Monday, 3 Aug 1998


Role of local and foreign players in the crisis

by Martin Khor, Director, Third World Network

In the continuing controversy of who is to blame for the East Asian crisis, the focus is put on local versus foreign players. In fact, a fair analysis would show that both are responsible. Local banks and companies made the wrong loan and investment decisions and they (and the governments) were wrong to assume the local currency would remain stable.

But foreign players must also carry their fair and heavy share of the blame. They advocated financial liberalisation, rushed in their funds that helped fuel the asset bubble, stampeded out even faster, imposed wrong policies when the crisis broke out.

MARTIN KHOR reports in the third part of a series on the background to the Asian crisis.


For those who blame the events in the region on domestic policies and practices, the East Asian crisis is portrayed as the result of wrong investments in non-productive activities by local businesses, fuelled by careless lending provided by local banks. 

That this happened is true and the local players concerned must accept responsibility for their role in the crisis. But that is only part of the story. 

The other part (and probably the larger part) is that the external liberalisation of financial activities resulted in huge inflows and then outflows of foreign funds, setting the stage and playing a major role in the crisis. 

The inflow of funds helped create the conditions for over-lending and wrong investments. The foreign funds came in the form of loans to the banking system or to private companies directly, or as portfolio investment through purchase of shares in the stock markets. 

A central feature of liberalisation is that when all controls are removed, it is very difficult to prevent the inflows of funds. 

And when too much foreign funds enter the market, they boost the supply of money and credit to unhealthy levels.  

Financial institutions flush with so much additional deposits and credit have to recycle them into loans to borrowers, in order to make a profit. 

But when there is too much money accumulating too quickly, it is increasingly difficult to find sufficient good projects to fund. For instance, it is not easy to find enough local manufacturers that can absorb the rapid increase in credit for production of exports. 

Among the easiest loans to give out are to those companies and individuals for purchase of shares and property, and for property development. 

Thus, the entry of foreign funds (a total of US$278 billion private capital flowed into Asian developing countries in 1994 to first half of 1997) contributed greatly to the rise in stock market prices, property prices, and the boom in property development. 

In retrospect, it is clear that the asset price boom was excessive, there has been much over-building and that some of the economies were "over-heating", or growing at a pace above their underlying sustainable potential output. The rather high current account deficits were one result of this.  

Moreover, when the financial institutions are flush with so much money, they can also be that much more careless with the quality of the loans they give out.

Businessmen who were influential and politically connected could also obtain large loans more easily. 

Whilst some of the loans funded economically sound projects, some went to projects which might have been viable only if the boom had continued, and which thus went bust when the crisis hit.

Other loans went into property and share trading or corporate restructuring and mergers, which did not directly result in increasing output in the "real economy." 

Given that a significant portion of the total loans had been sourced in foreign currency, far too little of the credit went into funding investments that produce goods or services for export. Thus there was not enough foreign exchange earned to service the foreign loans. 

The asset price inflation made the banking and corporate systems very dependent on the continuation of the high prices. This was because the high value of shares and property became the basis for collateral and in turn for the high level of loans.  

When share and property prices suddenly fell, the banks found that the value of collateral had dropped correspondingly and thus the asset backing for many of their loans had become inadequate. 

Meanwhile the corporate sector was hit by a "multiple whammy." 

First, the sharp drop in currency hit the firms that had taken foreign-currency loans. They had to pay much more in local currency to repay these debts. 

Second, the domestic interest rate went up sharply and the banks became very stringent in giving more loans, due to the governments taking on a tight monetary policy, partly as a result of policy imposed or advised by the IMF, in order to prevent further currency depreciation. This hit all firms, including small and medium enterprises that had not taken foreign loans. 

Thirdly, as the value of the companies' collateral dropped, their creditor banks began to ask them to "top up" the collateral or repay some of the loans. 

Fourthly, governments cut back on their spending, as a response to the crisis and to IMF policies. This affected the business of many firms directly or indirectly. 

Finally, consumer demand quickly dried up as well, as the rich and the middle class suffered wealth depletion from the stock market crash, as the higher interest rates squeezed the incomes of house purchasers, as workers lost their jobs or part of their wages, and as consumers were hit by rising prices brought about by currency depreciation. 

After a lag period of some months, the financial crisis wound its way into the real economy. By the first quarter of 1998, the Gross Domestic Product (measuring total output of goods and services) had fallen in Indonesia, Thailand, South Korea, Malaysia and Hongkong.

It will fall more sharply in the rest of the year.

This tragic sequence of events can on one hand be blamed on the local financial institutions and companies that made critical mistakes in loan and investment choices. It can also be blamed on the inefficient use of financial resources that went into non- viable projects. 

But to be fair the blame must also be placed on the global financial system, its major international players, its promoters and advocates. 

This system, so characterised by the sudden shifts of huge blocks of short-term capital, following fickle opinion on which countries are good or bad investment locations, has induced extreme financial fragility on emerging developing countries. 

They have faithfully followed the advice of the advocates (the G7 countries, the IMF and World Bank) of financial liberalisation.  

Having opened up their financial doors to the outside world, they are buffeted by first by large inflows of foreign funds (which they find difficult to use productively in the short run) and then by large outflows when the fashion changes overnight. 

The East Asian countries had followed a policy of keeping their currencies tied mainly to the US dollar, and had intervened to keep up their levels. Again in retrospect this was unwise.  

But for many years this policy had been implicitly accepted by international investors and bankers that retained high confidence that the currency rates would remain stable. 

It was also this expectation of stability that underlay the confidence with which local banks and firms took on foreign- currency loans and that also caused the Central Banks to have little concern over the rise in private-sector foreign debt. 

The first blow was struck by currency speculators who bet that the Thai Central Bank could not support the baht's link to the dollar. 

When the baht fell to the speculators, it triggered the avalanche that swept through the region.

With the depreciation of currencies, and expectations of a debt crisis, economic slowdown or further depreciation, substantial foreign funds left suddenly. Short-term loans were not renewed and new loans were not forthcoming. Investment funds sold off their shares in the local stock markets, causing share prices to plunge.

 The sale of shares by foreigners meant local currency was changed for foreign currency which in turn left the country, causing the local currency's exchange rate to drop further.  

Thus the falls in the local currency and in share prices fed each other. The prices of real estate also fell significantly.  

Whilst in other countries the withdrawal of loans and of profits from currency speculation may have been greater, in Malaysia the withdrawal of foreign funds from the stock market could have been the main form of foreign funds outflow.  

The effect of this was worsened in many of the affected countries by the withdrawal of local funds to abroad, and also for some period by the shift of deposits from local to foreign banks within the country.  

From the above analysis, it should be obvious that both local and external factors and players were responsible for the crisis. The external factors set the stage through advocacy of rapid liberalisation, triggered the crisis through speculation and then through massive funds withdrawal, and imposed wrong policies that worsened the crisis. 

The domestic factors include an imperfect understanding of the liberalisation process, resulting in lack of adequate safeguards; the assumption that the local currency would remain stable; an over-reliance on foreign loans and funds without due consideration of their volatility; channelling of too much funds into real estate and share purchases; and inefficient or wrong use of financial and corporate resources.

(To be continued).