored to the client, over-the-counter contracts, and as such are not generally public knowledge, the experience of such contracts in the Tequila crisis earlier in this decade provides some indication of the kinds of contracts that might have been involved. This short note thus suggests ways in which bank derivative contracts may have been linked to the rise in short-term bank lending to Asia and contributed to the four puzzles noted above concerning capital flows to the region. The detailed outline of the paper dealing with this opinion will be attached to the back of my report.

Japan

The worsening outlook for the Japanese economy and currency will add to the financial difficulties facing Asian economies. Japan is the largest economy, lender, investor and trading partner in Asia. The weakening Japanese currency may put additional pressure on regional currencies and lead to renewed financial instability across Asia. Monetary and fiscal policy may be loosened to ease the pain across Asia.

Japan is the largest economy in Asia

Economists are becoming more pessimistic about the state of the Japanese economy and currency. Japan's weaker economy and currency will likely be a new source of renewed currency instability in Asia. Japan is the largest economy, investor, lender and trading partner in Asia. The expectations are that non-Japan Asia will suffer a 1% contraction in its combined GDP this year, for the first time in decades19. Regional governments may come under greater pressure to ease their high interest rates and tight fiscal policy stances.

Hope of an export-led recovery have been dashed

A weaker Japanese economy and currency imply a lower intake of and increased competition to Asian exports. Some 12% of Asia's exports are sent to Japan. Japan accounts for 23% of Indonesia's total exports and 20% of China's19. South Korea may face greater competition from Japanese manufacturers. Japanese tourist arrivals in Asia may also decline. Non-Japan Asia's trade flows are contracting significantly.

Japanese investment and lending to shrink

The troubled financial system and a weaker yen will discourage Japanese direct investment into Asia. Japanese banks are substantially scaling back their overseas operations, especially in Asia, contributing to the regional credit crunch. Japanese manufacturers may transfer some of their production orders back home, further aggravating non-Japan Asia's financial and economic woes. Dollar servicing costs of yen-denominated foreign debts may be eased somewhat for some Asian economies.

Renewed pressure on the regional currencies

Japan's weakening yen could give rise to renewed pressure on several Asian currencies, which have fallen by 20%-70% against a strong US dollar since the second half of last year19. South Korea, which competes more closely with Japan, may directly feel the heat. Those currencies are still implicitly or explicitly pegged to the US dollar, particularly the Chinese renminbi and the Hong Kong dollar, which will come under greater pressure. Asia's economic restructuring would become more prolonged and difficult.

The Outlook for Japan

In many ways Japan is both the cause and the consequence of the crisis. Particularly the cause because Japan remains the economic locomotive of the region. It is by far the biggest economy; it is the most modern and advanced one. It was until recently a 4 trillion-dollar economy19. That is just massively huge, compared to any other power. So if Japan is not growing then the rest of the region suffers accordingly.

How could a wealthy, productive, sophisticated country have gone from enviable growth in the 1980s to stagnation in the '90s, and now be slipping into a downward spiral of recession and deflation?

There are two common explanations for Japan's plight: Explanation 1 is that it is mainly a financial problem. Japan's corporations are too burdened with debt, its banks too burdened with bad loans that have never been acknowledged. On this view, what Japan needs is a long, painful financial housecleaning18. Explanation 2 is that the problem is mainly psychological. When the "bubble economy" of the 1980s burst, consumers and investors went into a funk that has depressed the economy, and the depressed economy has perpetuated the funk. On this view, what Japan needs is a jump-start--say, a massive but temporary round of tax cuts and public spending programs that will restore confidence and get people spending again18.

Economic performance in Japan—the world's second largest economy, the largest in Asia, and the world's largest creditor country—is going from bad to worse. Faster growth in Japan would not only benefit residents of Japan, but also facilitate economic recovery in the rest of Asia.

It is now clear that Japan went into a policy-induced recession beginning in May 1997, when it attempted to correct a massive budget deficit through reduced government expenditures, increased social charges, and much higher income and value-added taxes. As a result of the ensuing economic downturn, Japanese imports stagnated. Indeed, Japanese economic performance has been disappointing during the entire decade of the 1990s. This poor performance resulted from Japan's earlier failure to deal properly with the collapse of its financial bubble.

In the early years of the 1990s, the stagnation of the real economy did not prevent Japanese imports from rising. This was because the yen was itself appreciating in the foreign exchange market and Japan was in the process of liberalizing its import barriers. Both forces abated or went into reverse in 1997. The yen depreciated significantly relative to the U.S. dollar, and given the large size of the Japanese economy relative to the rest of Asia, its enhanced competitiveness plus the absence of market growth put tremendous pressure on the balance of payments of the whole region. Thus Japan was a second engine of growth in Asia that was moving in reverse.

Current Macroeconomic Problems and Economic Profile of Japan

We will first start with an overview of the current Japanese macroeconomic problems as Roubini Nouriel published it:

1. Poor growth performance:

a. GDP growth was close to zero on average in the 1992-1995 period
b. Only modest recovery in 1996
c. Fall in GDP in 2nd and maybe 3rd quarter of 1996
d. Slow growth (or recession) expected in 1997 (2.7% IMF estimate).

2. Serious fiscal problems:
a. Large and growing budget deficits (as a % of GDP). 1990: 0.7%; 1996: 4.2%; 1997: 3.2%
b. High and growing public debt to GDP ratio. 1992: 63%; 1996: 89%; 1997: 95%
c. In the long run the fiscal problem is even worse because of demographic trends (aging of the population). There are serious implications for the solvency of social security system that may be bankrupt in a few decades. In this there are similarities with the US situation.

3. Weak labor market conditions:
a. Stagnating employment growth and serious employment uncertainty
b. High unemployment rate (3.3%) by Japanese standards
c. Loss of jobs due in part to a process of de-industrialization as large scale Foreign Direct
a. Investment (FDI) exported Japanese jobs to Asia and US
d. Trend towards “hollowing out” of the Japanese manufacturing sector.

4. Weakening of the trade and external accounts of the country:
a. Lowering of the trade and current account surplus. CA/GDP: 1994: 2.8%; 1996: 1.2%
b. Strong depreciation of the Yen relative to 1995 high levels (by 40% with respect to US $)
c. Structural long-term reduction of the trade surplus because of falling private and public savings rates. Private savings will fall because of demographic trends. Public savings fall also in the long run because of the problems of the social security system
d. A guess: the reduced current account deficit will significantly reduce trade tensions between the US and Japan in the short and medium run.

5. Excessively loose stance of macroeconomic policies:
a. Very loose monetary policy to stimulate recovery and save the collapsing banking system. Nominal short term interest rates are close to zero
b. Very loose fiscal policy to stimulate growth (a boom in “public spending and investment”)
c. A policy of weakening of the Yen to stimulate growth. The monetary and fiscal policy stance and the structural problems explain the Yen weakness.

Economics correspondent James Morgan about economic indicators:

Yen/Dollar exchange rate

Japanese stocks slid more than 1% before recovering. The yen fell to 134.48 to the US dollar – its lowest level since April 1992. The fear is that the influential Moody rating will affect the borrowing prospects of corporate Japan. Banks may be reluctant to lend more because of the large amounts of bad loans already on their books.

Economic indicators mostly bad:

· Growth is now likely to miss the official target of 0.1%. The economy could contract for the first time in more than 20 years.
· Confidence in the banking sector remains low following the collapse of Yamaichi Securities last November. It admitted concealing losses of more than $250m. The Japanese Ministry of Finance estimates bad debt held by all banks at ¥79 trillion ($590bn). The loans stem from property deals and speculative 'zai-tech' – literally 'financial technology' - made in the late 1980s.

% Age change in Japanese commercial property prices
· Property prices have crashed in major cities over the past five years. In Tokyo they are 70% below their peak.
· Consumer spending and confidence remains low according a number of recent surveys.

According to the World Bank, Japan’s long-running economic stagnation in the first half of the 1990s turned to full-blown recession in 1997. A sharp fiscal tightening in the early part of the year curbed consumer spending. Then the financial and economic crises in the rest of East Asia led to a sharp fall in export growth and to increases in the already huge bad-debt problems of Japanese banks, among the most prominent lenders to the East Asian crisis economies. The failure of important financial institutions toward the end of 1997 provoked a collapse in consumer confidence, and the economy spun into full recession. Since then, further declines in consumer and investment spending and confidence, declining output, rising unemployment, falling asset prices, rising bad debts, and tightening bank credit (despite near-zero policy interest rates) have created a vicious circle that is expected to generate a 2.5 percent decline in GDP in 1998. In addition, the yen depreciated sharply against the dollar before rebounding dramatically in October.

The initial impact was severe on the East Asian countries, both because of the demand contraction in Japan and particularly for Korea—the effects of yen depreciation on Japanese competitiveness in third country markets. Japan represents more than 60 percent of the region’s GDP, and its effects on the rest of the region through both trade and investment are more important than those of any other country.

Japan's stock and bond markets are artificially held up - even though prices have come down - by the government through the government buying its own bonds, so people's savings are invested in the government's own profligacy. It also buys the stock markets so that those savings are invested in companies that don't make any profits and haven't for years. That means that a lot of money that's saved by the Japanese public, usually through the post office, disappears into the pockets of companies and local government and other areas which are bankrupt corporations of the state. All that has yet to be revealed and sorted out9.

On top of that huge bank debts which have built up by lending both to Asia and the rest of the world over years. Japanese banks have lent this money indiscriminately without any attempt to sustain a proper return of their investments. Now, there is something like 100 trillion yen of bad debt, which has built up with yet no sign from the existing government that it really will get to grips with the banks. That means letting some go to the wall and restructuring others. Also organizing a banking system that can start to lend and help the economy grow12. There is no attempt to boost the spending by the Japanese consumer, and the government remains determined to try and keep its own spending under control. This sounds good, but because the authorities are so concerned about the cost of pensions and social security in the future as the population ages, they are not prepared to give the incentive to Japanese consumers by really cutting taxes – both corporate and income tax - on a significant basis to allow people to spend rather than save. The emphasis in Japan is always on saving rather than spending so there is no domestic demand. Above all, there has been no deregulation of the economy to allow Japanese consumers to take advantage of cheaper prices through imports and through competition in the retailing and distribution sectors.

For decades, it all worked well: Japan rebuilt itself into an economic superpower in the space of a generation. But what worked in the go-go days of high growth isn't working in a mature economy. Today Japan is saddled with one of the most over-regulated, inefficient economies in the world. And the role of the government seems to be growing, not shrinking. Japan's massive government-run postal savings system is expanding rapidly, stealing market share from private banks. The government lends that money out, once again competing with the banks. The state accounts for 37% of overall lending, up from 23% at the start of the decade17.

Furthermore, Japanese growth would dampen political pressures in the trade arena that the US is likely to face as its trade deficit, already at historically unprecedented levels and headed toward $300 billion, widens. Japan must rekindle domestic demand, address its financial problems, and undertake structural reforms. In the wake of the bursting of the asset bubble in the early 1990s and the subsequent collapse of its investment-led expansion, the Ministry of Finance pursued fiscal policies that were at times contractionary consequently weakening domestic demand. Actual fiscal stimulus undertaken by the government between 1992-97 was only around one-third the advertised amount7. When a more substantial stimulus was tried in 1995, the economy responded. After consumption taxes were raised prematurely in 1997, the economy tanked.

