David Dollar on Marking the 20th Anniversary of the Asian Financial Crisis


Welcome to the Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Nick Borst.

And I’m Sean Creehan. We’re analysts at the Country Analysis Unit, and our job is to monitor financial and economic developments in Asia.

Today, we’re kicking off a new series of episodes looking back on the Asian financial crisis, as we approach the 20th anniversary of that event. The series will feature interviews with experts from a variety of different backgrounds on why the crisis occurred and what lessons we can learn from it today.

To give you some context, the crisis started in July 1997, when Thailand depreciated its currency due to pressures on its exchange rate. The crisis subsequently spread to Malaysia, Hong Kong, Indonesia, South Korea, and even Japan. It led to a huge drop in GDP across the region, a sharp depreciation of local currencies, and massive losses to the stock markets.

I think it’s really important to look back on the crisis because it remains so influential today. The Asian financial crisis was a turning point for many countries, leading to significant changes in their domestic economies, as well as efforts to create new regional institutions.

Several Asian economies were recipients of international assistance during the crisis, which often required difficult domestic changes. After the crisis, there was a strong desire among many Asian countries to never be in that position again.

We’re not going to repeat the last crisis, so I think it’s always hard to see what the character of the next crisis is going to be. And, let me be clear, I would never think of this as the base case for the next one to two years, but I do think these risks are building up.

For our first episode, we sat down with David Dollar, a senior fellow at the Brookings Institution, to discuss his perspective on the crisis.

David has a lot of experience covering Asia. He has worked as an economist for the World Bank, covering a variety of Asian economies, and also served as the Financial Attaché for the US Treasury in Beijing. David has written numerous articles on Asian economics for a variety of different scholarly journals.

I think David covers a lot interesting ground in the interview, and it gives us a good foundation for the rest of the episodes that will follow. He covers issues like the key causes behind the crisis, how financial contagion led it to spread from country to country, and where Asian economies stand today in terms of their financial vulnerabilities.

He also had some great takeaways in terms of what lessons we should learn from the Asian financial crisis, and how those apply to a variety of the emerging markets today.

So without further ado, let’s listen to our conversation with David.

Well thank you very much David, for joining us today.

Looking back on the Asian financial crisis, we’re coming up on about 20 years now, in your opinion what are the main financial and economic factors that led to the creation of the crisis in the first place?

There were a lot of different factors behind it, so there’s always a risk of over simplification, but I think a couple of the key factors for that major Asian developing countries who are opening their capital account, and in my view I guess it’s easier to say ex-post, they seem to do it prematurely. In particular, some of them were trying to open a capital account while keeping a fixed exchange rate, which is difficult to do.

At that point, these were still somewhat risky. I’m thinking of countries like Indonesia, Thailand, Philippines. These were still somewhat risky environments in which domestic interest rates tended to be high. At the beginning of the ’90s, we had a recession in the US and the Feds had low interest rates for a while, and as countries opened up their capital accounts with fixed exchange rates, it became attractive particularly for the private sector to borrow from abroad.

I would point to a key statistic in trying to understand all this, is that in the three years before the crisis hit, foreign debt relative to GDP was about 100% to 167% for the four big Asian economics.

To make that a little bit more real, I was doing some work on Thailand before the crisis just on competitiveness issues, not macro issues, and visited some different types of firms, Thai firms, foreign firms, and I remember visiting a Thai firm that had borrowed in dollars at low interest rates, and they were producing parts for Japanese model cars, that are tailored to the Thai markets. These were…The Thai drive on the left-hand side, and you don’t need heat in Thai cars, it’s a particular kind of car. And so I ask the owner, isn’t he worried that there might be devaluation and what looked like low cost dollars? To produce for the domestic market could be a mistake. And he said, it’s not the policy of the government to have devaluation. And I went back a year later, after the crisis hit, he had a nice mango tree in the yard of his factory, and I saw the same guy, he was winding down the factory. And he said, the mangoes are the only thing this factory is going to be producing from now on.

It’s a very simple point that, he borrowed what he thought was inexpensive money to produce for the domestic market, and it turns out that whole package was unsustainable, so eventually they had significant devaluation, and it wiped him out.

The reason so many Asian economies had originally turned to fixed exchange rates, was that it was viewed as a great source of stability as they were developing. What happened with the fixed exchange rate system with that, these South East Asian economies, why did it turn from initially that something that might have been a bit beneficial to really an albatross around their necks?

