Miracle, Financial Crisis, Recovery in SE Asia by ygy16679


									    Miracle, Financial
Crisis, & Recovery in SE
    Politics of Southeast Asia

   Prof. Edmund Malesky, Ph.D.
   A Short Course on Miracles
• Think quickly! You just told that cute somebody
  at the cocktail party that you are a student of the
  political economy of Southeast Asia and they
  actually seemed interested. Now, you have to
  back up your bold claim with a little…you
  know… knowledge - but not too much!! Any
  more than a sentence, and the buffet table at the
  far end of the room will start to look a lot more
  interesting than you. What is your one
  sentence/cocktail-safe definition of the East
  Asian Miracle?
              Maybe a few images might help…
                                                 (Paste Link into Browser)
      Income/Life Expectancy

     GDP Growth – ASEAN 5

    Life Expectancy – ASEAN 5

  Life Expectancy – All SEA
 Here is the World Bank’s Definition
• Sustained high economic growth over
  many years with limited inequality.
  But why were they able to achieve it?
Economic Explanations

    –   Market Friendly: “…the appropriate role of government is to ensure adequate
        investments in people, provide a competitive climate for private
        enterprise, keep the economy open to international trade, and maintain a
        stable economy.”

    –   Export Orientation: “This is primarily a story about moving away from Import
        Substituting Industrialization and embracing the fruits of an open economy.”

    –   Institutions: The secret to East Asian development was their construction of an
        incorruptible (and highly paid) civil service, strong governance, and fair and
        equitable dispute resolution channels in the court system.

    –    Flying Geese: Development in Asia looks a bit like the arrow-shaped pattern
        of flying geese with Japan in the point position. Japanese companies invested
        in South Korea, Taiwan, and Hong Kong until they developed large and strong
        enough multinationals on their own to invest in the other countries of
        Southeast Asia. To join this club, a Southeast Asian country need only open
        its doors to Foreign Direct Investment and liberalize exporting.
         Total Factor Productivity
• In our reading for this week, Krugman takes issue with
  many explanations for the miracle, citing Young’s “Tyranny of

• Krugman (1994): “Their rise was fueled by mobilizing resources –
  increasing inputs of machinery, infrastructure, and education – just
  like that of the now-derided Soviet Economy…If there is a secret to
  Asian growth, it is simply deferred gratification, the willingness to
  sacrifice current satisfaction for future gain.”

• Bottom line is that East Asian Economies did not improve
  productivity, the efficiency of labor and capital usage over the time
  period studied.

• Krugman’s beef with the explanations of the Asian Miracle draws on
  one of the most important theories in macro-economics….
                  Solow Growth Model
                  (Review of Samphantharak Notes)
•   MIT Macro-Economist in the 50s and 60s
•   Developed a theory of economic growth, whether growth is derived from exogenous
    technological progress
•   We won’t derive the formula, but here are the implications of the model:

Two sources of economic growth:
1. Input accumulation
    • Capital accumulation (through higher savings)
    • Higher labor market participation, Lower unemployment rate & Longer
       work hours

2. Technological progress
    • Micro productivity growth
    • Macro efficient allocation

Input driven growth is transitory and cannot be sustained in the long run due to
   the diminishing marginal product of capital and labor.

Long run growth must come from technological progress
Where does technological progress
          come from?
Micro technological progress
• R&D is an important source of technological progress
• “Learning” or “Technology Adoption”

Macro (aggregate) technological progress
• More   efficient resource allocation
                   Accounting for TFP
                     Input Accumulation       Solow Residual
                                            Technological Progress

         gY = (1 – α) gK + α gN + α gA
 Our Dependent
 Variable is the     Growth in Capital    Growth in Labor
 Growth of Total      Accumulation            Market
   Output (y)                              Participation

Model assumes capital (K) and labor (N) are paid
according to their marginal products, so α = (labor
 So TFP is in the Residual
gY -α gY = (1 – α) gK + α gN + α gA

 α gA = gY - (1 – α) gK - α gN

Using this, we can decompose the growth of
  the SEA Tigers over the Miracle Period.
Alternative Calculations of TFP
     Bottom Line for Young and
• SEA wasn’t doing anything special, it was
  just mobilizing resources.
• Eventually this strategy would run into
  diminishing marginal returns.
• Economies only grow when they increase
               Critiques of Young
• Severe Measurement Errors in the calculation of capital
   – This is critical because TFP is in the residual. Any measurement error
     will also show up in the residual. If we overestimate, the capital stock
     we under-estimate TFP.