The errors in fiscal policy have been costly, particularly since monetary policy has been rendered relatively ineffective by the "liquidity trap"—interest rates are so low that they cannot be cut further—and by the accumulated problems of the banking system, which has been saddled with $500 billion to $1 trillion in bad loans2.

Now Japan faces a deflationary spiral. As prices fall, households and firms postpone purchases of durable goods in anticipation of lower prices in the future. Deflation contributes to high real interest rates, which in turn impede investment. With consumption and investment, the two largest components of domestic demand falling, inventories rise, prices fall, and the economy contracts. With the economy in decline, households increase precautionary saving, further depressing demand. The economy goes into a self-reinforcing spiral of contracting aggregate demand and supply.

In such a situation, the standard remedies are expansionary monetary and fiscal policies. Government spending boosts aggregate demand while an expansionary monetary policy reduces interest rate (stimulating investment), generates expectations of future price increases (discouraging postponement of expenditures on durables), and contributes to exchange rate depreciation (boosting foreign demand for domestic output). The preferred mix of policies in the current situation is subject to ongoing debate. The basic bone of contention is how Japanese households regard government spending. Some argue that they will simply increase saving to offset future tax liabilities, so that stimulus should come solely through monetary policy, though this would tend to generate a bigger exchange rate depreciation and larger trade surpluses3.

Thus a weaker yen is a component of almost any adjustment scenario. Since Japan is the world's largest net creditor, so international financial markets cannot discipline Japan for policy errors in the way the emerging markets of Asia were punished. The real risk is that Japanese households and institutions could lose confidence in the economy and the sanctity of the financial system and Japan could experience capital flight as detailed in Posen7. In such a scenario, the yen would weaken precipitously as the Japanese economy was contracting. An alternative scenario could be thought of as the Krugman-Makin-Meltzer prescription in which the yen weakens in response to monetary easing as part of a macroeconomic adjustment package that generates positive growth.

Japanese export – corporate sector

As Lawrence8 discussed it, Japanese companies are among the finest in the world in terms of the products they make. However, this should not allow for complacency, particularly given the Asian crisis and the resultant impact that will have on Japanese exports to Asia, coupled with domestic demand in Japan. The result will be profit and margin pressure – a key reason why manufacturing stocks have been hit in Japan as well as financial counters. Slower growth in Asia and rising prices due to currency devaluation will hit Japanese exports of capital goods to Asia particularly hard – which just happen to represent some 65% of total Japanese exports to Asia. Rising import costs will also hit Japanese production plants in Asia in the short term. Looking at specific country examples, Japanese exports to Thailand make up 4.4% of total exports. Japanese exports to Indonesia are 2.2% of the total, to Malaysia 3.7%, to the Philippines 2.0%, and to Singapore 5.1%. Taken together, these five currencies lost an average 20% against yen in 1997. J-curve theory suggests an immediate rise in the Japanese trade surplus with these Asian countries given the higher yen value; followed by a steep drop in volume terms, given the higher yen-based prices; and then a sharp drop in revenue terms. The speed of slow down in Asian countries will dictate how quickly this process takes place. Despite the efforts of some Asian governments to delay the inevitable, the slowdown will take place in short order. Indeed, we are already seeing signs of that. Thus, Japanese exports will be hit by the combination of slowing domestic demand and rising costs. This year, Japanese exports to Asia are likely to fall very sharply indeed, possibly by 25 to 30%. The one saving grace for Japan’s net trade balance with Asia, however, is that with Japanese domestic demand also remaining extremely weak, imports from the ASEAN, which make up around 15% of total Japan imports, will remain despite their newly found competitiveness.

All is not so bad for the Japanese corporate base in Asia. For one thing, the devaluation of the ASEAN currencies, together with the rise in the USD-JPY, will eventually make Japanese exporters to Europe and North America even more competitive. Japanese manufacturers focused on the twin virtues of continually increasing technology and added value product content and at the same time investing in and boosting the skill base of their labor force. By doing this they have created what has been termed the “cost structure revolution” which, supported by technological comparative advantage, has resulted in the “global natural monopolies”. The technological advantage is crucial because it allows grater pricing power and flexibility – Japanese exports of very high added-value product ranges that are not subject to cyclical disturbance will continue to Asian countries despite lower prices in those countries because there are not available domestic substitutes. Japanese manufacturers have applied an extremely strategic approach to investing and producing in Asia. Rather than just using it as a low-cost center, they have sought to maximize output efficiencies by placing production facilities in each Asian country that has a specific production comparative advantage. By making the domestic economy dependent on their capital and production, they frustrate domestic attempts at competition. Equally, while lower-value technologies are exported from Japan to take advantage of cost advantage, high-value technologies are most assuredly kept at home in Japan. In order to maintain its overall trade competitiveness, corporate Japan is thus exporting its production facilities and technology of low comparative advantage while maintaining its high-comparative-advantage potential at home.

Japan’s role in Asia

Japan's latest Tankan Survey as well as data regarding industrial production, inventories, retail sales and exports all confirmed a state of recession and deflation, indicating a likely 1% decline in Japan's GDP in 1998 and no growth in 1999, and a likely acceleration of consumer price deflation over the next few months. The massive fiscal stimulus package remains unconvincing. The yen could probably test the Y150/US$l mark in the coming quarters.

The gloomy outlook for the Japanese economy and the weakening yen have raised market concerns over the ramifications for the ongoing non-Japan Asia's financial crisis and spreading economic recession. Not only is Japan failing to serve as an engine of growth for Asia's troubled economies, it will also be a potential source of currency instability in the region over the next few quarters, thereby prolonging Asia's currency turmoil and adding to the difficulties of economic restructuring in the region. Japan's weakness will delay any eventual export-led economic recovery in Asia.

Non-Japan Asia is likely to see a 1% contraction in its combined GDP, the first time in decades. Regional currencies could come under increased pressure, and real interest rates are likely to remain firm for the rest of 1998. Regional central banks may come under greater pressure to ease their high interest rate policy19.

Japan is the largest economy in Asia

Japan's GDP in 1997 was almost twice as large as the combined GDP of non-Japan Asia. As the largest economy in the Asia-Pacific region, Japan will have a tremendous influence on the financial and economic trends across the region of non-Japan Asia.

Japan is a dominant trade partner

Non-Japan Asia (Greater China, South Korea and key ASEAN economies) ships about 12% of its total exports to, and sources 20% of its total imports from, Japan. A weakening Japanese economy will result in a slower intake of Asian imports at a time when Japan's neighbors are hoping to increase their exports to help stabilize the regional currencies and lead a broad-based economic recovery19.

Japan is unlikely to absorb much more of Asian exports because of its weak domestic demand and a falling currency. Fortunately, the currently robust US economy still represents the most important market for Asia's exporters. Nevertheless, the United States is now absorbing almost all of the Asian shock, which could give rise to trade friction down the road.

The latest view on the yen shows that it could test the Y150/US$l level over the next few quarters. A falling Japanese yen will make the above-mentioned situation even grimmer. It would further discourage Japanese import demand for Asian exports and present greater competition to Asian exporters in third markets. This is evident in Japan's widening current account surplus of late, despite its smaller trade surplus vis-à-vis the rest of Asia13.

The only positive trade effect coming out of Japan is that a weaker Japanese economy and yen should help mitigate the worsening terms of trade for developing Asia by depressing international fuel prices and the import costs of capital goods. Most of the Asian economies are net oil importers12.

The importance of Japan as a key export market varies among countries in Asia. Japan accounts for less than 8% of total exports for Hong Kong and Singapore. On the other hand, Japan's share of China's exports reaches 17%. If Hong Kong's re-exports originated from China and shipped to Japan were also included, China's overall export dependence on the Japanese market would have been as high as 19% in 1997. Indonesia's export dependence on Japan was the highest at 23%. Moreover, depending on the industrial structure of the economies they operate from, some Asian exporters, such as South Korea and Taiwan, will feel the pressure of the yen depreciation in third markets14.

Japan is a key source of Asia's tourism

Moreover, a weaker Japanese yen, together with the worsening economic woes and more cautious consumer sentiment in Japan, will dampen outbound Japanese tourists to Asia. In 1997, Japanese tourists accounted for about 10% of the total inbound tourist arrivals in non-Japan Asia. The impact would likely be greater for South Korea, Taiwan, the Philippines, Singapore and Hong Kong. This would further dampen the momentum of the turnaround in Asia's current account balance (8).

Japan is a large investor and lender in Asia

Japan has also been the largest source of foreign direct investment (FDI) in Asia. In recent years, Japan's FDI into Asia has been around US$10bn, up from US$8bn in the early 1990s19. A weaker Japanese yen should discourage foreign direct investment from Japan to the rest of Asia, which has been a key source of economic growth and financing for many Asian economies. This would just be the opposite from the experiences in the 1980s when a strong Japanese yen prodded many Japanese manufacturers to set up factories in Asia.

China and Indonesia top the list of the Asian recipients of Japanese FDI, exceeding US$2bn each last year. However, the importance of Japan as a source of direct investment varies across Asian countries and over the years. For instance, in recent years, Japan accounted for 9%- 10% of China's FDI inflows, while it provided 20%-30% for Thailand's FDI inflows11.

Moreover, Japanese banks have been key lenders in Asia. Recently, some of the Japanese banks have been substantially winding down their banking operations in Asia, which may lead to tighter liquidity and asset deflation within the region. This again is the reversal of the situation in the 1980s when a massive Japanese lending partly fueled the Asian boom. Hence, capital flows from Japan and directly into the region of non-Japan Asia may diminish this year and perhaps in 1999 (12).

A weaker yen would also prompt many Japanese companies to scale back their overseas operations in Asia and shift some of their production orders back home. It could be another reason behind the contracting trade flows in Asia. This would add to the rising unemployment pressure and accentuate the economic recession facing many Asian economies.

A weaker Japanese yen may, to some extent, ease servicing costs (in US dollar terms) of yen-denominated debts of Asian countries. However, as the US dollar-denominated foreign debts of many Asian economies are quite substantial, a weak yen does not help very much in relation to the debt burden for these economies. Savings in debt servicing depend on how long the Japanese yen remains weak. Nevertheless, for yen-denominated short-term debts, there could be significant savings in debt servicing costs in US dollar terms (19).

Greater pressure on Asian currencies

Finally, a weaker yen will add further pressure to currencies explicitly or implicitly pegged to the strong US dollar. The Hong Kong dollar and the Chinese renminbi, in particularly, are likely to come under greater pressure, at least in the short term. Serious questions are being asked as to whether these currencies can hold on to the US dollar if the outlook for the Japanese yen worsens substantially from the market consensus. A lot depends on how much further the yen will weaken, and when and how long it will stay at the lows. Overall, perceived and real currency risks are clearly increasing.

