Liberalization and Growth in Asia: 21st Century Challenges

Liberalization and Growth in Asia

Liberalization and Growth in Asia 21st Century Challenges

Mohamed Ariff Monash University, Australia

Ahmed M. Khalid Bond University, Australia

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Mohamed Ariff and Ahmed M. Khalid 2005 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Inc. 136 West Street Suite 202 Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data Mohamed Ariff, 1942– Liberalization and growth in Asia : 21-st century challenges / Mohamed Ariff, Ahmed M. Khalid. p. cm. Includes bibliographical references and index. 1. Financial crises—Asia. 2. International finance. 3. Asia—Economic conditions—1945– I. Khalid, Ahmed M., 1958– II. Title. 2004050643 HB3808.M64 2004 330.95—dc22

ISBN 1 84376 182 3 (cased) 1 84376 791 0 (paperback) Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall

Contents List of figures List of tables About the authors Foreword Hal Hill Preface Abbreviations 1 2 3 4 5 6 7 8 9 10 11

vi viii x xii xv xx

Liberalization: Asia’s new-found development strategy Asian financial markets: from crisis to recoveries China: a command economy responding well to market signals for a long while now India: more than a decade of liberalization, yet not fast enough Indonesia: liberalization amidst exchange rate and now growing political stability South Korea: a case of capital account liberalization, growth collapse and reforms to recovery Malaysia: liberalization with exchange and capital controls Pakistan: liberalization with internal and external shocks Singapore: continual reforms to maintain financial centre status Thailand: open external sector, exposed financial sector Lessons for development through liberalization

Select bibliography Index

1 24 61 94 131 159 188 219 257 295 325 356 376

v

Figures 3.1 3.2 3.3 4.1 4.2 5.1 5.2 5.3 6.1 6.2 6.3 7.1 7.2 7.3 8.1 8.2 8.3 8.4 8.5 9.1 9.2

Growth rates of real GDP, CPI and M2, China: 1961–2002 Exchange rate movement and interest rate spread, China: 1961–2002 Foreign reserves to import ratios and growth rates of M1 and M2, China: 1961–2002 Growth rates of real GDP, CPI and M2, India: 1961–2002 Foreign reserves to imports ratio and growth rates of M1 and M2, India: 1961–2002 Growth rates of real GDP, CPI and M2, Indonesia: 1961–2002 Exchange rate movement and interest rate spread, Indonesia: 1961–2002 Foreign reserves to imports ratio and growth rates of M1 and M2, Indonesia: 1961–2002 Growth rates of real GDP, CPI and M2, South Korea: 1961–2002 Exchange rate movement and interest rate spread, South Korea: 1961–2002 Foreign reserves to imports ratio and growth rates of M1 and M2, South Korea: 1961–2002 Growth rates of real GDP, CPI and M2, Malaysia: 1961–2002 Foreign reserves to imports ratio and growth rates of M1 and M2, Malaysia: 1961–2002 Exchange rate movement and interest rate spread, Malaysia: 1961–2002 Twin deficits, Pakistan: 1961–2002 Growth rates of real GDP, CPI and M2, Pakistan: 1961–2002 Foreign reserves to imports ratio and growth rates of M1 and M2, Pakistan: 1961–2002 Exchange rate movement and interest rate spread, Pakistan: 1961–2002 Domestic and external borrowing, Pakistan: 1961–2002 Growth rates of real GDP, CPI and M2, Singapore: 1961–2002 Foreign reserves to imports ratio and growth rates of M1 and M2, Singapore: 1961–2002 vi

66 83 90 96 108 133 136 145 162 175 185 191 204 209 228 232 233 251 253 260 263

Figures

Exchange rate movement and interest rate spread, Singapore: 1961–2002 10.1 Growth rates of real GDP, CPI and M2, Thailand: 1961–2002 10.2 Exchange rate movement and interest rate spread, Thailand: 1961–2002 10.3 Foreign reserves to imports ratio and growth rates of M1 and M2, Thailand: 1961–2002

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9.3

293 300 319 323

Tables 1.1 1.2 2.1

Schematic representation of policy mix in Asia Major outcomes of the liberalization process in Asia Overview of liberal policies in force prior to the crisis in selected countries 2.2 The baht currency crisis triggers a contagion, July 1997–December 1998 2.3 Foreign debt exposure and the financial crisis 2.4 Non-performing loans in Malaysia 2.5 Financial weakness rating following the crisis 2.6 Notable exchange rate declines and interest rate increases 2.7 International community commitments in response to the Asian crisis 2.8 Greater financial debt to support economic growth 3.1 Basic economic and social indicators of development in China, 1960–2002 3.2 Major financial sector reforms in China: 1980–2002 3.3 Performance of special export zones in China 3.4 Growth of financial and capital market indicators for China 3.5 Indicators of financial and capital market depth in China 4.1 Basic economic and social indicators of development in India 4.2 Structure of the Indian economy over 40 years of inward growth 4.3 Major economic and financial sector reforms in India, 1956–2002 4.4 Growth of financial and capital market indicators for India 4.5 Indicators of financial and capital market depth in India Appendix A record of bad interest rate management history 5.1 Basic economic and social indicators of development in Indonesia, 1961–2002 5.2 Major economic and financial sector reforms in Indonesia 5.3 Growth of financial and capital market indicators for Indonesia 5.4 Indicators of financial and capital market depth in Indonesia 6.1 Basic economic and social indicators of development in South Korea 6.2 Major economic and financial sector reforms in South Korea, 1961–2002 viii

9 19 29 33 37 39 41 42 45 56 65 70 76 87 91 97 99 110 116 124 130 134 146 150 156 164 168

Tables

6.3 6.4 7.1 7.2 7.3 7.4 8.1 8.2 8.3 8.4 8.5 8.6 8.7 9.1 9.2 9.3 9.4 9.5 10.1 10.2 10.3 10.4 11.1 11.2

Growth of financial and capital market indicators for South Korea Indicators of financial and capital market depth in South Korea Basic economic and social indicators of development in Malaysia Major economic and financial sector reforms in Malaysia, 1958–2002 Growth of financial and capital market indicators for Malaysia Indicators of financial and capital market depth in Malaysia Basic economic and social indicators of development in Pakistan Pakistan’s external debt payable in hard currencies Major economic and financial reforms in Pakistan, 1990–2002 Number of domestic and foreign financial institutions, Pakistan: as of 31 March 2002 Growth of financial and capital market indicators for Pakistan Capital market development in Pakistan: 1992–2002 Indicators of financial and capital market depth in Pakistan Basic economic and social indicators of development in Singapore Major economic and financial sector reforms in Singapore: 1967–2003 Growth of financial and capital market indicators for Singapore Indicators of financial and capital market depth in Singapore Cumulative average growth rates in trade and capital flows in Singapore Basic economic and social indicators of development in Thailand, 1960–2002 Major financial sector reforms in Thailand: 1979–2002 Growth of financial and capital market indicators for Thailand Indicators of financial and capital market depth in Thailand Elements of liberal policy mix needed for development Growth friendly policy outcomes in Asia, 1991–96

ix

181 183 192 198 206 215 226 230 236 246 247 249 252 268 272 277 278 291 298 304 318 322 337 339

About the authors Mohamed Ariff is a professor of finance at the Monash University in Melbourne, Australia and Renong chair professor at Universiti Putra Malaysia. He graduated with an honours degree from the National University of Singapore, and obtained an MBA and a PhD in finance from the Universities of Wisconsin (Madison) and Queensland; he also holds a professional accounting qualification. Scholarly articles and books authored by him on the financial economics of Asian capital markets, privatization, APEC development co-operation and tax compliance costs in Asia-Pacific are widely cited in Asian literature. His journal publications include contributions in internationally refereed journals: a short selection includes Kajian Ekonomi, Quarterly Journal of Economics and Business, Applied Financial Economics, Asian Economic Review, International Tax Journal, Journal of Business Finance and Accounting, Asean Economic Bulletin, Journal of International Financial Markets, Money & Institutions, Pacific Basin Finance Journal, and Global Business and Finance Review. Ariff worked as consultant to private firms, banks, stock/futures exchanges and international organizations (Harvard Institute for International Development, Ford Foundation, United Nations, etc.): engaged in research/teaching stints in Harvard, Melbourne and Tokyo Universities as well as University College Dublin on fellowship awards and visiting professorship. He worked in industry for ten years before joining academia. Over 1997–2002, he held the Bumi-Commerce Bank endowed chair professorship as an occasional visitor to Universiti Utara Malaysia. Ahmed M. Khalid is an associate professor of economics and finance at Bond University, Australia and holds a visiting faculty position at Lahore University of Management Sciences (LUMS), Pakistan. He worked as an assistant professor at the National University of Singapore. He specializes in applied macro- and monetary economics, econometrics and financial sector reforms. He obtained his MSc in economics from Quaid-e-Azam University, Pakistan and a PhD from Johns Hopkins University, USA. Apart from working as a project officer with the US Agency for International Development, he has been engaged as a consultant by the Asian Development Bank, UNDP and Haans Seidel Foundation and visiting consultant at the World Bank (2000): visiting scholar at the Limberg Institute of Financial Economics x

About the authors

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(LIFE) in the Netherlands (1998); and visiting professor at the Pakistan Institute of Development Economics (2002). His publications include a book (co-authored with Ariff), internationally refereed articles (Journal of Development Economics, Applied Economics, Empirical Economics, Journal of Asian Economics, Singapore Economic Review, Malaysian Journal of Economic Studies, Pakistan Development Review, etc.) and chapters in books.

Foreword Hal Hill This is a bold, ambitious and significant volume on eight highly important and mostly very large countries collectively inhabited by almost half of humanity. Practically all types of economies and shades of development experience are represented in this collection. Most are developing economies, but one (Singapore) is among the richest in the world, and another (South Korea) is an OECD member. Two of the world’s giants, China and India, are represented, alongside such populous states as Indonesia and Pakistan, and small open economies like Singapore and Malaysia. These are some of the fastest growing economies, mostly among the East Asian sample, but spreading to South Asia, India in particular. Four of the countries were severely affected by the East Asian economic crisis, and thus we also have puzzling examples of growth collapses (notably Indonesia) represented in this volume. There are other cases of countries evidently not living up to initial expectations, most notably Pakistan which is sometimes characterized as a case of ‘growth without development’. In terms of international economic integration, there are the three ‘always open’ economies (in the Sachs-Warner sense) in Southeast Asia. At the other extreme are the two giants, in transition from essentially closed and highly regulated economies to global commercial engagement. There are also the two resource-rich economies of Southeast Asia together with the two extremely resource-poor NIEs. Some countries have inherited and maintained good quality institutions, while others are regarded as ‘soft states’ with weak (and vulnerable to capture) bureaucracies. Some of the country sub-titles aptly summarize the authors’ assessment of the countries’ development trajectories. For example, China is viewed as ‘a command economy responding well to market signals’. Thailand is a case of an ‘open external sector [yet] exposed financial sector’. For India, it is ‘more than a decade of liberalization, yet not fast enough’. Singapore faces the challenge of ‘reforms to maintain [its] financial centre status’. This group of countries therefore provides the basis for a series of analytically rich and informative country studies. In such a heterogeneous collection, a major challenge is to maintain coherence while allowing for diversity. The authors have (sensibly in my view) emphasized the twin xii

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and inter-connected themes of liberalization and growth. These themes are surely central to Asia’s economic future. On the one hand, more open economies generally grow faster, and in any case liberalization, like it or not, is a twenty-first century reality. But one can of course debate, as the authors do, what exactly the concept means. Moreover, liberalization is a necessary but not sufficient condition for growth. The key challenge is how to manage it, to thereby achieve the rapid growth which is the only sure means of sustained and widespread poverty alleviation in the developing world. The central analytical framework comprises the four key areas of reform. For the real sector, this entails trade liberalization, the removal of anticompetitive restraints, and SOE reform. In the financial sector, the banking sector needs to be opened up and supervised, alongside other institutions of financial intermediation. Fiscal sector imbalances need to be restrained, in addition to other reforms of public expenditure and revenue. Finally, the external sector needs to be opened up, initially through the removal of restrictions on foreign exchange transactions for the current account, and later (with qualifications) for the capital account. In keeping with the book’s major themes, there is also a chapter on Asian financial markets in crisis and recovery. Developing the theme of a ‘world of increasing financial fragility’ this analysis competently takes us through the origins, management and aftermath of the past, turbulent decade. It also lays the foundations for a central theme of the volume: that the domestic financial sector should be integrated with the global capital market but, especially given short-term volatility in the latter, only when the necessary regulatory framework has been established. The authors have also been careful to inject some historical perspectives into their analysis. Indeed they are central to the story, in Asia ‘rediscovering’ a neoclassical development path. No less than a 1958 essay by Milton Friedman is invoked in support of the argument that openness to trade shifts resources into efficient sectors ‘without a development bureaucracy’. Yet, while liberalization is ‘the catalyst for growth in Asia’, the authors are careful to stress that the regulatory and institutional underpinnings of an efficient and prosperous market economy are complex. They are particularly concerned with what they regard (rightly in my view) as the ‘benign neglect of banking reforms’, ‘over-exposure to short-term capital flows’, and related financial sector issues. A summary chapter draws upon their earlier, well-reviewed volume, Liberalization, Growth and the Asian Financial Crisis. It expounds upon their ‘ten commandments of a free market economy’. These include effective diplomacy so as to minimize defence expenditure (a judgement no doubt buttressed by their work on the sub-continent and the Korean peninsula); the

