Manage Financial Flow

10.2 Timing is another vital issue.  Before adopting any policy in whichever direction, the government ought to ensure that all pertinent parties are ready.  For instance, the Asian financial crisis in 1997-98 was partly due to the fact that financial deregulation was opted when domestic financial institutions were immature to cope with strong competition from abroad while the central monetary authorities were not adequately experienced in supervision and regulation, without good timing of policy implementation, the government could easily encounter vicious circles.  Two explicit examples of these circles occurred when flotation of exchange rate was postponed and when ailing financial institutions were rescued.

10.3 Business and political influences are also important factors which may lead to some policy inconsistency and/or improper timing.  That is understandable as decision-makers of macroeconomic issues frequently encounter some trade-off.  But what the central authorities should constantly bear in mind is that macroeconomic policy errors regarding their consistency and timing are often difficult to rectify and tend to have a series of adverse repercussions.

10.4 formats as well as end uses of foreign borrowings are very crucial because they have immediate implications upon the vulnerability as well as debt servicing capacity of debtor countries.  The countries which leaned towards foreign direct investment (e.g. Malaysia and the Philippines) were less susceptible than the ones which heavily counted upon short-term loans (e.g. Thailand and Indonesia).  The degree of vulnerability is highly meaningful, especially in the case of small developing countries since capital flows are not only mobile to large extent but also huge relative to those countries’ foreign exchange reserves or monetary aggregates.

10.5 In short, the financial crises that Southeast Asian countries encountered were outcomes of mismanagement of capital flows together with mishandling of financial deregulation.

8.2 Two central policy issues, exchange rate and handling of problems at private financial institutions, deserve strong attention, since not only did they involve various parties and generate widespread repercussions, but they actually spurred up critical tension in financial markets and weakened investor confidence to a large degree.

8.3 In 1990 Thailand started recognizing Article VIII of the IMF, which led to three rounds of foreign exchange control liberalization (in May 1990, April 1991, and February 1994).  Another pivotal episode was the establishment of the Bangkok International Banking Facilities (BIBF) in March 1993 to serve as groundwork for international banking services and mobilizing capital across border to support regional economic growth.  The Bank of Thailand (BOT) quoted more competition and development of financial system as underlying rationale.  An immediate question is whether the BOT was aware that once local exchange rate was not market-determined, opening up the country’s capital account would totally nullify effectiveness of monetary policies, and since capital inflows (outflows) induced by higher (lower) domestic interest rates would cancel the intended tightening (loosening) of domestic liquidity.  Conceptually, the only discretionary instruments that remained effective were exchange rate and fiscal policy.

8.4 Three perplexing points about BOT’s actions are as follows.  First, according to internal reports, before starting BIBF, BOT was well-aware that liberal capital transactions would limit the capability of monetary policy if exchange rates continued to be tightly pegged to the basket.  Second, that basket-pegged exchange rate policy, which was initiated in 1984, was kept in use even after the capital account was liberalized and BIBF went into effect.  Third, fiscal policy was largely neglected as a means to tone down looming inflation and current account deficits.  Instead, the BOT resorted to higher interest rates so as to contain credit expansion and expenditures.  Eventually, influx of capital inflows, induced by interest rate differentials and minimal exchange risks, instigated overheating of the economy.

8.5 Given that the authorities knew beforehand that liberalized capital account could negate monetary policy, their hesitation to float exchange rates must have been an outcome of conservatism and/or business plus political influences, particularly those heavily hinging upon external debts.  One excuse for restricting exchange rate movement was to avoid bankruptcies of debtors and to uphold credibility of the nation.  However, a vicious circle or greater difficulties occurred as rigid exchange rates further encouraged foreign borrowings or higher exchange rates further encouraged foreign borrowings or higher external indebtedness which magnified the risk of bankruptcies, lower credibility, and other financial disruptions if floating exchange rate regime was chosen.  Therefore, several parties voted for postponing a flexible exchange rate system again.  In short, these exchange rate predicaments of Thailand demonstrate two prominent lessons for developing countries.  First, policy consistency should be continually adhered to.  For example, should foreign exchange funds be allowed to move in and out of the country liberally, their prices or exchange rates ought to be determined by market force of given an equal degree of freedom.  Second, once any policy change is deemed conceptually proper, it should be immediately implemented; delaying it for whatever reasons tends to complicate the matter.