• Naïve Assumptions
   – Cobb-Douglas function assumes constant returns to scale.
   – Perfect competition, which was not the case in SEA. Stiglitz (2001)
     famously argued that inputs do not get paid their marginal product.

• Micro-logic of the Theory
   – The Young assessment should find little evidence of innovation within
     SEA countries. Other studies have found examples of assembly-line
     and management innovations.
   – There appears to be evidence that SEA economies skipped whole
     generations of technological development. (The technology gap is
 Stiglitz Contribution to the Debate
• “The undeniable miracle was the high savings rates of
  the SEA economies.”
• Savings increases fuel the investment growth and
  workforce improvement.
• He argued that there is some lag between income
  increases and consumption. In these cases, economies
  can gravitate toward 1 of 2 equilibriums.
   – High growth with high savings.
   – Low growth with low savings

• Why did East Asia gravitate toward the high
  growth-high savings equilibrium, when the
  rest of the world did not?
         Summary of the Economic
        Explanations for SEA Growth
What under-girds input accumulation, and/or technological

1. High savings in physical capital
   - Domestic
   - (FDI)

2. Financial development (i.e. physical capital allocation)

3. Human capital accumulation and allocation

4. Openness in international trade
  - Export oriented industrialization
  - Free trade

5. Role of government policies
 Other Political Economy Explanations
• Revisionists
  – Selective Interventions/The Developmental State: “Industrial
    policy and interventions in financial markets are not easily
    reconciled within the neoclassical framework. Some policies are
    more in accord with models of state-led development.
    Moreover, while the neoclassical model would explain growth
    with a standard set of relatively constant policies, the policy
    mixes used by East Asian governments “led the market” in
    critical ways.” “Not only has Korea not gotten relative prices
    right, it has deliberately gotten them wrong.” (Alice Amsden and
    Robert Wade).

  – Relationship Networks: Close connections between
    government, business, and finance allow the government to
    direct development choices and pick winners. Moreover, strong
    social bonds allow for external enforcement of contracts.
 But why were they able to achieve it?

• Hybrid Theories

  – Critical Juncture: For the most part East Asia followed
    a neo-classical approach, but did diverge from it
    critical junctures in order to right the course.

  – Unsuccessful Interventions: East Asian economies
    did try to engage in selective interventions across a
    number of industries, but these interventions were
    generally successful. What worked was economic
            On-Going Debates
1. Miracle or not, why did such a large period of high
  growth with relatively low inequality occur in East
  and Southeast Asia?

• Explanations from some scholars:
  – 1. Cultural (Confucianism, "The Internal Dynamism of
    the Asian Man." Lee Kwan Yiew)
  – 2. Security (Doner, Ritchier, Slater….)
  – 3. Diffusion
  – 4. Networks and community ties
          On-Going Debates
2. Is the East Asian Experience unique?
  - Other economies have experienced faster
  growth with different policies.
  - Clear evidence of diminishing marginal returns
  to inputs.
  - Inequality eventually began to increase along
  with growth.
  - With so many developing countries, export
  orientation may not be the path to glory it once
         On-Going Debates
3. Did the Asian Financial crisis signal the
   end of the East Asian Miracle or was it
   just a blip on the overall growth
   On to the Crisis – What Happened?