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building of coalitions for liberal reforms; nurturing durable institutions; and care in the sequencing of reform, along the lines noted above. One volume on eight diverse economies cannot possibly be the last word on the subject. Inevitably, some readers may have wanted a different mix of countries or issues. Or guidance on the political economy of how to get ‘from here to there’. The authors clearly had to steer a course between continuity and coherence on the one hand, and country detail on the other. In my view, they have got the mix about right. The authors have written widely on Asian economic development issues. In this volume, they bring considerable wisdom and authority to a most demanding task. Hal Hill H.W. Arndt Professor of Southeast Asian Economies Australian National University Canberra February 2004

Preface This book is about sweeping new thinking spreading in Asia (and elsewhere too) on liberalization and what such economic and financial liberalization could do to the well-being of peoples of poor nations. The authors are indeed pleased to document, in this carefully analysed book, the myriad liberalization steps undertaken by eight Asian nations with potential lessons for other nations pondering how to improve the human conditions in the newer, increasingly globalizing world in the twenty-first century. It is not entirely unthinkable that some readers from nations not included in it may seek to emulate the success stories in Asia and even be forewarned to avoid the mistakes suggested from a careful study of the included countries. The authors have been researching the new thinking among Asian elites since 1996. They reported in a separate publication in 2000 some very interesting findings about the liberal reform experiences of thirteen countries over a span of 35 years ending in 1998. Those findings are extended in this later book by covering just eight countries as core cases of some very successful nations, while also describing equally interesting examples of a few nations that could not secure the prosperity through liberalization attempts because of conditions that prevented them from focusing on progressive ideas in the face of external and internal threats. Readers will find this book to be a good reference for a comparative understanding of how neoclassical liberal economic and financial reforms could be planned and executed in order to secure prosperity while also noting what pitfalls may prevent smooth transition to sustaining the prosperity in the face of major crises. The paths trodden by eight countries over about forty years were selected for study. Their experiences as evidenced by reliable statistics tell us it has not been smooth sailing, with some countries jolted by severe sidelining of liberalization because of internal and/or external threats. For example, Pakistan’s attempts to get its economy on the right path were thwarted by a lack of good neighbourliness on its left and right while the Cold-War-related interventions in its affairs led to costly and catastrophic war preparedness. Both these conditions naturally resulted in resources being directed to making weapons and not civilian goods. This nation failed to put reforms to work for her people’s benefits. Then there is the other example of China, which, motivated to preserve the Communist controls and aspirations of the controlling elites of that country, latched on to neoclassical economic and financial xv

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reforms to return its production processes more and more to the dictates of the market, instead of the whims of the central planners in that command economy. The reforms produced an economic revolution, some would say a miracle. This led this once foreign-currency-starved nation to boasting in year 2003 the world’s largest reserves on the back of a policy of cheapening its currency value to gain trade dominance: foreign reserves in 2004 were close to US$400 billion. That country’s experience could perhaps be matched, as it is very close to the economic miracles achieved by a few Fascist regimes in Europe in the 1930s and the early 1940s. There are other middle-of-the-road cases such as those of Malaysia and Thailand. With a long period of years spent on building peace bridges with neighbours to prevent hostility, these two nations secured sustainable prosperity over two decades at growth rates twice as high as in many countries while also democratizing the management of their countries based on one person one vote and multiparty democracy. GDP per capita in Malaysia went from 10 per cent of US GDP per capita to 40 per cent in just 20 years. Of course these two countries were not spared problems: they faced a major crisis, which was the 1997–98 Asian financial crisis. That crisis and the subsequent ongoing fight against religious terrorism following the September 11 incident left these economies in pretty bad shape and shaved half the hitherto-growth momentum and what they achieved over a quarter century before the crisis and before the terrorism-related crises in these countries. One salient finding is that these eight nations had mixed experiences on how reforms could alleviate economic woes of their peoples. Yet, overall, the early reformers and the later-reforming China and India had more successes than failures to secure improved well-being of their citizens. The financial crisis that pushed back the gains in some financially more open economies very severely – the case of Indonesia is one – suggests that there was something essentially wrong with these economies to have such severe effects from that crisis. It revealed that there were issues of (a) over-dependence on foreign capital flows, and (b) overvalued currencies, which, relative to China, were severely curtailing their ability to maintain competitiveness in the international marketplace for consumer goods as well as low-value consumer durables. The right thing happened by accident to them with the collapse of currencies of several of these countries, which rearranged their competitive positions in their favour thereby improving their trade after the crisis. The issue of how these countries are coping with the loss of competitiveness while also being willing to undertake wide-ranging reforms are two interesting questions to which the authors turn their scrutiny in this study. The seriously affected ones (Indonesia, South Korea, the Philippines and Thailand) underwent market-opening efforts under the tutelage of the Asian Development Bank, the IMF and the World Bank. Others (Malaysia and

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Singapore) managed to bring in similar reforms without the IMF oversight. The important thing is that all these eight nations undertook, and are continuing to undertake, reforms to secure the growth momentum lost in some cases after the systemic regional crisis in 1997–98 and also after the September 11 incident. Important reforms included free floating of the currencies: Indonesia, South Korea, Pakistan, Singapore (still follows a managed float regime) and Thailand. Or some adopted the intermediate step of basket-pegging currencies in the hope that at a future date(s) their currencies could be free floated: China and India. Capital controls that were rampant were slowly eased to provide at least their real sectors with easy access to capital. Even in the case of Malaysia with a fixed exchange rate from October 1998, corporations were never in any doubt that their foreign exchange needs would not be controlled by the authorities. To the contrary, the rules were softened for the production sector. Competition policy and exit policy for firms were promoted. Bankruptcy laws were honed carefully to ease exits for correct cases. Barriers to entry were removed as was done in the worst cases in South Korea with chaebols (powerful family or clan-held firms) forced to seek wider distributions of shareholdings. Some were broken up to promote competition. MacCarthy would have moved in his grave to note happily that others are following what he did similarly to break up the anti-competitive zaibatsu firms in Japan in the 1940s. This time it was the turn for South Korea to rein in the powers of the chaebols, which often interfered with democratic processes. Trade liberalization followed quickly. Imagine the inward-looking Indian government making huge reductions in tariffs ahead of its aspirations to be a member of WTO. Tariffs came down in many countries. Many countries abolished barriers to entry to all kinds of economic activities (not military ones), although in some cases, as in China, the only way is to enter the country through a joint venture, with state-owned firms increasingly being listed on stock exchanges or managed via private sector incentives, though not ownership, almost all the time. The financial sector reforms were also undertaken after the crisis. The collapse of this sector respectively in Indonesia, South Korea, Malaysia and Thailand led to restructuring reforms that made the hitherto very weak financial institutions reform their ways of doing business after an initial period of financial recapitalization efforts to put them on the mend. Some countries in the sample have signed WTO services agreements under which the financial sector will be open to foreign participation. Fiscal discipline returned to the countries after having been lost for a while because of the crisis. Budgets are more in balance in these countries, and governments are reforming ways to return subsidized activities to the dictates of the marketplace (except perhaps in the health and education sectors).

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Capital and money market openings along with efforts to build sound bond markets are seriously underway. Restrictions on ownership and entry are slowly being lifted. Some countries, Thailand is one, have made foreign ownership very easy. Monetary policy reforms took centre stage – given the high inflation after the crisis – in the forms of greater independence for the central banks, and setting up of good governance (Indonesia has an UNDP presence on this) framework. The prudential framework has been seriously re-examined with some countries attempting to set up separate prudential supervisory bodies as in Australia and the UK to improve the bad loans and banking supervision problems. In short, the twenty-first century challenges for these eight countries are being confronted squarely head on. Once the world settles to a more orderly situation from its terrorism-related activities, and the people of the world return to normal activities, it is not unthinkable that these already-ready-to-go early reformers may well secure higher growth rates than they are stuck with presently. In that prediction, the authors are very hopeful that it will happen. We see in this analysis very complex meshing of decisions in a coherent whole that secures growth and development, which brings prosperity to peoples of different doctrinal persuasions. We also note, in the case of those that failed to develop, a lack of consensus building to ensure peace with neighbours, a singular lack of a strong constituency for open liberal policies, and lack of open market signals, all of which only favours interest groups seeking to preserve the status quo profitable to these groups. The Communists have now returned to the market signals but they are still adamant where it really matters most. That is, to make far-reaching changes to private ownership, institutional changes on information freedom, freedom of association and to create a market-friendly environment for non-economic and non-financial activities of people. We would like to take some space here to acknowledge our gratitude to many who made this study possible. This work would not have been possible but for the support of our publisher, Edward Elgar, personally, from the outset. Edward saw a book of this kind being useful for many purposes, and we thank him and his hard-working editorial staff for their assistance over the years. Second, but not less important, are the many persons who helped us selflessly by sharing information during our visits to all these countries, where we met bankers, professors, consultants, government officials, officers in the central banks, etc. These people – there are too many of them to name here individually – have a good feel for what policies were good for their respective countries, and were not unwilling to share their views with us authors of how things could have been improved in many cases. Our research visits to these lands have endeared us to the attractions of these Asian countries as potential tiger economies of the future years in the

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twenty-first century once events come together to pursue right policies. After all such things happened with Deng in China or Dr Mahathir in Malaysia or Rao in India, who were all responding to market demands of their times with single-minded pursuit of changes in broad directions to secure prosperity for their peoples through the dangerous road of liberalization instead of controls. Finally, we would like to thank friends and scholars who have been very supportive of this study. Several research assistants helped us during the data collection and compilation phase: to them, our heartfelt thanks. Many scholars supported our efforts. First and foremost, we thank the anonymous referees in the UK for useful suggestions. David Cole and Betty Slade, formerly of Harvard University, encouraged this work as did the late economic historian, C. Manias Kindleberger. Limited research grants extended to the authors by the Monash University and the Bond University are greatly appreciated. Last, but not least, we thank our wives and children who have long supported our fascination with studies of Asia’s resurgence. Mohamed Ariff Professor of Finance, Monash University Melbourne, Australia (Visiting Renong Chair Professor, UPM, Malaysia) and Ahmed M. Khalid Associate Professor of Economics and Finance Bond University Gold Coast, Australia (Visiting Faculty, LUMS, Pakistan) August, 2004

Abbreviations ABC: Agricultural Bank of China ACs: Agricultural Cooperatives ACB: Agricultural Credit Bank ACU: Asian currency units ADB: Asian Development Bank ADR: American Deposit Receipts AFTA: ASEAN Free Trade Area ARF: ASEAN Regional Forum ASEAN: Association of Southeast Asian Nations ATMs: Automated Teller Machines BAAC: Bank of Agriculture and Agricultural Cooperatives (Thailand) BAFIA: Banking & Financial Institutions Act BD: Budget Deficit BDC: Bond Dealers’ Club B/E: Bill of Exchange BFC: Beijing Financial Center BIBF: Bangkok International Banking Facilities BIBOR: Bangkok Interbank Offer Rate BIR: Bureau of Internal Revenue BIS: Bank of International Settlement BJP: Bharatiya Janata Party BNM: Bank Negara Malaysia BOI: Board of Investment (Thailand) BOK: Bank of Korea BOP: Balance of Payments BOT: Bank of Thailand CAGAMAS: National Mortgage Corporation of Malaysia CAR: Capital Adequacy Ratio CDC: Central Depository Company (Pakistan) CDR: Credit-deposit Ratio CFC: Credit Foncier Company CFETS: China Foreign Exchange Trading System CGCM: Credit Guarantee Corporation of Malaysia CGT: Capital Gains Tax CHIBOR: China Inter-Bank Offered Rate xx

