East Asian Finance: Crisis Comparison and Policy Responses

1. Barbara Stallings International Studies Assn March 2011 A Tale of Two Crises:The Political Economy of East Asian Finance in the 1990s and 2000s

2. Agenda • Introduction • Literature and hypotheses • Financial policy changes after 1997 • Outcomes of policy changes • Korea case study • China case study • Conclusions

3. Introduction • Crises of 1990s and 2000s were both crucial for East Asia, but their origins and consequences were different • Why no financial crises in EA in 2000s, when finance was main source of crises there in 1990s and elsewhere today? • Two-part study: regional economic analysis and country political economy analysis

4. Literature and Hypotheses (1) • The 1997 crisis stimulated a new theoretical literature on financial crisis • Previous view: crises caused by loose macroeconomic policy or banking panics that spread • Neither fit the situation in EA in 1990s • New approaches came in two versions

5. Literature and Hypotheses (2) • Internal explanations for crises -- Macroeconomic policy errors (over-investment, fixed exchange rates) -- Financial sector weaknesses (poor regulation and supervision, lack of transparency, imprudent lending) -- Political improprieties (“crony capitalism,” moral hazard)

6. Literature and Hypotheses (3) • External explanations for crises -- Internal issues had existed for a long time without hindering success in EA -- Real changes were external, following liberalization of capital account -- Resulting large capital inflows and “sudden stops” led to crisis

7. Literature and Hypotheses (4) • Hypothesis 1: East Asia suffered both internal and external problems in 1990s; policy changes corrected problems, thus avoiding financial crises in 2008-09 • Hypothesis 2: Policy changes came about in different ways in different countries, depending on whether they suffered crises in 1990s or not

8. Changes after 1997 Crisis (1) • Banking sector -- Eliminate NPLs from balance sheets -- Recapitalize banks, sometimes nationalizing them in the process -- Privatization (or re-privatization) of banks, sometimes to foreign capital -- Improvement of regulation/supervision

9. Changes after 1997 Crisis (2) • Capital markets -- Main focus: promoting bond markets to provide alternative source of finance -- Various economic reforms were important: financial liberalization, opening capital account, pension reform -- Institutional reforms: better regulation and supervision, corporate governance

10. Outcomes of Changes (1)

11. Outcomes of Changes (2)

12. Consequences of Current Crisis • East Asian economies slowed, but recovered quickly through stimulus • Feedback of economic crisis to financial sector? Still early, but some indicators -- No bank failures -- Indicators deteriorated, but still strong -- Stimulus may lead to more NPLs in the future

13. Korea – 1997 Crisis • Korea’s 1997 crisis resulted from a poorly executed financial liberalization, which led to heavy borrowing, especially short-term • Cutoff of access to international financial markets triggered crisis • Government requested IMF loan in Dec. 1997; it was large but not large enough and poorly designed

14. Korea – Reforms (1) • After crisis, many banks were closed or taken over by the government and later reprivatized • An asset management company (KAMCO) purchased most NPLs • Regulation and supervision were consolidated; forward-looking approach was adopted

15. Korea – Reforms (2) • Deposit insurance limits were made clear to avoid moral hazard, and corporate governance and transparency were strengthened • Complete foreign ownership was permitted • Capital markets were a lower priority; similar reforms introduced

16. Outcomes (1) • Indicators of banking sector strength rose substantially • Both banks and capital markets increased finance to Korean economy, in part as result of policy changes • Economy was hit hard by fall in trade and withdrawal of international finance in 2008, but no crisis like 1997

17. Outcomes (2)

18. Korea – Reform Process (1) • Several approaches 1) Domination by foreign actors -- IMF imposed macroeconomic and structural reforms (especially financial opening) on an unwilling Korean government -- US government was partner, perhaps acting on behalf of US firms

19. Korea – Reform Process (2) 2) Domination by domestic actors -- Democratization was key factor, which changed the relative power of political actors in Korea -- This weakened the executive and led to “western style” reforms -- IMF as scapegoat, not main actor

20. Korea – Reform Process (3) 3) Interaction of foreign and domestic actors -- Role of political leadership (President Kim Dae-Jung) in mediating domestic and external pressures -- Kim persuaded labor to accept reforms -- Foreign actors played specific roles: pressed for recognition of NPLs, financial institution reforms, corporate reforms

21. China – No Crisis in 1997 • China escaped crisis in 1997 because financial sector was still largely closed; no international borrowing binge as in other East Asian countries • Growth slowed, which was met with stimulus but no devaluation • Saw neighbors’ crisis as a call for reform in China itself

22. China Reforms (1) • Reforms moved in similar direction as Korea’s, but did not go as far • AMCs were created to clean up problem loans in major banks • Major banks were recapitalized several times • Improved regulation/supervision (CBRC)

23. China Reforms (2) • Increased role of foreign capital -- Foreign banks purchased small shares of several Chinese banks -- IPOs in Hong Kong by largest state-owned banks -- “Strategic investors” -- But significant barriers remain for foreign ownership

24. Outcomes (1) • Like Korea, banking strength indicators in China rose significantly • China’s banks became increasingly oriented toward the corporate sector, although bond markets used mainly by government • Stimulus funneled through banks was key to quick recovery in China in 2009

25. Outcomes (2)

26. China – Reform Process (1) • Dominance by domestic actors is usually assumed by China scholars • CCP as ultimate source of decisions • Political leadership seen as important, especially role of Premier Zhu Rongji, but several variants re financial reform -- Zhu pursuing ideological agenda -- Zhu fighting for political survival

27. China – Process (2) • New literature suggests that external forces are also important in Chinese policy making -- International structural constraints -- Internalization of international norms • Case study of international role – explaining WTO accession, which is important for financial sector

28. Conclusions (1) • Support found for both hypotheses about political economy of finance in East Asia • Region did not have financial crises in 2008-09 (as opposed to serious economic problems) because of strengthening of financial sector after 1997 crisis • Different processes of policy change in crisis and non-crisis countries in 1997

29. Conclusions (2) • Despite support for the two hypotheses, there are some interesting caveats • Problems were created, as well as resolved, in cleaning up banks • Government role seems to have increased because of crisis • Both foreign and domestic actors can play a significant role; interaction is important