6.1 One very important reason why Thailand spearheaded the Asian financial crisis is that not only did a dominant portion of her external debts belong to financial markets which were highly sensitive to up-to-date news (unlike foreign direct investment), but an enormous share of those financial debts were short-term (Table 2).  Making the country’s financial status extremely vulnerable to changes in market sentiments.  Consequently, sudden decrease of investor confidence can, and did, spur foreign creditors or investors to immediately retrieve their funds.  Simultaneously, once panicked by possible or further currency devaluation and therefore more debt burden, short-term debtors rushed to terminate, instead of rolling over, their external debt obligations.  These pressures generated primary momentum behind detrimental net capital outflows from Thailand in 1997.

6.2 It should be noted that the Southeast Asian crisis differs from many previous crises in that the affected countries had high saving rates and government surpluses.  However, their excessive investment, rigid exchange rates, too early a domestic financial liberalization, lack of transparency, and ineffective law enforcement created doubts among traders and speculators about sustainability of stable exchange rates.  The resulting vulnerability to capital outflows was reinforced by heavy reliance upon short-term external debts.

6.3 Korea serves as another good example of excessive investment, lax discipline, government intervention, and high vulnerability.  Large corporate conglomerates (chaeblos) opted for heavy dependence on debt instead of equity finance.  Corporate entities that encountered financial difficulties were kept alive by debt rollovers, often demanded by government authorities.  The vulnerability of the banking system was increased by large exposures to chaeblos, compulsory lending to small-and medium-sized enterprises, politically influenced lending, and credit channeling from abroad.  Therefore, a large number of Korean firms received increasing amounts of short-term foreign currency debts, little of which were hedged.

6.4 The management of, and the supervision plus regulations of, Korean financial institutions paid too little attention of prudent analysis and containment of risks.  According to unofficial estimates, at the end of 1996 banks’ nonperforming loans, net of reserves, already reached 70% of their equity, indicating very poor asset quality.  During 1997, an unprecedented number of chaebols moved into bankruptcy as a result of several factors, including excessive investment (in such sectors as steel and autos) and cyclical downturn.

6.5 Strong government intervention (via directed credits, regulations, and subsidies) heavily influenced Korean industrial structure.  Worse yet, true fiscal positions were not as tight as they appeared to be, because of extra budgetary and quasi-fiscal operations.  The resulting lack of market discipline contributed to the problem of unproductive or excessive investment that played an important role in the buildup to the crisis.  Fortunately, those substantial short-term external debts of Korea were clustered among few conglomerates, so debt renegotiations were much easier and more successful than the similar attempts in Indonesia, where not only were debts widely scattered but political instability debilitated investor confidence.

6.6 Singapore, in contrast, was least affected by the recent capital account crisis because it had prudent banking regulations and rigorous supervisions.  Neither cronyism nor nepotism nor corruption distorted the allocation of resources.  Public officers acted as referees, not participants in the market, and good transparency functioned to check abuses of power and privilege.

6.7 Even though Singapore faced considerable net outflows of portfolio investment in 1996-97, such event represented temporary market reactions to export downturn (especially electronics) and Asian financial crisis.  Given that Singapore has a firm command on economic and institutional fundamentals, those disturbances turned out to be only transitory.

6.8 In the countries most affected by the crisis, the key factors that led to the difficulties are the following: (a) failure to dampen overheating pressures manifested itself in large external deficits and property plus stock market bubbles; (b) too long a peg of exchange rates encouraged excessive foreign borrowing without hedging; (c) formats of foreign borrowing mattered very much in that short-term debts generated extreme vulnerability while foreign direct investment was at the opposite end; (d) lax rules and financial oversight precipitated deterioration of banks’ asset quality; (e) poor transparency induced speculation; (f) political disarray and uncertainties weakened investor confidence

4.1 After periodic episodes of speculative attack in 1996, the Thai baht came under downward pressure again in January-February 1997, as currency traders questioned more about the sustainability of the U.S. dollar peg in the presence of a large current account deficit and erosion of external competitiveness due to the dollar’s continual rise against the yen and growing excess (Thai minus U.S.) inflation.  Though the authorities were at that time able to defend the baht through spot and forward intervention and temporary rise in interest rates, market traders viewed the measures as inadequate, especially when fundamental weaknesses in the financial sector were not remedied and equity prices continued sliding.  Meanwhile, there was little market nervousness in neighboring ASEAN-4 countries, which were less affected by the export slowdown in 1996 and encountered far smaller current account deficits.  However, as the situation in Thailand deteriorated worries that financial sectors in these countries might also be exposed to property gluts contributed to a downturn in equity prices, particularly in Malaysia and the Philippines.

