The East Asian Financial Crisis and Regulation

The East Asian Financial Crisis: Deregulation or More Regulation?

The East Asian countries were presented as an example for other developing countries (their progress was called “the east Asian miracle by World Bank”) until the East Asia financial crisis. Some blamed the government for the crisis saying, state intervention was the root of the problem. Some held the financial liberalisation process responsible, Even today, many scholars and experts hold different opinions on the roots of this crisis and the solution to it. There were many opinions on the crisis and critics of how to handle the crisis from left and right side of the scholars. While some critics said that the pegged exchange rates, exchange rates controls, guaranteed governmental bailouts for banks, the lack of prudential regulation and management of the financial system was the root of the crisis. Other critics said that financial liberalization was the real cause of the problem as it enabled to move massive funds from country to country to earn the maximum profits from speculating or investing in currencies and shares and get higher returns for providing loans.

Those who blamed the government for the crisis summarised some of the main causes of this crisis as follows:

• High debt/equity ratios; so much higher than in western countries.
• Overvalued currencies; they pegged their currencies to the U.S dollar.
• Lack of competition in the market.
• Government directed loans.
• High current account deficits.

Those who are in this group suggested that the above were the main causes of the crisis, but before we accept this explanation, we should first have a look at East Asian countries’ economic systems.

East Asian countries had some kind of Keynesian economic model. This allowed close and co-operative relationships between government, firms and financial institutions. Corporate debt/equity ratios in East Asia countries were higher than in western systems, because savings were higher (Gross domestic savings to GDP ratios in Asia were one third of GDP or more compared to 15-20 percent in western systems). Households who hold the majority of savings have those savings mostly in bank deposits, as it is less risky than shares. Banks have to lend and firms are the only major net borrowers in the market. Firms did have high debt/equity ratios, because firms, which aim to compete with major world industries, needed large sums of money. Equity and retained earnings were not enough to meet their requirements, therefore, this system allowed high debt/equity ratios and the governments were playing an important role allocating funds efficiently. Yet, this model made the

Financial system vulnerable to shocks, but as long as there was government protection the system worked well.

Was the financial liberalization the cause of the problem which generated huge amounts of capital inflow into these countries or were the capital inflows the evidence of the problems these countries’ economies were suffering? Why did they have financial crisis? Why did the attack on their currency cause a financial crisis? It did not have to.

They experienced this crisis because their financial institutions and firms were suffering currency mismatch. An increase in the exchange rate (depreciation) makes them default as their balance sheet deteriorates and cause a financial crisis.

Before the crisis occurred International banks and money traders thought that Asian currencies were overvalued. They started attacking those currencies. Asian countries tried to withstand against this attack, as they knew devaluation would impair those firms, which had borrowed vast sums of money in foreign currencies. Speculators won along with institutional investors, first in Thailand, selling Thai baht forward, making instant profits. The Asian governments tried to resist, but even central banks ran out of dollars and they allowed their currencies to devalue, stock market plummeted and now many companies would be in trouble. Let’s deepen our analysis, what made these exemplar countries experience this crisis. They had this financial structure for a long time and had experienced high growth performance until the crisis. When they embarked on financial deregulation, they removed or lessened controls on firms’ foreign borrowing and investments and failed to oversee the banking system.

Domestic borrowers started borrowing from abroad, as it was cheaper than home .For example; this caused unsustainable real estate boom in Thailand. Foreign debt escalated, most of it private and short term. This short-term capital flow plus the rise in US dollar against other currencies (interest rates increased in USA) contributed to overvalued currencies as exchange rates of local currencies had been fixed against the US dollar.

So one can say financial liberalisation caused this crisis. In fact, theory says that such liberalisation (deregulations) in the financial market, especially lifting restrictions on inflows and outflows of funds, would bring in foreign funds that accelerate a country’s growth by reducing the cost of capital and allocate the financial resources in a most efficient way to get the highest returns .On the contrary what we saw in Mexico, hot money flows lend themselves easier to financing consumption rather than growth. Short-term investments rarely contribute to actual production .In East Asia a big part of short-term capital was directed into speculative investments, which pushed up property and share prices. When the crisis started by attacking those countries’ currencies all creditors immediately tried to collect on debts, which lead to a chain reaction of general bank and financial insolvency. These countries’ government could not take action to stop it as they abandoned their means of controlling their financial system by deregulation. One should think about why China was not nearly as badly hit as its neighbours, because it was able to cut, not raise, interest rates in the crisis

despite maintaining a pegged exchange controls. India was relatively insulated from the East Asia crisis as well.