Right, something that we’re learning through all of this process as well, developing country that’s opening up, that’s just baiting the economy at low income, fixing your exchange rate to the US dollar has some advantages, if you really stick to it. It keeps your own inflation rate at a moderate level and creates stability, people don’t really have confidence in your domestic economy, but I think one thing we’ve learned is that it’s very difficult to open up a capital account in that environment.

There’s a sequence in which…I would say the sequence is, you want to strengthen your own domestic financial institutions, you want to start introducing flexibility into the currency, and then you only get to real the full opening of the capital account pretty late in the process.

In the end, there are a lot of different parts of the capital account. These countries were open to direct foreign investment, and I think that’s a smart strategy but that tends to be relatively sticky, it was opening up the portfolio side. So on the one hand you have firms like the one I described, that could borrow relatively easy in US dollars, and you also had certain amount of speculative money flow into these economies, they had property booms. I remember all the cranes, construction cranes in Bangkok, in the period leading up the crisis. People joked that the crane was the national bird of Thailand.

So there’s a real estate boom, some speculative money flows in, there were stock market booms. What we learned then is when this unsustainability, when things eventually come home to roost, a lot of that money can flow out very quickly. That’s the problem with really opening a capital account at too early a stage.

You explained it really well that because of the balance of payment crisis that was brewing, I wonder, one are the interesting about the Asian financial crisis is that there is also a banking crisis that went on in some of the countries, I’m wondering if you talk about that?

Excellent question.

Another key aspect of this crisis, it was very much a private sector crisis, and so it was the sense that…I think it’s fair to criticize the international financial institutions, I was working at the World Bank at the time, and there was a sense that it was really important to keep a tight lid on public sector borrowing and the total public sector debt relative to GDP, but we weren’t worried so much at the time about private sector debt. The idea was simply that private funds could take on debt and it may go bad, and then they go bankrupt, and that’s the normal part of a market economy.

What we learned in the crisis is that, private debt can become so large relative to GDP, that it generates a macro economic crisis. It’s not possible for the state to just walk away from all of that. And I think all of those governments ended up taking on a substantial amount of debt as part of a resolution of the crisis.

So one important lesson is the need for very good supervision of the banking system. So even if the lending went from private banks to private firms, there’s still a public interest in supervising that, making sure that, that’s stable and happening at a sustainable level.

Great. How did contagion between the different Asian economies exacerbate the crisis?

Well, the description I gave it pretty accurate for the big ASEAN economies, particularly Thailand, where things started, and Indonesia, to a lesser extent Malaysia and Philippines. But what’s interesting is that Korea then gets sucked in, and it’s a much bigger economy than the others, and I was just looking at some data. Their figures for foreign debt relative to GDP, are much smaller than the figures I cited for the Asian countries.

So in a lot of ways, Korea was starting to make some of the same mistakes, they had opened up the capital account, but they were the higher level of development, they had more sophisticated firms. But the contagion problem is that as South East Asia starts having trouble, capital flows out, investors have trouble distinguishing, which countries are going to have a crisis, and, which countries are not going to have a crisis.

So, a lot of money started flowing out of South Korea, which had opened up its capital account. So that I think South Korea had more of a liquidity problem, and it really needed a more classic IMF liquidity solution, that the approach of the international financial institutions was that all of these economies needed serious structural reform, as they had a lot of tough conditionality put into these IMF programs that frankly generated a lot of resentment.

I think it’s taken a lot of time for IMF to recover its reputation in Asia. But, the basic point about contagion, is that the big international banks and investors have trouble distinguishing who’s going to be a pretty good debtor, and who’s going to be a problem debtor, that’s mostly going to default, and then that environment they withdraw, they become risk adverse, they withdraw. And, then that precipitates more economic downturn than had to have happened.

So, just a quick follow up on that. Do you think that international investors have become more sophisticated at making those differentiations between various Asian economies or any emerging markets, or somewhat developed markets like Korea?

I’d like to think they become a little more sophisticated, but I still think contagion is a big problem in the world. We definitely do see a lot of hurting behavior among investors. Something will become sexy and money will flow into a particular country, and then a little something will happen, a lot of money will flow out. So, I don’t think we’ve completely solved this problem of contagion.

So, David, you’ve done a lot of work on China throughout your career. Can you talk about what China’s role was during Asian financial crisis? What did it do during the crisis? And, how did it impact how the country was viewed, both in the region and internationally?

