Asia's Financial Crisis:
Its Causes and Unlikely Impact on Australia
By Peter Swan

Through the period 1990-1996 the South-East Asian economies were by far the fastest growing in the world (see Chart 1). Average growth rates of between 8% and 10% were the norm for many economies such as China, Thailand and Malaysia. While the term ‘Asian Miracle’ has reverberated around the world over the last 25 years, these outstanding growth rates are not due to the corporatist and state-interventionist industry policies that many South-East Asian governments are credited with introducing to exploit emerging technological opportunities.

It is true that government support and underwriting has encouraged the development of the semiconductor industry in Taiwan and Malaysia, the electronics and chemical industry in Singapore and the motor vehicle industry in South Korea. This does not mean there is a secret recipe to create virtually unlimited wealth by protectionist ‘infant industry’ policies carried out at the expense of captive domestic consumers. The Asian Tigers do not possess a secret blueprint hidden in their genetic makeup to succeed. To the contrary, massive growth has been underwritten by, on the whole, sound fiscal policies, relatively low inflation, a strong export orientation, a very high savings rate (as high as one third of GDP), the release of labour from traditional sectors, considerable investments in providing for a more educated workforce, and the attracting of 40% of the private capital going to developing countries in the 1990s.

Studies indicated that about one half of the income growth could be explained by higher resource inputs. In other words, the outstanding performance of the region has been due largely to the adoption of sound, if fairly conventional, economic policies and the application of more inputs. Productivity growth has not been outstanding. If anything, the growth has been despite interventionist and protective policies introduced in some countries. The huge domestic and foreign investment incorporating the latest technology has also allowed the region to ‘catch up’ to the more technologically advanced West. However, lack of transparency in most of these markets has alarmed investors. Just as the Japanese growth miracle died in the late 1980s, such growth was doomed to slow at some stage. This general point is made by Christopher Lingle (1997) in his controversial book, The Rise and Decline of the Asian Century, and by Paul Krugman (1997, 1998) of MIT. However, it did not have to end with a bang in 1997.

So what went wrong? Most economists, including myself, have a great deal to be modest about in this regard because very few if any both foresaw the crisis and specified its timing.

What has caused the crisis?

Domestic savings were not sufficient to drive all the South-East Asian economies to continual rapid economic growth. Thailand and Malaysia ran current account deficits amounting to 10% of GDP funded by net private capital inflow throughout the 1990s. Indonesia, China and South Korea ran smaller but still substantial deficits in the 3% to 4% range (see Chart 2). Serious policy mistakes were made. Thailand, Malaysia, Indonesia and South Korea, along with Hong Kong, attempted to peg their currencies to the US dollar. This gave these regional currencies an advantage when the yen was strong and the US dollar was declining against other currencies. Export-led growth was facilitated. In the nineties, however, US policies that generated a strong greenback set the scene for disaster for those currencies pegged to it. China devalued its currency towards the end of 1994 and at the same time brought in export subsidies. South- East Asian exports in competition with China were hit hard.

The Japanese regulators, including the Ministry of Finance, refused to do anything about the huge bad debts of around US$366 billion run up by Japanese banks during the asset pricing bubble of the late 1980s. Supposedly, all the land in Australia could be purchased for less than the grounds of the Imperial Palace in Tokyo. Low interest rate policies designed to help the technically insolvent Japanese banks and kick-start the stalled Japanese economy led to massive capital injections into South- East Asia, attracted by high domestic
interest rates.

Foreign borrowing by Thai financial institutions at 5% or 6% in US dollars looked attractive when domestic investors were willing to pay in excess of 14% to fund highly speculative real estate and condominium developments. Private sector borrowing amounted to about US$60 billion. Restrictions on foreign investment in, and ownership of, financial institutions meant that they were inexperienced and poorly managed. There was no proper oversight of the financial soundness of these institutions by Thai regulatory authorities. While the asset pricing ‘bubble’ was alive and well in Thailand, the current account deficit increased as exports were priced out of the market and imports flooded in. There are currently many hundreds of thousands of condominiums in Thailand that are occupied only by mosquitoes, due to overly optimistic expectations of demand that never eventuated.