Abbreviations

CITIC: China International Trust and Investment Corporation CMDP: Capital Market Development Programme (Pakistan) CPF: Central Provident Fund CPI: Consumer Price Index CRS: Contract Responsibility System (China) CRR: Cash Reserve Ratio CSRC: China Securities Regulatory Commission DBS: Development Bank of Singapore EDB: Economic Development Board (Singapore) DFI: Depository Finance Institution DMB: Deposit Money Bank EIB: Export-Import Bank EIU: Economist Intelligence Unit EKB: Expanded Commercial Bank EPF: Employees Provident Fund ETDZ: Economic and Technological Development Zone EXIMBANK: Export-Import Bank (India) FC: Finance Company FCFSC: Finance Companies and Finance and Securities Company FDFI: Financial Development Financial Institution FDI: Foreign Direct Investment FEAC: Foreign Exchange Adjustment Centre (China) FEC: Foreign Exchange Certificates FIDF: Finance Institutions Development Fund (Thailand) FIR: Financial Intermediation Ratio FRN: Floating Rate Notes FTC: Foreign Trade Corporation FX: Foreign Exchange GATT: General Agreement on Tariffs and Trade GDP: Gross Domestic Product GDR: Global Deposit Receipts GDS: Gross Domestic Saving GFCF: Gross Fixed Capital Formation GHB: Government Housing Bank (Thailand) GIC: General Insurance Corporation (India) GICS: Government Investment Corporation of Singapore GITIC: Guangdong International Trust and Investment Corporation GNP: Gross National Product GS: Government Securities GSB: Government Savings Bank (Thailand) HCI: Heavy and chemical industries IBCL: Interbank Call Loans

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IBRA: Indonesia Bank Restructuring Agency IBRD: International Bank for Reconstruction and Development ICBC: Industrial and Commercial Bank of China ICI: Insurance Corporation of India ICICI: Industrial Credit and Investment Corporation of India IDFI: Industrial Development Financial Institution IDRA: Indonesian Debt Restructuring Agency IFC: International Finance Corporation IFCI: Industrial Finance Corporation of India IFCT: Industrial Finance Corporation of Thailand IH: Investment House IMF: International Monetary Fund IPO: Initial Public Offering IRDA: Insurance Regulatory and Development Authority ISI: Import Substitution Industrialisation KLSE: Kuala Lumpur Stock Exchange KSE: Korea Stock Exchange KSE: Karachi Stock Exchange LC: Letter of Credit LIBOR: London Interbank Offer Rate LUMS: Lahore University of Management Sciences MAS: Monetary Authority of Singapore MB: Monetary Board MBF: Micro-Bank Finance MFMC: Mutual Fund Management Company MOF: Ministry of Finance MTB: Market Treasury Bill NAB: National Accountability Bureau (Pakistan) NABARD: National Bank for Agriculture and Rural Development (India) NBFI: Non-Bank Financial Institution NBP: National Bank of Pakistan NCB: Nationalized Commercial Bank NCD: Negotiable certificate of deposit NEITS: National Electronic Interbank Trading System NETS: National Electronic Trading System NFEAC: National Foreign Exchange Adjustment Center NG: National Government NIE: Newly Industrializing Economy NPLs: Non-Performing Loans NSC: National Securities Committee NTS: National Tax Service (China) ODA: Official Development Assistance

Abbreviations

OECD: Organization of Economic Cooperation and Development OEZ: Open Economic Zone OMO: Open Market Operation OPEC: Organization of Petroleum Exporting Countries OTC: over-the-counter OUB: Overseas Union Bank (Singapore) PBC: People’s Bank of China. PBC: Pakistan Banking Council PBF: Provincial Banking Facilities PCBC: People’s Construction Bank of China POSBank: Post Office Saving Bank PRC: People’s Republic of China RB: Rural Banks RBI: Reserve Bank of India RCC: Rural Credit Co-operatives Repos: Repurchase Agreements RM: Malaysian ringgit RMB: remimbi SAEC: State Administration of Exchange Control SBI: State Bank of Indonesia SBP: State Bank of Pakistan SBPU: Surat Berharga Pasar Uang (Indonesia) SC: Securities Commission (Malaysia) SCs: Savings Cooperatives SDB: State Development Bank SEACEN: The South East Asian Central Banks SEBI: Security and Exchange Board of India SEC: Securities and Exchange Commission (Thailand) SECP: Securities and Exchange Commission of Pakistan SESDAQ: Stock Exchange of Singapore SET: Stock Exchange of Thailand SEZ: Special Economic Zone SIBOR: Singapore Interbank Offer Rate SICGC: Small Industry Credit Guarantee Corporation (Thailand) SIFC: Small Industry Finance Corporation (Thailand) SIMEX: Singapore International Monetary Exchange SOE: state-owned enterprise STAQ: National Electronic Trading System (China) SWIFT: Society of Worldwide Interbank Financial Telecommunication TB: Thrift Banks TB: Treasury bill TIC: Trust and Investment Company

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TRIS: Thailand Rating and Information Services UCC: Urban Credit Co-operatives UEM: United Engineers Malaysia UOB: United Overseas Bank (Singapore) USAID: United States Agency for International Development UPM: Universiti Putra Malaysia UTI: Unit Trust of India VAT: Value-Added Tax WTO: World Trade Organization

1. 1.

Liberalization: Asia’s new-found development strategy INTRODUCTION

This book provides a number of significant lessons from an in-depth study on how economic prosperity was secured over a lengthy period of over three decades by a number of Asian countries, where the economic agents carefully designed and implemented pro-growth liberal economic and financial policies. The book also examines a new phenomenon, financial fragility, in the more liberalized fast-growth Asian economies. Four economies, which had a high degree of financial fragility, bore the brunt of the more damaging side-effects of the Asian financial crisis. The crisis appears to have originated in some and not all because of a lack of institutional capacity to prudentially manage the capital structures of both the financial and the non-financial firms exposed to domestic and foreign short-term capital. Since the early 1990s, a serious mismatch had developed between the duration of investments and the shortterm cash flows supporting these long-term investments in the fast-growth economies, thus making them ripe for a financial crisis. Some development lessons are being learned from this episode and the crisis had a far-reaching impact on the rest of the world, and even affected the thinking of the IMF and the World Bank as no other crisis did in recent memory. The study covers eight countries, which had followed three different models of economic development even though they have now converged to a free market strategy: the capitalist, the mixed and command models. Some followed predominantly capitalist neoclassical policies that promoted increased competition, less regulation, withdrawal of the state from production activities and more external openness. One outstanding example of these has been Malaysia, till 1997, when it introduced some illiberal policies in order to stop the crisis from spreading. Others such as India, which had unsuccessfully followed a mixed economy government intervention development strategy, had recently become convinced that the road to growth has to be through the accelerated pursuit of liberal policies. Pakistan, another example of a mixed economy, is also included in this study. We also study China, a transitional economy, which had abandoned the command economy statist model in favour of making transition to a market economy model.1 1

2

Liberalization and growth in Asia

Very important lessons are learned from the understanding we provide to the reader from this extensive research on how these eight countries with different past policy models are now converging towards a neoclassical liberal model of development strategy. We believe that the lessons from this study of the so-called Asian Miracle2 are in fact based on sound principles of competition, decontrol on prices, and restructuring towards more efficient combination of resources to produce goods and services that markets demand. In short, the successful formula for development appears to be based on neoclassical principles that are consistent with (1) liberalization in the real and financial sectors as well as (2) reduced intervention by government while not losing sight of the need for (3) strict standards of prudential financial management needs of both the real and the financial sectors. By the early 1980s, the more developed economies in the OECD grouping had matured to become more services-dominated economies with income growth well below 4 per cent per annum. This led to a lowered capacity to fully employ available resources, in particular capital, which found its way out of these countries as foreign direct investment (FDI) in real investments and portfolio investments in the financial markets.3 Most developing Asian countries were caught between the Communist preaching that planned growth by the state was possible and the free market based development thinking consistent with neoclassic economics. Amidst this debate in the 1950s, a few early reformers such as Hong Kong, South Korea and Singapore, put more of their unused resources to full use through liberalization. For the first time, this formula secured a respectable high rate of economic growth during the period spanning the 1960s to 1980s. The early reformers also included such countries as Malaysia, Thailand and Indonesia. Thus, the five economies from this group included in this book enable us to learn lessons on Asia’s liberalization and growth strategy. The experiences of these countries provide lessons on how a developing country could use a free market based economic strategy for development. Then there are the cases of the mixed economy strategy of the late starters such as India, a very large economy like that of China, which pursued state interventionist strategy unsuccessfully to build industrial and infrastructure capacities. The original vision of government intervention strictly meant to enlarge indigenous capacity in infrastructure and in enhancing industrial capacity soon degenerated to become a scheme of financial suppression and of government interventions in the production of many other goods and services. India’s state sector at one time produced almost a quarter of the GDP. Its high taxation has diverted resources to a parallel black economy reported in the popular press to be about 50 per cent of the official economy.4 We examine India and Pakistan, as a representative of such mixed economies that had experienced varying degrees of financial suppression and

Liberalization: Asia’s new-found development strategy

3

state interventions. The study of these countries enabled us to learn lessons on development failures of the mixed economy model of development. These countries have started to turn to liberalization in the late 1980s in a desperate turnaround in the face of popular displacement in national elections of hitherto well entrenched political parties.5 The liking for liberal reforms has grown steadily since then in these countries even as we completed this study. But the vested interests in these economies, which had gained the most from the interventionist policies of the past, are putting roadblocks to continuing liberal reforms. Thus, governments are hesitant to pursue reforms vigorously. These countries are thus again losing sight of the importance of Asia’s newfound strategy of liberalization that had already been tested by them in recent years with at least limited success since the early 1990s compared with lack of success using other strategies. With the demise of the Soviet Union and with it also the abandonment of the dogma of the planned or command economy model, China started the road to serious experimental reforms in the 1980s since then characterized as a market economy model. We include China in this study to learn lessons about how successful transition to a market economy model could be made of the Soviet-style economies through economic restructuring of the command economy. The reforms, in China, came as a result of a new regime looking for a new strategy to bring prosperity to China after Mao, China’s self-proclaimed Great Helmsman, died. After Mao’s death, the Gang of Four, who allegedly usurped power, had been arrested.6 Some 85 per cent of China’s output was then being produced by loss-making inefficient state firms. To unshackle the moribund economy, a quick fix was sorely needed. So, the Communists turned to the market to do the job after failing to make the great leap forward from practising state planning. A doctrine to legitimize the new regime was also needed in the late 1970s. A formula was found to attract capital and technology from the capitalist world – among them the Chinese migrants living in more open economies with lots of capital – attracted to the market of 1.2 billion people. China put to use massive unused resources at the disposal of large foreign capital and also released the pent-up enthusiasm of the people by slowly granting limited private ownership of land, capital and enterprises in a still largely statist society. These two factors served as the basis of growth to date in China. It appears that China has made limited success in smothering the inefficiency of its state sector by the efficiency of the foreign and domestic private sectors. After 20 years, the proportion of GDP produced by the state sector is less than half that at the time of initiating the new strategy. It is a clever strategy. A limit to this policy pursuit is bound to be reached some time in the near future as long as the state’s and the financial sectors’ inefficiency is not tackled. China’s initial success is so well publicized that no further discussion is needed.

4

Liberalization and growth in Asia

Including China in this study provides important lessons on the failure of the command economy model and on how a transition could be made towards a market economy model through experimental liberalization. The remainder of the chapter is divided into six sections. The reader is given a quick overview in the next section, of Asia’s convergence in recent years on a strategy of liberalization. There, we describe the process of development failures over the last 40 years, as well as the development successes in later years. The common characteristics of slow and fast growth in Asia are then identified in section 3. Sectoral reform policies are discussed in section 4. The common outcomes of growth experience are described in the next section, where the reader will find the most useful characterization of the strategy that is at the root of the so-called Asian Miracle. The chapter ends with an overview of the remaining chapters of the book.

2.

ASIA REDISCOVERS THE NEOCLASSICAL PATH TO DEVELOPMENT

To understand Asia’s convergence to the contemporary liberal development strategy, one has to retrace economic development history during the post-war years. Asia’s experience in this regard is a mixed one in so far as there were well-publicized experimentations with several approaches to development planning. Some approaches were dictated by political doctrines of a country while other approaches were very much based on the experiences of others who had adopted different strategies and had secured successful social and economic development. In any case, the post-war period up to 1990 may be characterized as a period of intense rivalry among nations for three competing approaches to economic development. Some political pundits may draw parallels in such characterization as being equivalent to the three political doctrines of the Cold War years to 1990. This is far from it, the view we express is based on the choice of development model rather than the political window-dressing of these models. At the background of this intense competition was the great Marxian economic experiment to create the Utopia that was thought possible based on the Marxist–Leninist command economy model. That experiment started with the 1919 Leninist takeover of Russia, which slowly developed the Soviet model of the centrally planned economy with collectivization of individual property rights (and limitations on individual freedoms). Asia, which had not seen much development during almost two centuries of its colonial domination by the West and, in later years, by Japan, was ready to adopt any model that promised to deliver favourable outcomes. The alternative to the command model was the then existing mainstream Western economic

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5

thinking loosely characterized as the free market economy. That suggested a model based on private-sector-owned free enterprises making goods and services in competitive markets made possible by an environment with little government intervention but with transparent rules strictly promoting competition, which reduced prices of goods and services to yield normal profits for producers and lowest possible prices for the consumers of the goods and services. Economists have begun in recent years characterizing this minimum interventionist market economy model as being consistent with the neoclassical development model. Some Asian countries wanted to limit the role of government to somewhere below the level of the omnipotent state in the Soviet model and the limited government of the capitalist model. Thus was born the third strategy, which was named the mixed economy model. This model was in fact sold to the peoples in Asia as the socialist model for development. Even the Communists tried to use the term ‘socialist’ for their command economy model. It turns out that the mixed economy socialist model was a way for several Asian countries to stand aloof halfway between the super-power rivalry that promoted the command economy model and the pure capitalist model as the only alternative worth pursuing. It was equally feasible in the 1950s to have defended the mixed model as one with market signals not state signals, and things would have been far better than what actually happened. Nonetheless, that is the way the three models were sold to the public as stark choices. Thus, the super-power rivalry to win Asia’s underdeveloped countries to one side of the persuasion was the driving force that led to the adoption of a given development strategy amongst the three. The mixed model was chosen by some countries with large populations (Brazil and India), and therefore large consumer markets, as import substitution strategy.7 China, the other country with a large population, chose the Marxist–Leninist state planning model from 1949, while India embarked on the import substitution strategy from about the early 1950s. In general, it was a country’s relationship to the super powers that dictated the choice of the model. No systematic examination was made as to whether interventionist strategies could secure development even though some of the approaches were not consistent with mainstream thinking in economics. China, North Korea and Vietnam adopted the command economy model, which was consistent with their membership in the Communist bloc of nations. These decisions were made more in view of the Cold War realpolitik than any systematic analysis about the superiority of the strategy for development purpose. Thus, development was planned by the state through collectivization of agriculture and state ownership – strictly the proletariat control – of industrial enterprises. Capital had no role to play in this model.