                      The Financial Crisis –
• Western investors loaned money to banks in East Asia.
• Those banks funneled the loans to investment projects
  at low rates of interest and took very little in collateral.
• When these investments did not perform, currency
  speculators bet that the baht was overvalued and began
  to sell baht on the open market.
• The value of the baht fell causing other investors to
  worry about currencies in the rest of Asia.
• Pandemonium struck.
•   I was one year out of college, spending my summer in Thailand, and getting paid in $. Life was good for me.
    I now feel very guilty about this.
                The Players
4 Groups of Countries
  a) Countries whose actions set the stage for the crisis.
     •   China – Devaluation of the Yuan in 1994 lowered the
         effective price of Chinese products in areas where many
         SEA companies competed.
     •   Japan – Economic stagnation throughout the 1990s slowed
         FDI into region and limited exports.
  b) Countries who were hammered by the crisis.
     •   Thailand, Indonesia, Malaysia, S. Korea, and to a lesser
         extent the Philippines.
     •   Currencies dropped roughly 50% and GDP growth slowed
         or in the case of T, I (by 15%) and S. K (by 2.8%) reversed.
         The worst US recession was 2.1 % in 1987
              The Playahs
4 Groups of Countries
  c) Countries who survived due to high foreign
     reserves and/or economic fundamentals.

  d) Countries who escaped because their
     currencies were not convertible (Vietnam,
     China, Laos), or who were otherwise not
     highly exposed to foreign portfolio flows
     (Cambodia, Burma).
                Da Playuzz
• 4 Groups of Investors
  – 2 from Developed Countries
    • Institutional Investors (Banks, Pension Funds)
    • Currency Speculators
  – 2 from Southeast Asia
    • Domestic Banks and Financial Corporations
    • Domestic Long-Term Investors (factories, real
               The Players
• International Organizations
  – Many were involved but the one we will be
    most concerned about today is the role of the
    IMF both before and after the crisis. De facto
    this means the US, and Robert Rubin,
    Secretary of the Treasury were also involved.
              Economics Primer 1
•   The Balance of Payments always balances.
    – There is a direct connection between current account deficit and foreign
    – A purchase is always accompanied by an equal sale. Purchase of a
      good requires the sale of an asset and vice versa.
    – Trade deficit is paid for by inflows of foreign capital. Countries use
      foreign inflows to buy imports abroad.
    – Economists believe that countries current account deficits should equal
      their capital account surplus.
    – Countries with current account surpluses accumulate high levels of
      foreign reserves, as countries buy their products in foreign currency.

    – As Prof. Samphantharak reminds us, a short-term current account
      deficit is not by itself problematic; the problem is when expected
      future capital inflows may not be enough to balance the deficit.
       Deep Level Explanations
• The Asian economic miracle led to a situation where
  institutional investors felt confident loaning money to
  banks in Asian developing countries for two reasons:

   – They expected Asian economic growth to continue indefinitely
     and wanted to take advantage of that growth.

   – Felt if there was a bad turn and Asian banks (and Thai finance
     companies) defaulted on the loans that the IMF would bail out
     those banks and thus indirectly the institutional investors.

