Road to Recovery: Restoring growth in the region could be a long and difficult process      

by
Joseph Stiglitz
Senior Vice President and Chief Economist
The World Bank

In 1975 roughly six out of 10 East Asians lived on less than a dollar a day. By 1995 it was down to roughly two out of 10. Although we do not have precise estimates, tens of millions of people have been dragged back into poverty by the current crisis. I have no doubt that the accomplishments of the East Asian miracle will be more durable than the misery caused by this crisis. But restoring growth in Asia could be a long and difficult process.

Why has the downturn been so deep?

One year after the collapse of the Mexican peso in December 1994, Mexico’s economy was growing strongly. In contrast, unemployment continues to rise in Asia (up from 2% to 6.9% in Korea) and industrial production and other indicators of economic activity continue to fall. In 1998, Thailand will see its first year of negative growth in over three decades; it will be the second year of negative growth in more than 30 years for Indonesia, Korea and Malaysia, contrary to the consensus forecast which predicted positive growth.

The experience of dozens of countries with financial crises in the last decades has shown that they can often produce deep and prolonged downturns. Even a relatively mild financial crisis can help initiate and exacerbate a downturn, as evidenced by the U.S. Savings and Loan debacle and the 1990-91 recession to which it contributed.

An important implication of this unfortunate wealth of experience is that we should recognize the large amount of uncertainty and base policy on conservative forecasts of economic activity, recognizing the asymmetries of risk; in particular the downside risk that a shortfall in demand can push a weak economy into a deep recession through a vicious cycle of bankruptcy, financial market collapse, and more falling demand. Basing the initial policy responses in Asia on overly optimistic scenarios may have made it difficult to develop policies to protect against the worst outcomes, thus exacerbating the downturn.

When an economy is overheating, that is, when it is trying to produce above its capacity, then contractionary policies can help restore balance with little economic damage. But the East Asian economies were in rough macroeconomic balance, as evidenced by their low and, in some cases, falling inflation rates. The result was that the shock of the Crisis knocked them out of this balance, leading to a severe economic contraction.

This should have been predicted using standard macroeconomic models. We knew that consumption would drop because of the dramatic plunge in the stock markets, which lowered wealth and increased uncertainty about the future. We also knew that investment, typically the most volatile component of output, would fall sharply due to higher interest rates, decreased availability of credit and, again, increased uncertainty about the future.

Offsetting these certain declines was the hope that net exports would rise because of devaluation. Unfortunately, export growth (measured in U.S. dollars) has been slow in some countries and nonexistent in others. Among the reasons: roughly 50% of East Asian trade is intra-regional; excess capacity in the region has been driving prices down, and many exporters are having trouble getting access to credit. In addition to these predicable problems, the yen has continued to slide, the Japanese economy has been worse than expected, and El Niño has brought drought to the region.

The link between the financial system and the economy

The concerns based on these traditional ways of thinking are amplified by more recent ideas about the link between the financial system and the economy. The financial system is the "brain" of the economy, mobilizing savings and allocating it to investment. When this brain malfunctions, the consequences can be enormous. Consider three examples.

	What matters for private-to-private capital flows, which were at the heart of the East Asian crisis, is not the promised interest rate but the return that investors expect to get, adjusted for the risk they face. Measures that weaken the economy and promote uncertainty rather than confidence can lead to capital flight — and falling exchange rates. Since increasing interest rates might actually lower the risk-adjusted expected return, thus worsening the exchange rate, the usual trade-off between interest rates and exchange rates may disappear.
	The effects of El Niño on the weather have hopefully passed. But because of the drought, many farmers cannot buy seeds and fertilizer necessary for next year’s crop out of their own income. And because of the high interest rates and lack of available credit, they are having difficulty borrowing for these investments.
	Increased uncertainty about the future can have a severe contractionary effect on exports and the economy. No American importer that needs clothing for Christmas, for instance, wants to risk finding out in November that the company they contracted is bankrupt and will be unable to meet delivery.

Policies for recovery

The analysis of the interaction of the financial system and the economy has several policy implications. First, it provides a rationale for an expansionary macroeconomic stance. In the last few months real interest rates have come down and fiscal policies have been relaxed, steps that should help reduce the contractionary effects on the economy. But the scope for expansionary policies within the region (outside Japan) may be greatly circumscribed without external financial assistance. And without aggressive expansionary policies, there may be a continued downward slide, and a slower recovery.

Second, quick and decisive actions to strengthen the financial system are necessary to restore confidence. But they can be done in a manner that continues credit to exporting firms and maintains banks’ "informational capital," their knowledge of who they can best lend money to and how they should supervise them, and, at the same time, pays due attention to moral hazard concerns. Specific programs to provide credit to those sectors most adversely affected or which can jump-start the economy are essential; these include agriculture, small and medium-sized enterprises and exporters.

