In June 1999, Norman Chan, then deputy chief executive of the Hong Kong Monetary Authority, delivered a speech that surveyed the wreckage of the Asian financial crisis. The region’s regulators and central bankers were still reeling from the economic violence that had wiped out years of economic growth, sent currency values plummeting and revealed the deep flaws in Asia’s financial systems.
Chan, who is now chief executive of the HKMA, pointed to the usual suspects: weak domestic banking systems, excessive corporate leverage, and an over-reliance on currency pegs to eliminate foreign exchange risk. But he also argued that not all of the blame for the Asian financial crisis should be laid at the door of those within the region.
“What happened to the very elaborate and sophisticated risk management systems of these international banks?” asked Chan. “And why did they not function to reduce the banks’ exposure to unsound lending?”
These questions would be asked even more loudly within a decade, when the near-collapse of the US financial system caused a global slump, provoked a widespread backlash against investment banks and — most importantly of all — inspired central bankers to experiment with a series of monetary policy manoeuvres that continue to define the global financial landscape.
Those with a superstitious bent could be forgiven for preparing for more calamity. Between 1997 and 1998, the Asian financial crisis caused chaos throughout the region. Between 2007 and 2008, the financial crisis spread from subprime lenders and securitization vehicles to the entire US banking system, and from there to much of the developing world. As this article was being written in February 2018, Asia appeared likely to escape the curse of a crisis every decade — but few saw the last two disasters coming.
Is Asia, or indeed the world, due another financial crisis? And has the region learned enough from the fall-out of the last two to avoid the worst effects of a financial and economic storm that will offer a real test to just how much progress the region has made over the last 20 years? GlobalCapital Asia attempts to find out.
Blame game
The old adage that five different economists will give you six different opinions may be a little unfair, but it roughly describes the situation with research into financial crises. John Maynard Keynes and Hyman Minksy essentially reduced the explanation to “animal spirits”, moments of excessive hope and fear that can fuel bubbles and burst them just as quickly. Ben Bernanke, who made the Great Depression a focus of his studies before becoming chairman of the Federal Reserve, blamed a fall in the money supply, echoing the ideas of Milton Friedman. The most recent global crisis has been blamed on moral hazard, securitization, too much government, not enough government and everything in between.
Johanna Chua, chief emerging Asia economist at Citi, admits financial and economic crises are almost impossible to predict with any degree of certainty. But, she says, there are clues.
“Every crisis is different but history seems to show that monetary policy normalization in the US can lead to problems, especially when it is in combination with a build-up of leverage,” says Chua.
The Federal Reserve conducted a steady series of hikes from 2004 to 2006, culminating in a 5.25% rate in June 2006. In little over 12 months the first signs of the coming crisis were starting to show. Within two years, the US financial system was on the brink of collapse.
This link is clearly anecdotal but it is far from an outlier. A series of hikes in early 1980s were followed shortly after by the Latin American crisis. When the Fed next went on another hiking spree in 1994, Mexico faced a banking and currency crisis. Some economists point to those same rate hikes as a partial cause of the Asian financial crisis.
There is far from unanimous agreement on the role of rising rates in causing problems down the road. Benjamin Nelson, an economist at the Bank of England, studied the link between US monetary shocks and bank balance sheets in 2015 and found only a “modest” causal relationship. In the same year, Ola Sholarin, an economist teaching at the University of Westminster, looked specifically at the risks for emerging markets and warned that “even a small percentage increase in interest rates is likely to cause shockwaves across developing countries”.
Disagreement is natural. The relationship between policy moves at the Federal Reserve and the health of emerging market economies is undoubtedly fluid. The impact of interest rate differences on foreign exchange rates is one obvious means of contagion; the heavy offshore financing of many Asian banks, corporations, and even governments is another. But if rising US interest rates are an important determinant of future crises, investors and corporate executives should be worried.
Although the Federal Reserve did not follow its central banking counterparts in Switzerland and Japan by moving into negative interest rates following the global financial crisis that started in 2008, it did move close to zero: its last rate cut, in December 2008, pushed the Fed funds rate to between 0% and 0.25%. That no doubt helped stem the pain banks, corporations and whole economies felt in the wake of the crisis, but there is a risk it has built up problems that could once again leave Asia exposed to a crisis not of its own making.
Jerome Powell, the new chairman of the Federal Reserve, has made clear he maintains the same rate-hiking bias of his predecessor, Janet Yellen. The Fed raised rates three times in 2017, ending the year with a Fed funds rate of 1.25%-1.5%. Most economists think we are only at the beginning of a long, albeit potentially slow, cycle of rate increases.