       • There was now a problem of Moral Hazard- The IMF previous
         bail-outs of Mexico and Argentina led institutional investors to
         believe that they had a one-way bet (i.e. they couldn't lose).
Net Private Capita Flows/GDP
Balance of Payments
Balance of Payments
              Economics Primer 2
•   The domestic Asian bank or finance company was
    essential acting as a conveyor bet for foreign funds.
    – It receives loans in dollars or yen, but it wants to invest
      domestically in Thailand, so it goes to the foreign exchange
      (forex) Market and exchanges western currencies for baht.
    – The demand for baht has increased, so the value of the baht
      should rise….
    – but the Thai government was maintaining a fixed exchange rate;
      it would respond to the rise in the baht by selling baht and buying
      foreign currencies.
    – This kept the price of the baht stable but had two other effects:
        • Thai Central Bank exposure to Foreign Currencies Increases.
        • Domestic money supply increases.
        • As a result, there was more money in the economy to invest.
          Could have let the baht just rise. Soon the increased investment
          started to fuel more imports and lead to a current account deficit.
Foreign Exchange Exposure
      Domestic Financial Sector
         (Haggard 2001)
• Moral Hazard 2: The close connection between
  government, investors/bankers in S. E. Asia.
  – Governments were interested in directing investment
    into profitable sectors and would coerce banks
    through tax breaks, subsidies, and direct coercion to
    invest in businesses that they normally would not
    have at very low rates of interest..
  – This appeared to be positive when these countries
    were trying to develop exporting industries, but it
    quickly became corrupted when banks started to loan
    to favored government companies (holding very little
    collateral as security)
   An Example from Indonesia
• In Indonesia, 6 of the top 15 banks had
  the government as the largest shareholder
  and Suharto family members tended to
  receive the vast majority of the loans.
  – Bank of Duta- lost $500,000,000 but was
    bailed out by two other conglomerates
  Government Lending Policies in
        Other Countries
• Malaysia was trying to direct investment to
  help out ethnic Malays or bumiputras.
• Thailand was directing investment.
  through the bank of commerce (BBC).
• In Korea, government connections fueled
  lending to the Chaebol.
             Non-Performing Loans
•       Because the lending was based on political
        connections, banks funneled loans from international
        institutional investors to private companies with little
        concern for the profitability/risk ratio of the investment
        or the assets they would receive as collateral. 15
    –      15% of the loans in Indonesia were non-performing (meaning
           that investment was not growing enough to pay back interest
           payments and the collateral held was less than the value of
           the investments)
    –      In Thailand, 24.4% of BOC's loans alone were non-
           performing, but was kept afloat with a 7 billion dollars from the
           Thai Government. According to the government resolution
           justifying the bail-out, the Central Bank of Thailand was
           inclined toward political interests. In short, several politicians
           were beneficiaries of BBC loans.
Total Non-Performing Loans
       Lack of Transparency
• Overall, it was very difficult for any of
  these connections to be observed or
  corrected, because financial records were
  poor, manipulated, and often did not list
  non-performing loans.
 Bottom-Line on Local Finance
• Another one way bet for local investors:

 Heads the investor wins, tails the
 taxpayer loses. Government was
 highly unlikely to let insolvent banks
  Here come the speculators…
• Currency speculators in developing countries began to
  notice Thailand was running a massive current account
  deficit - 8.4% of GDP in 1996.
   – This was the result of the Chinese 1994 devaluation and the
     decline of the Japanese Yen against the dollar by 35%.
   – Thai goods were becoming relatively more expensive abroad
     relative to Chinese goods and very expensive in Japan
     (Thailand's most important market) where consumers could now
     afford much less.
   – As word started to leak that many investment in these markets
     were non-performing and many investments went
     sour, institutional investors became less likely to lend money to
     banks or finance corporations.
   Here come the speculators…
• Lack of foreign investment should have led naturally to a
  decline in the baht on foreign exchange markets.
   – After all, there was less demand for it.
• But the Bank of Thailand needed to maintain the value of
  the baht, so it started to sell foreign currency to prop up
  the baht.
• This action was causing Thailand to deplete its foreign
• Thailand could have raised interest rates to raise the
  currency value, but this would have made it expensive to
  invest in Thailand -- just as Thailand was entering a
• Notice: It was not just the current account deficit, it was
  the fact that currency speculators did not believe
  Thailand could attract enough investment to maintain it.
   Here come the speculators…
• Currency speculators began to bet that the government
  would rather let the value of the currency decline rather
  than turn the screws on the domestic economy.

• A devaluation of the baht would hurt the government's
  reputation, but also hurt Thai banks and businesses who
  held their savings in baht or were owed money in baht.

• Speculators began to sell short: They borrowed baht on
  the international market, expecting the value to
  decline, and promised to sell them for dollars at the
  current rate. After the baht fell, they could pay back that
  baht loan at a substantial profit.
              Inside Thailand….
• But it wasn't just speculators: Local businessmen
  borrowed baht to pay of loans that were denominated in
  dollars. Middle class Thais sold their holdings of Thai
  government bonds and began to buy US Treasury bills
  denominated in dollars.
• The baht's value began to fall and the Government now
  had two choices.
   – Let the value of the baht fall all the way to its natural level
   – Or defend it all costs by selling foreign reserves.
   – Instead, Thailand hedged as long as it could. Its President
     Chavilit pledged to defend the peg and on the July 1, 1997 made
     a formal statement that Thailand would not abandon the peg.
                   An Investment Tip
• Whenever you hear a national leader formally pledge
  to defend a currency as long as possible….                       sell!
• The very next day Thailand devalued, but readjusted to a
  new peg. They did not let their currency float.