6

Liberalization and growth in Asia

So, the financial sector was reduced to one that served the circulatory function of enabling payments to factors of production and also payment needed in the process of exchange of goods and services. Financial markets were forcibly divorced from playing any role in the market pricing of capital assets as resource allocation institutions. For example, the command economies had banking, but banks were 100 per cent collection and distribution agencies and not maturity transformers collecting short-term deposits and converting these at an appropriate price to long-term loans nor delegated risk monitors of the public’s savings invested as borrowed money by the firms. The countries at the border of these Communist nations were persuaded by the capitalist developed nations to follow the neoclassical model of development. Here the argument of Campos and Root (1996) is very convincing. The countries in the Western Pacific and in the Indian Ocean served to keep Communism in the Asian heartland. In that model, varying degrees of state interventions were justified in some disguised forms in contrast with totalitarian control in the former command model. For example, Japan had credit targeting as did South Korea and Indonesia to favour some industries to develop more than others. Taiwan engaged in a number of forms of government assistance to encourage medium and small enterprises to become nimble exporters of consumer durables to the whole world: this country even adopted ‘land to the tiller’ reform to privatize state ownership of lands. Nevertheless these East Asian free-enterprise-based economies refrained from total government ownership of real sector firms though ownership of financial institutions in South Korea and Indonesia was favoured during the early stages of development in the 1970s. Thus, these economies – we analyse South Korea, Indonesia, Malaysia, Singapore and Thailand – remained largely capitalist with some degree of government intervention in the real and in the financial sectors. One characteristic they shared was greater and greater openness to the rest of the world to enable an export-led growth strategy as a feature of their development strategy. Following that growth process, these economies were able to secure a high degree of exposure in trade and capital flows. Expressed as a percentage of GDP, these countries had a very high trade sector, such as South Korea’s 16 per cent. They also attracted foreign capital flows amounting in some cases (Malaysia being one) to almost 20–30 per cent of their GDP in some years. By the amount of the dependence on external economy (trade and capital flows), all these countries had high exposure to the foreign sector whereas other economies had very low foreign sector exposure. The third model is the socialist mixed economy model, which can be described as follows. Through some amount of government interventions in the production process – this took the form of outright rejection of private ownership in some selected segments of the economy as well as the financial

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7

institutions – the state took an active part in the production process. For example, about 200 central government enterprises in India produced many goods and services making up anywhere from 20 to 40 per cent of GDP. This was the halfway-house experiment compared with Communist China, which produced 85 per cent of its GDP through its 28000 central government owned firms and many times more than that number of firms owned by the provincial governments. The Vietnamese had 78000 firms practically producing the entire output of the economy. Prior to the reforms of the 1980s, Malaysia’s 900-odd state firms produced almost half the GDP then. With privatization in the 1980s, the number has been reduced to a manageable 150. What differentiated a mixed economy model from a totalitarian economy was the relatively larger private sector control of the economy in the former compared with the almost total control of the economy in the latter. But government intervention was present in both the mixed and the command economies to a greater degree than would be the case in the free market economies such as Thailand. The difference was one of degree, and not of substance. The book finds that constraining the market forces from working out efficiency gains in these economies from these interventions led to serious development failures. As early as the mid-1970s, Asia’s development strategists in government, industries and customer groupings started to realize the failures of the interventionist development programs in both the mixed economies and the command economies. Meanwhile, out of necessity dictated by a general scarcity of economic resources, four Asian ‘tiger’ economies namely Hong Kong, South Korea, Singapore and Taiwan were putting in place more open economic management programmes. That openness to the world secured for them a close to double-digit economic growth as soon as these economies dismantled state interventionist programmes, which they had adopted during the early 1950s. Successful development experiences of these tiger economies were quite obvious for others to see. Their success could not be ignored for too long by the followers of mixed and command economy models, which had not produced favourable outcomes after 30 years of experimentation. In the 1980s, a consensus started to emerge among economic agents in the mixed and the command economies to adopt a policy mix of the type followed by these tiger economies. Thus, Asia converged towards more and more openness and liberalization as the keys to securing economic growth. It took a long time for the ready acceptance of what has turned out to be a development model consistent with the mainstream neoclassical model of development. It came after its successful experimentation by the early reformers, the tiger economies as well as the potential tiger economies of Malaysia, Indonesia and Thailand.8 After the demise in 1991 of the former Soviet Union, the mixed economy and the

8

Liberalization and growth in Asia

command economy model of development strategy had become discredited. Asia at last converged towards liberalization and openness as the routes to securing economic and social development. Perhaps it is apt here to refer to an earlier prescription for growth. Friedman advocated openness and said that, given more openness aimed at creating conditions for efficiency and openness in trade, resources would move to create the growth without a development bureaucracy.9 This appears prophetic when we note that this was said over 40 years ago and many nations ignored this advice preferring to interfere with the market forces which create efficiency and resource allocation much better than via interventionist strategies.

3.

COMMON FEATURES OF GROWTH AND SLOW GROWTH IN ASIA

It is quite evident from the discussion in the above two sections that the Asian economies experimented with three development approaches over a lengthy 45-year period. The result is a conviction based on actual results that growth could be secured by active pursuit of liberal policies. That it took so long a time to realize a workable policy mix is not surprising given two factors described in our discussion. One was the Cold War rivalry that promoted the now defunct command economy model. To some extent, the adoption of the mixed socialist economy model was a knee-jerk reaction arising from security considerations to keep a distance from the two super powers, a sort of self-preservation using pseudo-economic arguments. The other factor was the general absence of a democratic will to pursue reforms in some countries because of several factors, which do not concern us in this chapter. What concerns us is that those countries that chose a total statist interventionist model took longer to reorient their development strategies than did the countries with some democratic processes in political management. These two factors are societal level variables that preconditioned a given economy to take the choices that they actually made under the prevalent circumstances during the post-war years. Of greater interest to the reader is an examination of common characteristics of the three paths to development. First we examine the policy mix pursued by those countries under the more successful liberalization and openness to which most Asian countries appear to be converging at the beginning of the twenty-first century. Table 1.1 is a representation of the sort of policies put into effect in some preferred sequences in the eight economies. These reforms can be described in a simple phrase. That phrase is ‘returning economic activities to respond to market signals wherever market failures are unlikely’. Described in another way, these reforms are consistent with the

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9

mainstream neoclassical economic principles of (1) competition to promote efficiency in production, (2) market creation to promote allocation efficiency in producing real goods and in allocating capital and other resources and (3) reduced prices of goods and services to promote consumer sovereignty. Two important further outcomes of openness to the rest of the world are (4) increased trade and (5) capital resource flows. Let us now examine how the fast-track free market economies differed from the slow growth economies in taking the steps enumerated in Table 1.1. Table 1.1

Schematic representation of policy mix in Asia

A: Real sector

●

●

● ●

●

●

B: Fiscal sector

●

●

●

●

C: Financial sector

●

●

●

Relax barriers to entry in domestic real sector to increase competition Relax barriers to entry of foreign firms in domestic sector to increase competition Private sector is recognized as the engine of growth Laws on property rights, incorporation laws, shareholder rights to safeguard capital from trade union control, bankruptcy laws, etc. Capital account openness (FDI, dividends, etc.) and investor protection Reduce the state sector and natural monopolies through privatization and/or corporatization to improve efficiency and to reduce burden on budget Balanced budget principle promoted with limits on government borrowing Taxation reforms to create incentives for enterprise and profit seeking Reduce corporate/income tax but diversify tax sources to increase revenue Strengthen tax and government administration via userpay schemes Remove, in steps, controls on interest rates so that the market can price risk Relax entry barriers in financial institutions to create competition to drive down the spread in deposit and lending rates Modernize and create specialization in financial services industries to improve service standards and to reduce costs of financial services Continued overleaf

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Liberalization and growth in Asia

Table 1.1

Continued ●

●

●

●

D: External sector

●

●

●

●

Create entities to diversify money market transactions to provide signals about risk in base rates, T-bills, bank bills, etc., and to deepen markets Create entities to engage in securitization of corporate and government capital funds in the bond and share markets Capacity for risk management through market forces and derivative markets Prudential rules and strict implementation to remove financial fragility Reduce tariff steadily so that firms compete internationally to gain efficiency, market access, and even technology Relax foreign exchange controls: unify different rates for producers first; create private markets for pricing of currency rates; remove, in steps, exchange controls for non-producer sector; have laws to impose controls during crisis Maintain current account balance and improve the reserve support for trade If feasible, adopt at correct time, truly free float of the economy

Sources: Extensive references to the sources are given in the remainder of the book.

4.

SECTORAL REFORM POLICIES

Real Sector Reforms The eight countries that adopted three different development strategies had significantly differing approaches to each of the A, B, C and D of liberalization. Real-sector openness in the command economies is still largely absent even in 2005 as is also the general reluctance to privatize the state sector for fear of creating unemployment.10 While entry of foreign capital has been permitted in some sectors, which are often restricted to operate in small geographical alien production zones, these foreign firms also face barriers to trade in the domestic economy because of the high import tariffs imposed if the goods are sold to the national markets. Though the private sector is recognized implicitly as the source of growth by the political masters in these economies, private ownership incentives are largely lacking in command

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economies. China is making reforms to its legal and judiciary systems dealing with commercial transactions, but these are still in the early stages. Thus, in the case of the command economy model, real-sector openness is far from present. In the case of the mixed economies, only in the late 1980s and in the 1990s were the laws passed to create greater real-sector openness. For example in India, the negative list, which restricted a large number of economic activities to be undertaken only by the state, was disbanded in 1991. This means that domestic firms may undertake any economic activity (except those few in defence and certain essential food items) in any part of the country unlike in the command economy countries. Even foreign firms that are producing as joint venture firms with 49 per cent share ownership with local firms have no barriers to entry in other production activities of the joint venture partners ever since reforms were put in place. Thus, until 1990, there was very little realsector openness in the mixed economies, but there has been greater openness since then. Foreign firms with greater than a 49 per cent share ownership are permitted to operate only in the export processing zones with no tariff and lower tax rates very similar to the situation in command economies. Pakistan, another mixed economy, had few barriers and low tariffs on exports but had substantial price controls on several items produced domestically. Pakistan has also slowly lifted price controls since the mid-1980s thus exposing the real sector to competition and efficiency. Pakistan’s economic problems arise from capital shortage and from a severe weakness in the fiscal sector caused by high debt servicing arising from heavy defence expenditures (see Chapter 8). In the cases of the free market economies – for example South Korea – it will be observed from the information presented later in this book that the real sector was the first sector to be opened to competition. South Korea relaxed controls on domestic production as did Taiwan, Malaysia, Singapore and Hong Kong as far back as the 1950s thus removing barriers to entry in domestic production. Even better, capital controls for both the domestic and foreign firms were lifted in the late 1950s when parliaments passed laws in what was then Malaya and in Singapore to attract foreign investments.11 These laws also permitted tax holidays of up to five years to be given to certain firms that satisfied a condition called ‘pioneer industry status’. Through these and other means, the free market economies opened their real sector to greater and greater domestic competition as well as in later years to foreign competition. Unlike the command and mixed economies, the state was not the preferred producer in the real sector although some of the countries (South Korea and Indonesia) at some stages had state-owned financial institutions. With privatization too the same trend can be seen. The free market economies generally did not encourage state ownership in the real production sector. As a result these did not have the same extent of state involvement in