Downgrading economic forecasts across the board

In sum, the risk of a new round of regional currency instability is clearly greater in this context. The implication is that the currently large "Asian risk premium' will not disappear any time soon. Currency and interest rate volatility could be rising. Real interest rates across Asia may have to remain firm, dashing any hope of a meaningful economic recovery in the short term. Asia's economic slump could be steeper and more widespread (15).

Non-Japan Asia's trade flows are contracting, with exports falling by 1% and imports by 8% this year. An export-led economic stabilization is likely to materialize in the short term. We have already revised down non-Japan Asia's GDP growth for 1998 to -1% from the earlier forecast of 1.5% growth, compared with 6.5% in 1997. A regional economic recession is no longer a risk but a reality (19).

The five Asian economies expected to face economic contraction for 1998, as measured by real GDP growth. They are Indonesia (-14.7%), Thailand (-8.7%), South Korea (-6.5%), Malaysia (-3%), and Hong Kong (-2%). The only four Asian economies with positive growth are also forecast to decelerate noticeably this year: GDP growth will likely be 0.8% for the Philippines, 0.9% for Singapore, 4.8% for Taiwan and 6% for China (19).

Japan in the Asian Financial Crisis

Since Japan is the world's second largest economy (and the largest in Asia) developments within its borders have implications not only for itself, but the rest of the world as well, particularly the rest of Asia and the United States, its largest trade partner. Indeed, the faltering Japanese economy is potentially a significant impediment to economic recovery in the rest of Asia. It is an exaggeration – but not much of one – to say that Japanese capital and Japanese technology were the building blocks for the rise of Asia. Mote than any, other country, Japan was exposed to Asia, in terms of both commercial bank lending and foreign direct investment.

Then Thailand let the baht go, and the ASEAN currencies fell like dominoes, one after another, followed by the Korean won and the Taiwan dollar. Japanese banks, which had spent the previous seven years trying to gradually write off massive bad loans suddenly, faced with a new and significant threat to the health of their loan books. Japanese banking industry’s loan exposure to Asia is around $150,000 billion, roughly three times the U.S. banking industry’s loan exposure to Asia. Much of this has been to Asian companies, and thus threat is largely of the need to roll over or refinance loans rather than one of default. However, coming on top of the existing bad loans in the system (Japan’s top twenty banks have around Y18 trillion in bad loans), this is a further blow, in terms of both financial institution profitability and the ability to operate-news of such bad loans resulting on a so-called Japan premium whereby Japanese financial institutions have to pay above the market in order to get funding in the money market. Added to the bank loan exposure to Asia, one should also include bank deposits and the purchase of Asian stocks and bonds by banks and other Japanese institutional investors (12).

Japanese manufacturing companies had also become heavily exposed to Asia, initially as a low-cost labor center for production facilities and later as a strategic area for production and sales, representing an increasingly important part within the global production wheel. After Japanese multinationals set up in the region, suppliers, either within their own keiretsu or outside, sold them needed parts from Japan – a traditional pattern in Japanese offshore investment. The results were impressive, at least from a Japanese point of view. Between 1985 and 1993, Asia’s trade deficit with Japan exploded, rising to almost $55 billion from just over 9 billion in 1985. Japan also increasingly exported technology to Asia, both because it wanted to boost the technology no longer had a comparative price/value advantage and thus could afford to be used by others rather than kept in Japan. Between 1986 and 1993, total Japanese technology exporters to Asia rose from 38% to 47%. The combination of Asia’s low-cost base and Japanese high-volume production technique was irresistible, resulting in higher margins and higher profits. The yen also played the important role. By weakening sharply from April 1995 to May 1997, not only against the dollar but also more importantly against the Asian currencies, it reduced import costs for Japanese companies based in Asia. Asia took on increasing importance for corporate Japan, with 45% of Japanese total exports going to Asia (7).

Japanese banks were keen to lend in Asia, principally because their own customers – Japanese manufacturing companies – were already there. Domestic demand in these countries was very strong, and for Japanese banks as well as the manufacturers, Asia offered the chance of higher margins. For the past decade, Japanese banks and companies had been shifting “human capital” to Asia, and away from Europe and North America – in relative rather than nominal terms. Their involvement concerned long-term fundamentals, just as much as short-term profit potential. In addition to using Asia as a cheaper export base, they were attracted by the demographics of the region – large youthful populations whose increasing consumption and yet high savings rates represented strong potential, in terms of both markets to be tapped and labor.

Within Japan itself, the only area of the economy, which was actually doing well in the second quarter of 1997, was exports. Domestic consumption collapsed after the tax hike. Corporate bankruptcies rose sharply, land prices continued to fall, and total real economic activity of the population plunged. The banks offered near-zero deposit rates, the population preferred to keep more money in cash - but not spend it. The banks, life insurers, and securities houses, the resulting fall in the Nikkei 225 hurt their stock portfolio holdings. This is very important in Japan because banks and other financial houses count paper profit on these stock positions toward their capital base and their capital adequacy ratios. The Nikkei 225 continued to decline and with it paper profits on their books – and thus their capital base (20).

Exports were the only positive field in Japan’s economic. Thanks to the fall in the yen and the significant productivity improvements, along with strong demand in Asia and North America, Japanese exports in the first half of calendar 1997 boomed.

When the Asian crisis came, the banks, life insurers and brokers were faced with the triple whammy of tightened global liquidity, falling stock prices hurt their balance sheets, and the prospect of yet more bad loans as a result of the situation in Asia.

In sum, the Asian currency crisis caused instability within the Japanese financial system given further bad loans incurred by the banks, reduced stock portfolio profits on bank balance sheets, valuation losses to Japanese exporters in Asia, and a worsened outlook for Japan trade. It did have some positive impact, however, although it most certainly was not seen that way initially. The Ministry of Finance had long held the view that Japan’s twenty largest banks were too large – and would not be allowed – to fail. However, the Asian currency crisis and the resultant instability within the Japanese banking system forced it to take a different view. When the Hokkaido Takushoko Bank (commonly known as “Takugin”) found itself facing financial difficulty – as in immediate financial difficulty in terms of an inability to raise cash, for it had been in trouble for years – the expectation still was that the Ministry of Finance would bail it out or save it by merging it with another bank. The Ministry of Finance tried, but eventually on November 17, Takugin was allowed to fail. Japan’s financial system was in trouble and the authorities did not appear to know what to do about it. The following week, the financial markets received the stunning news that Yamaichi Securities, one of Japan’s Big Four brokerage houses, had also failed. Japan’s oldest brokerage, it left behind some Y3.2 trillion in debt. More important than the nominal profitability losses of Japanese banks, brokers, and life insurers which followed on from the Asian currency crisis was the overall threat to financial system confidence. It has not been strong for some time anyway, but in 1997 it received a body blow. Japanese banks faced the prospect of a rising cost of funding – the “Japan premium” in the money markets, falling asset markets, rising bad loans, and depositors standing in line to get their savings out. The financial system itself faced the threat of meltdown. Because of Japanese bank loan exposure to Asia, this in turn back into falling stock prices in Asia, the two feeds off each other (12).

Given the extent of bad loans still in the system and stock portfolio losses on books, there will be further failures of financial institutions, including second-tier securities houses and banks. The smaller life insurers are also threatened. Given Japan’s market structure of cross-share holdings, lifers are among the largest holders of bank-sector shares. They are also heavily exposed to banks and brokerages through subordinated loans, which incidentally are not covered by Ministry of Finance guarantee. In addition, while the largest of the lifers are on a relatively sound balance sheet shooting, the smaller ones are faced with low interest rates, rising cancellation of insurance policies, and stock losses. Given deregulation to date, which has resulted in higher premium and dividend at home, many have no choice but to invest it the offshore markets, notably, of course, in the U.S. Treasury market, given its liquidity, size, and high real and nominal yields. Fears that Japanese financial institutions could repatriate large amounts of offshore investment thus seem overdone. To do so would be take away their highest-yielding assets, thus essentially committing corporate suicide (18).

Japan – Challenges and Opportunities

Now, Japan must start sending out solutions. For John Miller opinion, what is needed the most for Japan, as a whole is deregulation. In the longer term, two key incentives for reforming the finance sector are the big bang, which will lead to much greater competition and for which the healthy Japanese financial institutions are furiously preparing, and the demographic question. Japan’s budget deficit remains a critical structural problem. In order to finance the ensuing need for rising social welfare payouts and a falling tax base, the Ministry of Finance faces the task of cutting deep into the budget deficit, in fact making it into a surplus. Deregulation will be a crucial platform for this, because spending cuts and tax hikes alone will not produce the desire results, given weak consumption and domestic demand. Deregulation is the key, whether in finance, real estate, or manufacturing. Further, deregulation is crucial in freeing up the Japanese financial sector to produce better and higher returns-to offset the higher obligations they will face in the years to come.

Several things are needed:

First and foremost, the Ministry of Finance and the Bank of Japan need to clearly say that the financial system as a whole will be protected. The have indicated this by their actions in the market; however it needs to be made clear verbally as well. Not all of this concerns poor fundamentals – not all the lifers, banks and brokers being hit by the vicious combination of stock market losses, higher cost of funding, and bank and insurance policy withdrawals are financially weak.

The second point is that the Ministry of Finance must make it crystal clear that those financial institutions that do not face up immediately to their situation, by either merging with others or writing off huge loan/stock losses, will be closed down. This sounds potentially dangerous, but not to do so is much more dangerous. At present, almost all financial institutions are being tarred with the same brush. The threat is thus that relatively healthy institutions could be dragged down, even to the point of failure, given the general crisis in confidence.

Third, the Ministry of Finance also has to make clear that deposits are safe and will be guaranteed. The interests of stockholders are not guaranteed and should not be. The price of investment has to be the possibility of losing everything you put in. That is the part of the game. Second-tier banks have forced deposit runs because depositors had little faith about the guarantee or were uncertain.

In addition, rather than the Bank of Japan just injecting countless trillions of yen into the financial system, the fledgling Deposit Insurance Corporation (DIC) should be given real powers, in both financial and regulatory terms. On the financial side, the DIC’s own reserves are paltry and completely inadequate to deal with the task in hand. These need to be significantly boosted, most probably by bonds guaranteed by the government, which would be bought by the Ministry of Finance’s own trust fund bureau. The funds from these would be used by the DIC to buy failed financial institution bad debts in order to protect depositors and at the appropriate time sell these on. In addition, the DIC should be given regulatory “teeth”: It should be allowed to investigate the entire financial system and if necessary shut down errant banks, rather than just wait for them to fail before guaranteeing their deposits through bad debt purchases. Also, public funds have to be used. Public funds should be used in order at first to shore up confidence and then the system itself. The need for public funds has to be addressed and explained, however. Finally, the Bank of Japan needs to keep interest rates where they are for the rest of this year at the least, to allow banks and other financial institutions to rebuild their battered balance sheets.

As it was published by Nouriel Roubini, Japan needs:

1. Financial markets liberalization (important role of financial markets for growth):
- Financial restructuring of the banks and reform of banks’ supervision activities
- Liberalization of derivatives markets
- Liberalization of insurance markets and services
- Expansion of shareholder rights
- Improvement of disclosure procedures
- Creation of an independent institution similar to the US Securities and Exchange Commission
- Develop venture capital institutions
- Allow the formation of holding companies.

