Ty Mukherji by 67v8g3So


									                                                                               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


       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
4.   Asia Economic Monitor (AEM). 2004 edition. url:
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-

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