12

Liberalization and growth in Asia

the real sector as did the command economies. Nevertheless those that had state firms quickly set about disbanding them by either selling them to the private sector or corporatizing their activities. In the early 1980s, Malaysia sold most of its 900-odd state firms to the private sector as did Singapore after adopting a privatization master plan in 1985: see Ariff and Thynne (1989). Compare this with the reluctance even after 30 years of growth in China to tame the bloated state and military firms! Bold moves were taken in China in 1999 to deal with them. In the cases of the mixed economies too, privatization has not proceeded at sufficient speed to return competition and efficiency to these firms to reduce the burden these firms impose on government budgets in those countries. Thus, in general, the first important step in successful liberalization appears to be a willingness to improve production efficiency through policies aimed at greater real-sector openness. The free market economies undertook these reforms in the 1950s whereas the command and mixed economies have only taken limited reform steps to liberalize their real sectors and to transfer government-owned firms to the private sector. Pertinent details on each country can be found in the remaining chapters of the book. Financial Reforms Reform of the financial sector is the next important feature of liberalization in Asia. Domestic financial firms were the targets of reforms in the initial stage. Korea, for example, eased entry restrictions in the late 1960s and permitted more banks, finance companies and others, including foreign banks, to be licensed. Specialized institutions were created to cater to a more diversified economy of the 1970s. More development banks, merchant banks and investment banks were licensed as were also agricultural and small–medium enterprise banks. Similar reforms took place in Taiwan and in Singapore and in Hong Kong. In command economies, 100 per cent of assets were owned by the state banks whereas in a matured typical free market economy, the bond and the stock markets will hold about 60 per cent of the assets in an economy: but very few countries fall in the latter category. The last two economies above, with a vision to serve as international financial centres, brought in a greater degree of modernization in the money, capital and derivative markets. Securitization was encouraged and this led to explosive growth in the money and capital markets. New listed firms increased at an annual rate of 8–12 per cent per year as a result of which the Hong Kong stock exchange emerged in the 1990s as the second largest in Asia next to the Tokyo stock exchange. The real-sector openness was matched with substantial openness to the rest of the world in the financial sector. Hong Kong and Singapore had a very large representation of foreign financial institutions as

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did South Korea. Thus, the expansion of the money and capital markets increased the standards of service to customers, improved mobilization of savings and offered new financial services. The rest of the countries (one exception being Malaysia) in this group were quite satisfied with limited openness in the financial sectors for fear of the bigger financial institutions of the larger economies weakening the domestic firms. This was a sort of infant industry protection argument common in the world trade rules applied to the financial sector, which led to the growth of oligopolistic banking in most Asian countries. Oligopolistic banking has inherent weaknesses as has been found after the Asian financial crisis in 1997. A virulent type of oligopolistic banking system actually emerged. It is one where the government-owned or controlled banks promoted a quangzi or network among the political elites, big business and state officials to facilitate lending to not-so-profitable investment activities. This has been noted by the IMF in its 1997 and 1998 reports as the ‘crony capitalism’ that led to bad banking practices. Contrast that with the experience of the command economies. In these countries, the monobanking structure peculiar to them underwent great changes. In the domestic financial sector, new banks, still owned by the State, were created to provide competition in the banking sector. Specialized banks were created to cater to agricultural, industrial and in some cases provincial (e.g. Bank of Guangdong in the South of China) capital demands while investment trusts12 were created to cream off the abundant savings running at 40 per cent of GDP. In China, this happened in the 1980s. The reader will note that the expansion of the financial services industry was done in time to serve the expanded financial activities consistent with expanded economic activities. As will be seen later in the book, financial deepening doubled with these limited reforms over the period. That was inevitable because a failure to take these steps would have created huge illegal underground financial structures, which would have led to economic chaos in China. However, the reader should take note that these institutions are still state owned and are managed by government employees with no private incentive schemes. Thus, astute observers have remarked that the banking system is so poorly managed that a disaster could be waiting to happen if their inefficient management is not corrected soon. Second, the banks are still predominantly serving the state firms. China has recently taken some steps to improve the capital allocation function of the banks or the function of maturity transformation.13 Without the financial sector providing allocation efficiency and as a consequence providing the risk management function of monitoring the real-sector investment efficiency, the banking system is still reduced largely as the provider of the payment function, a condition no different from that of the discredited command economy era. Thus, modernization and expansion of the banking system is perhaps complete

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Liberalization and growth in Asia

now but not its efficient management to deliver the important function of oversight of the real-sector investments. In the mixed economies of South Asia, the financial sector was turned around increasingly to serve the clever schemes of the governments. The banks were nationalized in all South Asian countries from about 1960 to 1986. This decimated the private sector banking. Government-owned banks increasingly provided improved banking services to the people in the interior of these countries, but over time, the standards of services had deteriorated. The banks were also directed to lend to preferred sectors – for example, cottage and heavy industries – and preferred segments of the populations. These directed credit schemes developed a system of widespread abuse in lending from which the financial sector has still not recovered in some of these countries. Some initial steps have been taken to address the problems created by the inefficiency of the financial sector. These steps have identified nonperforming loans to be many times the Basle recommended level of 3 per cent of the loans outstanding after provisioning for bad loans each year. Even as far back as 1995, non-performing loans of the Indonesian state banks were 15 per cent with return on assets of 1 per cent: the corresponding number for private banks was 5 per cent with return on assets of 4 per cent. In addition, capital adequacy, which had improved to about 8 per cent share capital in the free market economies by 1997, has also declined. Thus, unlike the fast-track tiger economies, the mixed and command economies have still not reformed their financial sectors to serve the expanded economies in ways that these are capable of contributing if proper reforms are put in place in the financial sectors. Fiscal Reforms The command and mixed economies undertook very few fiscal reforms even as late as the 1990s whereas such reforms were carefully put in place in the free market economies as early as the 1980s. Consequently the free market economies had achieved balanced (in some cases surplus) budgets in the late 1980s whereas the mixed and command economies have persistent budget deficits over the study period. What are the reforms undertaken? The major reforms concern reducing tax rates in the fast-track economies, diversifying the tax base (in Indonesia in the 1980s, in India in 1997 and in China in 1995–96) and improving the tax collection mechanism in all of them. These measures improved revenues to the governments to build capacity to sustain public sector modernization and capacity building programmes. Another fiscal reform, which significantly supported growth of the real and the financial sectors, was the use of fiscal policies to attract foreign firms to

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locate production in these countries. In return for reduced tax or tax holidays provided by fiscal policy reforms, governments in the free market economies attracted foreign direct investments as far back as in the 1950s to attract capital. With the foreign capital came market access to the developed countries as well as new and modern production technology to these countries. For instance, manufactured export items of Malaysia constituted about 85 per cent of all exports in 1995 compared with the 1970 figure of about 20 per cent (Asian Development Bank 1997b). This was largely made possible by the discriminatory use of fiscal incentives to attract foreign direct investments. As a result, Malaysia attracted the most direct investments amounting in 1994 to 28 per cent of its GDP, the highest in Asia. Prudential reforms had been lacking in all Asian countries except Hong Kong and Singapore, the two financial centres.14 As a result, prudential reform is likely to become a major focus in the future. In particular, after the Asian financial crisis has been shown to have been generated from the incipient financial fragility in the financial management of the economies, such reforms become more urgent. One could make a reasoned comment (see Chapter 2 for details) that the lack of a willingness to stamp out financial fragility has been a source of this. Reforms are in the making in the international institutions and in the national central banks to address this urgent problem. Time will tell us the steps that will be taken. In February 1998, the IMF made a bid to also expand its role by monitoring the banking sector. This does not portend well. Instead of turning over the bad bank management to be monitored and disciplined by both shareholders of the banks and the markets, bureaucratic supervision by the IMF is unlikely to be effective. Recall the fact that even a large bureaucracy that had very modern supervision of credit unions in the USA failed to prevent their spectacular failures, something that cost 3.5 per cent of the GDP of the USA over 1987–91. External Sector Reforms The signal achievement of the early reformers who secured a fast-track development is in the opening of their economies to the external sector with more merchandise trade and more trade in capital flows. This sets the early reformers apart from the rest of Asia. This also engendered a weakness that, in later years, was to become the Achilles heel that precipitated their severe suffering from the 1997 Asian financial crisis. Each chapter of this book has special sections devoted to this aspect. Therefore, in this section, the reader will be provided with only a broad overview. Tariff reduction policies were the first set of reforms to be undertaken to expose domestic firms to increasingly more competition to improve efficiency. The world trading arrangement also favours an average tariff of

16

Liberalization and growth in Asia

under 5 per cent in free trade areas. The average country tariff rate has been reduced substantially from as high as close to 100 per cent in Korea and 140 per cent in India in the early years. The average tariff in the free market economies in the 1990s, was about 15 per cent, and they are planning to reduce it to zero in some free trading zones amongst the ASEAN countries. The second aspect of this reform is the relaxation of restrictions to the entry of foreign firms to undertake domestic economic activities. Both these aspects have been commented upon in our earlier discussion on real-sector reforms. Two remaining aspects of external sector reforms are (1) current account opening, which is the lifting of restrictions on foreign currency trade by producers and individuals as well as (2) capital account freedom. The latter is the freedom granted to producers and individuals to move capital and capital services, income, such as royalties and dividends, across national boundaries. In the MacKinnon–Fry–Shaw advocacy on sequencing of financial liberalization, capital account openness is recommended only after real-sector opening is completed successfully. Similarly, current account openness is recommended after domestic real-sector reforms are completed.15 Capital account openness particularly to domestic individuals and producers is only to be made available after all other reforms have been properly implemented. It has been suggested that the freeing of the current account before freeing the real sector is a reason for the Asian financial crisis that rocked six economies (five are included in this book; the Philippines are not included) in Asia in 1997–99. The free market economies created current account openness only in the limited forms of currency peg or basket pegging as early as the late 1970s in some cases and in the late 1980s in certain others. Of course China has still not opened its current account nor has it granted capital account openness to most producers and all individuals. The mixed economies took limited steps to free current accounts in the 1990s while also relaxing controls on capital account restrictions to most producers. Controls are still in place for individuals. Thus, the fast-growth economies of Southeast Asia and South Korea had adopted current and capital account openness by the late 1980s.16 The slow growth economies have been reluctant to adopt external openness for the very good reason that their belated real and financial sector reforms had not yet produced the extent of success found in the free market economies that made the latter to adopt external openness. Hence, they are not ready to adopt the final set of reforms that is essential at the proper time to secure greater income growth than can be achieved with limited reforms. One exception is Taiwan. Just as in the case of Chile, Taiwan had suffered a boom–bust episode in the capital market in the 1980s. This had prompted Taiwan (as did Chile) to institute some residual controls on the current accounts. This, and the huge foreign currency reserves it had, prevented the new Taiwan dollar from depreciating in the first few months of the Asian crisis.

Liberalization: Asia’s new-found development strategy

17

Current accounts of the free market economies had become a destabilizing force of these fast-track economies from more external openness. With greater external openness, economies with full current account openness (IMF Article 8 provisions) had developed larger external linkages to trade and capital flows in the 1980s and especially in the 1990s. For example, South Korea’s external sector is close to 70 per cent of its GDP and Malaysia’s exposure to foreign direct investment in 1994 was 28 per cent of its GDP. Compare these figures with trade exposure of about 9 per cent of GDP and capital flow of about 1 per cent of GDP in the case of India in 1995. The over-exposure to the external sector had made the currency rate very sensitive to current account balances in the free market economies. When current accounts started to get into deficit in the 1990s, first in Thailand, then in Indonesia, etc., the managed exchange rates of these countries came under severe strain. This started happening from late 1994, but the currencies were defended with reserves. However, on 2 July 1997, the depreciation was a full 10 per cent, and the crisis took root on that day in Thailand. That led to the exchange rate overshooting in the second half of 1997. These countries suffered the calamitous effects of the financial crisis, which led to grave economic recessions in all these economies. In summarizing the discussion in this section, it is in order to make some general observations about the common experiences of the Asian economies. Liberalization, in fact how far back and to what extent liberalization had been undertaken, appears to be the catalyst for growth in Asia. The early reformers, especially the free market strategists, secured fast track growth. China seems to have made good progress, partly under desire to behave to gain WTO membership (it has since gained membership in 2003). However, its high growth has also been orchestrated very well given its presumed access to a large market and its cheaper and still abundant production resources. The late and hesitant reformers such as India and Pakistan have now begun to adopt the same path to secure economic growth as did the early reformers. Initial results in the cases of the mixed economies, as will be seen in the rest of the book, provide reason to be optimistic about their longer-term successes. These countries may be able to garner good growth in the future provided the antireform platform is neutralized in favour of continuing vigorous reforms.

5.