The Thai government either believed that a so called ‘stable’ currency was necessary to attract foreign investors, or was sufficiently weak to be dictated to by borrowers with large repayments falling due. In either case, the government, together with officials who should have known better, maintained the baht at the same fixed rate with the US dollar as conditions worsened, rather than allowing the baht to float, as does the Australian dollar. No fundamental actions were taken to make the baht viable as other currencies were relatively depreciated. Exceedingly high interest rates leading to the likely collapse of the Thai economy would have been required to defend the indefensible. In a freely floating exchange regime the exchange rate adjusts so as to equate supply and demand for the currency. This makes it much harder for speculators to make virtually certain gains at the expense of the nation’s taxpayers.

Officials, often allied with interested parties, believe that they are immune from so called ‘speculative’ attack when they set rates at levels they know to be entirely unrealistic. For example, some years ago the Australian Wool Reserve Price Scheme continued to purchase virtually the entire Australian wool clip and nearly all private stockholdings worldwide at prices far higher than any foreign buyer or consumer was willing to pay. Eventually, the Australian Labor (Keating) Government walked away from it, realising there were limits to the extent that taxpayers were willing to pay to bail out such stupidity. The collapse of the Wool Reserve Price Scheme and the huge stockpile which still overhangs the market are as much due to the actions of Australian woolgrowers producing wool to satisfy the irrational demands of the Wool Board as they are a consequence of international speculation.

Similarly, with respect to the currency. The Thai Central Bank could use US dollar reserves to protect the artificially high value of the currency. Perhaps the aim was to protect poorly supervised domestic financial institutions that had borrowed massively in US dollar denominated currency to underwrite the speculative building and asset boom under way. If the baht depreciated, these borrowers would be unable to repay their loans in US currency. Only a finite supply of US dollar reserves could be used to protect the overvalued baht. Foreseeing what was about to happen, traders would rationally sell baht to the Central Bank in exchange for dollars knowing that as the supply of dollars dwindled they could not lose. In fact, the very sale of baht made the subsequent collapse of the exchange rate inevitable as all existing reserves were dissipated. No malevolent intervention by foreign speculators of either Jewish or Gentile origin is necessary to explain the collapse of the Thai baht, as the MIT economist, Paul Krugman (1997, 1998), has pointed out.

Recently, the Thai Central Bank has admitted that its actions are going to cost the Thai taxpayer dearly for many years to come. The Bank lost US$23 billion in its unsuccessful action to prop up the baht prior to its collapse on 2 July 1997 when it was floated. In addition, it lost another US$25 billion or A$37 billion it its attempts, also unsuccessful, to prop up failing financial institutions. Fifty-six institutions were closed last December and less than half the assets are expected to be recovered. The loss on the institutions alone is more than the entire Thai budget (see Sydney Morning Herald, 6 March 1998:26). It is doubtful if the Central Bank of Thailand had very much control over losses made in its name when it is essentially subject to ‘persuasion’ from the government and finance ministers. Greater independence, such as that possessed by the New Zealand Central Bank, would be of particular assistance to central banks in the region.

The guiding hand of the state helped the private sector make huge investments in Malaysia and elsewhere in South-East Asia in production facilities for computer chips and electronics generally. In the last few years the demand for this kind of production from South-East Asia has fallen greatly. Similar misguided industry policy in South Korea contributed to a glut of production facilities in the vehicle industry. Corporate sector borrowing has reached about 200% of GDP with a debt to equity ratio for major companies in excess of 400% and bankruptcy rampant. In 1997 13,971 firms in South Korea went bankrupt. The debts of eight large chaebol (conglomerates) alone amounted to US$21 billion. Strong union pressure has contributed to an enormous rise in manufacturing wages, putting them at well in excess of UK levels, and perhaps double that of some of their competitors.

The Chairman of the US Federal Reserve, Alan Greenspan, has commented adversely on the turnaround in capital inflows in South-East Asia from 8% in 1996 to minus 2% in 1997: the turnaround does ‘not appear to have resulted wholly from a measured judgement that fundamental forces have turned appreciably more adverse. More likely, it is a process that is neither measured or rational …’ His remarks have been endorsed by the Governor of the Reserve Bank, Ian Macfarlane (1998). The Deputy Governor, Stephen Grenville (1998), points out that ‘as often happens in financial markets, euphoria turned to panic without missing a beat.’