I think China played a useful stabilizing role during the East Asian financial crisis and that was appreciated around the region. China was at a lower stage of development than those big ASEAN economies. It had definitely not started opening up its capital account other than welcoming direct foreign investment in some sectors. They’ve chosen to peg their exchange rate to the dollar in the mid-nineties and I think that’s a reasonable choice for a low income developing country. They did not have particularly large imbalances at that point, so it’s hard to argue that there was a problem with level of the exchange rate. They were becoming a significant exporter by the mid-1990’s, so as the crisis played about in 1997-1998, there was a lot of debate within China about whether they should devalue.

The other countries I mentioned, like Thailand, Indonesia, South Korea…They all had to let their currencies devalue and that actually gave them a certain impetus stimulus to their economy.

South Korea, in the end, bounced back remarkably quickly, even though the crisis was quite deep. So, there was talk in China about…Did China need to devalue to stay competitive with these other economies. And, given that they were not hit very hard by the crisis and that they had a growing share of world exports, I think they did the…What I think of as the mature thing, which is, that they kept their currency stable, so they were a source of stability. I think some of the key U.S. officials had a good dialog with China at this time. If China had devalued, there was a danger of, kind of, a long cycle of competitive devaluation. If Indonesia, and Thailand, and South Korea, for example, had not been able to come back into the export market in a significant way.

Now, it wasn’t that long after the Asian financial crisis that China undertook its own pretty significant banking sector clean up. Was that, in any way, catalyzed by the Asian financial crisis? Or, was that proceeding on a separate track entirely?

That’s a good question. Certainly I do think the crisis had an effect, overall, on Chinese reform. They had started talking, as early as the early 1990. They talked about a reform agenda, definitely including opening up the capital account. I think, the severe crisis in those other countries, the IMF programs, the harshness of conditions, all of that made the Chinese a little bit shy about certain types of financial reform. At the time, it was probably a good thing because now we’re 20 years later.

I, personally, wouldn’t mind seeing a little bit more financial reform in China, given its stage of development. But, yeah, I think it did…I don’t think the crisis had that serious an effect on the Chinese economy, but it made them more wary. They had a lot of bad debts building up in their banking system, not related to this crisis, but related to, frankly, related to the large role of state enterprises in the system. And, the fact that state enterprises were getting a lot of loans and were not really under very strong financial discipline. So, they had their own problems building up. It wasn’t long after the financial crisis that they aggressively tackled some of those. Part of that was, in order to set themselves up to join the World Trade Organization.

I think we’re lucky that China didn’t look at the East Asian financial crisis and decide that all of global capitalism was a bad idea. They took the lesson that some financial liberalization is risky, but they moved ahead with their trade liberalization, and with opening up for direct investment. And, cleaning up state enterprises in the late 90’s, that was definitely an important part of this whole reform agenda.

Do you think that China, in the end, may have actually benefited from the crisis? Clearly they’re preparing to open up with the WTO, but firms relocating some of their manufacturing base from Southeast Asia to China in the wake of the crisis? Is that a dynamic at play?

I think that’s a very interesting hypothesis. Before this crisis, there seemed to be this fairly steady process, in which, a lot of people forget a lot of labor intensive manufacturing was strong in Japan, if you go back to the 50’s. Then, a move to South Korea and Taiwan. It seemed to be moving to Southeast Asia. I do think the crisis interrupted that. Unless those countries with complicated, political economy situations, ASEAN has never lived up to its potential. It could integrate, and be a market of 500 million people, but there are lots of restrictions remaining. Trade restrictions among these ASEAN countries. So, it never quite lived up to its potential. China learned some of the lessons and then joined the WTO, opening up in the 2000’s. So, in a lot of ways, China took what could have been a wave of investments going into those other countries, a lot of that ended up going into China.

So, one of the reasons we’re doing this series, is we’re interested in the history of the Asian financial crisis, but we’re also interested in what these economies and financial systems look like today. Maybe you could give us, your kind of sense, of how they have changed. How the key crisis economies have changed over the past 20 years.

I do think the big ASEAN countries, and South Korea, even more so, took to heart this lesson, that the fact that something is private sector debt, doesn’t mean the public institutions can just ignore it, lave it all up to the market. I think, South Korea in particular, you’ve got pretty strong banking supervision. Koreans seem determined not to have another financial crisis. So, when the global financial crisis hit, which started in the United States, South Korea weathered that rather well. I think that’s evidence that they’ve done a much better job with their banking supervision. And, in that earlier crisis, the East Asian crisis, they did let one of their really big firms, so-called chaebol go bankrupt, so I think it also helped break up a little bit of the crony capitalism that was existing in that situation.

