The various financial crises experienced by the Southeast Asian economies (and later Russia) can be characterized as the equivalent of deposit runs on banks. Although the details differ from country to country, in the several years preceding the crisis foreign funds flowed into each economy in unprecedented amounts, largely in the form of short-term debt denominated in the currency of the lending country. Borrowers, in particular, trusted their governments to maintain the value of their domestic currencies so that their debts in those currencies would not change. When some triggering event in each case caused doubt about the government's commitment, investors ran for the proverbial door, cashing in local currencies for dollars, yen, and other stable currencies.
In his opening address, Richard Cooper reminded the audience that, unlike Mexico several years before, few Asian countries had been running large budget deficits. Although each of the countries had current account deficits that required foreign financing, as Sebastian Edwards noted, these deficits generally were declining and, with the exception of Thailand and Malaysia, were not large relative to GDP (Table 1). Each of the countries, nonetheless, experienced a financial crisis because it had microeconomic weaknesses that were exposed when, for different reasons, both domestic and foreign investors suddenly lost confidence in local currencies.
Current Account Deficits as a Share of GDP in Southeast Asia, 1993-97
What Went Wrong: A Financial View
Weak financial systems were the heart of the problem. When finance functions well, savings are channeled to socially productive investments. In emerging markets, banks play a dominant role in this intermediation process. In recent years, however, capital markets have become increasingly important, especially as local governments relaxed restrictions that once prevented foreign investors from buying equity or bonds issued by local corporations.
But as the development of Western economies has demonstrated, financial systems will not function properly unless they enforce the basic rules of a working market infrastructure. Banks must be supervised effectively to ensure they do not take excessive risks and that they maintain the resources to pay back depositors. Markets will not allocate funds to worthy borrowers unless investors have accurate and timely information about them and use that information effectively. Corporations must follow appropriate rules of governance to ensure that managers, as agents for shareholders, act responsibly. When these elements of a financial system are not in place, it is more than likely that, eventually, too much money will be sent to the wrong places and that economies will become vulnerable to a sudden collapse of confidence among firms and investors.
That, of course, is exactly what happened in Southeast Asia and Russia. Each country that experienced a crisis of confidence had significant shortcomings in its banking and financial markets, as well as in its systems of corporate governance.
Several of the papers presented at the conference focused, in particular, on flaws in the equity markets in the affected region. For example, Campbell Harvey and Andrew Roper argued that corporate managers bet their companies by trying to offset declining profitability with ever-increasing amounts of borrowing in foreign currency. As Michael Adler underscored in his paper, the bets clearly turned sour when the currency crises hit, because much of the borrowing was in foreign currency and companies could not generate enough of their weaker, local currencies to service it. Thus, while Harvey and Roper applauded capital markets in the region for mobilizing substantial amounts of new funds and enhancing liquidity, they found that shares of Southeast Asian companies earned returns in the 1990s that, adjusted for risk, were well below those generated in equity markets in other countries, especially in the West. Michael Pomerleano and Xin Zhang enhanced these findings with their own statistical analysis. Based on available data, they demonstrated not only that Southeast Asian corporate equities earned poor risk-adjusted returns, but also those returns did not, on average, cover the cost of capital.
In short, the Asian miracle that had produced consistent growth for many years—in Thailand for four decades—also generated both too much and the wrong types of investment. The markets did not prevent this outcome. According to Pomerleano and Zhang, many investors in Southeast Asia displayed a strong preference over the past decade for so-called glamour stocks (with relatively high price/earnings ratios), which outperformed a group of value stocks (with relatively low ratios of market value to book value). In this respect, capital markets in the region behaved in a very similar fashion to the American markets, where high-tech stocks—especially Internet stocks—have significantly outperformed the rest of the market.
The weak systems of corporate governance in Southeast Asia also failed to discipline excessive risk-taking and investment by companies in the region. On the surface, as Ken Scott described in his paper, this conclusion seems inconsistent with the fact that many Southeast Asian corporations (an estimated 50-70 percent) are closely controlled by a single family. In principle, concentrated ownership should eliminate the so-called agency problem that arises when diverse shareholders fail to effectively supervise corporate managers. However, many of these family-owned companies were managed poorly and they channeled investment funds—in many cases with the implicit backing of local governments—to related companies and personal commercial ventures. As a result, investment decisions often were products of government-determined priorities and possible conflicts of interest rather than of the application of commercial criteria. Furthermore, as Scott explained, in Southeast Asian countries, minority shareholders had little ability to prevent corporations from making unwise decisions. There is no real market for corporate control in Asia, and the concept of strong, independent directors is not well established.