COMMON DEVELOPMENT OUTCOMES

This section is concerned with the measurement of significant outcomes of the liberalization over the post-war period. ‘What are the highlights of liberalization and growth in Asia?’ is the question we attempt to answer in this section. Key macroeconomic variables are identified in order to quantify the extent of the favourable development outcomes in Asian economies following different

18

Liberalization and growth in Asia

paths originally but now converging towards the free market model of development. These outcomes are presented in terms of the three strategies described in the previous section as the models followed by the eight countries. Income growth, which is an indication of economic prosperity, is one measure. Another important measure is the inflation experiences of these countries as it is a litmus test of the efficient management of an economy. The third measure is the monetary depth (M3/GDP) to describe the growth in the monetization of these economies through diversification and depth of the money markets. The fourth measure included is the financial intermediation ratio (private) as a measure of how much of the assets of an economy are held in the form of securities in the financial institutions. Table 1.2 provides a summary of these statistics for two groups, namely the early reformers (Indonesia, South Korea, Malaysia, Singapore and Thailand) and the late reformers which includes mixed economies (India and Pakistan) and command to market economy (China). The numbers speak for themselves. Up until 1997, the income growth rates for early reforms are very high and average around 7.5 per cent. These high growth rates (and success in population control measures) led to significant improvements in per capita income levels in the first group of countries. Even Indonesia was able to improve its per capita income thus driving down the poverty level which was 60 per cent of the population in 1965 to as low as 8 per cent of the population in 1996 (before the ravages of the financial crisis pushed up the poverty levels allegedly to 50 per cent). In the best case of Singapore, per capita income level in 1995 was about 76 per cent of the US per capita level compared with 23 per cent of the US level in 1965. South Korea, which was among the poorest countries in 1954, had emerged as a newly industrializing economy (NIE) by the late 1970s. In 1997, Korea became the twenty-fourth member of the exclusive club of the developed nations, the OECD. The mixed economies of India and Pakistan, however, experienced frequent swings in their economy growth path with the highest growth rate of 5.8 per cent achieved in the early 1990s when the liberalization process was initiated. The initial enthusiasm for reforms in the mixed economies led to high growth in the late 1980s and early 1990s. The growth rate in India reached 6.3 per cent during 1986–90. With protectionist sentiments returning in the 1990s, which led to rolling back some reforms, the growth rates have subsided to lower levels in the South Asian economies. In the case of China, which embraced reforms soon after the death of China’s helmsman Mao Zedong, 24 years of reforms have made it possible to stimulate private-sector-led growth complemented by the growth made possible by foreign capital attracted by the vast unused human resources, which also helped China to smother the stateowned firms’ inefficiency. Overall then, the more liberal the policies pursued

Liberalization: Asia’s new-found development strategy

19

by an economy, the greater have been the growth rates and the lower the inflation rates. Table 1.2

Major outcomes of the liberalization process in Asia

Outcomes

Early reformers

Late reformers India and Pakistan

China

7.5 7.9 7.1 8.3 3.7

3.7 3.9 5.5 5.8 4.4

– 9.35 12.02 8.26 8.0

Inflation 1961–70 1971–80 1981–90 1991–95 1996–2000

53.7* 11.3 4.99 5.29 6.4

4.94 10.29 7.93 11.75 7.46

– 1.4 7.5 40.1 1.96

Money depth** 1961–70 1971–80 1981–90 1991–95 1996–2000

53.45 50.82 64.34 78.75 94.92

32.84 41.26 50.47 56.39 52.68

– – 68.55 95.09 122.81

Intermediation ratio 1961–70 1971–80 1981–90 1991–95 1996–2000

14.96*** 31.84 51.58 69.32 85.85

14.72 20.69 27.25 27.86 26.65

– – – – –

Income growth 1961–70 1971–80 1981–90 1991–95 1996–2000

Notes: Income growth and inflation are percentage growth rates per annum: others are percentage of GDP per annum. – indicates that the data were not available. * Inflation during this period is highly inflated due to an average of 210 per cent inflation in Indonesia. Inflation in other countries in this group was in single digits. ** Figures not available for Malaysia; 1961–70 figure is average for South Korea and Thailand only; 1971–80 figure is an average for South Korea, Singapore and Thailand only. *** Average for South Korea, Malaysia and Thailand only.

20

Liberalization and growth in Asia

However, the inflation experience of China was very high until recently compared with the mostly single-digit inflation rates of the early reformers. The latter had experienced double-digit inflation arising from the oil-price-led inflation of the 1970s. Inflation has been well managed and kept under control in the free market economies. Inflation rates in the mixed economies (India and Pakistan) were also lower than those in the command economies. Lack of expertise on price management and a failure to sterilize capital inflows to prevent them affecting money supply in the former command economy of China are two important reasons for the high inflation rates in these countries during the transition phase towards a market economy model. Financial reforms also appear to have improved the securitization in and the depth of the money and capital markets. The monetary depth has almost doubled in the early reformers from 54 per cent in the 1960s to 95 per cent in 1996–2000. The mixed economies of India and Pakistan started with a lower base of 33 per cent (M3/GDP) in the 1960s but experienced a significant increase to around 56 per cent by 2000. In the case of China, monetary depth has also doubled especially with the high savings from high income growth in the domestic sector and with the inflow of foreign capital. Improved depth (even while lacking improved transaction rates) in the money market enables market signals to be given about the price of money market instruments if interest rates are freed. By the mid-1990s, most countries in the sample have freed at least in part most of the controls on interest rates. Hence, the money markets in Asia are beginning to be ready to provide economic information on the price of money in the money markets. Financial intermediation ratios (FIRs) have also improved in all these countries. The rate has increased to almost fivefold in early reformers as a result of greater financial reforms put in place to enable the financial sector to service the real sector. For example, the assets held in the financial institutions of the early reformers were about 86 per cent of their GDP in 1996–2000. Compare this high rate with their initial position of 15 per cent during 1961–70. It is interesting to note here that the mixed economies of India and Pakistan also started with the same base of 15 per cent of FIR (private) to GDP ratio but could only manage to double it to 27 per cent in 1996–2000. China only started reporting on private FIRs in 2002. Based on these numbers, China’s private sector FIR was 155 per cent, which surpasses all countries in the early reformers group. Therefore, financial liberalization in all these countries appears to have improved capacity in the financial sector to handle the greater volume of economic activities, and, with it, greater financial activities. Summarizing the discussion on the outcomes of reforms, the reader will now appreciate the beneficial effects of Asia’s newfound strategy of liberalization. Economic development did take place at faster rates when a

Liberalization: Asia’s new-found development strategy

21

liberal mix of policies supplanted interventionist strategies in the command and mixed economies. Significantly higher growth rates were experienced by the early reformers, which started the reform process much earlier than did the others. These countries had made so much improvement to the relative prosperity of their people that it was, as noted earlier, dubbed the Asian Miracle. As we have discussed in this chapter, there is nothing miraculous about that outcome. It is the cumulative effects of sustained liberal reforms that secured greater prosperity observed in the free market economies compared with the late adopters of this neoclassical strategy for development. Detailed statistics on each country have been averaged to provide the information on these four desirable outcomes of the development experiences of eight countries at various stages of development.

6.

OUTLINE OF THE BOOK

It is time now to describe the structure of the book. This chapter serves as an overview on growth through liberalization. The next chapter traces the genesis of the Asian financial crisis to events and structural weaknesses in the financial sectors of a few fast-growth economies, all of which had severe financial fragility. Chapters 3–10 are about the development experiences of eight Asian economies. Included here is a group of five early reformers, Indonesia (Chapter 5), South Korea (Chapter 6), Malaysia (Chapter 7), Singapore (Chapter 9) and Thailand (Chapter 10), that had followed the earlier successful experiences of the tiger economies to secure growth through greater external openness to trade and capital flows. Some would say that the developments of these are like flying geese following the lead of the tigers! These are the very same economies that suffered, as we will document, from a general lack of capacity to prudentially manage the financial institutions. We also have a group of mixed economies such as India (Chapter 4) and Pakistan (Chapter 8) included in this book to study the transformation to reform these economies. China (Chapter 3) is included as a representative of a later reformer or command economy. China is a Communist country trying to make the transition towards a market economy model of development. The country chapters also describe the failures to secure sufficient growth to bring prosperity to the peoples of India and Pakistan. These countries had pursued varying degrees of financial suppression while also creating a large state sector under an earlier planned economy model, which failed, over 25 years, to create the kind of growth they thought was possible. These countries have adopted the reforms of the free market economies since the late 1980s. Their collective experience is very relevant for the 126 developing countries in the world. The reader will find how their later adoption of liberal policy mix

22

Liberalization and growth in Asia

is an interesting departure from the interventionist model being pursued in a large number of countries. The final chapter is a discussion about development lessons from this study. Relevant lessons are itemized and expanded in that chapter. The reader will find that growth is possible for any country through careful pursuit of neoclassical principles of using free markets to create competition for efficient production as well as efficient allocation of economic resources provided the external openness is appropriate for the stage of economic development. If sufficient prudential structures are not strictly adhered to in the management of the financial sector of an economy, then conditions favourable for a financial crisis will emerge as happened in the 1990s. This calls for prudential re-regulation in the financial sector while pursuing liberalization as an active policy strategy.

NOTES 1.

State intervention was legitimized in Marxist economics. Around the time immediately after World War II, the appeal for state intervention in Asia could also be reasonably justified by the Keynesian formula of pump priming the Western economies to absorb unused human resources. The futility of deficit-financed interventions became obvious in the 1970s after Milton Friedman showed the link between deficit budgets and high inflation. Thus, these contrasting approaches to growth appeared at that time to be sound strategies in the 1950s. 2. The phrase ‘Asian Miracle’ started appearing in the literature in 1993 and was popularized by several World Bank publications. We provide liberalization as the key to how fast-track development was secured in several Asian countries. Other writers, for example Campos and Root (1996), suggest that growth was made possible by a social contract between the governed and the non-Communist governments to deliver social development in return for keeping Communism out. Chowdhury and Islam (1996) attribute fast growth to good macroeconomic management. 3. According to IMF and World Bank statistics, FDI increased by the end of the 1990s to US$330 billion while the portfolio flows are estimated to be about US$120 billion. 4. India had deferred tax reforms till the 1990s. Other Asian countries had undertaken tax reforms in the late 1970s and during the 1980s. Extensive tax reform put in place in India in 1996 is expected both to increase incentives for entrepreneurial efforts as well as return the black market economy to the mainstream. 5. We observe that those countries that have democratic platforms to express discontent with government policies were able to make the turnaround to reforms much faster than those that had no democratic platforms. Asia’s Soviet bloc countries (and military dictatorships) had wallowed in poor development over very long periods whereas those countries with democratic traditions made quick transitions to make policy switches. Therefore the common assertion by some Asian leaders that democratic freedom and development are antithetical is not true in the long run. 6. A struggle for power that ensued after the death of Mao is at the root of the search for reforms. Deng Xiaoping, the eventual winner in the power struggle, made a surprising return to power even though he was twice incarcerated by Mao’s regime as a ‘capitalist’. He was the principal person responsible for the overthrow of the so-called Gang of Four, which included Mao’s wife, who took power after announcing the death of Mao. Market-based reform, because it delivered prosperity, appealed to the ruling elites in order to establish political legitimacy of the Communist control of this country.

Liberalization: Asia’s new-found development strategy 7.

8.

9. 10.

11. 12.

13.

14. 15.

16.

23

Import substitution strategy was based on the assumption that by putting to use unused economic resources to produce the badly-needed goods and services in poor countries, such as India, the state would reduce poverty. Economic development would soon ensue. Initially, the plan called for building infrastructure and industrial capacity. However, politicians slowly diverted this strategy to serve their purpose of targeting investments to some sectors to attract popular support for political parties. By the 1960s, the import substitution strategy had degenerated towards credit targeting schemes. Different shades of this were practised by many countries including Japan, Indonesia and others. By the mid1980s, almost all countries had abandoned these schemes as unsuitable. Although it has been said, these potential tiger economies had suffered setbacks from becoming the new tiger economies after the 1997 Asian financial crisis. It was generally suggested in the early 1990s that Malaysia and Thailand would graduate to become the new tiger economies. Since the financial crisis hit them, such discussion has disappeared from the press. For a full discussion of this point see Ariff (1998c). The extent of the state involvement in production in China is still very high. Some estimates reported in the financial press suggest that active privatization may release millions of workers in these countries. China may experience unemployment of about 15–20 million people in the non-agricultural areas: it already has substantial unemployment in the heavyindustry belt where reforms have led to corporatization of loss-making firms. In December 1998, China’s military announced that it has forthwith taken steps to refrain from producing civilian goods and services. Thus, the inevitable taming of the state firms must come soon with attendant problems. These were the first two countries to have specific laws to attract foreign investment. The laws were included in the Economic Incentives Act, which has become a major reference point for capital account opening in Asia. The largest investment trust in China failed in the second half of 1998, as in many other economies, because of lack of central bank prudential supervision of its activities. The failure of GITIC, one of 260 such investment corporations in China, led to the discovery that only 17 cents in a dollar of investments could be found when the assets were put in the hands of the courts! Before the collapse, GITIC had US$60 billion in assets. A large number of such unsupervised investment firms have been permitted to fail in China. This is evidence of the serious state of the financial affairs in China’s statist financial sector. Banking theory suggests that banks perform the very useful function of collecting small deposits and then make large loans to firms: this is their maturity transformation function. Banks are presumed to be good at monitoring whether the firms are efficient in using the borrowed money. That is the delegated monitoring function of banks, which is largely absent in command economies as well as the mixed economies, the latter because of rampant state intervention. As financial centres, these sectors account for almost a sixth of the GDP of these economies. The financial sector normally contributes about 5–8 per cent to the GDP in most countries. More will be said on financial liberalization and sequencing of reforms. Though there is a lack of complete consensus on sequencing, there is general agreement that the external openness should be after real-sector reforms are completed. There are exceptions to this rule, as is the case of Indonesia. In the case of South Korea, one has to be cautious about such assertions. South Korea postponed full reforms to open the economy to foreign entry as late as was possible. For example, capital account openness came only in mid-1996 just before its admission as the twenty-fourth member of the OECD grouping. In fact some observers have mentioned the lack of two-way openness in South Korea as a glaring anomaly in South Korea’s commitment to liberalization.