In South East Asia, similar things, but not quite as strong. I mentioned a moment ago, that it seemed that production was moving from Japan to South Korea, Taiwan, then to South East Asia, I think, we were a little too quick not to recognize how special Japan, Taiwan, South Korea were, in terms of a lot of characteristics that are very strong for growth. And, the fact that they were strategic allies of the United States, that had special access to the U.S. market. So, I think that these countries, have taken to heart, the need to do a better job with supervision. But, definitely we see differentiation among them.

In the wake of the crisis we saw a lot of these countries really build up tremendous foreign exchange reserves. In your opinion, how useful as a deterrent was this build up in FX reserves?

Yes, so I think, partly that reflects frustration with the way IMF handled the whole Asian crisis. And then frankly, the United States is the biggest shareholder in the IMF and there was a sense in Asia, that the U.S. was tougher on these countries, than they had been, for example, on Mexico in an earlier crisis period. So, there was a determination to build up reserves and never have to go back to the IMF. A little bit of that makes sense, but I do think the overall reserve accumulation went too far in Asia. The Chinese in particular, it was a combination of motives, but the Chinese built of four trillion in reserves. I don’t think that, that’s particularly helpful. And, in the process, they generated larger current account surpluses than they needed to generate, that created trade friction. Overall, Asia’s continued to have a lot of trade friction with the United States. So, I think that’s an unfortunate consequence of the crisis. I think it started out as a desire to accumulate enough reserves to protect oneself, but then it became very convenient way to continue to support export growth at rates that were unsustainable.

So, on that note of some of these crisis countries being reluctant to go to the IMF again, how useful do you think these various regional initiatives that we saw that were strengthened in the wake of the crisis? Like, the Chiang Mai Initiative, AMRO, Asian Bond Market Initiative, are these kind of regional bodies sufficient to help Asia in another period of financial instability or at the end of the day, are you still going to need the big, kind of global, multilateral institutions?

So, I think the regional initiatives are not very deep and not very important, to be frank. So, I don’t see that the Chiang Mai Initiative really does much, and the Asian bond market is still a disappointment. The truth is, there’s a lot of enmity among countries…different countries in East Asia. It’s amazing they have as much trade and direct investment as they do, and that’s a positive. But, financial integration in Asia has been very difficult. I think probably because they two biggest economies are China and Japan and they have all kind of historical problems that they haven’t really gotten over. So, I do think the global institutions as quite critical, if there were some kind of crisis that involves some of the Asian countries. I do still think the IMF is the best hope for the global stability.

So, that interesting because reading about the discussion of the time, may be a formation of an Asian monetary fund to help solve future crisis. It’s interesting to hear you characterize it as a lot of disagreement and enmity amongst Asian countries that may prevent that sort of coordination because at the time, at least in some of what I’ve been reading, there’s this sense that maybe the developed countries, European, American interests were a little bit skeptical of some of the use of IMF facilities in some of these countries. It sounds like what you’re saying, is maybe even that idea, that old idea of an Asian monetary fund is, kind of, politically unfeasible at this point.

Right, so this might seem slightly inconsistent, but I’ve been a supporter of this new Asian Infrastructure Investment Bank because I think we have a system, in which there are different, multilateral development banks and they coordinate a lot, they compete a little bit. I don’t see that, that’s a market or a niche where there’s a problem. On the other hand, I don’t think having competing regional or global monetary funds is going to be helpful. When you get these crisis you do need some type of policy reform and the IMF might not have gotten the policy package exactly right. But, as I said, South Korea bounced back very quickly and the other countries bounced back fairly quickly. I think the IMF has learned the lesson that some of the conditionality was really unnecessary and they should focus on what’s necessary to restore macro-economic stability. So, I think the IMF does a good job at what it’s supposed to do and having a, kind of, competing institution where you can go, and look at what kind of analysis and conditions they’re going to offer. I don’t think that, that’s going to be helpful in a crisis situation.

So, David, looking at Asia today, what are the big financial vulnerabilities that you see? Are there things that we should be concerned about? How does Asia compare to the Asia of pre-crisis 1996-97, in terms of financial stability?

So, in general, things are better. A lot of the countries that had serious crisis’ in ’96, ’97, ’98, they’ve strengthened supervision, macro-policies. Ironically, I do think there are financial vulnerabilities building up in China. They’re somewhat different. So, China certainly does not have this problem of foreign debt, relative to GDP. I think, China’s been very, very careful about opening up some aspects of a capital account. So, you’ve not had a lot of portfolio foreign capital flowing into China.

