Ty Mukherji April 25, 2005 Econ 181 The Southeast Asian Economic Crisis of 1997 One theory that explains the cause of the Southeast Asian economic crisis of 1997 was the existence of two conflicting financial systems: a relationship-based system as well as an arm’s length Anglo-Saxon system. When used in conjunction, the unified system is prone to shocks as was the case in 1997 when four economies were sent into a tailspin. In order to understand the implications of the two financial systems working together as well as the future of the economies of Southeast Asia (since 1997), a background on the Asian economic model as well as a brief history of the events of the 1997 crisis are necessary. The Asian economic model is characterized by a heavily interwoven relationship between politics and business. Specifically, politicians and government officials have a strong stake in molding the direction of the private sector. Politicians are able to pick and choose which businesses (or industries) investments are channeled to, sometimes assuring rapid growth and high employment in the sectors of their choice. A far-cry from the western, “free-market competition” model, the Asian model does have advantages in that money can be siphoned to industries and sectors that are seen as too risky to private investors, thus promoting necessary growth in these areas. The deliberate channeling of capital can be advantageous to developing countries (i.e. those in Southeast Asia) by guaranteeing stable economic health. In addition, the government protects the domestic economy from foreign competition by imposing tariffs and other regulations. One of the main by-products of the Asian economic model is the formulation of large businesses that, after being nurtured by state-led financial development, become strong competitors in the foreign arena. For example, the heart of the South Korean economy is composed of thirty large corporations (known as “chaebols”) that receive special treatment (e.g. low- cost loans and financial assistance) and effectively dominate the private sector of the economy. Chaebols such as Samsung Group and Hyundai Motor Co. have experienced great success through the Asian economic model. On the downside, traditional criticisms of the Asian model include a very poor human rights record and widespread corruption (1). The Southeast Asian “tiger” economies are those that experienced significant growth in the 1980s and 1990s by taking advantage of high foreign capital influx and concentrating on developing export-oriented industries. These tiger economies include Thailand, Malaysia, South Korea and Indonesia and attained significant growth in a relatively short time period. In July of 1997, the value of the Thai baht, which is pegged to the value of the U.S. dollar, began to plummet. Under increasing pressure, the Thai government devalued its currency. The International Monetary Fund (IMF) proceeded to provide $16 billion in aid; however, Thailand felt the repercussions of their faltering currency in that they were now forced to borrow money at a 15 percent rate (2). Like clockwork, the currencies of Myanmar, the Philippines, Malaysia, and Indonesia, all fell. Almost all of the countries sought international aid from the IMF in order to appease the effects of the crisis, which were substantial. The value of the Malaysian market lost 29% of its value, and the effects from the crisis were felt worldwide, as the Dow Jones experienced its largest one-day point drop in history (1). It will be shown that the primary cause of the preceding events was the conflict between two different financial systems The purpose of a financial system is to direct funds to their most efficient and productive uses. In addition, a successful financial system assures that a large percentage of the return is paid to the person or entity that originally allocated the resources. The first type of financial system that will be discussed is the relationship-based system. In this case, the entity that finances is guaranteed a return by being given authority over the financed firm. For example, by being given partial ownership of a firm, a financier has greater incentive to work in the best interests of the financed firm. This creation of an almost symbiotic relationship enables the two groups (the financier and the financed firm) to work together towards financial efficiency. In order to prevent a multitude of other financiers establishing the same type of relationship with the financed firm, the financier will oftentimes have monopoly rights. Through government regulation and opaque financial dealings, barriers to entry are established in order to protect the symbiotic relationship. The second type of financial system that will be discussed is the arm’s-length, Anglo-Saxon system. The arm’s length system is one in which the financier no longer has the intimate relationship with the financed firm. Instead, the interests of the financier are guarded by contracts and the financial transactions are affected greatly by the market and the prices it dictates (3). The key differences of the two systems concern the existing legal system and the transparency/opacity of financial transactions. Relationship-based systems have the ability to thrive on their own without significant legal intervention. As a result, these systems tend to prosper in areas where laws are poorly written. Since the financier has power over the firm it finances, it follows that the decisions it makes are in the best interests of both parties. As a result, explicit, binding legal contracts are unnecessary in order to achieve financial cooperation between the two groups. Oftentimes the financier works to promote a healthy relationship with the financed firm so as to ensure future transactions and dealings, without all of the legal red-tape. On the other hand, the arm’s length, Anglo-Saxon model requires heavy legal involvement in order to make sure the financier and the financed firm cooperate fairly since in this system each entity acts in its own best interests without much compassion for the other party. It follows that the arm’s length system prospers in areas of the world with strong legal systems (with “common- law tradition”) such as the United States. The second key difference, transparency/opacity of financial transactions, deals with how easily (or difficult) it is to watch and monitor financial transactions from a public viewpoint. In the case of the relationship-based system, where financiers have monopoly power, the financial decisions are opaque in order to protect the symbiotic relationship from competition. As a result, financiers are more compassionate towards the financed firms. For example, when Mazda struggled with increasing debt, the financier Sumitomo Bank rescued the company from financial disaster in order to maintain the beneficial relationship. The market-based arm’s length system, which is built around the idea of competition and “survival of the fittest”, allows for transparent financial interactions so as to provide an equal amount of information to all market contenders (3). Although strikingly different in the way business is conducted within each, both the relationship-based and arm’s