These charges of irrationality in terms of international portfolio investment are not borne out by existing research prior to the meltdown that finds, to the contrary, such flows reduce the cost of capital in the recipient country and do not increase the volatility of equity returns. Nor is there evidence that uninformed investors produce contagion effects (see Stulz, 1997, and the references cited therein). Moreover, the currency movements and turnaround in capital flows seem to be a consequence of more serious underlying problems rather than causal factors.

A combination of large current account deficits, inflexible over-valued exchange rates, considerable under-utilised capacity and enormous private sector borrowing underwritten implicitly by the State were common to Thailand, Indonesia and South Korea. The financial meltdown contagion spread rapidly. First, from Thailand to Indonesia and then from Indonesia to Malaysia and South Korea. The mechanism by which it spread appears to have been the attempted withdrawal of short-term loans by banks once they recognised the similarity in conditions between those South-East Asian countries and South Korea. The monetary authorities were unable to resist the downward pressure on the won, exchange reserves were depleted and in December 1997 an IMF bailout of record proportions, US$59 billion, was negotiated. By late January the won was about 40% lower than in July 1997.

The Tobin Tax

Emeritus Professor James Tobin, Nobel Laureate in Economics, is one of many who believe that the fundamentals in South-East Asia are sound: ‘South Korea and other Asian countries are being punished for offences they did not commit. They have inflation and government budgets under control.’ He sees the financial turmoil in South-East Asia as being due to banks failing to rollover short-term loans, leading to a panic in which every short-term investor is trying to withdraw funds before all the other investors do likewise.

In his view the culprit is liberalisation and globalisation of financial markets. In common with Dr Mahathir Muhammad of Malaysia, he believes that speculation is bad, even it the culprits are not members of the Jewish faith. To overcome the problem with liquid international capital markets and short-term speculative currency flows he has revived his earlier (1971) proposal for a tax on currency transactions, to be administered by the IMF.

Interestingly, Australia is at the world forefront in terms of experience both with administering a Tobin-style tax and in terms of understanding its implications. All transactions on the Australian Stock Exchange (ASX) have been subject to such a tax, called stamp duty, well before Professor Tobin became an advocate of the idea. Partly as a result of research by Professor Michael Aitken and myself (1995), the Queensland government halved the rate of tax from July 1, 1995. The market capitalisation of the top 90 stocks rose by $4 billion within three trading hours of the announcement. Far from adding to volatility as short-term speculation is encouraged, as predicted by Professor Tobin, the result was the opposite. Share price volatility fell substantially as turnover rose by about 20%. Transaction costs other than the tax component itself fell substantially. The net gain to investors, after allowing for the revenue loss to governments, is of the order of $4·5 billion in present value terms (Aitken and Swan, 1997, 1998).

What this indicates is that a tax on foreign currency flows is likely to be counter-productive rather than helpful. However, as the Economist (24/1/98:71) points out, not only is the tax likely to be easily avoided but its impact is likely to be largely felt by ‘local firms desperately trying to hedge or repay debts denominated in dollars,’ rather than by foreign speculators. An alternative along the lines of Chile is to limit short-term loans and bank deposits from abroad. It would appear in the case of Chile that, while there has been a reduction in these sources of funds, they have been largely made up by other sources of funds. Hence, the net position has not altered much.

The current situation in Indonesia

The crisis in Indonesia is as much political as economic or financial in nature. The refusal of President Suharto to comply with the IMF guidelines, in particular their requirements to reduce the massive transfers to members of his own family, has led to a meltdown of the currency. The rupiah fell to an intra-day low of almost 17,000 to the US dollar, compared with about 2,500 in mid-1997. This is a collapse of nearly sevenfold magnitude. It has slightly recovered since then, but is still indicating a massive level of devaluation. With severe inflation induced by high import prices due to the devaluation, riots, student protests and scapegoating of the Chinese minority population in Indonesia, the situation is looking very grim (see, for example, SMH 16/2/98). Most Australian companies have evacuation plans in place.