2. Deregulation and fostering of competition in domestic markets:
- Improve services productivity through deregulation and competition. Right now the low productivity service sector is a main drag on the economy and negatively affects the competitiveness of the export sector as well. Sectors requiring deregulation include retail, transportation, telecommunications, and telephone service.
- Foster competition through further trade liberalization and avoid further Yen depreciation
- Reduce oligopolies with aggressive competition policies.

Administrative and political reform:
- Reduce the powers of the bureaucracy
- Reduce the power of the Ministry of Finance and dismantle it into several smaller agencies
- Regional decentralization to reduce central power
- Change the voting system towards a pure majoritarian system that will in the long-run lead to a two-party system. Evidence on the benefits of a two-party system over coalition governments.
- Reduce the number of government ministries

Educational reform:
- Foster basic research rather than applied research in the universities and academic research institutions
- Stimulate other forms of basic research (via government funded research)
- Develop a system of merit-based rather than seniority-based promotion in research and academic institutions
- Foster individual innovation and creativity in the educational system.

Risk Analysis for Japan

Throughout most of the 1990’s, Japan’s economic situation was characterized by slow real GDP growth accompanied by little or no inflation, huge foreign exchange reserves and multi-billion dollar current account surpluses. But the worsening trend in many of the key indicators has accelerated, culminating last year in Japan’s deepest recession in the post-World War II period. The economy contracted in four consecutive quarters, resulting in real GDP falling 2.6% for 1998. At the same time, unemployment rose to over 4.2%, gross fixed investment dropped more than 7% and available financial credit fell more than 25%. The Nikkei stock market index also continued its steady decline during 1998, falling more than 25% from its high of 17,300 in February 10 a 13-year low of under 12,900 in October 1998. Since then, the index has behaved erratically, bouncing between 13,000 and 15,000 as the market struggles to adjust to the moribund economy.

In an unusual editorial comment, the OECD’s most recent assessment of Japan described the economic condition as “grave” and that the “critical situation calls for bolder policy action than has been adopted to date”. Japan’s inability to come to grips with the deep financial problems faced by its banks and the unwillingness to undergo the long-overdue structural reforms highlights the internal turmoil that the country finds itself in today. There are no prospects for any kind of robust economic recovery in 1999. Nevertheless, the effects of high government spending over the past several years-combined with the nascent economic recovery in key parts of East Asia and efforts to clean up the banking sector--may allow the decline in Japan’s economy to slow in 1999.

Inflation, always low in Japan, has disappeared in virtually all sectors to be replaced by deflation that started in the overpriced asset sector (stocks and real estate) and spread to other areas of the economy over the past several years. Although short-term interest rates remain at or near historic lows (under ¼%), longer-term rates moved up in recent months as the government issued more bonds to finance the growing government budget deficit. From three-quarters of a percent as recently as last October to over 2% by the end of the year, higher long-term rates (ten years and higher) have become a major worry to analysts concerned about the domestic economy. In an attempt to offset the upward trend in long-term rates, the Bank of Japan announced in mid-February a 10 basis point cut in the unsecured overnight call rate it charges banks to a new record low, 0.15%. Although the discount rate remained unchanged at 0.50%, there is a growing sense that the Bank of Japan will finally take advantage of the deflationary environment and strong yen and further ease monetary policy by boosting the money supply, perhaps through expansion of its money market operations. Clearly, the government’s attempts to stimulate the economy through a looser fiscal policy has not worked, and instead has contributed to a rapidly growing budget deficit—now equal to 10% of GDP—and the recent escalation in long-term rates. There is also an ongoing debate about how appropriate it is for the government to pressure the Bank of Japan to directly underwrite government debt by taking over the role of the Ministry of Finance’s Trust Fund. In any case, the Bank of Japan will more likely respond to growing political pressure by increasing its purchases of bonds, at least in the secondary market.

Although Japan’s exports dropped in 1998 due in part to the effects of the Asian crisis, its current account surplus will remain well over $100 billion annually and exports will likely resume their upward trend in 1999. The high current account surpluses account for some of the strength of the yen as Japanese exporters sell dollars and buy yen. The strengthening of the yen that began in mid-1998 has concerned Japanese economic officials who are worried that exports—the only strong part of the economy—will suffer. It appears that the Japanese government has decided that the 109-110 yen/US dollar level is the intervention point, below which the government would likely sell yen and buy dollars. The Clinton Administration also seems interested in seeing the yen weaken against the dollar.

Japan’s single biggest problem remains the banking sector. In comments directed at Japanese policymakers, Treasury Secretary Rubin argued in early February that Japan needs to strengthen its bad debt-laden banking system. Self-assessment by Japanese banks shows bad loans totaling nearly $800 billion, or nearly 19% of GDP, and the government’s efforts to clean up the situation has only just begun. Last fall, two of the major credit rating agencies—Moody’s and Fitch IBCA—downgraded Japan’s long-term ratings from AAA to Aa1 and AA+, respectively, in response to the ongoing banking crises and deep recession. Japan’s strong external sector, especially its enormous foreign exchange reserves, has helped keep Japan in its current group rating.

China And The Asian Financial Crisis

China's slowest economic growth rate in six years is providing new fodder for economic analysts who want Beijing to come up with its own New Deal to spur the economy and protect the disadvantaged.

(April 14, 1998) the State Statistical Bureau announced that China's annual economic growth rate had slowed to 7.2 percent in the first quarter. It was the lowest growth rate since before the late Chinese leader Deng Xiaoping made his famous trip to China's south in 1992 and spurred a period of extremely rapid growth.

The statistical bureau said inventories in the first quarter climbed to $67.2 billion, up 14.2 percent and equal to about 7 percent of China's annual gross domestic product. Mounting stockpiles of goods, combined with a 1.5 percent drop in the retail price index, helped send industrial profits plunging.

Anxious to prevent social and labor unrest that could result from growing ranks of unemployed workers and civil servants, Hu Angang, an influential economic analyst, has called for a Chinese-style New Deal. 22

Forecasting a sharp increase in unemployment, the Beijing-based policy analyst appealed for the government to stimulate growth, create jobs, pour money into infrastructure and set up better social security systems.

While rapid by U.S. standards, China's current growth rate is barely fast enough to generate jobs for the tens of millions of Chinese seeking work as they flock to the cities from the countryside and as ailing state-owned enterprises lay off unneeded employees.

"Growth below 5 percent will create a great deal of social unrest," Huang Yukon, chief representative of the World Bank, predicted during a World Economic Forum in Beijing this week.

"The pressure on the government is tremendous," said Frederick Hu, head of Asia economic research for Goldman Sachs & Co. in Hong Kong. Hu believes that growing unemployment poses the biggest threat to China's economic reform program.

The new estimate of first-quarter growth is less than the 7.5 percent estimate that Premier Zhu Rongji gave earlier this month. It also falls short of the 8 percent growth target Zhu has set for the year and well below last year's rate of 8.8 percent.

Moreover, according to the statistical bureau's chief economist, Qiu Xiaohua, "The deterioration in the efficiency of firms is even worse than we expected."

While most economists don't favor a Roosevelt-style spending program, many people think that Beijing needs to do something to keep the economy from grinding to a halt.

"Is some form of stimulus needed? My answer is yes," Hu said. "Inflation is dead in the water. China must maintain a delicate balance between reform and reflation."

Not everyone agrees. Andy Xie, vice president of Morgan Stanley Asia Ltd., says China should be cautious. "The problem in Asia is that there has been too much investment," Xie said, and too much of that has been wasted.

"Today's Asian crisis tells us that if today's high growth is tomorrow's bad debt, then it's better not to have the growth at all," he said.

As it is, rates of return on private foreign investment in China slid from 8.4 percent in 1993 to 4.7 percent in 1996, Xie said, making it less profitable -- and more hassle -- to invest in China than to put money into a U.S. money-market fund.

"That suggests that China needs massive restructuring, not massive investment," Xie said.

But proponents of an economic stimulus say that China still needs certain kinds of public investment. While Japan, already well equipped, lavishly adds new ports, bridges, roads and rails, China desperately needs better highways, airports and other facilities.

"China is not Japan," said Zhu Xiaohua, chairman of the publicly listed Hong Kong subsidiary of China Everbright, a diversified retail, infrastructure and bank holding company. "China still needs infrastructure."

The slowdown in China's economic growth has added a sense of urgency to China's long-delayed overhaul of money-losing state-owned enterprises that continue to be a drag on the economy.

The prestigious Qinghua University management school expects to begin a two-month crash course in accounting for recently retired ministers and vice-ministerial-level officials so they can audit some of the country's biggest state-owned enterprises. Senior officials are needed because the chief executives of many big firms hold ministerial rank.

The inspectors will try to obtain true consolidated balance sheets for the firms and determine the central government's capital stake so the firms can be restructured or sold.

"Many people want to separate the government's roles as regulator and owner, but we have to figure out a way to do that," said Chen Xiaoyue, associate dean of Qinghua's school of economics and management.

Laurence Brahm, who runs a Beijing-based consulting firm called Naga, said he visited an iron and steel mill in Anhui Province with 20,000 workers that needed only 2,000. The firm is supporting 15,000 spouses, retirees and children, too. Using technology from the 1960s and 1970s, the plant can't compete with steel mills in South Korea and elsewhere.

Huang, the World Bank representative, notes that between 6 percent and 25 percent of the costs to big state-owned enterprises go to social welfare expenses, in many cases erasing whatever profit margins those enterprises might have.

Even if China stems the tide of red ink, executives and economists say the nation must find new growth areas.

Zhu, the China Everbright head, is sanguine about that. He noted that while old industries such as timber are having massive layoffs, entire new industries are springing up. He cited the pager industry, which didn't exist a few years ago and now employs a million people, including those in manufacturing and sales, operators and other service people.

But building new industries takes time, and this year economic policymakers might have miscalculated what will be needed to sustain the growth pace they want.

"The overwhelming issue is growth," said independent economist Fan Gang, who said policymakers had delayed decisions while awaiting a reshuffling of government positions in March.

Fan said China's growth rate might continue to taper off through late in the year.

"It's too late for a stimulus policy," he said. "Because of the time lag, it may take six months to recover" and achieve the growth targeted for this year.

Zhu Vows To Boost China's Economy

China's new premier, Zhu Rongji, pledged today to fend off the Asian financial virus and keep economic growth at 8 percent, while asserting his support for the handling of the 1989 Tiananmen Square protests.

But while Zhu, 69, did not stray from the usual government positions during his first press conference as premier, he projected a relaxed, personal style, bantering with foreign and domestic journalists during a live television broadcast and fielding questions on everything from economic reform and slothful civil servants to the Tiananmen Square massacre and his personal concern about the future.

If the new premier is going to blaze new trails, for now they seem to be mostly economic ones. Zhu, who is also the number-three person in the Communist Party, was most cautious in answering political questions.