2. 1.

Asian financial markets: from crisis to recoveries INTRODUCTION

The Asian financial crisis started when the previously basket-pegged Thai currency was free floated on that fateful Thursday, 2 July 1997. It had led to the collapse of what was dubbed by the Asian Development Bank the ‘Asian Miracle’.1 One of the devastating effects of the event was the sharp decline in economic growth from an average of above 5 per cent before 1997 to negative growth in 1998. The affected countries under the IMF reconstruction schemes (and Malaysia), incurred an estimated cost of about 20 per cent of the GDP or about US$25–35 billion over the following three years in order to recover control of their economies. The aftermath of the Asian crises has been discussed widely in the literature.2 Here we will provide a brief description of the causes of that crisis. The main focus of this chapter is, however, on policy responses and their impacts in dealing with the crisis as well as lessons to be learnt from the responses by individual countries to this major collapse in the growth trend. One important point must be noted. Although many Asian countries covered in this book were hit by the crisis by varying degree, due to space constraint it is difficult to present a detailed analysis of the policies of each of these countries. In this chapter, we focus on three representative countries, namely Thailand, Malaysia and Indonesia. These three countries present three different scenarios and policies. Thailand, though it had a long history of liberal policies, is considered to be the source of the crisis and was the first one to accept an IMF bail-out plan and has shown remarkable recovery since 2000. Malaysia, on the other hand, decided not to accept IMF aid but imposed capital and currency restrictions to recover control of its economy. These controls worked well and Malaysia also showed an unexpectedly early recovery from the crisis without incurring a huge debt burden through an IMF bail-out. Indonesia, however, was the last Asian country to be hit by the Thailand episode but went into a series of other crises and was still trying, in 2003, to gain control of the governing of this huge land. The rest of the chapter is organized as follows. We first discuss Asia’s financial fragility in section 2. Section 3 provides a quick overview of the 24

Asian financial markets: from crisis to recoveries

25

liberal policy experiences of selected countries. The background to the genesis of the crisis is provided in section 4 which deals with the bigger picture of the currency volatility that had become a permanent fixture of the post-Bretton Woods world with more or less market-determined exchange rates. Section 5 discusses some major factors responsible for the Asian drama. The policy responses and their impact in three crisis-hit economies (Thailand, Malaysia and Indonesia) is detailed in section 6. We end with general observations of the salient points covered in this chapter.

2.

A WORLD OF INCREASING FINANCIAL FRAGILITY

The Asian financial crisis started when the previously basket-pegged Thai currency was free floated.3 We want to first make a statement of verifiable fact about Asia’s growth experience before examining the genesis of this crisis. The path to growth over the last quarter century, it will be seen throughout the remaining chapters of this book, is very assuredly liberalization, which did help Asia to secure higher growth than ever before. The readers may just note this stylized fact that will emerge at the end of the book while this chapter examines the financial crisis. The crisis unleashed by the currency volatility, in this instance in July 1997, has an historical root stretching back to 1946. The world bottled the currency volatility genie for 26 years through the Bretton Woods Agreement. That agreement enabled the world to rein in stable prices for that long a period. Through the sterling performance of the GATT (now the World Trade Organization), the volume of trade in goods and services increased, while the traders did not have to worry about how the exchange rates would affect their sales. In 2002, the total value of trade in goods and services amounted to 23 per cent of world GDP. The weaker currencies of smaller economies were given protection from volatility by the stronger currencies of the developed countries through a system of cross-fixing their vulnerable exchange rates to the much stronger currencies of the developed countries. Smaller economies faced greater weakness from exports of less competitive commodities and/or less aggregated goods. Under the agreement the more prosperous economies thereby provided exchange rate stability maintaining a fixed exchange rate regime by themselves. Of course that agreement broke down in 1971. Richard Nixon, the American President, is famously linked to this event when he disconnected America, a key participant, from the fixed exchange system linked to the dollar peg via the price of gold. This let the exchange rate genie out. The fixed exchange rate system of the world came unstuck from that American decision, and has led to very high exchange rate volatility ever since. Since the early 1970s, exchange-rate-led instability has periodically set back growth

26

Liberalization and growth in Asia

prospects mostly in those countries, such as Thailand, that used basket-peg currency management.4 During the years from 1971 to 1989, there were 49 cases of documented banking crises, most of which were related to weakening currencies.5 The costs arising from the increasingly exchange-rate-led crises have been quite high. Let us add up the costs to economies from a few crises since 1981. These cases are well documented with several published: the cost to Chile was 30 per cent of GDP during 1981–86; 20 per cent in Malaysia to redress the effects of a currency speculation and the failure of cooperatives, 1985–88; 20 per cent in Venezuela, 1990–91; and 18 per cent in Mexico for recovery from the now famous tequila crisis of 1994. A total of 35 banking crises have been reported over 1990–98. Almost all these had some connection with exchange rate instability. The countries under the IMF reconstruction schemes, together with Malaysia, incurred a cost equivalent to about 20 per cent of GDP or about US$25–35 billion from 1997–2001 to regain, in part, their previous growth path. Japan, whose economic troubles have several other causes, is reported to have allocated ¥60 trillion (US$440 billion at the 1998 exchange rate), to rescue its banking system to make it healthy enough to resume its important role in the recovery of Japan and indeed Asia from the crisis.6 Of the 50 top banks in the world, 14 are from the Asia Pacific region with a total asset base of US$4700 billion measured in 1995–96 exchange rates. The capital to assets ratio of 11 of them from among Japan’s top banks is 5.1 per cent. The average capital base was much higher for the other 36 banks from OECD countries in the top 50 list. Four UK banks included among the 50 had a capital to assets ratio of 7 per cent while the German banks had about the same ratio as the Asian banks in the table. The US banks had the highest ratio of about 8 per cent of assets. These numbers are based on book values reported in financial statements compiled according to the generally accepted accounting principles. The worldwide flow of money in search of higher returns in the money, bond and share markets has increased during the same period as well. Globalization in the sale of money as opposed to the sale of goods and services (Bhagwati 1997) has brought opportunities to make huge gains for those doing the money transmission business across national boundaries. The total estimated value of the daily transactions in currencies for 2001 is US$1550 billion.7 Some sources estimate that this level of monetary exchange activities is about twelve times the currency exchange needed to support the world trade in goods and services. Thus, the intensive currency trade is closely connected to the flow of money to the more liberalized economies, and thereby exchange rate volatility is a serious candidate as a destabilizer of economic and social development in small nations.

Asian financial markets: from crisis to recoveries

27

With opportunity for profits in the trade of money as opposed to profits from the trading in goods and services has come a powerful Wall Street lobby to open barriers to entry for short-term capital into the financial markets of the world. Though exact statistics are not available, there are some ball-park numbers reported in the press and in the Internet. For example, due to the persistently low real interest rates in Japan’s financial markets, Japanese investors invested large amounts in the US short-term money market during the latter part of the 1990s, something like US$120 billion in the bills markets. Given the large size of the US market, a placement of that magnitude by the Japanese does not necessarily result in volatility. That is not the case when large short-term flows take place into and out of small economies.8 For instance, the entry of investors into the then newlyliberalized Korean share market in the late 1980s led to a temporary increase in share prices, which collapsed when the foreign investors withdrew shortterm capital from the market. The 1993 stag attack on the emerging share markets led to huge price increases and diversification gains for international portfolio investors. Share prices collapsed after the withdrawal of foreign portfolio investments during 1994–95.9 The flow of foreign capital, when it is invested as physical assets through foreign direct investments, does not cause such destabilization of the currencies of the recipient countries. Money put in cement and machines cannot be moved suddenly. Asia’s share in the latter was consistently a third of the current US$300 billion or so foreign direct investment flows during most years over 1987 to 1996 on an annual basis. These flows to the developing countries have been growth promoting in that FDI brings also a network of markets for the developing countries to connect them to the world and the technology for the locals to work with, and hence, perhaps learn to operate new applied technologies. Tax incentives and, in some countries, subsidized financing incentives have been offered by many countries to attract foreign direct investment. Five of the fast-growing developing countries, China, Indonesia, Malaysia, Singapore and Thailand, alone attracted about US$70 billion of the US$300 billion worth of FDI in some years during 1987–96.10 This has been a tremendous boon to growth. Not surprisingly, after a temporary decline in this flow following the onset of the Asian financial crisis, the FDI flows started a gradual increase in late 1999.

3.

A LOOK AT ASIA’S FINANCIAL LIBERALIZATION

The rest of this book provides a lengthy documentation of the steps taken during a 25-year period by Asian countries to implement programmes of economic and financial liberalization. Such reforms by a group of early

28

Liberalization and growth in Asia

reformers produced very high economic growth rates of about 6 to 8.5 per cent in South Korea, Malaysia, Singapore, Thailand and Indonesia. These five countries had together therefore amassed huge foreign reserves from the healthy external sectors from the mid-1980s to 1996. These reserves have been an instrument, a critical one, which had helped the central banks to defend the basket-peg put in place, in some cases, as long ago as ten or more years before the crisis. There are five chapters, one for each country, in the rest of the book that detail the liberalization programmes followed by them where readers can get detailed statistics for these countries. China, in many ways still a command economy with tens of thousands of central and provincial government-owned inefficient state enterprises and a largely state-owned financial sector, has invited multinationals and overseas ethnic Chinese capital to its shores to generate private sector growth. This experiment can be characterized as a major effort to smother the inefficiency of the state enterprises by expanding the incentives-based private sector’s capacity to generate efficiency. Previously, this strategy also helped this domestic-capital-starved country to upgrade technology, which it could illafford to buy at that particular stage of its development. China too built a huge foreign currency reserve estimated at end-2002 at US$286 billion. This, along with the huge reserve of Hong Kong that China can rely on, provides enough support to stabilize the currency. Detailed information about the progress of China can be found by the reader in a separate chapter of the book. This is the background of one situation at the time of the crisis. A few other countries that did not go that far in adopting liberal policies also secured growth but at a much lower rate. Pakistan and India are these reluctant or late reformers. In both of these cases, post-liberation growth experiences have been significantly higher than growth in the pre-reform era. Growth in the post-reform period has gone up by about 2 per cent per annum (to make an average of 5 per cent per annum growth) from the pre-reform growth rates of 3 per cent, these countries were stuck at over long periods of poor growth. These countries were not seriously affected by the financial crisis simply because they still had some degree of controls on imports. They had also not built up short-term capital flows in their banks or their firms to the same extent as the fast-track countries did in the 1990s. Details of the reform policies and their impact are discussed in exclusive country chapters in this book. Table 2.1 provides a brief, very basic, summary of the liberalization policies already in place prior to the onset of the crisis. There are only four countries included in this table for the purpose of getting the general framework for analysing the crisis. A quick review of its contents provides the flavour of the reforms of the three different experiences of the eight countries. The early reformers had undertaken extensive reforms so much so that they had almost full current and capital account openness. They had a private-sector-led real

Asian financial markets: from crisis to recoveries

29

Table 2.1 Overview of liberal policies in force prior to the crisis in selected countries Countries Sectors Early reformers Korea Real sector

Fiscal sector

Description of state of liberal reforms

Entry barriers to domestic sector not eased for foreign firms; through MFN and infant industry provisions of the GATT, tariff reforms delayed as long as possible; by 1993, tariff reduced to very low levels of about 17% for foreign goods Tax reforms in 1981 broadened tax base. Many state banks State ownership of financial institutions; 1985–86 reforms to divest share ownership; still significant shareholding kept

Financial sector Entry barriers to foreign banks eased as South Korea developed external economy in the 1970s and 1980s; generally suppressed sector

Malaysia

Exchange rate

From US$ peg to managed exchange rate in 1990; daily fix; capital account opening only in July 1996