East Asia countries had high level growth rates, were running budget surpluses, and built up high quality manufacturing industries, savings were high. Income had soared, health improved and poverty plummeted dramatically. Some had not suffered a single year of recession in 30 years. All those had been done by government’s guidance prior to the so-called E. Asia crisis, which coincided with deregulation of the financial system. Countries like Argentina, Uruguay, Brazil, and Turkey, all suffered financial crisis after deregulations of financial markets. A study done by Demirguc-Kunt and Detragiache (1998) shows that financial liberalisation made crisis more likely and increase financial fragility.

East Asian countries were unprepared when they removed many restrictions on their financial system and liberalized it. While they liberalized their financial system they lacked doing the necessary regulation and creation of new watchdog bodies which could supervise and oversee the banks and other financial institutions operations. There were not strong, prudential bodies that could eliminate or reduce the asymmetric information problems of adverse selection and moral hazard. Weak regulations and monitoring systems allowed the banks and other financial institutions to exploit the opportunities created by financial liberalization. Banks are blamed for lending unsafe loans and it was widely believed that banks would be bailed out if they became insolvent. Furthermore, many accused western banks and financial institutions of lending excessively to those countries.

What about the idea of financial liberalization, deregulating the financial system? How correct is it to treat financial markets like goods markets? To suggest Laissez - faire type of policy in financial markets and applying demand – supply diagrams which we use in goods markets to analyse financial markets?

Finance is interested in the exchange of money today for the promise of repayment tomorrow. The existence of uncertainty, lack of complete future markets, and the risk of bankruptcy make finance different. Information asymmetries will always exist; there will never be a state of perfect information, besides, investment decisions will not necessarily be improved by better information and transparency. If it would, Sweden, Finland, Norway would not have had financial crisis. They are not enough to underpin robust financial systems. We need the state as a regulatory authority to complement the markets.

Noam Chomsky (1999) argues that 30 years ago about 90% of foreign exchange transactions were related to real economy (trade and long term investment); today over 90% of a vastly greater sum consists of short-term flows, about 80% less than a week duration. These short-term flows speculate against currencies or exchange rate fluctuations. According to data from The Bank of International Settlements, a total of 184 billion US dollars entered Asian developing countries as net private capital flows in 1994-1996. In 1996, 94 billion US dollars came in and even as late as the first half of 1997, 70 billion US dollars poured in. With the financial crisis starting in June, a total of 102 billion US dollars flew out in the second half of 1997.

This shows how volatile capital flows can be and makes the probability of crisis likely. I think this can be the response to those who suggest that financial liberalisation will allocate the funds more efficiently and investment thus become more efficient. Neoclassical economic school that is behind financial liberalisation (they want deregulations in all markets) wants the state out of the economy completely. Deregulating markets will prevent governments from pursuing any economic and social policy. From economic theory we know externalities, we know when something is good for an individual, it does not follow that is good for society as a whole. This is where the government comes into action, which tries to maximize common good for the nation. A project might not be profitable for an individual, but it may bring benefit to the whole society or vice versa.

To understand this crisis and prevent it from happening again one should understand how these countries achieved significant growth rates before the crisis. East Asian countries did not have free markets or western type civil liberties they did have strong, authoritarian governments who made long run economic decision in the sacrifice of short term individual interest. When they liberalized their financial market Individuals, firms and banks did not make their business decision on the basis of long run interests of the common good but on the basis of short term interests of themselves. Adverse selection and the moral hazards problems which caused the Asian financial crisis can be reduced by establishing regulatory institutions and monitoring systems, but will never be removed completely.

I believe that the East Asian financial crisis was brought about by many factors. These included; bad economic decision, ongoing decline in economic performance of these countries before crisis, lack of transparency in the system, undemocratic, corrupted governments combined with the adverse selection and moral hazards problems in the banking industry and financial liberalization triggered the crisis.

If there were robust, prudent financial institutions, strong, effective regulatory and monitoring bodies with little and no corruption limit and control harmful effects of financial liberalization of markets.

What East Asian crisis and other financial crisis provide evidence that the first part of financial liberalization should be to create regulatory and monitoring bodies that holds the financial instability under control created by financial liberalization. There should be some transition period that this type of regulatory framework can be created. Therefore, developing countries who want to liberalize their financial system must follow a gradual path and be cautious. The ironic part of this story is that trying to liberalize the markets by deregulating shows us we still need regulations, rules and monitoring systems.

References

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