He said the Communist Party was "of one mind" about the "political disturbances" in Tiananmen Square in 1989. The massacre there of hundreds of student-led democracy demonstrators by Chinese troops acting on Communist Party orders remains in the minds of many Americans an important obstacle to better Chinese-U.S. relations. Zhu said the Communist Party had "drawn conclusions" about the incident, and that "those conclusions will not be changed." (23)

His comments appeared to shut a door for many Chinese who hoped that Zhu, whose party membership was stripped in 1958 and restored in the late 1970s, might prod the party to reverse its verdict on the 1989 uprising and rehabilitate many damaged careers. Unlike his predecessor Li Peng, who issued the martial law order in May 1989, Zhu was based in Shanghai and he managed to persuade most demonstrating students to leave Shanghai's main square.

On economic issues, he displayed stronger views. He said he will end the system in which state-owned companies and ministries provide free or extremely cheap housing to employees. "We will stop all the allocation of welfare housing and all housing will be commercialized," he said.

He also said he will launch a health-reform program during the second half of this year and overhaul the grain-distribution system for more efficient pricing. And he restated his determination to repair the ailing commercial banks and stop the financial hemorrhaging at state-owned enterprises within three years, a timetable many analysts consider optimistic.

Zhu displayed his sterner side in warning that charges and fees at local levels exceed an acceptable tax burden on Chinese citizens and have prompted "a lot of complaints." He said, "This policy must be reversed."

Zhu said his economic reform plans will not be altered by the financial crisis sweeping across Asia. He promised to stimulate domestic demand to keep growth at 8 percent while preventing inflation from rising above 3 percent.

The Chinese premier also reaffirmed his confidence in Hong Kong's economy, which has come under heavy economic pressure since its stock market plunged in October and neighboring countries fell into financial turmoil. If Hong Kong ever needs and requests Beijing's help, Zhu said, "China would spare no expense to maintain the stability of Hong Kong and protect the Hong Kong dollar's peg to the U.S. dollar."

Zhu's press conference marked the end of the 15-day session of China's National People's Congress, a body of representatives that is usually asked to ratify decisions made by the ruling Chinese Communist Party. Outgoing premier Li took over as the body's new chairman.

But the traditionally meek Congress made the biggest gesture of dissent in its history when 45 percent of its delegates voted against or abstained from a vote on the crime report presented by the government's top prosecutor.

The record-setting low point of support for the government report was seen as an indication that members of the legislature remain unsatisfied with efforts by the government and the Communist Party to stop widespread corruption.

China: The Problems

BANKS: The government channeled 75% of bank credit into state enterprises. But this practice has produced at least $240 billion in bad debt and created a bank insolvency crisis.

EXPORT SLOWDOWN: Coastal provinces absorbed billions in foreign investment to build factories for overseas markets. But Asia, which accounts for half of exports, has collapsed, and foreign investment has slowed.

SPECULATION: Billions have poured into office buildings and shopping malls in Beijing, Shanghai, and Guangzhou. Overcapacity and new debt problems for the banks are the result.

JOBS: As state-owned enterprises pile up losses, more are shutting factories,producing new jobless masses--maybe twice as high as the official statistics.

Can China Avert Crisis?

China's economy is wobbling, and a major shift in policy toward public spending is about to change history.

The swank bars and restaurants of Shanghai are filled with nervous talk these days about how the bottom is falling out of the local real estate market. Shanghai's five-year construction binge soaked up $18 billion and astounded the world with its audacity. But now the city touted as the financial capital of the world's next superpower is filled with half-empty office towers and the concrete shells of apartment buildings. It may be Asia's biggest property glut yet.

Hundreds of miles away, in an export zone of the Pearl River Delta, the general manager of an import-export firm in Guangdong is worried, too. His company has been a star exporter of shoes and textiles. But now his suppliers are laying off half their workers, unable to compete with rivals in Southeast Asia who lowered prices after their currencies tumbled. With earnings dropping, this manager thinks he may have to cut workers too. (24)

China's economy is starting to sputter as the big sources of its economic strength all show signs of fatigue. Foreign investment is slowing because cash-starved Asian companies can no longer afford to build in China. Exporters are seeing business shift to cheaper factories in Thailand and Malaysia. The real estate boom in the rich coastal provinces is turning into a bust. Unemployment is rising, and bad loans keep piling up in the state-owned banks, threatening the health of the entire economy. True, China does not have the convertible currency and massive short-term foreign debt that triggered the meltdowns across Asia. But there are enough similarities that the outside world is now asking if China can avert a crisis.

Acutely aware that the country must change course, Beijing's mandarins are scrambling for solutions. As thousands of delegates meet in Beijing for the National People's Congress, the Chinese are waiting eagerly for signs of decisive action from new Premier and economics czar Zhu Rongji. ''We need a New Deal with Chinese characteristics,'' says Chinese Academy of Sciences researcher Hu Angang, recalling the bold economic activism of the U.S. six decades ago.

The pieces of China's new deal are still taking shape as the country's best and brightest pen white papers by the score. Much hinges on the outcome of leadership changes and a major shakeup of government ministries now under consideration. But some key elements are emerging: Instead of devaluing its currency to boost exports, the government will try a major policy shift. To stimulate domestic growth it will abandon its current austerity program and promote hundreds of billions of dollars in new investment over the several years, much of it in public works and housing. The government will likely raise most of these funds by significantly expanding its fledgling bond market and loosening up on credit. And Beijing will inject $32 billion in fresh capital into the country's four top banks so they can start shedding bad loans.

TWIN OBSESSIONS. For Zhu Rongji, who is expected to take over as China's Premier at the Congress, the moves to prime the pump signal a big change in thinking. Through administrative fiat, Zhu--nicknamed Lao Ban, or The Boss--started to choke off credit in mid-1993 to squeeze out speculation in the property and stock markets. His other obsession has been stopping inflation, which has cooled from 22% in 1994 to less than 1% now. Associates say Zhu ignored appeals to ease up on his fight against inflation until the Asian crisis was well under way and its implications for China were clear. But by December, he realized that China's own economy could stall disastrously if he didn't step on the gas, risking the ire of die-hard conservatives who oppose any increase of inflation and deficit spending. Perhaps in anticipation of his new role as Premier, Zhu has been having sympathetic meetings with unemployed workers.

Party members are steeling themselves for a more fundamental reform of China's state-run capitalism. The country needs a modern banking system, not the profligate method of state-directed credit it has now. The Chinese must treat foreign investors as genuine partners and not as gullible sources of cash and technology. And the government must realize that the easy days of export-led growth are ending and that the task of building a domestic economy lies ahead.

What's amazing is how swiftly the Asia crisis has undermined China's growth formula. Under Deng Xiaoping, Beijing let the coastal provinces invest willy-nilly in hundreds of thousands of real estate and manufacturing ventures. The boondoggles and corruption were astounding. Zhu finally started cutting off the flow of cheap bank loans to pet projects. The austerity drive left even many sound companies starved for funds and forced to lay off workers. But Zhu and other leaders figured that as long as export industries remained strong, the economy would keep growing briskly. Officials figured they would have years to fix the state sector and perfect their brand of red capitalism.

But export growth may slow to 5% this year, from 22% in 1997, and cities from Beijing to Shanghai are feeling the pinch. The coastal factories, many of them started by the go-go party cadres, are having trouble finding buyers for all their low-grade air conditioners, vacuum cleaners, and consumer electronics.

Consumer demand is dropping fast, and many retailers are desperate for shoppers. At Beijing's new Cofco Plaza shopping center, for example, the top two floors are empty of shops. And the designer clothes and bedding sold in the largest third-floor shop come from boutiques elsewhere in the building in order to fill up otherwise unoccupied space.

Such signs are alarming. If growth slips below 7%, the economy will not generate nearly enough jobs to soak up the 6 million Chinese entering the workforce each year, as well as the 12 million laid off by restructured state enterprises. Unemployment is expected to jump by an additional 10 million through 2001. The steel industry will dismiss a half-million workers--38% of its workforce—by 2000. The country's textile machine will probably lose 600,000 jobs in the next few years. City officials are frantically trying to retrain these former factory hands, many of them over (40).

Chinese policymakers know that a significant slowdown could force them to devalue their currency. That would send a new jolt through the world economy. Devaluation’s, warns Zhu Min, an economic adviser to the Bank of China's president, would lead to ''export wars in the second half of this year and a vicious cycle of depreciation’s.'' A slowdown could also trigger the kind of social unrest that horrifies China's leaders. And if China slides into stagnation, the world loses one more important source of growth.

FEUDING PLANNERS. That's why re-igniting growth is a central part of the new plan. But don't expect to see a lucidly packaged, well-organized stimulus program emerge from the Congress. Instead, the cadres will unveil remedies piecemeal as disagreements rage over the details. Even the official China Daily newspaper is reporting the debate among technocrats over the wisdom of abandoning fiscal rigor and risking the creation of another bubble. Sinologists say current Premier Li Peng favors only a 10% increase in government spending, below Zhu's target. Yet, at the end of the day, analysts expect the government to boost its spending on public works and other projects as much as 20% a year.

Much of this is to come from vast personal savings--some $560 billion piled up in state-run commercial banks throughout the country after a decade of economic growth. The goal is to ladle this money into everything from Beijing's fourth ring road to Shenzhen's subway to such megaprojects as the Three Gorges and the Yellow River's Xiaolangdi dams. The usual way to capture these savings would be to issue bonds. But ordinary Chinese investors have traditionally steered clear of long-term debt instruments, either because interest rates are low or because it is too difficult to sell them on a secondary market. Banks also are not eager to see a major bond market, which could divert funds from their deposits and make it more difficult to carry their estimated $240 billion in dud loans.

Yet policymakers are actively debating several bold ideas that could vastly expand China's debt markets. One would be a major expansion of corporate bonds, which authorities until now have kept at under $2 billion a year. Liu He, an official at the State Information Center, recently proposed a big increase in the number of highway and railroad bonds. A more controversial idea is to let cities and provinces sell bonds both at home and abroad, a scheme Zhu opposes because local officials could go overboard again. The central bank is also considering an expansion of the money supply later this year through new loans to commercial banks. Plans are afoot to bankroll construction of $350 billion in apartments over three years. The central bank also would earmark loans for infrastructure projects and small businesses.

The most urgent task Zhu faces, however, is to clean up the banking system. A key first step is Beijing's recent decision to pump $32.5 billion in capital into its four main commercial banks by issuing new state treasury bonds. This will boost banks' capital levels to meet international standards, making it easier to carry nonperforming loans, lower lending rates, and increase profitability.

The government is also making attempts to curb the rampant growth in finance companies, which were notorious for providing loans to speculative investments. Computerization of bank data is making it easier for regulators to monitor loans. Zhu also wants to dramatically reduce the number of branches of the People's Bank of China to lessen the chances of local meddling. Top bank executives at the regional level now are appointed directly by Beijing and no longer report to provincial governments or party officials. Wang Qishan, former president of China Construction, has been named Vice-Governor of Guangdong Province, where he will try to ensure that local cadres don't dictate bank lending.

GREEN LIGHTS. Beijing will also sweeten terms for investors from the U.S. and Europe. ''When the economy is bad, the authorities are polite to people like me,'' says William A. Hanbury Tenison, chief representative of Jardine Fleming Securities Ltd. in Shanghai. ''At the moment, people are very polite.''

