I showed in this column last week how simple explanations for the Asian currency crisis (like going too fast or liberalising too much) were wrong, and how the lessons from each country were different. The one factor common to all countries was the financial panic that spilled across national boundaries. We need to build defences against such panic in India. But even more we need to absorb the very different lessons from each country.
The problem started in Thailand and then spread. Storm clouds had been gathering over Thailand for some time. It had a fixed exchange rate (and so did Malaysia). So, when the dollar strengthened after 1995 , this pulled up the Thai baht Malaysian ringgit too, and affected their export competitiveness. Thailand’s current account deficit rose to a whopping 8 per cent of GDP, as high as Mexico’s when, that country went bust in 1994.
The fixed exchange rate created perverse incentives for banks and finance companies. They found they could borrow in dollars abroad at low interest rates, and re-lend the money locally at high interest rates. Money for jam, it seemed. In theory there was a currency risk—devaluation could greatly increase the cost of servicing the dollar debt.
But the fixed exchange rate created the illusion of zero currency risk. And so Thailand and Malaysia both used dollars to finance a domestic lending boom, which took bank credit to more than 150 per cent of GDP.
Now, borrowing to finance export-oriented industry was always viable. But foreign bankers started believing they could place unending billions in miracle economies to earn miraculous returns. Soon most of the flood of dollars was channeled by banks and finance companies into real estate, sparking a property boom and gross over-building. This bubble had to burst one day. Initially, banks lent happily against property as collateral.
But when the property bubble burst, property prices crashed, and the finance companies suddenly found the collateral insufficient to recover their loans. Most of the financial system went bust. Meanwhile, the Thai government used up its entire foreign exchange reserves trying to prop up the fixed exchange rate. When it finally gave up and let the baht float, panic set in, and the baht plunged.
Not even a huge IMF rescue package could reverse the trend. Indeed, in Thailand, Indonesia and Korea, the currency plunge actually worsened after the announcement of IMF packages. Suddenly confidence in the Asian miracle was replaced by blind panic, which spread from Thailand to Malaysia, the Philippines and Indonesia.
Indonesia had only a modest trade deficit and modest lending boom. But its financial system was a disaster. Lending was based on good connections rather than hard-nosed appraisals, and lending to friends and relatives of President Suharto (who dominated business) was mandatory. A lot has been written in praise of “Asian values” and “guanxi” that sparked the Asian miracle. Such values included unquestioning obedience to the leader, using family connections and informal networks to do business rather than formal contracts enforced by law, directing money to favoured people in the expectation that the benefits would trickle down. Although many loans turned bad, although there was much corruption and favouritism, this system worked as long as most of the money went into export-oriented (hence competitive) production.
Alas, this changed when euphoric foreigners started throwing billions without scrutiny at the supposed Asian miracle. Indonesian businessmen increasingly went for reckless diversification or real estate. Gullible foreigners believed any loan to a Suharto relative carried an implicit government guarantee. Steady Safe, a taxi company with a turnover of just $ 9 million in 1996, could borrow a whopping $ 270 million from Pere-grine (the high-flying merchant bank of Hong Kong simply because one of its owners was a Suharto. Peregrine deservedly went bust because of this.
Many other lenders are in dire straits, and bemoan the lack of information systems and corporate transparency in Asia, saying this misled them badly.
The problem was worst in Indonesia, where many audited accounts turned out to be fiction (accounting standards are low), many liabilities were not recorded in balance sheets, and companies booked huge off-balance sheet loans. In early l997, Indonesia and Korea were thought to “have a foreign debt of around $ 100 billion each. But soon enormous unreported debts came to light, and it now seems their foreign debt may be $ 180 billion to $ 200 billion each.
The biggest information gap was in regard to short-term debt, which ballooned to levels that look incredible in retrospect. If only we had known, say bankers, we would never have lent so much.
Korea had other problems. It had become rich through the “chaebol” system. Businessmen had little money of their own, so the government directed enormous amounts of bank credit to favoured “chabeol” (business conglomerates) to enable them to build huge empires. In the USA, prudent companies have as much equity as debt to guard against a business downturn. But in Korea companies had mind-boggling debt-equity ratios of up to 1,000.
This was a very high-risk strategy, yet it worked long enough to make Korea rich. However, now that it has graduated from labour-intensive products to sophisticated ones, its fragility is manifest. Several chaebol (Hanbo, Sammi, Kia) went bust even before the currency crisis. Korea needs a major structural adjustment towards western corporate norms.
Several lessons follow from the crisis. They show, surprisingly, that Indian rules already ensure that the excesses of east and south east Asia will not occur here. The main lessons are:
(1) Do not have a fixed exchange rate. This is already me case in India.
(2) Do not let your current account deficit balloon to 8 per of GDP as in Thailand. India’s current account deficit is below 1.5 per cent of GDP.
(3) Do not allow your banks and finance companies to borrow in dollars and re-lend in local currency. This is already the case in India.
(4) Make sure you record all foreign debt, especially short-term debt. Indian rules ensure this.
(5) Have proper audited accounts for companies which list off-balance-sheet liabilities like guarantees and options. India already has such provisions.
(6) Do not encourage high debt-equity ratios for companies. This is the case in India.
You may think this makes India look good, but please do not swell with national pride. India remains poor with a per capita income of $ 320 whereas Thailand has touched $ 3,000 and Korea $10,000.1’» is no consolation for a poor man to know that the rich also have problems.
Some miracle economies (China, Hong Kong, Singapore, Taiwan) have weathered the currency storm. This shows it is possible to grow very fast and yet avoid the debacles of Thailand or Korea. That is what India needs to aim for, instead of taking comfort in poverty-with-stability. We need to emulate the Asian success based on outward-orientation instead of self-sufficiency, on market-friendliness rather than public-sector-friendliness, on high standards of education, and a high savings rate. Finally, the Asian crisis shows that the ill effects of weak financial and information systems greatly magnified by full convertibility. The financial herd can stampede in and out again.
The long-run solution is to have excellent information systems, good corporate governance, and institutions that encourage contrarians in financial markets.
That day is, alas, a long way off. Till then, we need capital controls. We should ban or severely curb short-term debt. We should discourage NRI bank deposits of less than two years’ maturity.’
This will inhibit the inflow of dollars. But we now know that too little can sometimes be better than too much.