Below is an excellent post by Barry Eichengreen, Professor of Economics and Political Science at UC Berkeley, at the new blog VoxEU. The post posits that the biggest risk to Asia is an asset crash, and looks at America’s experience during its industrializing phase to see what lessons might be learned. He determines that whether a crisis led to an economic recession depended on the strength and responsiveness of the banking system. He does not reach any conclusions, noting that while Chinese banks have improved, there is no assurance that the powers that be would bail out banks that have substantial foreign ownership.
Based on my experience with Japanese banks in the 1980s, I suspect (and hope to be wrong) that their systems and processes are likely to be weaker than widely believed. The Japanese knew that they were behind the West in financial services and did not want the world to know of their weaknesses. Their protective impulses stemmed from pride (who wants to admit their failings?) and pragmatism (Western firms entering the market might be able to compete more effectively against them if they knew of their skill gaps). I would therefore bet the Chinese banks are similarly less capable than their PR would lead us to believe.
On July 2nd we celebrate the tenth anniversary of Thailand’s devaluation, the event that unleashed the Asian crisis. “Celebrate” seems like an odd word to use in this context, recollections of crises not typically occasioning the popping of champagne corks. But there are in fact achievements worth celebrating. For one thing, Asia has not experienced another crisis. For another, it rebounded quickly after 1997-8 and is again the fastest growing region in the world.
But is Asia’s rapid growth sustainable? And is the region really safe from crises? Views here fall into two camps. First are those who argue that Asia has effectively bullet-proofed itself from financial crises. Its central banks have accumulated massive foreign reserves. Debt ratios have fallen, maturities have lengthened, and a growing share of debt to foreigners is denominated in local currencies. Even if sudden reluctance on the part of foreign investors to renew their maturing claims creates problems for banks and firms, then the national authorities can provide the resources needed for repayment. They are no longer constrained by the commitment to maintain pegged exchange rates.
Members of the second camp argue that less has changed than meets the eye. Exchange rates are more flexible in theory than in practice. In a number of countries, South Korea for example, short-term debt is rising again. There still exist weaknesses in banking systems, most obviously in China. The quality of corporate governance continues to lag. Past is prologue, in this view. It is impossible to rule out another crisis like that of ten years ago.
I am inclined to split the difference. I would argue that Asia is still at risk but that any crisis will take a different form than in 1997-8. The trigger would not be currency devaluation by a country facing difficulty in financing a large current account deficit but rather a sharp drop in asset valuations that causes China’s investment boom to bust. If asset valuations do crash, leveraged investors will be forced to sell into falling markets. Volatility having risen, banks and funds will be forced to liquidate positions to satisfy prudential guidelines. Because they use positions in more liquid markets to hedge stakes in less liquid markets, if an adverse shock to the relatively illiquid markets materializes they then have the option of selling holdings of more liquid instruments to reduce the net loss from the portfolio. This will create a tendency for volatility to spill across countries.
We have considerable experience with these sorts of investment-led booms and busts, not least in my own country, the United States before 1913. The US then, like China now, was undergoing a period of rapid growth and becoming a major force in the global economy. This was a process of extensive growth, where the availability of resources to the modern sector was effectively unlimited. In America this meant unlimited land, which attracted capital and labour from abroad. In China it means unlimited labour, which attracts capital.
Both booms were fed by technological and organization revolutions: in the United States the process of railroadization, the advent of the multidivisional corporation, and mass production; in China the commercialization of enterprise and export orientation. In neither case was a government budget deficit or a consumption binge at the root of events, as in many episodes of rapid growth that culminated as in crises in the final decades of the 20th century, especially in Latin America.
This US. boom was punctuated by financial crises, in 1853, 1873, 1884, 1890, 1893, 1902 and 1907. Why is not hard to see. Despite the development of rating agencies, investment banks and railway gazettes, information about investment opportunities was imperfect. Accounting and corporate governance standards were lax. Most railroads did not even publish annual reports until the 1890s, and those that did so were unaudited. The New York Stock Exchange ostensibly made disclosure a requirement for listing, but there were many different places to trade stocks in the United States, and when a company threatened to list elsewhere the NYSE bent its rules. The US banking system was notoriously fragile. Regulation was weak, and there was no central bank to act as lender of last resort.
It took the crisis of the 1930s to bring about real reform, including creation of the Securities and Exchange Commission and the Fed’s recognition of its responsibility to act as a lender of last resort. That crisis, which had a number of elements in common with its pre-1913 predecessors, disrupted not just the US. economy but the surrounding region and the world. One worries that a sharp slowdown in China, in which growth falls by, say, half from its current levels, could have equally dramatic effects.
But would China’s growth in fact fall dramatically? Here again it may be revealing to consider US. experience in the 19th century. Of the seven peacetime asset market busts, major recessions occurred in a bare majority – that is, four. The average fall in output in these four episodes was 7 per cent from peak to trough, significant by the standards of the Asian crisis. In contrast, in the 1873 and 1884 crises and the Rich Man’s Panic of 1902, equity markets fell by some 23 per cent in real terms, but economic growth barely budged.
What was different in these episodes? In 1902-04 there was no adverse impact on the banking system. In 1884 the banking and financial system in New York City was disrupted, but problems there were resolved before they could spread. 1873 is a more difficult case. If there is an explanation for why the real effects were not more disruptive, it is that strong banks launched lifeboat operations on behalf of their weaker brethren, acting like quasi lenders of last resort. The fact that the US. was not yet back on the gold standard, which had been suspended in the Civil War, was also important for removing a constraint on their freedom of action. It is clearly better to avoid a banking panic in the first place. But the lesson of this history is that if you are going to have crisis, it is important to resolve it quickly.
This brings us to the key questions. How weak or strong are banking systems in Asia? And how confident should we be that, if a financial bust implicates the banking system, the resulting problems will be resolved quickly?
On the first question, the only safe statement that is there are no safe statements. Internal controls and supervisory standards have been raised throughout the region, but in many cases practice still lags principle. In the first quarter of this year, the prices of the shares of emerging Asian banks were up in Thailand, Malaysia and Korea but down in Indonesia. This tells us something about where, in addition to China, banking problems lurk.
If a crisis erupted, would the authorities intervene quickly and forcefully? The Chinese authorities have plenty of resources with which to recapitalize the banks. The question is whether they would be prepared to use them now that foreign financial institutions have taken stakes. A public sector bailout of the banks would be a subsidy to these foreign institutions, and the government might hesitate to use the hard-earned tax dollars of Chinese residents in this way. To be sure, the best course would be to provide the liquidity now and defer questions of burden sharing to later. But there is an issue of whether the Chinese authorities will appreciate this distinction.
In all, there are many uncertainties. Officials and investors should not take time out to celebrate. They have too much to worry about.