Third, reforms need to be cognizant of capital-asset values, which have been battered by large unanticipated changes in exchange rates, land and real estate prices, etc., increasing uncertainty and dampening economic activity. One implication: some structural reforms that might be good in the long run can have disastrous consequences in the short run. If the U.S., for instance, had tried to eliminate distortions in agricultural and energy prices in the mid-1980s, the process would have worsened the Savings and Loan crisis.

Fourth, corporate restructuring is essential. But this should consider that even a well-managed firm can go bankrupt as a result of large devaluations, increases in interest rates, and falls in demand. We must take great care in identifying firms to survive and in assessing their financial needs. Systemic bankruptcies, with creditors of bankrupt firms also going bankrupt, will make corporate restructuring all the more difficult.

Prospects for East Asia

The export boom that some thought should have followed the large devaluations has not materialized. Meanwhile growing excess capacity in many industries, associated with low spending by consumers and investors, is leading to lower export prices. So, even if export volumes pick up, the dollar revenues may still stagnate.

The continuing uncertainties in the region will stymie the return of capital flows, and there are reasons to believe that capital may continue to leave the region, even if confidence were to be restored. Asian investors had invested heavily in their own and neighboring countries; their portfolios were less diversified. Now, they may seek more balanced portfolios, and that may mean more capital from certain countries heading to the U.S. and Europe.

Balancing these concerns are Asia’s underlying strengths which supported growth over three decades, including high savings rates, a well-educated labor force, high levels of technology and an outward orientation.

The Future of globalization

The East Asian crisis, following on the "miraculous" recent decades, has one again shown that globalization is double-edged, bringing risks with opportunities. If East Asia had not been outward-looking it would not have enjoyed the considerable benefits brought by trade and foreign direct investment, which is comparatively stable and brings with it not just capital but also technology and access to foreign markets.

The crisis reinforces the belief that countries will benefit most from globalization when they have transparent, robust and well-regulated financial markets. This cannot be accomplished by overnight deregulation. In the rush to open East Asia to free movements of short-term capital, many people had warned that these flows could be very volatile. This warning was fulfilled in East Asia, which suffered an outflow of over $100 billion in the last months of 1997 – roughly 10% of the gross domestic product. Few economies could withstand a shock of this magnitude.

More generally, there is little evidence that full capital-account liberalization contributes to investment or growth. What is clear is that short-term capital flows increase volatility, which is bad for growth. Our research shows that countries which have gone further in financial liberalization, including capital-account liberalization, are more likely to experience a financial crisis. Our research also demonstrates the large adverse effects of financial crises on growth. At the same time, in prudent countries increased short-term debt is matched by increases in reserves: a perverse process whereby developing countries borrow money at high interest rates from industrial-country banks only to relend it (as currency reserves) at low interest rates to the Treasuries of these same industrial countries.

Policies need to be designed which will both inhibit the flow of volatile short-term capital and, at the same time, encourage long-term capital, especially foreign direct investment. Three sets of policies are now being widely discussed. The first is to eliminate distortionary policies which directly encourage short-term capital or do so indirectly, by restraining long-term capital.

The second is strengthening the financial sector by making borrowers and lenders pay the full costs of their risks.This includes imposing risk-adjusted deposit premiums and risk-adjusted capital adequacy standards; if the bank lends to a risky firm, it will be forced to put up more capital. The regulatory structure will have to be adapted to the situation of the country, including its capacities for supervision; direct restrictions, such as exposure to foreign liabilities and real estate lending may have to be imposed. In all countries increased transparency is essential, but we should note that even countries with advanced institutional structures, such as those in Scandinavia, have faced severe financial crises recently.

Measures aimed at the banking system may not be enough; after all, two-thirds of Indonesia’s external debt was borrowed directly by corporations. Thus, the third set of policies are aimed at the corporate borrowing abroad. These include Chile’s effective tax on short-term investment (which has not impeded total capital flows, although it has lengthened their maturity), or the reduction (or elimination) of tax deductibility for interest on corporate debt denominated in foreign exchange.

Such policies may not work perfectly, but it is better to have a leaky umbrella on a rainy day than no umbrella at all. It is inconsistent to rule out government "interference" with the market while still suppporting bailouts which are, after all, massive government interventions. Whether justified or not, the existence of repeated bailouts nationally and internationally means that individuals and firms do not bear the full costs of the risks they create. As a result, we cannot count on the free market to lead to the best outcome and thus some government action may be required to "correct" private incentives.

When firms impose costs on society, for instance through pollution, we tax or regulate them. Similarly, when they impose risks on the entire society by incurring short-term debt, the question should not be whether government action is desirable, but whether we can find actions whose benefits exceed the ancillary costs. There is every reason to believe that we can.