Causes and Prevention of External Debt Crises

1
Causes and Prevention of External Debt Crises

• Yen Kyun Wang
• Department of Economics
• Chung-Ang University, Seoul
• July 6-7, 2004
• UNESCAP, Bangkok

2

• Introduction
• Asian financial crisis was a debt crisis
  (over-borrowing by private firms).

3

• Many changes after the crisis.
• -But slow structural adjustment
• -Directions for reforms on corporate governance,
  and conglomerate (chabol) are debated Western
  style or Traditional style?
• Not adequate measures yet against volatile
  short-term capital flows-receiving, source
  country or global level

4

• In Korea per capita income10,000 in 2003, same
  as that of 1996
• A Author Causes- weak fundamentals and policy
  distortions, aggravated by herding and contagion

5

• Will Discuss
• Over-investment mechanism
• New method of calculating real effective exchange
  rates showing large degree of overvaluation in
  East Asian currencies before 1997
• Others
• Crisis prevention measures

6

• Causes of external debt crisis in East Asia
• Mechanism of over-investment and over- borrowing
  a mix of
• export-oriented , conglomerates-based
  economies, excessive governmental intervention

7

• Boom period rapid expansion of investments of
  large corporations and chabols
• Downturn period further expansion,and no
  contraction of facilities of firms due to
• - implicit government guarantees, too-big-
• to-fail legacies to large firms and banks
• Government rescuing failed large firm
• loans based on mutual payment guarantees among
  chabol affiliate companies
• - no strict screening by banks of investment
  projects

8

• Weak corporate and financial governance
  system-small shareholders with no voice
• Convoy-style management of chabol saving weak
  firms,setting up new firms by funds of strong
  firms
• Lay-off was illegal, weak social security net
• Strong labor unions

9

• Desire of large shareholder to prevent dilution
  of ownership prefer debt to other means
• Average debt/equity ratio, 1988-1996
• - Indonesia, Thailand, Japan 200.
• Korea 347
• - in manufacturing sector in 1997
• Korea 396. Japan 200, US 150, Taiwan 82

10

• Bank loan growth GDP growth
• -Korea 17.1, Phil. 22.8, Thailand 10.4,
  Indonesia 5.8 Singapore 2.8,Japan 1.28
• Bank loan growth industrial production
  growth
• - Indonesia 22.0, Korea 9.4, Singapore 6.9,
  Japan 1.1

11

• Growth rates (total assets, share capital, sales)
  of firms of Korea much higher than those of
  Taiwan
• Net Profits of firms of Korea a quarter of those
  of Taiwan, half of those of US.
• Investment rates of East Asian countries 30-40
  of GNP
• -Philippines, Taiwan 20-25

12

• Incremental capital output ratio increased
  substantially in the region,1987- 1992 to
  1993-1996
• Interest Coverage Ratio less than 1(business
  profit before tax and interest payment is less
  than interest cost) in Korea 11 out of 30 top
  chabols

13

• In 1979-1980, external debt crisis occurred in
  Korea, due to over-investment in heavy and
  chemical investment projects by government during
  1973-79,
• aided by oil shocks, high interest rates,
  internal political turmoil
• -19.7 depreciation, industrial restructuring and
  economic Stabilization programs

14

• Overvaluation and large current account deficits
• -Many writers(e.g., Ann Krugman, Ronald Mackinon,
  Roubini) no overvaluatin in East Asia before
  1997
• - they used CPI or WPI as deflator in
  calculating real exchange rates
• - years before 1997, export prices did not
  increase much, low inflation, but rapid increase
  in wage rates in East Asia due to boom and
  shortage of skilled labor
• -New calculation of real effective exchange
  rates using unit labor cost( base year1985)

15

• Exchange rates in Korea 30 overvalued in 1996
  (pegged nominal rate, 59 increase in ULC) using
  ULC as a deflator
• -If WPI is used, 6 overvalued.
• -if CPIs are used, 16 overvalued
• similar in other countries
• In China in 1994, 50 depreciation
• In Japan in 1996, 16 depreciation
• - eroding competitiveness of export goods of
  EA countries

16

• Current A/C deficits/GDP(danger level 4-5) 9
  in Thailand in 1995 and 1996
• - Malaysia 10and 3.7in 995,1996. Korea 5
  in 1996.
• Indonesia 4, 1995-97.
• Philippines 5-7 , 1993-97

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• Conventional rules of thumb for danger levels
  external debt should not exceed of 40 of GNP or
  200 of exports, and debt service ratio not
  exceed 25
• Foreign /GDP Indonesia 56-69, Phil. 50-71 in
  the 1990s. Malaysia 40, Korea 28 in 1996
• Foreign debt/exports 220 in Indonesia(danger).
  127 in Thailand, 120 in Philippines
• Debt service ratio 37 in Indonesia in 1996,
  Phil 14