But, they do…They have created problems for themselves on the real side, with over-investment in a lot of different sectors of the economy. So, now they’ve got excess capacity, the returned capitals declined, investment is naturally slowed down. But, the country still has a very high savings rate. So, you start to see a lot of capital flow out of China. They have capital controls to try to manage that, but last year 725 billion dollars net flowed out of China. So, somehow a lot of money is getting out. They’ve built up that big pile of reserves to four trillion dollars, they’ve now used a trillion to try and keep the currency from depreciating too much. I support that they’ve used the reserves. What’s the point of having the reserves, if you aren’t going to use some of them. And, three trillion is still a nice spot pile. But, there is a risk. If I were looking for any risk in Asia, it would be a risk of unruly devaluation of the Chinese currency because of excessive capital outflow that really cannot be stopped. I call it excessive because I think it would be hard for the rest of the world.

Imagine if China had a trillion dollars of capital outflow in a year. I think it would be hard for the rest of the world to absorb that. It’s unsustainable. I think, we probably would get some ugly currency movements. We’re not going to repeat the last crisis, so I think it’s always hard to see what the character of the next crisis is going to be. And, let me be clear, I would never think of this as the base case for the next one to two years, but I do think these risks are building up. China should be more aggressive about reining in leverage, encouraging consumption, and trying to bring down that saving rate. It’s just really hard to see how they can use almost 50% of GDP in savings. It’s just really hard to see how that could work out well. It either leads to over investment at home or it finances excessive capital outflow.

Exactly. And, at the same time, many of these South East Asian countries, have become very dependent on Chinese growth, in terms of, trade and other things.

Thank you. I had written a couple of little notes to myself, and one was, China risks, which I just talked to you about. And, the other little note that I wrote to myself was, other countries are too optimistic about China. As you say, their growth is very, very tied to China. I see this in South Korea, for example. Right now, there’s some political tension between South Korea and China, but economically, the nearby countries tend to have a very optimistic view that China’s going to keep growing well. And, that may very well turn out. But, if there is some kind of financial crisis in China, it is going to have very serious spillover on the rest of the region. Then, we’ll find out how good their financial regulations and their macro-management is.

So, David, as we wrap up here, maybe you could just give us your view of what the enduring lessons of what the crisis are. You’ve talked a bit about it, but how would you summarize it for supervisors, governments, private investors going forward?

To me, the most powerful lesson was the difficulty of this transition from which macro and financial policies make sense at low income and all the truly high income countries have a lot of similarities, in terms of, flexible exchange rate, open capital account, strong supervision of banking. How you get from the low income package to the high income package is really, really difficult. It’s east to lay out a simple sequence that you want to build up your domestic financial institutions first, and introduce flexibility into the exchange rate before you open the capital account. But, it’s much harder to do these things, that just to say them. How do you build up robust domestic financial institutions that know how to evaluate in price-risk. And then, what does it mean to introduce some flexibility into the exchange rate? In general, you have fixed exchange rates, you’ve got flexible exchange rates, a lot of countries try to go with something in between that can create all kinds of moral hazard and other problems. I’m just impressed at how difficult it is and almost no one makes this transition without some kind of financial and balance of payments crisis.

A quick follow up on that, is there something particularly unique about China going through this transition, and that a lot of other countries that may have navigated it, were relatively small compared to the global financial system, to the global trade flows, whereas China now, even though they’re still developing and relatively poor on a per-capita basis, I mean, they’re swaying the entire world.

Yeah, I think that’s really good point. I’ve done some advisory work for Vietnam, for example. Vietnam, if they make some macro and financial mistakes, if you get a 20% devaluation of their currency, that could be a shock, but it also has the positive stimulative effects. But, China’s the biggest trading nation. It’s a developing country in terms of its institutions, but it’s the biggest trading nation, the second-biggest recipient of FDI, the second-biggest GDP in the world. So, we don’t really know. The one reason I’m nervous about them, just letting the currency completely flow in this situation, is their size and the fact that there’s no history here of flexibility. If they start letting the currency depreciate as the market seems to want it to, we don’t really know how far that could go. And, if Vietnam’s exchange rate depreciates 20-25%, and then maybe it bounces back, they’ve had a couple of episodes. If the Chinese currency does something like that, that I think, would be extremely disruptive to the world economy. So, it’s really a special case.

Well, great. Thank you so much David. A lot of useful takeaways from this conversation.

Good, great to talk to you.

We hope you enjoyed today’s conversation with David. For more episodes like this, you can find us at iTunes, Google Play, and Stitcher. For even more content, look up our Pacific Exchange Blog, available at FRBSF.org. Thanks for joining us.