When President Suharto was sworn in to his seventh five year term in March 1998 he said ‘we will never enjoy again economic growth such as we have experienced for more than the past quarter of a century. … As a nation, we can no longer afford to lead an affluent life.’ His outlook for Indonesia is pessimistic even if his own family is well catered for. The US$43 billion dollar aid package from the IMF is under threat because of President Suharto’s desire to set up a currency board to peg the rupiah at an artificially high exchange rate, given the current lack of confidence in both his health and his economic leadership.

Perhaps the biggest stumbling block of all is his unwillingness to make any of the reforms to the Indonesian economy that would hurt the major monopoly businesses of his children and the very large economic gains they have made at the expense of the Indonesian people. The fear is that if a currency board were to be established with the rupiah pegged at an artificially high exchange rate it would be short-lived. President Suharto’s family would, it is believed, transfer wealth from rupiah into US dollars at the artificial rate and then the currency board would collapse, leaving the country worse off than it is at present.

The Howard Government’s message to the IMF is to be more sympathetic towards the difficulties being faced by the Indonesian government. The problem confronting the IMF, the US public, and in particular the US government and Mr Clinton, is that there is no viable alternative to President Suharto in Indonesia. Nationalism, and in particular religion, together with the army are the only forces that are likely to be able to hold the archipelago together. Nepotism could be the factor that impoverishes the Indonesian nation.

China

So far China has managed to avoid the crisis situation that has occurred in Indonesia, and in particular has been able to maintain the value of its currency and that of Hong Kong’s. This is in part because of large foreign exchange reserves and an influx of investment from multinationals and overseas Chinese. It recently announced a A$48 billion package to bail out its four major state banks due to bad loans. There is a great deal of pessimism about the extent of the bad debt problem in China with unofficial estimates of these bad debts ranging from about 18% to an astonishing 60% of GDP. GDP last year was around US$900 billion. Any truth to these figures would indicate that the Chinese banks’ bad debt problems are really very severe.

Clearly, China is very worried about the implications of the South-East Asian meltdown because of its own precarious position. In fact it has already announced that it will dismiss up to half of its higher ranking public servants, possibly as many as four million bureaucrats (SMH 7/3/98:19). This would be expected to reduce both the bureaucracy and corruption, endemic in China. The effective bankruptcy of its banks and its inflated bureaucracy which has bred massive corruption are really not as severe for China compared with the position of its State Owned Enterprises (SOEs), which employ about 100 million people. However some commentators believe that jobs for nearly 50 million of these would be lost if the necessary reforms to the state-owned sector are undertaken by China’s economic supremo and Prime Minister, Mr Zhu Rongji.

In essence, the loss-making SOEs are part of the welfare system. With unofficial estimates of unemployment as high as 20% and climbing, China could be in for an extraordinarily difficult and precarious time with the development of more social unrest and greater political instability. If, as seems probable, China’s exports begin to be priced out of world markets it will be forced to devalue the yuan. The lack of convertibility of the currency is no different from an exceedingly high Tobin tax and will not protect it. The current peg for the Hong Kong dollar is unlikely to survive any adjustment to the yuan.

Japan

Unfortunately, the Japanese economy is relatively stagnant, and extraordinarily vulnerable to the Asian economic crisis. In fact, the very slow growth of the Japanese economy over most of this decade has been one of the factors giving rise to the Asian crisis. The very weaknesses in the Japanese economy make it very unlikely that the Japanese will be able to intervene with large investments to ease the crisis in the rest of Asia (see, for example, SMH, 18/2/98:10). Intervention to assist South-East Asia is even more unlikely given the huge losses of the Japanese banks and the revelations of corruption in the Ministry of Finance and in the banking system itself in Japan.

The implications for Australia

I have painted a picture of the Asian scene, warts and all, and none of it looks particularly hopeful for Australia and our economy. If the Chinese yuan devalues then we are going to see even further falls in the Australian dollar and realignments of world currencies. The Australian dollar has already fallen about 15% relative to the US$ due to the Asian crisis, and this has helped to preserve the competitive position of Australia’s exports. Had the Reserve Bank intervened in order to maintain the then existing parity with the US$, depleted reserves and driven up interest rates, Australia might well be in the same crisis position as some of our East Asian neighbours.