• Speculators thought they could invest more, local Thais
  began to pull out their savings, and I was able to eat out at fancy restaurants every

• By the end of the summer, the Thai baht would drop
  from 25 baht to the dollar to 63 baht to the dollar.
  Finance models tell us that a normal devaluation to
  make Thai companies cost competitive would have been

• But loss of confidence caused it to drop farther ---a loss
  of confidence caused by the Thai President's decision.
    So that explains Thailand
• But how do we explain the spread from
  one economy to the next over the next
• "Excess variability and co-movement of
  portfolio flows and asset prices that is
  not explained by economic

• 3 Explanations for Contagion
  – Brute Force Economics
  – Emerging Market Portfolios
  – Cascading Information Flows
         Contagion: Brute Forces Economics

•    Two Variants
    1.    Similar fundamental economic problems. Large current
          account deficit and non-transparent financial rules.
          Malaysia, and the Philippines were in similar situations. But
          what about Indonesia its trade deficit was less than 4% of
          GDP - less than Australia's.
    2.    Linkages through trade or FDI --Indonesia can be explained
          because it was a trade competitor to Thailand and a
          devaluation would make its goods relatively more expensive.
          It would need to devalue as well. But how do we explain why
          South Korea was taken down by the crisis. It was one of the
          world's most powerful economies and its economic problems
          were not nearly so severe. A devaluation in Thailand was no
          threat to Korea, Nor was a Korea a large market for Thai
          products, which could be eliminated from Korean books by
          "Just a rounding error."
Contagion: Emerging Market Portfolios

•    2 Variants
    1.   Samphantharak’s “Common Banker Puzzle.”
         •   When two country’s borrow from the same banks, a crisis in one
             will trigger a squeeze in the other regardless of underlying

    2.   Actions of International Investors
         •   Big western investors were holding all of their developing country
             bets in umbrella “Emerging Market Portfolios.” When one country
             ended up in crisis, they dumped their entire portfolios and fled to
             safer ground. The tech boom beginning immediately after the
             crisis may have been impart fueled by this exodus.
         •   Less drastic version: Once an investor faces a loss in one
             emerging market, she may sell other emerging market assets to
             shore up her overall position
            Contagion: Cascading Information Flows
                                   (Banarjee 1992; Mendoza 1994)
• Explanation by Example

                   Huyen, Prof.
Only Prof.         Malesky’s RA is
Malesky knows      interested in         Thuba and
the question for   decentralization.     Mike,Huyen’s
the Politics of    She checks out a      teammates, see
SEA Final          number of books       her check out the      The rest of the SEA class sees Thuba and Mike at the library
                   from the library on   books and assume       checkout counter. Knowing their proximity to Huyen, they
                   decentralization.     she knows              assume she knows something. Pandemonium strikes, the
                                         something about        library is emptied of books on decentralization, and on the
                                         the final. They also   day of the final, everyone receives a question about …….
                                         begin researching      colonial influence.
  Contagion: Cascading Information Flows

• Cascading information is extremely helpful
  explaining what happened in 1997.
• There were only a few truly knowledgeable
  investors in the region. Others simply
  watched their actions carefully and
• When they re-adjusted their portfolios, the
  others followed suit.
  Contagion: Cascading Information Flows

• A few things to keep in mind about the
  – This is entirely rational behavior (bounded rationality). People
    have limited time and calculating ability to study every country all
    the time.
  – As a result, it is rational to rely on clues or signaling devices like
    more informed investors.
  – An entirely rational process led to an irrational over-reaction by a
    large group.
          Responses to Crisis: The International
          Monetary Fund Enters the Fray

• A Joke: What does the IMF stand for?
  – aM
  – F (In really really really big trouble)!
           Responses to Crisis: The International
           Monetary Fund Enters the Fray