4.2 Severe pressures on the Thai baht reemerged in early May 1997, prompting the central bank to intervene heavily in the spot and forward markets, before moving on May 15 to introduce capital and exchange controls, aimed at segmenting the onshore and offshore markets, and allow interest rates to rise.  However, these measures failed to restore confidence in the currency, and strong pressures continued in the second half of May and June.  On this occasion, the neighboring ASEAN-4 countries suffered limited spillover effects, but these pressures abated fairly quickly as the authorities intervened in their exchange markets, raised interest rates, and, in the case of Malaysia, introduced limits on swaps by nonresidents not related to commercial transactions.

4.3 Underlying these currency attacks was a tightening in global financial conditions resulting from the sudden rise in Japanese bond yields and the sharp rebound of yen, which reduced the attractiveness of borrowing in Japan to finance investment in high-yielding markets elsewhere,, including Thailand which was heavily reliant on short-term capital inflows.  International investor–commercial banks, investment banks, and hedge fund–played a role alongside domestic investors in taking short positions against the baht, which they viewed as providing a one-way bet given the exchange rate peg, weak fundamentals, and relatively low funding costs.

4.4 Large and continual capital outflows made it inevitable of Thailand to abandon its exchange rate peg against the U.S. dollar-dominated basket on July 2 and allow the baht to float.  After dropping initially by 10%, the baht continued to falter because of intensified worries about politics, an economic package to support the new exchange regime, and weaknesses in the financial system.  The fall of the baht value immediately raised doubts about the viability of exchange rate arrangements in neighboring countries.

4.5 The initial victim was the Philippines, where the authorities had also maintained an exchange rate peg to the U.S. dollar.  After trying briefly to defend the peg through interest rate hikes and intervention, the authorities floated the peso on July 11, and subsequently imposed restrictions on the sale of no deliverable forward contracts to nonresidents in an attempt to limit speculation against the peso.  Spillover effects spread quickly to Malaysia, where the authorities opted to allow the ringgit to depreciate rather than raise interest rates, and also to Indonesia, where on July 21 the rupiah fell sharply within the official intervention band.  Subsequent measures to tighten liquidity condition in Indonesia failed to stem the growing exchange market pressures, and the authorities allowed the rupiah to float on August 14.  At the time of the rupiah’s float, the Thai baht weakened by a cumulative 18% against the U.S. dollar, compared with more moderate falls of other ASEAN-4 currencies by around 10%

4.6 The situation, however, worsened markedly in September and October 1997, reflecting concerns about the effects of currency depreciation and higher domestic interest rates on highly leveraged corporate and financial sector balance sheets, and about the authorities’ commitment to implement policies needed to restore exchange rate stability.  The imposition of controls on capital outflows during the crisis further undermined investor confidence.  Although hedge funds played a role in the crisis of the Thai baht, they were not a major driving force behind the downward pressures on ASEAN currencies in the third quarter of 1997.  Instead, domestic investors, debtors seeking to hedge their foreign currency exposures, and international commercial as well as investment banks played important roles in paring down domestic currencies.  By mid-October, the cumulative declines of currency value versus the U.S. dollar exceeded 30 % for Indonesia and Thailand and 20% for Malaysia and the Philippines.

4.7 As the Southeast Asian crisis deepened, spillover effects began to spread to other countries in Asia, reflecting the same concerns (export competitiveness and soundness of financial system).  The Singapore dollar and New Taiwan dollar weakened moderately in July, and the Hong Kong dollar came under temporary attack in early August.  Contagion of financial crisis could easily occur in other parts of the world because of three primary reasons.  First, financial markets around the world are linked up with each other to a large degree by technological advancement.  Second, owners of surplus funds ordinarily diversify their investments to different countries or continents in order to maximize returns while limiting risks.  Third, financial crisis in one country or continent typically has adverse psychological impact upon investor confidence in other countries or continents.  Therefore, globalization of financial crises, as a result of the one in Southeast Asia, could come as no surprise.