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• Foreign liabilities/assets(relative to BIS
  reporting banks)
• -1103 in Thailand. 400 in Indonesia, 375 in
  Korea
• -Serious mismatch. Borrowed short, lent long in
  foreign currency

19

• Boom-bust cycle, busting of asset price bubble
• -Asset price bubbling, building permit declined
  drastically, many construction companies bankrupt
• -In South East Asia, drastic decline in asset
  prices,stock prices, property stock prices,

20

• Poor corporate and financial governance
• -maximizing interests of chabol oweners
• -group chairman had big power, but no legal
  responsibilities, standing above law
• -financial institutions under direction of the
  government, government-directed loans.

21

• Deterioration of terms of trade
• In Korea -12 in 1996, -11 in 1997
• Unit value index of electronic exports
• 100 in 1995, to 31 in 1996
• Share of electronic exports in total exports in
  1996 19
• UVI of total exports 100 in 1995 to 86.6 in 1996

22

• Lack of transparency in financial statements of
  corporations and banks
• -Was different from western accounting practices
  announced bad loan rate-6. Perceived rate-30

23

• High share of short-term debt in the total
• Thailand 61-72 in 1994-95, Korea 50 in 1996
  (58 end of 1996)
• Short- term debt/foreign reserves
• -In 1996, 203 in Korea.
• -177 in Indonesia. 100 in Thailand. Philippines
  80
• (Short term-debt debt service)/foreign
  reserves in 1996 Korea 243, Indonesia 294,
  Thailand 123, Philippines 137

24

• M2/foreign reserves, years before 1997
• - Korea 6-7. Phil 5, Thailand 4, China 9-26
  Taiwan 5-6
• Average annual ratio of Net FDI/GDP in 1992-96
• -Korea 0.2. 0.7 in Thail, 1.8 in Indonesia,
  1.7 in Phil, Malay 6.2

25

• Rigid labor market and inadequate education
  system
• -lay off was illegal
• -enrollment in secondary school in the same age
  cohort in Thailand 30,, Indonesia 20.

26

• Wrong sequence of liberalization
• Capital liberalization first before strengthening
  financial institutions
• Weak financial system, not exposed to foreign
  competition, very vulnerable to short-term
  capital flows
• Low profit rates of banks, large bad loans, large
  share of government directed loans

27

• Poor supervision and regulation of financial
  institutions
• - lack of information on transactions of funds
  abroad, no limit to risk exposure of financial
  institutions
• - no strict evaluation of lending projects

28

• Moral hazard on the side of international
  lenders
• Over-lent, believing in bail-out by the
  government
• Gov. policy failure in handling failed companies
• -direction to keep lending failed large firms
• -Congress holding submitted laws to allow firing
  by firms

29

• Prevention measures
• Export-oriented growth
• Economic reform and market opening
• -deregulation
• -reducing government intervention
• Correction of over-borrowing mechanism
• -Ceilings on total investments (25 of net
  assets) and maximum debt/equity ratio of 200 of
  chabol member firms - restricting investments in
  Korea

30

• Strong corporate and financial governance
• Transparency in business management and
  accounting
• Correction of continuous current account deficits
  and large debt
• Managing boom inflows of s-t capital, macro and
  micro policy

31

• Exchange rate system
• Flexible basket currency system, ensuring
  constant real exchange rates and current account
  balances would be better than floating or fixed
  exchange rate system
• use unit labor cost indices as a deflator, when
  calculating real effective exchange rates- better
  indicator of international competitiveness of
  tradabe sector

32

• Control of excessive short-term capital flows
• Short-term loans, portfolio capital
• -Impose tax such as Chilean reserve requirement
  w/o interests
• Development of domestic demand oriented and
  service industries
• - deregulation, free economic zones, market
  opening and reforms.

33

• Structural adjustment
• Leave non-viable firms to creditors, not
  government
• Strengthening regulations and supervision-limit
  exposure to risk
• Competitive education system , more investments
  by the government.

34

• Collection Action clauses and Sovereign Debt
  Restructuring mechanism
• Avoid moral hazard to international lenders
• Provide information on the international capital
  market to developing countries

35

• Regional surveillance and financial
  cooperation
• Real side business tie-ups, FTAs in some or all
  industries, education and training, environment,
  arms reduction
• Financial side
• -Exchange rate cooperation
• -Pooling some of international reserves at
  private banks and use it in need
• -Asian Monetary Fund
• -Establish a regional crisis prevention
  framework, conducting on-the ground analyses
  using data collected within the region