length systems have advantages and disadvantages. The relationship-based financial system has traditionally come under attack for its lack of market signals. Because of the lack of competition and transparency in the relationship- based system, the market is unable to send informative price signals to businesses. On the other hand, the intense competition present in arm’s length systems allows for accurate price assessments for investments and projects. An example that illustrates this key difference is the credit market. In the relationship-based system, when a financier is determining the borrowing rate for the financed firm, it not only evaluates the firm’s present capability to pay back debt, but also it’s long-term ability to repay. The arm’s length system is characterized by solely concentrating on the short-term and whether or not the financed firm can service the debt now. The advantage of the arm’s length system in this case is that the competition allows for a competitive interest rate that reflects the correct compensation for the risk involved in the loan. On the surface, it seems that the relationship-based system, by not producing an interest rate that reflects the market behavior, is deficient; however, this imperfect reflection actually has advantages as well. In a competitive, arm’s length model, a financier may not be in a situation to “internalize” some of its long-term value to help a struggling firm in the short-run. As a result, the struggling firm is most likely weeded out in exchange for a stronger firm. The beauty of the relationship-based system is that financiers can take advantage of their monopoly power by providing aid to struggling firms in the short run (by charging a much lower interest rate for debt) and recover its losses in the long run (by charging a higher interest rate when the debtor is stronger). The capability of exchanging short-run losses for long term gains is the main strength of the relationship based system, but as stated before its inability to reflect correct price signals is its downfall. Rajan and Zingales sum up this disadvantage by claiming that, “if investment decisions are not driven by prices, then prices become less effective in providing economic directions because they reflect less information.” (3) The financial systems of Southeast Asia were predominantly relationship-based prior to the late 1980s. After this point a significant capital shortage developed within the economies, which prompted the influx of a large amount of foreign capital to compensate. This movement of capital went hand in hand with foreign countries (e.g. the U.S.) desiring globalization. As the large amount of foreign capital flooded the Southeast Asia, the markets that presided there (Thailand, Malaysia, Indonesia, etc.) did not possess a sophisticated institutional infrastructure to handle the contracts between the domestic markets and the foreign investors. According to Rajan and Zingales the flow of arm’s length capital from foreign investors was channeled to a relationship-based system. The lack of price signals in the relationship-based system resulted in the misallocation of foreign capital and the lack of strong contract legislation left foreign investors unprotected. Due to the lack of protection, foreign investors took the logical step in keeping their investments short-term, in order to save themselves if the situation turned awry. Eventually, the situation did turn awry (possibly due to the depreciation of Japan’s yen or ineffective macro-economic policies in Southeast Asia) and foreign investors began to withdraw their large amounts of capital. Since the Southeast Asian economies were heavily interwoven with financial relationships, the hardships were felt all across the market. Foreign investors, who were used to open-market situations where they immediately withdraw from struggling situations, did just that. The problem was that all of them did just that, leaving the Southeast economies high and dry. The eventual result was the crisis of 1997, which started with the depreciation of the Thai currency. Rajan and Zingales point out that a serious crisis such as the Southeast Asian crisis of 1997 provides an effective avenue for institutional reform. After the United States weathered the Great Depression, institutional reforms were adopted in order to end relationship-based dealings in the United States. The Southeast Asian economies should not necessarily follow suit in banishing relationship-based finance all together (since it has been shown that most of the time it lends itself to the Asian economic model); however, it was shown that the relationship-based system struggles with capital allocation and in the long run the arm’s length system is the only successful system to correctly allocate capital. Since the 1997 crisis, the Southeast Asian markets are beginning to prosper once again. Specifically, the markets have gathered strength through increased exports coupled with increased domestic demand, making the markets less reliant on foreign capital for prosperity. In addition, domestic capital flows have reached new highs in the post-crisis era (also protecting the economies from foreign capital withdrawal). In terms of institutional reform and policy revision, the Southeast Asian countries have taken significant strides in placing importance on exchange-rate flexibility, stricter monetary/fiscal policies, and promoting private investment (4). These small strides, although noteworthy, will not be enough, as the opacity and lack of bank supervision (stemming from relationship-based finance) will still haunt the Southeast Asian economies when dealing with the Western players (5). Many economic experts give the relationship-based system leeway due to the tiger economies’ incredible growth in the 1980s; however, it has been shown that until these economies change their financial system to the arm’s length system, long-term crises will still be apparent through capital misallocation. Although most experts agree that the root cause of the Southeast Asian crisis of 1997 was the conflict of two very different financial systems, another theory that has been proposed is simply over-production and over-expansion by domestic Southeast Asian firms. A future investigation into this topic would allow for greater understanding and breadth concerning the crisis of 1997 (6). Literature Cited 1. “Issues and Controversies: Asia’s Economic Crisis”. Facts on File News Services. url: http://www.facts.com/icof/i00063.htm 2. “What’s Happening to the “Tiger” Economies of Southeast Asia?” Griswold, Dierdre. Workers World. 16 October, 1997. 3. “Which Capitalism? Lessons from the East Asian Crisis. Rajan, Raghuram G and Zingales, Luigi. Journal of Applied Corporate Finance. 4. Asia Economic Monitor (AEM). 2004 edition. url: http://aric.adb.org/aem/dec04/coverdec04.pdf 5. “Lessons from the Asian Crisis” (speech). Yellen, Janet. Chair, Council of Economic Advisers. April 15, 1998. Council on Foreign Relations, New York, N.Y. 6. “Firm Failure and Crisis: The Experience of South Korea”. Wong, Kar- yiu. Journal of the Korean Economy, Vol. 1, No. 1. Spring 2000. p. 23- 51.
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