There is, however, reason to be optimistic about the likely impact of these rate increases on Asian economies. In large part, this is because of lessons policymakers learned in the late 1990s, when a currency crisis led to widespread economic turmoil — and provoked serious questions about how much Asian economies could rely on foreign capital.
Bye bye baht
The Asian financial crisis is far enough in the past that many executives and bankers today have no strong memory of it, let alone any experience of working through it. But for those who were there, the crisis will never be forgotten.
The usual starting point of the Asian financial crisis is taken to be July 2, 1997, when Thai authorities backed out of a protracted fight with hedge funds betting against its currency and announced they were ending a decade-long peg against the dollar. The Thai baht collapsed, other Asian currencies became targets, and a wave of revaluations, capital flight and economic woes spread from country to country.
Indonesia’s economy lost 58% of its value in dollar terms between 1996 and 1998, erasing more than a decade of growth, according to World Bank data. That was the most extreme case but countries across the region suffered severe economic contractions over the same period — more than 37% in Thailand and South Korea, 28.5% in Malaysia and 10.3% in the Philippines.
The response of policy bankers to this crisis was almost immediate. Thailand, the Philippines, Indonesia and Taiwan allowed their currencies to float. Korea, Thailand and Indonesia shuttered banks. The International Monetary Fund, the World Bank, the Asian Development Bank and a host of bilateral lenders approved $112bn in loans in 1997 alone.
The lasting change, however, may have been a recognition that Asian countries could no longer rely on foreign lenders for capital. Heavy foreign currency funding may not have in itself caused the crisis, but it certainly exacerbated it. Even worse was the fact that this borrowing was often at short maturities, adding a dangerous asset-liability mismatch to the mix.
Since the crisis, there have been widespread attempts across the region to develop domestic funding markets, insulating governments and corporations from the risk of international capital flight. There have even been grand plans for regional financial integration, giving extra weight to the Association of Southeast Asian Nations (Asean) and leading to the establishment of the Asian Bond Markets Initiative, a 2003 agreement between the Asean, China, Japan and Korea that was explicitly designed to help avoid another financial crisis.
The development of Asian bond markets was a key factor in the region’s subsequent impressive resilience to the global financial crisis that started in the US mortgage market in 2008 and quickly spread across the world. China, Indonesia and Singapore continued to grow throughout the crisis, while India, Malaysia, the Philippines and Thailand came roaring back after brief contractions. (South Korea was harder hit, suffering an almost 20% fall in dollar-denominated GDP between 2007 and 2009, according to World Bank data.)
The desperation among Asian governments to bolster their domestic markets after the 1997 crisis has not been a uniform success across the board, but Asia has become much more self-reliant when it comes to raising money.
China, where domestic funding dominates and foreign investors are only beginning to get access, is a prominent example. Although the country is still making gradual steps to allow more foreign investors into the local bond market, this is happening at a slow pace — and offshore issuance faces an often onerous approval process.
China can handle the pressure
China is certainly no stranger to bubbles. Between 2006 and 2008, the Shanghai Stock Exchange index rose by 485%. In the next 12 months, Chinese stocks lost more than 70% of their value. Nor is this volatility a relic of past administrations. In June 2015, after current supremo Xi Jinping had been in power for more than two years, China’s stock market began an eight-month plunge that wiped out around 50% of its value from peak to trough.
But stock market woes and banking crises are very different things. The animal spirit argument certainly seems to apply to stock markets, where stocks and whole indices can zig and zag on little more than a whim. China’s wider financial system is arguably too carefully managed to allow these same spirits to cause a bust, despite the mountain of debt the country has stacked up. (All sector debt is worth 260% of GDP, according to the IMF.)
“I used to be seen as the leading bear on China, now I am sometimes called the least optimistic of the bulls,” says Michael Pettis, professor of finance at Peking University’s Guanghua School of Management. “This shows how much attitudes have changed. China has significant problems driven by debt, but it is unlikely to have a crisis. That’s because a crisis is just one way of resolving a debt problem. The other way is the Japanese way, with 20 years of low growth. The option for China is not crisis or rapid growth, but crisis or many years of slow growth.”
Chua agrees with the broad point, although she sounds more optimistic when comparing China to Japan, which is now into its second decade of economic stasis.
“I don’t see China as the trigger for a global or even region-wide crisis,” she says. “Their issues with leverage have a lot of caveats. They’re financing it domestically. They have lot of potential for growth. They can still pull rabbits out of the hat, whether in service sector growth or moving up the value chain in manufacturing.”
It would be foolish to bet against another crisis hitting the global financial system, and Asia along with it. But the lessons learned from the Asia financial crisis made a big difference on the region’s resilience during the global financial crisis. They also suggest that Asia is unlikely to get the blame for the next time those animal spirits are unleashed. z
Additional reporting by Paolo Danese