Causes and Prevention of External Debt Crises

Yen Kyun Wang Department of Economics Chung-Ang University, Seoul July 6-7, 2004 UNESCAP, Bangkok
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 Introduction Asian financial crisis was a debt crisis (over-borrowing by private firms).

 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 flowsreceiving, source country or global level
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 In Korea: per capita income:$10,000 in 2003, same as that of 1996 A Author: Causes- weak fundamentals and policy distortions, aggravated by herding and contagion

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

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

 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-bigto-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
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- 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
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 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%

 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%

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 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%
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 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

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 In 1979-1980, external debt crisis occurred in Korea, due to overinvestment 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
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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 year=1985)
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 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
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 Current A/C deficits/GDP(danger level: 4-5%): 9% in Thailand in 1995 and 1996 - Malaysia: 10%and 3.7%in 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

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 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,

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 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.

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 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
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 Lack of transparency in financial

statements of corporations and banks

-Was different from western accounting practices: announced bad loan rate-6%. Perceived rate30%

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 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%
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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%

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 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%.

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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
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 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

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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
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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
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 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
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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

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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.
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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.

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

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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
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