They're about to get even nicer. Chinese authorities will soon sign off on major infrastructure projects involving Western multinationals that have been bogged down for years. In February, for example, Royal Dutch/Shell Group finally got the green light for a $4.5 billion chemical complex, China's biggest foreign investment ever. Jack Perkowski, chairman of Asimco, a direct-investment fund with 17 joint ventures across China, is currently negotiating two more ventures, which are suddenly going more smoothly. ''For everything in the contract, we're finding more flexibility now. We're seeing tangible signs,'' he says.

Reforms aimed at streamlining China's stifling bureaucracy would improve the investment climate immensely. Reducing the power of the Ministry of Post & Telecommunications, which both regulates and operates most of the telephone system, would help open China's phone market. Limiting the ministries' role in industry also could weaken China's ability to impose onerous rules on technology transfer and local content.

Beijing may even make it easier for foreigners to turn a profit, something it has not cared much about. Watch for new low-interest loans and reduced tax rates for particular infrastructure projects built by foreign joint ventures.

Ambitious stuff. But will it be enough? A good clue will be in how China tackles its banking problem. Although Western analysts praise the $32 billion capital injection as an important first step, ''in terms of solving the problem, it's only a fraction of what they need to do,'' says Standard & Poor's China analyst Wayne Gee.

China's banks probably need a much more massive injection of new capital so that they can write off bad debts to state enterprises. Western economists also fear that China's short-term foreign debts--the Achilles' heel that brought down Thailand and South Korea--may be understated. Officially listed at $15 billion, the real figure could be several times that if the offshore borrowings of Chinese corporate branches in Hong Kong and the U.S. are included. Beijing's $140 billion in foreign reserves is still a comfortable cushion, but China may be more vulnerable to an external financial shock than it thinks.

KOREAN MODEL? Throwing money at the banks won't work unless they also start lending on the basis of credit analysis, rather than politics. Also lacking so far is a comprehensive plan for the banks to wipe bad debts off their books, which is necessary if they are to stand on their own as profit-making institutions. China does not have a legal framework for banks to seize corporate assets and sell them off to outside investors. And because there is no insurance program to protect depositors, shutting down bad banks is difficult. There isn't even a system to monitor the assets of state banks. All of these issues are now being debated actively in the Chinese press, but decisions aren't expected in the coming months.

The government also has not figured out what to do with the largest state-owned enterprises, the biggest money-losers in the system. Beijing has been urging strong state companies to buy up the weaker ones to create conglomerates modeled after South Korea's chaebol. The well-run Baoshan Iron & Steel Corp. in Shanghai, for example, is being strong-armed into buying a poorly run metallurgy company, while Beijing's Snow Lotus Cashmere Co., one of the profitable textile makers, may have to acquire other, money-losing cashmere producers. ''We are being encouraged to take over a hurting enterprise, but I'm not sure that that is a sound strategy,'' says General Manager Li Yuanzheng.

The crisis of Korea's chaebol may well force Beijing to abandon this model and even to rethink the party's emphasis on large corporations. Now, policymakers are exploring special loan funds for smaller businesses, and they may make it easier for private enterprises to issue stocks and bonds. Ready cash raised in 1997 from Hong Kong's securities markets was supposed to ease the pain of restructuring state-owned behemoths. But that money has now dried up. So the government plans to approve $3.7 billion worth of initial offerings in China's domestic markets this year, a sum that may grow. Trouble is, regulators fear that if failing companies manage to list, the already shaky credibility of China's bourses will be undermined further.

Opening up the interior of China to serious economic development could offset the slowdown in exports and boost demand for locally made goods. Beijing is hoping its ambitious public-works program will spread the wealth to such interior cities as Wuhan and Zhengzhou. They also want to help the three-quarters of China's population that lives in rural areas but who account for only 45% of retail sales. The average annual income of a Chinese farmer is a mere $250, whereas city residents pull in about $620. But this will take years: The roads and power generators must be built before industry moves en masse to the hinterland.

Give credit to Zhu Rongji and China's ablest bureaucrats for recognizing a developing crisis and mobilizing to solve it. Outsiders applaud his ambition. ''Zhu is shooting for the moon, but even if he ends up only half way there, it will be a tremendous acceleration of what we have seen so far,'' says Nicholas R. Lardy of Washington's Brookings Institution.

Yet Zhu and his colleagues have only a few years to reignite China's economy with public works and public debt. If they succeed, China's economy will be vastly more market-oriented but with the party still at the helm. If they fail, China will have the same problems it has today, except it will have a lot more debt and far fewer options. Six months ago, the Chinese thought they could avoid the fallout of the crisis. Today, the crisis is already forcing major change in Asia's most dynamic economy.

China's Financial Situation Optimistic in May Statistics released by the People's Bank of China (PBOC) show that the outstanding amount of broad money (M2) by the end of May was 0.9 percent higher than that in April -- the first reversal this year of a downward trend. The PBOC also announced on June 9 that the outstanding amount of loans increased by more than 11 billion yuan over the same period last year, residents' deposits maintained a rapid growth, and the Renminbi exchange rate remained stable.

According to the statistics, by the end of May the outstanding amount of broad money was 9.39 trillion yuan, up 15.5 percent from the same period last year; while that of narrow money (M1) was 3.36 trillion yuan, up 10.8 percent; and money in circulation (M0) was 998.44 billion yuan, up 10.1 percent. By the end of May, the outstanding amount of loans was 7.73 trillion yuan, up 15.2 percent from the same period last year, and the outstanding amount of loans by state-owned banks was 6.06 trillion yuan, up 14.8 percent, which is 0.1 percent higher than that in April.

Newly increased loans in May totaled 74.33 billion yuan, an increase of 11.1 billion yuan over the same month last year. Of the total increased amount, 15.04 billion yuan belongs to medium- and long-term loans, an increase of 9.23 billion yuan over the same month last year.

By the end of May the outstanding amount of deposits was 8.62 trillion yuan, up 16.7 percent from the same period last year, which is 1.2 percent higher than in April. Of the total amount of deposits, enterprise deposits accounted for about 2.8 trillion yuan and residents' deposits were 4.97 trillion yuan, up 12.8 percent and 17.5 percent, respectively. The statistics show that by the end of May the excess reserve rate of state-owned commercial banks was 8.6 percent, indicating that they have fairly strong payment ability.

Risk Analysis for China

Unlike many of its neighbors in Asia, China’s economic prospects appear positive. Real GDP growth, which averaged more than 12% annually during the early to mid-1990s, has slowed steadily during the last four years. From around 7% in 1998, China’s real GDP will likely slow further to 6% in 1999, reflecting a slowdown in domestic demand due to rising unemployment affecting consumer confidence. The government’s current $100 billion spending program on infrastructure will help offset the expected slowdown in consumption and a weak export sector.

Average annual inflation has fallen dramatically since peaking at over 24% in 1994. For all of last year, prices apparently fell slightly due in part to falling food prices. Inflation for 1999 will likely return, with prices rising at an annual average rate of about 4% as the government restructures state-owned enterprises and imposes price floors in certain industries.

The export sector remained weak in 1998, as exports to neighboring countries in Asia fell at a double-digit rate in response to the deep recessions in many of the economies. Due also to the relative strength of the Chinese renminbi, strong export growth is unlikely to return in 1999. Because of weak import growth, the trade surplus remained high in 1998, reaching just over $40 billion for the second year in a row. The current account surplus also remained high at over $23 billion and will fall only slightly in 1999 before declining more substantially over the next several years. Exports to the U.S. jumped 14% in 1998 to over $71 billion, thereby boosting its bilateral trade surplus to $58 billion.

A continuing issue confronting the government in 1999 will be the exchange rate policy, which fixes the value of the renminbi at 8.3 renminbi/US$. After the large depreciation of most of the neighboring economies in Asia in 1997, China came under pressure to allow its currency to fall in order to maintain its competitiveness against the other exporters in Asia. Its decision to hold the line helped keep inflation in check but also hurt China’s exports. China’s ability to maintain its exchange rate is greatly enhanced by its $145 billion in foreign exchange reserves, as well as by the continued high levels of foreign direct investment—estimated in 1998 to have about equal to the $44.2 billion that entered the country in 1997. In light of the expected weakness of the Japanese yen through 1999, it is increasingly possible that China will decide to allow its currency to devalue later in the year. Any devaluation will be small, however, to avoid importing additional inflation. Meanwhile, Hong Kong’s pegged currency is also expected to remain steady during most of 1999, though the economy will remain in a recession.

Economic consequences of the Asian financial crisis The economic fallout from the Asian financial crisis has been disastrous for the MSIs. Economic contraction has followed the collapse of the exchange rate. Stock market values have plunged, unemployment has risen, financial and nonfinancial firms have gone bankrupt, and pessimism is almost universal. Of course there are silver linings. Economic reform has been speeded up, and some desirable political change has occurred, but much more needs to be done.

Some neighboring countries' economies have also suffered, including those of Hong Kong, Malaysia, the Philippines, and Singapore. These economies may grow 3 percent less in 1998 because of the Asian financial crisis. The impact on the world economy as a whole is probably a loss of output in 1998 of around 1 percent (15).

A currency crisis automatically causes a liquidity squeeze, much higher interest rates, and a credit implosion. Thus the sectors in the MSIs and nearby countries that are most likely to be hardest hit are the domestic financial service industries, especially weak banks and other undercapitalized financial intermediaries. They will have to be re-capitalized and restructured. Where permitted, foreign firms will likely be enticed to invest in the ailing financial industries, and significant portions of these domestic industries might come under foreign control.

Meanwhile the bankruptcy of many nonfinancial firms and high real interest rates will curtail real domestic investment in the affected economies. Although painful, this will help correct the overcapacity in industry and the overbuilding of commercial and residential sites. In addition, consumption is being curtailed because of a drop in confidence along with the decline in real income. Intra-Asia tourism is also being hit hard. For example, Australia and New Zealand have seen almost a complete cessation of Korean tourism, which had been growing very rapidly (17).

Finally, the immigration of guest workers is slowing down and may be reversing. Hong Kong is seeing fewer requests for foreign domestic servants, and some of the foreign servants are returning home. Similarly, Malaysia no longer has a labor shortage and will need fewer foreign workers (18).

A Negative Impact to the US (25)

The unsettling economic instability in Asian markets, coupled with Japan's prolonged economic weakness, is likely to have two effects on the U.S. First, capital will flow from Asian markets to the U.S. as investors seek safe harbor in U.S. companies, bonds, and currency.

In addition, a wave of fear will also flow to the U.S. as Asian currencies are devalued and financial institutions, like Japan's Yamaichi, collapse. The question is, which of these opposing forces will prevail in affecting the U.S. economy?

American assets, especially U.S. government securities, have become safe havens for nervous investors around the world. Foreign acquisition of U. S. government securities jumped from approximately $79 billion in 1994 to $138 billion in 1975, $245 billion in 1996, and an estimated $235 billion this year (first seven months at an annual rate). These data are from the Federal Reserve.

Even though Asian purchasers have increased their demand significantly, more of the flow is coming from non-Asian countries. For example, last year, $98 billion was purchased by Asian countries (including Japan) and $147 billion by the rest of the world, especially the United Kingdom. What we seem to be seeing is a flight from the worrisome Asian currencies as well as a flight from the Euro.