The role of foreign investors in the Asian debacle also has been the subject of much debate. It is widely accepted that foreign banks extended excessive short-term credit (in foreign currency) to emerging-market borrowers and pulled back when crises hit. But some leaders in these countries have criticized foreign equity investors for destabilizing local equity markets by being too fickle and dumping their shares at the first signs of trouble. Michael Barth and Xin Zhang provided strong evidence refuting this view, showing that foreign investors tended to hold their equity investments for longer periods than did local investors. John Rea, in formal comments on this paper, added evidence that foreign mutual funds were net buyers of equity during part of the crisis period. Rea and several participants did note, however, that some institutional investors (understandably) were net sellers once countries had abandoned their exchange-rate pegs.
Michael Adler dissented from the view that foreign investors played an overall stabilizing role, arguing instead that foreign investment initially contributed to bidding up share prices to excessive levels and thus, in the long run, proved destabilizing. Jarrod Wilcox expressed a similar view, attributing share-price increases to buying by foreign investors who relied on quantitative models driven by indexes, growth, and momentum factors, rather than on value and corporate fundamentals. Antoine van Agtmael added that direct and portfolio foreign investors displayed naïveté by failing to exercise their rights as minority shareholders to demand better corporate governance.
In sum, the crises in Southeast Asia and, to a certain extent, in Russia dramatically demonstrated the strong nexus between a sound financial system and the performance of the underlying economy. When the financial system malfunctions, the effects are not confined; they are manifested in potentially sharp declines in real output. The crises also highlighted the particular inadequacies of emerging financial markets and the difficulties they face being integrated into a rapidly moving, large-scale global financial market during the process.
The participants generally agreed that equity investment appears to be recovering and that good investment opportunities exist in Southeast Asia. But many also voiced a cautious view of future economic recovery in the Southeast Asian countries at the epicenter of the crisis. A number noted that relatively little corporate debt has been restructured in most of the affected countries, with the possible exception of Korea. William Cline expressed optimism, however, suggesting that despite the recent crises, capital flows would revert to a sustainable long-run trend by 2001 (probably about half the $200 billion annual levels seen in 1996), which favors closer integration of emerging and developed country capital markets. Cline also predicted that future cross-border flows increasingly would take the form of bond rather than bank financing.
Setting the Reform Agenda
The conference was not organized to generate consensus policy recommendations for financial systems in emerging market countries. But while some themes were subjects of sharp debate, the participants generally endorsed several ideas—including many already in the public domain:
Accurate and timely disclosures by firms and governments of their financial positions—or transparency—is a necessary, but not sufficient, condition for ensuring appropriate levels of investment and their allocation. The Asian crises also have underscored the need for the emerging market countries to develop more effective means of corporate governance. As Scott made clear in his paper, improving corporate governance does not mean copying Western legal systems. Nevertheless, corporations should focus on implementing and enforcing rules that prevent corporate managers from exploiting conflicts of interest—for example, by engaging in transactions with affiliates or other closely held companies on other than arms-length terms. In addition, Scott emphasized the importance of increasing the capacity of regulatory and judicial systems to handle disputes over corporate matters.
Lenders and equity suppliers must obtain relevant information and act on it rather than engaging in wishful thinking, as appeared to be the case with many investors prior to the crises. The trend toward indexed investment vehicles blunts the usefulness of information, however, since investors buy the index rather than purchase shares in individual companies or sectors. This suggests that quantitative investment models driven by indexes, growth, and momentum styles may not be appropriate for emerging markets because they implicitly assume good corporate governance and market infrastructure. More value-oriented, company-specific analyses are needed that recognize inherent risks and price investments accordingly. Many foreign investors may also demand improved minority shareholder rights. Countries without strong minority shareholder protections are likely to lose important foreign investment.