Chart 3 sets out the changes to Australia’s imports between 1988 and 1995. The growth has been from A$42·5 billion to A$77·5 billion. It can be seen from the chart that the major change over this period has been the declining share of imports from Japan, falling from 27% to 21%, and a rising share of imports from China with a rise from 3% to 7%.

Chart 4 shows the changes to Australia’s exports over the same period. Once again there is a rise from around A$42 billion to A$72 billion, but still well short of Australia’s imports – indicating that we are still running a trade deficit. It can be seen that again the major change has been a decline in Japan’s share from 40% to 34%, with a major rise of exports to Korea from 7% to 12%. This makes Australia quite vulnerable. Exports to the USA have shrunk from 15% to 9%, while exports to Singapore have gone up from 5% to 8%, and to New Zealand from 7% to 11% of the total.

The most immediate transmission mechanism for the Asian turmoil to translate its impact to the Australian economy is through our trading arrangements and, in particular, through our exports. Australia’s trade with key Asian nations was reduced by up to a third in the December quarter of 1997 (SMH, 21/02/98). Of about 200 companies surveyed by the Metal Trades Industry Association, 57% reported export orders reduced. Thailand, the first country to be hit with the crisis, has massively curtailed its imports, which have fallen by about 24% in the last three months (the latest three months of 1997). Industrial production has also fallen very considerably, from a position where it was growing very rapidly to an 11·4% decline towards the end of 1997.

Estimates put out by the tourism industry suggest that operators could lose up to A$5 billion from the collapse of Asian tourism, and with more Australians taking cheap Asian holidays. Australia’s farmers expect to lose up to A$1 billion, or 5%, in income this year, as Asian export markets dry up. Cattle, wool and cotton growers are likely to be the hardest hit. The Howard government has already announced that it will subsidise sales of wheat to Indonesia, but these kinds of subsidy schemes may be extended to other products. Australia’s vehicle exports have been hard hit with Mitsubishi announcing an almost 50% fall in orders (SMH, 2/03/98). Falling Asian tourist numbers are impacting on casino turnover.

An area in which Australia’s universities are potentially major losers is in foreign students coming from South-East Asia. At the moment overseas students contribute about A$3 billion to the Australian economy, making it one of Australia’s most profitable and fastest growing export industries – that is, until recently. There were 143,000 students coming to Australia in 1996. Nearly 85% of students come from Asia, with South Korea being the principal source country; then Indonesia, followed by Malaysia, Japan and Singapore. India is relatively small by comparison. By far the most popular courses at university for overseas students are business administration and economics, including finance, with only 12% studying science.

The universities with the largest numbers of overseas students are Monash (around 5,400), the Royal Melbourne Institute of Technology (nearly 5,000) and the University of New South Wales (nearly 4,000). For those economies hardest hit by the meltdown, like Thailand, Indonesia and South Korea, there is likely to be a net reduction in student numbers in the next year or two, compared with the very considerable growth that has been occurring over the last few years. Fortunately, so far university enrolments have not fallen overall. However, the number of visa applications from some countries such as Malaysia and Hong Kong has fallen by as much as 45% (SMH, 10/3/98:9).

To some extent, growth in student numbers from other countries may replace declines in student numbers from the most affected economies. Stagnation or decline in overseas students is going to make things very difficult for universities in a period of declining funding, particularly declining funding from the Commonwealth government. The internal distribution of funds, with local undergraduate economics/commerce students paying more in HECS levies than internal student allocations at many universities, indicates the magnitude of cross-subsidies taking place internally within universities, which discriminate against business/economics/commerce students.

Current loss of export income to Australia is so far relatively minor, but the impact of the Asian meltdown is not so much a question of whether it will occur, but when. In fact its impact is likely to be felt increasingly in the next few months. The impact on unemployment, already over 8% in Australia will take longer, but there will obviously be, in the longer term, adverse consequences for employment. The real issue is whether the contagion will spread to other major economies. The extraordinary growth in the Dow Jones Index in the United States, leading to very high price/earnings ratios at almost record levels, means that the market is highly volatile – look at the big changes in October of last year, with huge fluctuations in the global share markets.