The reasons for these flows are reasonably clear. Returns are relatively high in the U.S., the dollar has been appreciating, underlying trends look positive, and the nation as well as the economy look pretty stable.

Will the real problems from Asia infect Americans with worry, fear, and anxiety? Although the writer is correct to note that the U.S. will suffer some negative effects, these are unlikely to be as severe as, for example, the Latin American debt crisis of the last decade when American banks and companies were much more exposed. The U.S. economy got through that crisis with little general impact, although specific banks and companies were hit hard.

China has its own problems, independent from those of the other Asian countries. (In fact, most of the Asian problems were independent of each other. They had the same root cause, though: non-economic allocation of capital that produced low or negative returns and that often had little prospect of paying back investors, be they bank lenders, shareholders, or government backers.

The difference with China is that its currency is not really convertible, which tends to confine the problems to the domestic sector more than in the other Asian economies.

All in all, the U.S. is likely to export less to Asia and import more. This could have a macroeconomic drag on the economy next year and shift resources from export to domestic sectors. However, at the rate the American economy has been growing, this may have little overall impact even though specific companies and industries are likely to be affected, both positively and negatively.

With Japan and the other Asian countries ailing, it's only a matter of time before China's economy is affected. At that point, roughly 25 percent of the world's economy ($8 trillion out of $32 trillion) will be suffering. How can this not have a negative impact on the U.S. economy?

The negative impacts of the Asian crisis are likely to be dominant in the near-term. Overall, Standard & Poors DRI assumes that growth next year will be half a percentage point lower, due to the crisis. We are currently predicting a 1998 growth rate for the U.S. economy of only 2 percent.

On the negative side, exports to Asia will be significantly weaker because of the downturn in Asia and the weaker currencies there. On the positive side, there is a "flight to quality" to the U.S. and, because of lower expected inflation, the Fed will be less likely to raise interest rates.

Impact on Banking and Financial Services

How exposed are the banks of the major industrial countries in these Asian economies? Bank lending data pose a particular problem because of offshore banking centers, such as Aruba, the Bahamas, Hong Kong, and Singapore. Often the banks in these centers simply provide a conduit for funds that ultimately are used outside the center. At the end of 1996, the U.S. banks reported 29.1 billion in loans outstanding to Indonesia, South Korea, Malaysia, the Philippines, Taiwan, and Thailand. There was an additional 14.4 billion loaned to Hong Kong and Singapore for a total of 57.9 billion. This amounted to 34.9 percent of all U.S. international lending. The greatest U.S. exposure was in Hong Kong and South Korea. As for other major lending countries the United Kingdom reported 50.8 percent of its loans to these eight Asian economies and Germany 33.6 percent.

Japan’s bank exposure was particularly high. It reported 62.3 percent of its international lending to these Asian countries. In the offshore centers, Japan reported 87.5 billion in Hong Kong and 58.8 billion and Singapore. For Thailand, Japan reported 37.5 billion in claims, and more than 20 billion each in Indonesia and South Korea.

The U.S. Federal Financial Institutions Examination Council provides more recent data than those available through the bank for International Settlements. The Bank for International Settlements data also have been adjusted somewhat to eliminate double counting and to be consistent across reporting nations. The Council data indicate that U.S. bank claims in these Asian economies declined after December 1996 from 45.2 billion for these eight Asian economies to 41.9 billion as of June 30th, 1997. This amounted to 0.2 percent of total U.S. banking assets of 2,552.5 billion and 1.5 percent of total banking capital of 272.8 billion. It appears that U.S. banks had become aware of the increasingly risky loan environment in Asia and in 1997 had been reducing exposure accordingly.

U.S. banks do not seem to be excessively exposed to the Asian economies suffering from currency weaknesses. This is a vastly different picture than was presented at the onset of the Latin American debt crisis in August 1982. In December 1982, U.S. banks were owed 24.4 billion by Mexico alone. This amounted to 34.6 percent of their total capital and about 2.0 percent of their total assets.

The global capitalist system, which has been responsible for the remarkable prosperity of this country in the last decade, is coming apart at the seams. The current decline in the US stock market is only a symptom, and a belated symptom at that, of the more profound problems that are afflicting the world economy. Some Asian stock markets have suffered worse declines than the Wall Street crash of 1929 and in addition their currencies have also fallen to a fraction of what their value was when they were tied to the US dollar. The financial collapse in Asia was followed by an economic collapse. In Indonesia, for instance, most of the gains in living standards that accumulated during 30 years of Suharto's regime have disappeared. Modern buildings, factories and infrastructure remain, but so does a population that has been uprooted from its rural origins. The Japanese banking system is in deep trouble. The world's second largest economy just reported an annualized 3.3 % decline in economic activity for the second quarter. Russia has undergone a total financial meltdown. It is a scary spectacle and it will have incalculable human and political consequences. The contagion has now also spread to Latin America.

It would be regrettable if we remained complacent just because most of the trouble is occurring beyond our borders. We are all part of the global capitalist system, which is characterized not only by free trade but also more specifically by the free movement of capital. The system is very favorable to financial capital, which is free to pick and choose where to go, and it has led to the rapid growth of global financial markets. It can be envisaged as a gigantic circulatory system, sucking up capital into the financial markets and institutions at the center and then pumping it out to the periphery either directly in the form of credits and portfolio investments, or indirectly through multinational corporations.

Until the Thai crisis in July 1997 the center was both sucking in and pumping out money vigorously, financial markets were growing in size and importance and countries at the periphery could obtain an ample supply of capital from the center by opening up their capital markets. There was a global boom in which the emerging markets fared especially well. At one point in 1994 more than half the total inflow into US mutual funds went into emerging market funds.

The Asian crisis reversed the direction of the flow. Capital started fleeing the periphery. At first, the reversal benefited the financial markets at the center. The U.S. economy was just on the verge of overheating and the Federal Reserve was contemplating raising the discount rate. The Asian crisis rendered such a move inadvisable and the stock market took heart. The economy enjoyed the best of all possible worlds with cheap imports keeping domestic inflationary pressures in check and the stock market made new highs. The buoyancy at the center raised hopes that the periphery may also recover and between February and April of this year most Asian markets recovered roughly half their previous losses measured in local currencies. That was a classic bear market rally.

There comes a point when distress at the periphery cannot be good for the center. We believe that we have reached that point with the meltdown in Russia. We are not making any predictions about the stock market, but we am ready to assert that we have reached that point. We have three main reasons for saying so.

One is that the Russian meltdown has revealed certain flaws in the international banking system, which had been previously disregarded. In addition to their exposure on their own balance sheets, banks engage in swaps, forward transactions and derivative trades among each other and with their clients. These transactions do not show up in the balance sheets of the banks. They are constantly marked to market, that is to say, they are constantly revalued and any difference between cost and market made up by cash transfers. This is supposed to eliminate the risk of any default. Swap, forward and derivative markets are very large and the margin razor thin; that is to say, the value of the underlying amounts is a manifold multiple of the capital employed in the business. The transactions form a daisy chain with many intermediaries and each intermediary has an obligation to his counterparties without knowing who else is involved. The exposure to individual counterparties is limited by setting credit lines.

This sophisticated system received a bad jolt when the Russian banking system collapsed. Russian banks defaulted on their obligations, but the Western banks remained on the hook to their own clients. No way was found to offset the obligations of one bank against those of another. Many hedge funds and other speculative accounts sustained large enough losses that they had to be liquidated. Normal spreads were disrupted and professionals who arbitrage between various derivatives, i.e.: trade one derivative against another also sustained large losses. A similar situation arose shortly thereafter when Malaysia deliberately shut down its financial markets to foreigners but the Singapore Monetary Authority in cooperation with other central banks took prompt action. Outstanding contracts were netted out and the losses were shared. A potential systemic failure was avoided.

These events led most market participants to reduce their exposure all round. Banks are frantically trying to limit their exposure, deleverage, and reduce risk. Bank stocks have plummeted. A global credit crunch is in the making. It is already restricting the flow of funds to the periphery, but it has also begun to affect the availability of credit in the domestic economy. The junk bond market for instance has already shut down.

The pain at the periphery has become so intense that individual countries have begun to opt out of the global capitalist system, or simply fall by the wayside. First Indonesia, then Russia have suffered a pretty complete breakdown but what has happened in Malaysia and to a lesser extent in Hong Kong is in some ways even more ominous. The collapse in Indonesia and Russia was unintended, but Malaysia opted out deliberately. It managed to inflict considerable damage on foreign investors and speculators and it managed to obtain some temporary relief, if not for the economy, then at least for the rulers of the country. The relief comes from being able to lower interest rates and to pump up the stock market by isolating the country from the outside world and squeezing short sellers. The relief is bound to be temporary because the borders are porous and money will leave the country illegally, the effect on the economy will be disastrous but the local capitalists who are associated with the regime will be able to salvage their businesses unless the regime itself is toppled. The measures taken by Malaysia will hurt the other countries, which are trying to keep their financial markets open because it will encourage the flight of capital. In this respect Malaysia has embarked on a beggar-thy-neighbor policy. If this makes Malaysia look good in comparison with its neighbors, the policy may easily find imitators, making it harder for others to keep their markets open.

The third major factor working for the disintegration of the global capitalist system is the evident inability of the international monetary authorities to hold it together. IMF programs do not seem to be working; in addition, the IMF has run out of money. The response of the G7 governments to the Russian crisis was woefully inadequate, and the loss of control was quite scary. Financial markets are rather peculiar in this respect: they resent any kind of government interference but they hold a belief deep down that if conditions get really rough the authorities will step in. This belief has now been shaken.

These three factors are working together to reinforce the reverse flow of capital from the periphery to the center. The initial shock caused by the meltdown in Russia is liable to wear off, but the strain on the periphery is liable to continue. The flight of capital has now spread to Brazil and if Brazil goes, Argentina will be endangered. There is general panic in Latin America. Forecasts for global economic growth are being steadily scaled down and I expect they will end up in negative territory. If and when the decline spreads to our economy, we may become much less willing to accept the imports, which are necessary to feed the reverse flow of capital, and the breakdown in the global financial system may be accompanied by a breakdown in international free trade.

This course of events can be prevented only by the intervention of the international financial authorities. The prospects are dim, because the G7 governments have just failed to intervene in Russia, but the consequences of that failure may serve as a wake-up call. There is an urgent need to rethink and reform the global capitalist system. As the Russian example has shown, the problems will become progressively more intractable the longer they are allowed to fester.

The rethinking must start with the recognition that financial markets are inherently unstable. The global capitalist system is based on the belief that financial markets, left to their own devices, tend towards equilibrium. They are supposed to move like a pendulum: they may be dislocated by external forces, so-called exogenous shocks, but they will seek to return to the equilibrium position. This belief is false. Financial markets are given to excesses and if a boom/bust sequence progresses beyond a certain point it will never revert to where it came from. Instead of acting like a pendulum financial markets have recently acted more like a wrecking ball, knocking over one economy after another.

