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Miracle, Financial Crisis, & Recovery in SE Asia


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Title: Miracle, Financial Crisis, & Recovery in SE Asia

Miracle, Financial Crisis, Recovery in SE Asia
  • Politics of Southeast Asia
  • Prof. Edmund Malesky, Ph.D.
  • UCSD

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 littleyou 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
Income/Life Expectancy
GDP Growth ASEAN 5
Life Expectancy ASEAN 5
Life Expectancy All SEA
Here is the World Banks 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
  • 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
    Youngs Tyranny of Numbers.
  • Krugman (1994) Their rise was fueled by
    mobilizing resources increasing inputs of
    machinery, infrastructure, and education just
    like that of the now-derided Soviet EconomyIf
    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.
  • Krugmans 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
  • MIT Macro-Economist in the 50s and 60s
  • Developed a theory of economic growth, whether
    growth is derived from exogenous technological
  • We wont derive the formula, but here are the
    implications of the model
  • Two sources of economic growth
  • 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

Where does technological progress come from?
  • Micro technological progress
  • RD is an important source of technological
  • Learning or Technology Adoption
  • Macro (aggregate) technological progress
  • More efficient resource allocation

Accounting for TFP
Input Accumulation
Solow Residual
Technological Progress
  • gY (1 a) gK a gN a gA

Our Dependent Variable is the Growth of Total
Output (y)
Growth in Labor Market Participation
Growth in Capital Accumulation
Model assumes capital (K) and labor (N) are paid
according to their marginal products, so a
(labor income/gdp)
So TFP is in the Residual
gY -a gA
a gA
  • (1 a) gK a gN

a gA gY - (1 a) gK - a 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 Krugman
  • SEA wasnt 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 stock
  • 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
  • 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 decreasing).

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
  • 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
  • What under-girds input accumulation, and/or
    technological progress?
  • High savings in physical capital
  • - Domestic
  • - (FDI)
  • 2. Financial development (i.e. physical capital
  • 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 orthodoxy.

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
  • Did the Asian Financial crisis signal the end of
    the East Asian Miracle or was it just a blip on
    the overall growth trajectory?

On to the Crisis What Happened?
The Financial Crisis Abridged
  • Western investors loaned money to banks in East
  • 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
  • Countries whose actions set the stage for the
  • 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.
  • 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
  • Countries who survived due to high foreign
    reserves and/or economic fundamentals.
  • 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 investment.
  • 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
  • Countries with current account surpluses
    accumulate high levels of foreign reserves, as
    countries buy their products in foreign
  • 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

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
  • 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
  • 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
  • This kept the price of the baht stable but had
    two other effects
  • Thai Central Bank exposure to Foreign Currencies
  • 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

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
  • 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

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 sink.

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 reserves.
  • 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 recession.
  • 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
  • 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
  • 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 night.
  • 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 15.
  • 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 year??

  • "Excess variability and co-movement of portfolio
    flows and asset prices that is not explained by
    economic fundamentals.
  • 3 Explanations for Contagion
  • Brute Force Economics
  • Emerging Market Portfolios
  • Cascading Information Flows

Contagion Brute Forces Economics
  • Two Variants
  • 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.
  • 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
  • Samphantharaks Common Banker Puzzle.
  • When two countrys borrow from the same banks, a
    crisis in one will trigger a squeeze in the other
    regardless of underlying fundamentals.
  • 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

Contagion Cascading Information Flows (Banarjee
1992 Mendoza 1994)
  • Explanation by Example

Huyen, Prof. Maleskys RA is interested in
decentralization. She checks out a number of
books from the library on decentralization.
Only Prof. Malesky knows the question for the
Politics of SEA Final
Thuba and Mike,Huyens teammates, see her check
out the books and assume she knows something
about the final. They also begin researching
The rest of the SEA class sees Thuba and Mike at
the library checkout counter. Knowing their
proximity to Huyen, they assume she knows
something. Pandemonium strikes, the library is
emptied of books on decentralization, and on the
day of the final, everyone receives a question
about . 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 imitated.
  • When they re-adjusted their portfolios, the
    others followed suit.

Contagion Cascading Information Flows
  • A few things to keep in mind about the theory.
  • 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?
  • I
  • 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 better.
  • "A cute and cuddly IMF wouldn't be doing its
  • 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
Not really so bad, right? Think of parents
bailing a college student out of a credit card
  • Lend money in the short term to get them over the
  • In exchange for the money, ask officials to
    reform their economies to get over the worst
    excesses of crony capitalism
  • Require them to maintain high interest rates to
    entice capital into staying in the country
  • Ask for prudential fiscal reforms such as
    balanced budget, paying back loans, and
    committing to inflation.
  • Wait for investor confidence to return and the
    viscous circle to turn into a virtuous circle.

And Robert Rubin, U.S. Secretary of the Treasury,
had successfully employed the strategy in Mexico
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
  • 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 run.
  • 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 right?
  • 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
  • Malaysias logic after attempting orthodoxy under
    Anwar Ibrahim.
  • 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
  • Investors needed to sell foreign exchange to
    government at a fixed rate.
  • Short-term investment was limited.
  • Investors were upset and sharply criticized the

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
Why is growth not at the same high rates?
  • 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 China)
Poverty is also declining
  • 228 million people raised above 2 a day.

Reserves Under Pressure in Some Countries due to
Todays Crisis
Never Again No more BOP exposure, impacted SEA
economies have become creditor nations.
Running Positive Current Account Balances
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 Environment?
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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