4.8 Table 3 demonstrates that the 1997 reduction in developing countries’ net private capital inflows were entirely due to Asia.  Within Asia, Thailand was not the only country which saw a drastic plunge of net capital inflows.  The Philippines, Indonesia, and Malaysia were in a similar plight.

2.1 Formats of capital inflows posed challenges in terms of their contributions to productivity and repercussions upon recipient countries’ macroeconomic policies as well as financial systems.  In these respects, foreign direct investment and other long-term flows were superior to short-term flows, especially the ones into banks and other financial institutions.  Unlike China and Vietnam (where foreign direct investment dominated net private inflows), ASEAN-4 and Korea before the crisis chose to rely upon growing shares of short-term debts (Tale2) which brought about a large degree of volatility to flows of funds across border.  In Thailand, for example, short-term inflows were abundant amounting to 7-10% of GDP each year during 1994-96, while foreign direct investment languished at about 1% of GDP.

2.2 Remarkable increases of net capital inflows into almost every region (except Africa) in the first half of 1990’s are immediately evident in Table 3.  Asia kept on capturing the largest portion (42%) of developing country’s net private capital flows.  Another distinguished feature of Asia is that its net capital inflows in the form of short-term credits, listed under the category “other net investment,” represented the biggest among all continents’.  This verifies that Asian countries attracted strong attention from international investors and financial intermediaries in the early 1990’s.  That is particularly so in ASEAN-4.  Table 4 demonstrates that ASEAN-4 absorbed rising net private capital flows.  Within all members of ASEAN-4, Thailand was the most reliant (10.2% of GSP in 1989-95) and debt commitments far overwhelmed both foreign direct investment and portfolio investment.

2.3 Among the incentives encouraging borrowings from abroad was capital account liberalization, relatively high domestic interest rates by international standards, and exchange rate policies that appeared to provide assurance that the price of foreign currency would not increase to outweigh interest differentials.  Burgeoning capital inflows resulted in growing foreign exchange reserves, increasing commercial banks’ liquidity and foreign liabilities.  Any country’s foreign exchange reserves should then be measured not just in terms of import spending but also foreign liabilities.  For instance, Thailand’s foreign exchange reserves more than doubled between early 1992 and early 1996 (reaching the peak at US$ 38 billion), while during the same period its commercial banks’ foreign liabilities grew from US$5 billion to US$ 46 billion, or from 6% to 24% of their total liabilities.

2.4 One salient feature of the Thai economy, which is similar to some of its Asian neighbors, is the prevalence of family businesses.  This tightly knit family relationship is applicable to a large number of business segments in Thailand, including local public companies listed in the stock market.  Along the growth path, even though these family businesses were considerably dynamic, they always tried their best to retain management authority within their families.  That is an underlying reason why both domestic and foreign debts were hinged upon to a much larger extent than equity as a source of finance.  Even among non-financial firms listed in the equity market, their average debt-to-asset ratios surged from 1.58 in 1994 to 1.98 in 1996.  In the meantime, their debt servicing capacity, as measured by the ratio of before-tax and before-interest revenue to debt outstanding, fell from 14.2% to 10.7%.

2.5 Family businesses did not neglect tapping funds from the local stock market.  But the funds mobilized from such source were not meant to substitute for debs.  Instead, they were intended to serve as a stepping stone for further borrowing via debt instruments.

2.6 Two other reasons favor debt financing.  First, similar to those in several other countries, Thailand’s tax system allow private corporations to deduct interest payments, but not dividends, as expenses before tax computation.  Such allowance gives a privilege to debt financing (over equity) in lowering the overall cost to borrowing entities.  Moreover, this tax distortion is also resorted to as a means to evade tax burden.  For instance, instead of directly utilizing their own funds as equity, private companies deposited such funds at financial institutions and borrowed the same amount back so as to gain tax deduction.  Second, tedious procedure of raising funds via equity and the absence of bond markets encourages borrowers to count upon debts as a primary source of financing.

2.7 Access to offshore funds or BIBF corresponded well to the preference of Thai family businesses, as low foreign interest rates together with minimal exchange risks (due to basket-pegged exchange rate policy) helped reduce their operating costs but not their management control.  It is thus unsurprising to find that private non-bank entities accounted for most of the colossal increase in the country’s external debt outstanding after the authority liberalized capital account.