The Asian currency crisis will increase US imports due to low prices of Asian export goods, and the very high US dollar is already curtailing US exports and adding to the current account deficit. Apart from the benefit to US terms of trade, the result may be the trigger that leads to a major correction to the Dow Jones and to share prices globally. So far the US economy has been growing in a very healthy manner as part of a very long-term boom. But any slowdown of growth in the US economy and relative stagnation in the rest of the world could once again make things very difficult for Australia in the next few years.

What this indicates is the complacent attitude taken by the Howard Government to reform. Potential hand-outs of hundreds of millions of dollars to the Darwin to Alice Springs railway and similar ventures, together with increased protectionism (or the slowdown in removing protection to motor vehicles, footwear, clothing and textiles), are further signs that the hard decisions are not being made fast enough in Australia. In the lead up to the election I believe we will see more announcements such as the complete privatisation of Telstra to show that Australia is willing to face business realities in the 21st Century.

We cannot afford such a complacent attitude in a time when there are an enormous number of reforms that ought to be being made in this period of relative prosperity and good growth. In the tax area it is not the GST but a requirement to index capital taxes for inflation while it is low and to remove highly inefficient State taxes, such as stamp duty on both share transactions and houses and bank deposit/withdrawal taxes. More privatisation combined with greater competition (e.g. the electricity industry in NSW) is required, together with labour market reform. The obstructionist role of the Senate has, in my view, not served Australia well in this regard.

Unless we are willing to make major reforms, the Australian economy is more likely to be vulnerable to the Asian crisis, which is certainly more than a financial crisis. It is becoming an economic crisis and a crisis of confidence in governments, especially in Indonesia. Only if we overcome complacency do we have a hope of being relatively immune to the swirling turmoil that could well engulf us, coming from South-East Asia.

References

Aitken, Michael J., and Peter L. Swan, 1995, ‘The cost and responsiveness of trading equity in Australia,’ Working Paper, Securities Industry Research Centre of Asia-Pacific, Department of Finance, University of Sydney.

Aitken, Michael J., and Peter L. Swan, 1997, ‘How Much Did We Gain from the Halving of Stamp Duty,’ ASX Perspectives, 2nd Qtr: 4-10.

Aitken, Michael J., and Peter L. Swan, 1998, ‘Highlights of the Impact of a Transactions Tax on Investors: The Case of Australia’s Stamp Duty Reduction,’ Working Paper, Securities Industry Research Centre of Asia-Pacific.

Grenville, Stephen, 1998, ‘The Asian Economic Crisis,’ Talk to Australian Business Economists and the Economic Society (NSW Branch), Sydney, 12 March.

Krugman, Paul, 1997, ‘Currency Crises,’ Prepared for a conference, October.

Krugman, Paul, 1998, ‘What Happened to Asia,’ Conference Paper in Japan, January.

Lingle, Christopher, 1997, The Rise and Decline of the Asian Century, Asia 2000 Ltd, Hong Kong.

Macfarlane, Ian J., 1998, ‘The Asian Situation: An Australian Perspective,’ Talk to the American Australian Association, New York, 11 March.

Stulz, Rene M., 1997, ‘International portfolio flows and security markets,’ Working Paper, Ohio State University, August, prepared for a National Bureau of Economic Research conference.

Reserve Bank of Australia, 1997, ‘Semi-Annual Statement on Monetary Policy,’ Reserve Bank Bulletin, November: 7-19.

Reserve Bank of Australia, 1998, ‘The Economy and Financial Markets,’ Reserve Bank Bulletin, February: 1-25.

Peter L. Swan is National Australia Bank Foundation Professor of Finance and Head, Department of Finance, University of Sydney. An earlier version of this paper was presented to the Chinese Australian Academics Society on 13 March 1998. The author wishes to thank Jay Muthuswamy, Jeff Sheen and Lily Rahim for their assistance with source material. 

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