There is much talk about imposing market discipline but, imposing market discipline means imposing instability, and how much instability can society take? Market discipline needs to be supplemented by another discipline: maintaining stability in financial markets ought to be the objective of public policy. This is the general principle that I should like to propose.

Despite the prevailing belief in free markets this principle has already been accepted and implemented on a national scale. We have the Federal Reserve and other financial authorities whose mandate is to prevent a breakdown in our domestic financial markets and if necessary act as lenders of last resort. I am confident that they are capable of carrying out their mandate. But we are sadly lacking in the appropriate financial authorities in the international arena. We have the Bretton Woods institutions, -- the IMF and the World Bank -- which have tried valiantly to adapt themselves to rapidly changing circumstances. Admittedly the IMF programs have not been successful in the current global financial crisis; its mission and its methods of operation need to be reconsidered. I believe additional institutions may be necessary. At the beginning of this year I proposed establishing an International Credit Insurance Corporation, but at that time it was not yet clear that the reverse flow of capital would become such a serious problem and my proposal fell flat. I believe its time has now come. We shall have to establish some kind of international supervision over the national supervisory authorities. We shall also have to reconsider the workings of the international banking system and the functioning of the swap and derivative markets.

George Schultz argued that it is better if markets are allowed to look after themselves than if regulators look after them. There is an element of truth in his argument: regulators do make mistakes. The IMF approach clearly did not work, otherwise we would not find ourselves in the current situation. But that does not mean that financial markets can look after themselves. Everybody looking out for his or her self-interest does not lead to equilibrium but to what Alan Greenspan called irrational exuberance and afterwards panic.

George Schultz inveighed against the moral hazard of bailing out irresponsible investors and speculators. Here he has a valid point. Bailouts did encourage irresponsible behavior not so much by speculators -- because we know that we have to take our lumps when markets decline -- but by banks and other lenders who could count on the IMF coming in when a country got into difficulties. The IMF imposed tough conditions on the country concerned but it did not impose any penalties on the lenders. This asymmetry in the treatment of lenders and borrowers is a major source of instability in the global capitalist system and it needs to be corrected. It has to be a focal point in the soul searching that the IMF must undergo, but I am glad to say that the IMF is learning fast. In its $2.2 billion program in Ukraine, it is imposing a new condition: 80% of Ukraine's treasury bills have to be "voluntarily" rescheduled into longer-term, lower yielding instruments before the program can go forward. This is a long way from the Mexican bailout of 1995 where the holders of Mexican treasury bills came out whole.

The moral hazard now operates in the opposite direction; in not enabling the IMF to do its work when it is most needed. Congress bears an awesome responsibility for keeping the IMF alive. I am convinced that the attitude of the Congress was already an important element in the failure to deal with Russia. As you probably know I have foundations in many of the formerly communist countries. Some of these countries are badly hit by the fallout from the Russian collapse. Countries like Moldova and Romania have no one else to turn to but the IMF. The IMF is perfectly capable of assisting them. It would be tragic if it ran out of resources.

Replenishing the capital of the IMF will not be sufficient to resolve the global financial crisis. A way has to be found to provide liquidity not only at the center but also at the periphery. I believe there is an urgent need for the creation of Special Drawing Rights, which can be used to guarantee the rollover of the already existing debt of countries, which receive the IMF's seal of approval. If there is no reward for good behavior, meltdowns and defections will multiply. But such radical ideas cannot even be considered until Congress changes its attitude towards international institutions and the IMF in particular.

So far our stock market has escaped relatively unscathed and our economy has actually benefited from the global crisis but make no mistake: unless Congress is willing to support the IMF, the disintegration of the global capitalist system will hurt our financial markets and our economy as well because we are at the center of that system.

Avoiding Future Crisis

The job won’t be easy. Countries suffering from dramatic currency devaluation’s, heavy debts and credit shortages-Thailand, Indonesia, South Korea, Malaysia and the Philippines-will need to clean up banking systems, make structural changes to reduce cronyism and government-business collusion, work with overseas creditors to restructure foreign currency debt and improve disclosure and accounting standards. But others will have to play a role as well, most importantly the three pacific powers – Japan, China and the United States. In my mind, the single most important issue is for Japan to create new demand at home so that it can import more from the rest of Asia. Japan has the credibility to make a difference. The issue is one of will. China, which devalued its currency in 1994, needs to hold the yuan firm in order to preclude another devastating cycle of competitive devaluation’s in the region. Asia must resist calls for protectionist measures against Asian imports, even in the face of sharply higher trade deficits. Also, it is very important for the Clinton administration to step up its efforts to obtain Congressional support for fast-track negotiating authority and to prevent interest rates from rising.

Determining the relative importance of each of these measures depends on one’s view of how to crisis began. For those who believe that the countries in crisis brought their problems upon themselves through poor economic management and bad government, the solutions will need to be largely homegrown. For others, such as Japan’s vice minister of finance Mr. Sakakibara who believes that Asia’s downfall is really a crisis of global capitalism, involving both borrowers and lenders, solutions will need to be systematic and global in nature. The different diagnosis of how the Asian patients ended so ill produced, not surprisingly, different perceptions of the seriousness of the problem. The crisis has reached a plateau but we don’t yet know if it’s a peak. There could still be a serious worsening of the situation, especially in Indonesia, but also possibly in Thailand. There could be possible social and political turmoil as economic activity slackens off and the ranks of the unemployed swells. That, in turn, could re-ignite concerns if not panic on the part of foreign creditors and investors. Hopefully all the powers to be, will get together, much like they did in the mid-1980s, during the Latin American crisis, and solve this situation. Although things seem to be winding down, the slightest mistake could prove disastrous.

The most important lesson of the recent currency crises in emerging markets is that only countries with central banks, such as Thailand, Indonesia, and Russia, have devalued their currencies. Countries without central banks, such as Argentina, Hong Kong, and Panama, have in some cases suffered speculative pressure, but have not devalued. Economists, governments, and the International Monetary Fund have been reluctant to acknowledge the pattern and draw the logical conclusions from it. Instead, they have flirted with such ideas as imposing capital controls, increasing international surveillance, and giving more money to the IMF. These ideas are all second- or third-best solutions. They fail to eliminate the institutions most responsible for the currency crises--central banks in emerging markets--and so they almost guarantee future currency crises.

Lessons from the Asian financial crisis

A valuable lesson from the Asian financial crisis is the enhanced appreciation of the importance of private financial institutions in a well-working economy. As economies grow and become more complex, increasingly private financial intermediaries must perform the task of directing resources to their most productive uses. To be efficient, they must be exposed to competition, including competition from abroad. However, prudential overseers must play an essential role in the financial system. Since this is a governmental function, it is imperative that regulators and inspectors be well trained and be permitted to do their job without outside distortions (8).

Another generally recognized lesson from the Asian financial crisis is the importance of transparency and proper accounting standards. Nothing can undermine confidence faster than the recognition that it is impossible to obtain critical data, such as the amount of short-term foreign debt or the amount of nonperforming loans, and the discovery that contingent liabilities, such as commitments in the forward foreign exchange market are not being shown on balance sheets. Without transparency and proper accounting standards, global markets are likely to mistrust the financial instruments issued and to treat them badly (13).

Yet another lesson is that exchange rates need to be more flexible than some countries have permitted in the past. Unless capital markets are deep and sophisticated, it is unlikely that optimal exchange rates can be determined solely by private markets, which in the case of Asia would have led to real appreciation of the very currencies that subsequently had to be devalued. The governments of developing countries need to take a hand in managing currency values but not through rigid pegging.

More attention will also have to be paid to how current account deficits are financed so as to avoid undue reliance on short-term or easily reversed financial instruments. This will require prudential oversight to make sure domestic borrowers do not get hooked on easily available foreign funds--the problem of tapping the interbank market through foreign branches is particularly worrisome. Tolerance will have to be shown for some controls imposed by developing countries to limit their exposure to volatile funds10. The IMF along with others insists that financial liberalization not occur until the financial system of a country is well prepared to handle the freedom.

The crisis in Asia is still unfolding and further disturbances cannot be ruled out, especially in light of significant, unanticipated setbacks. The magnitude of the recessions in the affected Asian countries has exceeded all initial expectations. Political instability and the related social and economic disturbances in Indonesia in May 1998 hindered their progress. The further weakening of the Japanese economy has had a particularly large, negative impact on demand in the region and on international financial market sentiment. Following the several waves of pressure on emerging markets since 1997 that had emanated mainly from Asia, Russia became a new source of contagion during August 1998, causing confidence to deteriorate further globally. Brazil, which has taken steps to address its chronic fiscal imbalances and obtain large-scale financial support for its program of economic reform from the international community, has been susceptible to market contagion and volatility. It is a real risk that market confidence may not recover for some time, which could imply significant net outflows of foreign capital from many economies, as witnessed in the Asian crisis countries, with prolonged depressive effects on trade and activity. However, this risk can be contained, as long as the Asian crisis countries and other affected economies continue to implement the right stabilization and reform policies that will help to generate recovery.

Despite the significant setbacks that have occurred in the resolution of the Asian crisis, there has also been notable progress in some countries in the implementation of corrective policies and stabilization of exchange rates:

The exchange rates of the Asian crisis economies have strengthened from their lows, which were reached in the first part of 1998. While the Indonesian rupiah remains deeply depreciated, it too has recovered significantly.

In Korea and Thailand, interest rates have declined markedly since January as currency pressures have eased. In fact, and both countries, interest rates have fallen to pre-crisis levels.

Korea and Thailand, in particular, have made significant progress in macroeconomic stabilization and have begun to implement structural reforms. In Indonesia, the modified policy program in effect since late June 1998 has been implemented broadly as planned, with some positive results.

The turnarounds in current account positions, from deficit to surplus, have been rapid and large for all three countries.

Equity prices rose significantly from their lows in Korea and Thailand in 1998.

Reserves have strengthened substantially in Korea and Thailand, and Korea made repurchases to the IMF under the Supplemental Reserve Facility totaling 2.8 billion in December 1998, indicating the progress made in the countries emergence from its foreign exchange crisis one year earlier.

Conclusion

The Asian financial crisis demonstrates that even successful countries can be affected if they ignore the evidence of deficiencies in their financial systems. What differentiates the countries that were infected with the Asian flu from those that were not? The major differences are to be found in political systems. Policy uncertainty is an essential ingredient in triggering a financial and economic crisis, and it was present in all countries infected by the Asian financial crisis. Countries with well-working political institutions can make policy adjustments to an impending debacle, even if the problem is only discovered after another country goes into crisis.

Ideas for changing the existing architecture of the global financial system grow out of the experience of the Asian financial crisis and recognize the dominance of private sector funds in global financial markets (10).

More is involved in ideas to build stronger national financial sectors through a combination of adopting global financial standards, providing an international surveillance mechanism that would monitor compliance with the standards, and possibly adding international enforcement if the standards are ignored. A crisis makes change possible, and the Asian financial crisis is just the kind of watershed event that could energize an international reform effort.

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Links to the Asian Crisis

Derivatives and Global Capital Flows: Applications to Asia
What Caused Asia's Economic and Currency Crisis and Its Global Contagion?
Asian Financial Crisis
The East Asian Financial Crises: An Analytical Survey