Participants broadly agreed on the need for more effective supervision of banks in emerging markets—which for the foreseeable future will continue to be the main vehicles through which savings are channeled into investment. But many urged these countries to encourage foreign ownership of their banks. As experience in Argentina indicates, foreign banks introduce new commercial credit cultures, software and hardware, and managerial techniques that improve bank risk-management. Furthermore, foreign banks can break the links between domestically owned institutions and local governments that, in the case of each of the relevant Asian countries, led to the allocation of funds by government-determined rather than market criteria.
The Asian crises clearly demonstrated the need for emerging-market countries to continue developing the instruments and infrastructure of their capital markets. As Cooper noted, banks are inherently fragile because their deposit liabilities are liquid, but most of their assets are not. In contrast, bond and equity markets transfer risks directly to investors. While those markets are susceptible to fads and contagious runs, they do not require constant supervision of their soundness and safety, as is the case with banks. Governments are less likely to use capital markets than to use banks as vehicles for directing investments to favored companies based on non-commercial criteria. Moreover, bonds can help firms lock in long-term local currency funding at fixed rates and thus help stabilize borrowers and markets in troubled times.
To function effectively, however, capital markets require an appropriate technical and legal infrastructure. The World Bank is helping countries requesting assistance to construct this infrastructure. Furthermore, while foreign direct investment is useful, if not essential, to promoting economic development, emerging-market countries should encourage local residents to participate more in their own capital markets. Michael Adler argued that such participation might require countries to provide disincentives for investment abroad. Jarrod Wilcox disagreed, arguing that local investors should be allowed to invest offshore to prod domestic firms to offer more attractive investment opportunities.
Participants vigorously debated, but did not reach consensus on, two policy recommendations with significant support in the international policymaking community:
Capital controls are designed to insulate countries from the rough and tumble of global capital markets. But Wilcox argued against containing either inflows or outflows of capital. Adler and Sebastian Edwards added that capital controls are too easily circumvented, especially in times of crisis. David Folkerts-Landau agreed, but nonetheless suggested that countries should not liberalize their capital accounts if their banking systems are unable to handle sizable capital inflows and outflows. At the same time, efforts should be made to relieve the need for controls as quickly as possible.
Sebastian Edwards paid special attention to the desirability of discouraging short-term capital flows and focused on the reserve requirements maintained by Chile during the 1990s on foreign borrowings of less than a year's maturity. While Edwards supported the consensus view that the Chilean requirements shortened the maturity of new capital inflows, he found they did not significantly alter the average maturity of the outstanding stock of foreign currency liabilities and thus did not materially affect Chile's exposure to potential capital outflows. Moreover, according to Edwards' statistical tests, the requirements did not appear to enhance the ability of Chilean monetary authorities to use high-interest-rate policies to control inflation (without attracting excessive capital inflows).
A key question is whether foreign investment in the countries affected by the crises will remain anemic, thus reducing the need for countries to protect themselves by discouraging the inflow of such funds. Similarly, will emerging market borrowers temper their foreign currency borrowing? Participants generally concluded that investors and borrowers have learned some lessons from the crises, but many also cautioned that, in the markets, memories can be short.
Amendments to Bond Contracts
Proposals to amend bond clauses to facilitate restructuring in the event of a future crisis—majority voting rather than unanimity requirements, the creation of standing creditors' committees, and clauses mandating a sharing of recoveries among all creditors—attracted even more divided opinion. Several participants applauded such devices as necessary to speed corporate-sector adjustment following a major economic shock. But many from the private sector—notably, from the investment and commercial banking industries—strongly criticized the provisions, contending they would redline borrowers who used such contracts out of the capital markets.
In his closing remarks, Andrew Sheng voiced a view that attracted wide approval: At bottom, the Asian financial crisis reflected a failure of local and global risk management. At the local level, firms that over-leveraged failed fundamental rules of managing risk (echoing findings in the Harvey/Roper paper). Similarly, governments that failed to adequately supervise their banks and that pegged their exchange rates for too long also failed the test. So did investors at home and abroad.
Sheng also emphasized that participants are operating today in a global marketplace, where risks transfer rapidly across borders, making risk management everyone's responsibility. But financial systems are still regulated at the national level. Going forward, the challenge for all concerned is to identify global, cross-border risks and then determine how best to measure and manage them so local financial markets can weather global shocks.
Papers Presented at the Conference