• Nobody who needs help likes the IMF much. If anyone
  did, it would be a bad sign.
• The IMF is the lender of last resort; it is the place you go
  when you have no other options.
• Lenders of last resort practice tough love, to give you
  what you need rather than what you want, and to force
  you to pull yourself together and make changes for the
• "A cute and cuddly IMF wouldn't be doing its job."
• But the converse isn't true, just because people hate the
  IMF doesn't mean it is doing its job well. These days
  most people and the IMF staff themselves have
  questions about the response. Let's probe to see what
  they did.
       The Basic IMF Formula
•         money so bad,
    LendNot reallyin the short term to get them over
    the crisis Think of
•        parents for the
    In exchange bailing amoney, ask officials to
    reform their economies to get over the worst
          college student
        out of of crony capitalism
    excesses a credit card
                                    And Robert
•              fiasco. maintain high interest rates to
    Require them to                  Rubin, U.S.
                                   the country
    entice capital into staying inSecretary of the
•                                  Treasury, as
    Ask for prudential fiscal reforms such had
    balanced budget, paying back loans, and
    committing to inflation.       employed the
•                                    strategy in
    Wait for investor confidence to return and the
    viscous circle to turn into a virtuous 1995.
    But there were problems…
1. Medicine worse than the disease
• The IMF demanded that the countries practice
   fiscal austerity-- that they raise taxes in order
   to avoid large budget deficits?
• Why budget deficits? This wasn't the problem
   at all ; trade deficits were the problem.
• The idea was to restore investor
   confidence, but it caused a two-edged problem
   1. If countries could achieve a surplus, the recession
   was worsened because demand was reduced.
   2. If they didn't , it sent the message that the country
   was in chaos and fed the electronic herd's panic.
        But there were problems…
2. Structural reform:
•     Bank reform just fine, but what did reducing special perks for
      Suharto cronies do?
•     Korea just needed short term creditors and encouragement to
      rollover loans, but the IMF bailout of $57 billion insisted on
      fundamental overhaul of Korean economy.
    –      easing purchases of Korean businesses
    –      easing imports
    –      breaking up Chaebols.
•       The reforms made the short term transition painful, and made
        firms that were survivable in the long run insolvent in the short
•       The proper institutional foundations may not have been in place
        for such a drastic shock.
    But there were problems…
3. A new type of moral hazard
• Reform was so painful (to avoid investors
  losing confidence), countries now have an
  incentive to wait too long to seek modest help.

• Perhaps, they will just hoard foreign reserves.
  But this is money that could go for
    But there were problems…
4. Martin Feldstein: Why did they have the

• A major portion of US debt (in the form of T-bills)
  is held by Japan and China. Can they impose
  changes on us?
 The Alternative Solution: Malaysia
• Malaysia’s logic after attempting orthodoxy under Anwar
   – Currency crises are self-fulfilling.
   – If investors think that the currency will depreciate in the
     future, they will sell the currency now– causing the depreciation
     (or devaluation) of the currency now (This has certainly
     happened with bank crises.
   – The solution: Stop the outflow. Impose capital controls
       • Investors needed to sell foreign exchange to government at a fixed
       • Short-term investment was limited.
   – Investors were upset and sharply criticized the actions
10 Years Later: What do we know?
• The East Asian Economies have recovered and
  are growing again at rapid rates.
But Growth Has Settled on a Lower
      Trajectory than Before
Why is growth not at the same high
• Labor growth has not declined
• Education rates have not declined either
• Total Factor Productivity was hurt by the
  crisis, but is back to pre-crisis levels.
But fixed Investment declined after
             the crisis
  On the other hand, FDI is now
        starting to pick-up
(Despite significant FDI heading to VN and
     Poverty is also declining
• 228 million people raised above $2 a day.
 Reserves Under Pressure in
Some Countries due to Today’s
      Never Again: No more BOP
exposure, impacted SEA economies have
       become creditor nations.
Running Positive Current Account
Never Again: Flexible and Strong
       Exchange Rates
Not struggling to balance in
        current crisis
On the downside, inequality may
be increasing in some countries.
Improvements in the Business
       Concluding Thoughts
• How have different regime types fared
  over the past twenty years in SEA?
• Was the crisis just a blip and is SEA back
  on the road to recovery?
• Have changes in political institutions
  helped or hurt the recovery?

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