Interest rates

Slow adoption of reforms; only long-term rates reforms in 1988

Real sector

Real sector laid open to foreign firms with even 100% equity ownership; tariff reduced to low levels in the late 1980s; tax incentives and others for firms bringing FDI

Fiscal sector

Tax reforms in the late 1980s and early 1990s. Privatization used to divest and private sector management of public services

Financial sector Banks in private sectors; central bank task to grow domestic institutions; already present foreign banks required by 1995 to be locally incorporated; bank modernization and improved supervision Continued overleaf

30

Table 2.1

Liberalization and growth in Asia

Continued

Countries Sectors

Description of state of liberal reforms

Malaysia

Exchange rate

Early removal of fixed rate: 1978; capital accounts have been open since then as well

Interest rates

Interest rates administered with consultation with the banks; this was changed till no controls were placed on interest rates

Hesitant reformers India Real sector

Fiscal sector

Real sector under heavy government intervention rapidly decontrolled for both domestic and foreign entry since 1991 still not fully liberalized; mostly 51% foreign equity: priority areas up to 100% equity; capital controls relaxed since 1994; from a base of under US$200 million in the 1980s, FDI has grown to about US$3000 million in 1996; in 1991, about 24% of the output from government-owned inefficient enterprises; privatization plan not actively pursued yet; no tax reforms till 1996 Tax reforms announced in 1997

Financial sector The banking sector has high non-performing loans: reforms not yet implemented; stateowned financial institutions still dominate the sector since reforms have been instituted during 1993–94 in all sub-sectors Exchange rate

Exchange rate liberalized in 1994; capital account reforms extensive; limited currency convertibility for individuals; exchange rate volatility has declined since then; a form of free float offered

Interest rates

Heavy interest rate intervention and controls; reforms extensive; not yet fully effective

Transitional economies China Real sector

Transitional economy and central planning led to domination by state enterprises (about

Asian financial markets: from crisis to recoveries

31

80000); major reforms initiated in mid-1990s to form private enterprises; reforms to attract foreign capital; established Special Export Zones; trade liberalization taking place as part of commitment under WTO charter; capital account partially open. Huge FDI flows Fiscal sector

Reforms to the state-owned enterprises helped to reduce pressure on state budget to subsidize the loss-making state firms

Financial sector Banking reforms started in early 1990s; new banks and specialized banks set up in the 1990s; money and capital market reform initiated

Sources:

Exchange rate

Still managing a pegged exchange rate

Interest rates

Interest rates are gradually liberalized; real interest rate moved to positive as a result of sharp decline in inflation towards the end of 1990s

Please see the tables in each country chapter for sources.

sector dominating output despite still having some state involvement, though not as much as in the other two groups of countries. These had greater openness to the world, and so had large foreign portfolio and direct investment as a feature of their growth, which is now known to have been a source of instability. The financial sector was also mostly under the control of private firms, though in South Korea some state ownership (about 13 per cent of the assets in the banks) existed especially in the foreign exchange banks. India is taken as a case to illustrate the long delayed reforms being rushed onto this large economy during a short period of 12 years. After initial reforms, the country took a major miscalculated step to explode atomic bombs, and later long-range missiles, which frightened the external world away from taking advantage of the liberal conditions to enter that country for economic activities. Nevertheless, it had at the time of the onset of the financial crisis, a greater degree of openness without the huge short-term capital chasing low profitable investments that the other five fast growing countries were busy putting in place. The transitional economy is represented by China in Table 2.1. China managed to cover the inefficiency of the state firms (and financial sectors) in the real sector by smothering it with the efficiency of the private sector. This has been achieved by an elaborately planned FDI-originated huge stimulation

32

Liberalization and growth in Asia

of the real sector activities driven by the foreign owners of capital and the Chinese small businesses owned for the first time as private sector enterprises. In summing up this quick review of this book’s central theme, which is liberalization, the reader will find one common theme. The financial sectors of the very same countries that were affected quite badly by the crisis can be described as being wide open. The exchange rate was basket-pegged; the interest rates were fully responding to the world rates; there was foreign capital especially of the short-term kind, which is now linked to the onset of the crisis, supporting huge expansion by the domestic firms investing these resources in such low-profit schemes as infrastructure, land-based tourism and property ventures. There was a mismatch between the average maturity of the bank deposits and that of the bank lending. As long as the basket peg could keep the exchange rate as high as possible, the short-term money would keep coming as capital flows, and there would be no liquidity problem in the financial sector. The canalization in the financial sector will go undisturbed. The acquiescing central banks from Seoul to Jakarta were not in a hurry to consider enforcing already available (for example in Malaysia) prudential norms nor putting into effect new reforms to remove this dangerous source of banking fragility in their economies.

4.

THE 1997 ASIAN FINANCIAL CRISIS

The Genesis of Crisis It is unlikely that a financial crisis11 has a single cause since several factors work together and then lead to what later becomes labelled as a crisis. The particular event that may trigger a crisis may be termed the contagion event.12 In that sense, the dramatic and rapid decline in the volatility of the Thai baht is the contagion event for the 1997 Asian financial crisis. Table 2.2 offers a chronological record of how the contagion spread to the rest of the world. As can be seen in that table of events, the crisis appears to have affected the immediate neighbours in Asia first, then spread to the stock markets, and then to the world at large. The Asian financial crisis began to assume a world dimension by the end of 1998. This was aggravated by the political destabilization in several affected countries, notably Indonesia, and mistakes in the implementation of the IMF programme of assistance. These factors led to the crisis being dragged on from the end of 1998 and into 1999. The highlights of the events unleashed by the baht contagion may be summarized by making a few generalizations. The contagion from the baht crisis spread quickly before the end of the year to the Philippines, then to Malaysia, then to South Korea, and then to Indonesia, where it took on a virulent dimension by the worsening political instability surrounding the end

Asian financial markets: from crisis to recoveries

33

Table 2.2 The baht currency crisis triggers a contagion, July 1997–December 1998 Description of what happened 1997 2 July

Thailand

After four months of defending the weakening baht, the Bank of Thailand announced free float of currency Baht loses 10% of its pre-float value

20 July

Philippines

IMF grants US$1000 million as emergency grant after peso falls outside a widened band to defend the basket peg IMF warns Thailand to cut its spending, requests it to take a loan from the IMF

July (undated) Malaysia

The trade economist Bhaghwati condemns free trade in money

24 July

Malaysian Ringgit comes under speculative attack; the famous Mahathir attack on speculation such as that on George Soros

11 August

Thailand Indonesia

Asia 4 September

Philippines

Malaysia

IMF led by Japan’s pressure pledges US$16 billion to Thailand as rescue package Indonesia’s rupiah under attack; Bank Indonesia’s attempt to contain the troubles proved unsuccessful Asian stock markets plunge in unison: Manila 9.3%; 4.5% in Jakarta, etc. Philippine peso falls to the lowest level before central bank intervenes to maintain basket peg Malaysia spends US$20 billion to prop the share market

8 October

Indonesia

Indonesia considers asking IMF for an emergency bailout

27 October

USA

New York share market loses 7.2% in value

23–28 October Hong Kong

Hong Kong share market declines by nearly 25% in value Continued overleaf

34

Table 2.2

Liberalization and growth in Asia

Continued Description of what happened

3 November

Japan

Japan’s Sanyo Securities files for bankruptcy

South Korea South Korean won loses 7%, biggest oneday loss South Korea begins talk with IMF for tens of billions of dollars in emergency aid 8 November

Japan

20 November

South Korea South Korean Stock Market plunges with a loss of 7.2%

24 November

Japan

25 November

South Korea South Korea agrees to IMF conditions for restructuring $55 billion

3 December

Malaysia

22 December

South Korea South Korean won plunges further

25 December

Japan’s third financial house to apply for closure, the seventh largest: Yamaichi Securities

Tokyo City Bank, a regional bank, closes

Malaysia imposes tough reforms including cuts IMF and lender nations move to finance US$10 billion loan to Korea

1998 12 January

Hong Kong

Peregrine of Hong Kong files for liquidation from share market loss

17 January

Indonesia

Indonesian president fires the central bank governor

21 May

Indonesia’s President Suharto resigns after a wave of bloody riots

11–27 August World

Stock markets plunge around the world in expectation of interest rate rises in the USA

20 August

Paul Krugman comes out in support of temporary imposition of fixed exchange rate as the desperate Plan B for a troubled world

(Internet)

Asian financial markets: from crisis to recoveries

35

1 September

Malaysia

Malaysia announces going back to fixed rates (RM 3.8=US$1) from November 1998. All free market currency transactions are abolished

27 September

Japan

A major leasing company in Japan files for bankruptcy

2 October

USA

The Long Term Hedge Fund is reported to have lost US$5 billion The Federal Reserve mounts a rescue by putting together a consortium to rescue the Long Term Hedge Fund The Fed announces interest rate cuts, and the share market rebounds

17 October

USA

Two more rate cuts follow by 20 November 1998

December

Asia

Most currencies that had overshot (baht, rupiah, peso, ringgit and won) recovered about half way from their worst declines; rupiah gained the most from its low of some Rs20000 to Rs7600 to US$1

Source: Internet publications of Asian Economies Reports, 1997–99.

of a 34-year authoritarian rule. By the end of 1997, currency depreciation in US dollar terms was severe and unprecedented in Asia. Losses relative to the June 1997 exchange rates were: the baht lost 56 per cent; Philippines 54 per cent; Malaysia 40 per cent; South Korea 78 per cent; and Indonesia 76 per cent. Second, the contagion weakened those affected countries’ ability to sustain their existing levels of imports, which forced them to take measures to reduce them, and then borrow to redress the damage to the financial system to meet trading commitments. This led to the third effect: Indonesia, Thailand, the Philippines and South Korea came under IMF reconstruction schemes while Malaysia decided to ride the crisis with its own resources. Fourth, the share markets of the neighbouring countries, then the world, started declining by up to half or more as interest rates were about to go up a year after the onset of the crisis. This led to some spectacular bankruptcies among banks and large securities, leasing, etc. companies. Fifth, the contraction in regional trade brought declines in the exchange rates of several other countries. Examples are the Singapore dollar, Australian dollar and the yen. Towards the end of 1998 most of the Asian currencies had recovered from their overshot levels by about

36

Liberalization and growth in Asia

half or more. But at the 1999 levels, almost all Asian currencies were a good deal cheaper than they were in June 1997. However, some later shocks such as the SARS virus in Asia led to another regional economic downturn and the stock currency markets suffered again. The effect on the financial systems has been very severe indeed. The effects and the policy responses are discussed in a later section in this chapter.

5.

FINANCIAL FRAGILITY: ROOT CAUSES OF THE CRISIS

Build up of Foreign Currency Loans The discussion up to this point suggests that the baht contagion had a common origin in six currencies, all of which appear to have some role in each other’s volatility. These are the baht, peso, ringgit, rupiah, the won and the Singapore dollar. The reader will recollect from the survey on liberalization that the central banks of these six currencies regularly intervened to defend these currencies from some targeted levels. Next, these very same countries have been documented as practising connected bank lending, which has been documented as having led to significant non-performing loan build-up in the financial sectors. Third, it is in these six countries that a large number of financial institutions failed or large-scale banking reform efforts have been mounted within a year of the onset of the Asian financial crisis. This last item is in a sense sufficient evidence of the serious financial fragility that had existed in these six economies. Therefore, the next task in this chapter is the analysis of how financial fragility occurred. We first identify the international exposure of the banking sector in selected Asian countries: see Table 2.3. These statistics refer to the percentage changes in the domestic banking sector’s foreign loans (see columns 2 and 3) and in the private sector’s foreign origin loans in selected countries where data are available (unfortunately no data are available for China). The banking sector’s exposure to foreign currency loans grew by large margins during the years 1996 to 1998. The two economies with the biggest increases in foreign loans in the private sector are Thailand (108 per cent) and South Korea (104 per cent). Similarly, the changes in the banking sector’s foreign loans in 1996 alone are very large in South Korea (90.6 per cent and 70.7 per cent within 1997 and 1998) for example. In these countries, the value of foreign currency loans increased by a very large percentage. Banks in two countries almost doubled foreign loans: Thailand by 90.7 per cent and Indonesia by 90.6 per cent. Others too had large loan increases in both the private and banking sectors. These high levels of loans were forthcoming after the liberalization of

Asian financial markets: from crisis to recoveries

37

Table 2.3 Foreign debt exposure and the financial crisis (percentage change, annual average) Bank foreign liabilities

Growth in outstanding private debt securities

June 1997 Dec. 1997 1992–94

Indonesia S. Korea Malaysia Thailand

(%) 23.4 90.6 25.5 85.7

(%) 24.1 78.7 22.6 67.6

(%) 83.0 29.0 –11.0 100.0

1994–96

1996–97

1997–98

(%) 143.0 140.0 124.0 108.0

(%) 57.0 31.0 17.0 15.0

(%) –2.0 –4.0 –3.0 –3.0

Source: Bank of International Settlements and IMF (November, 1998).

the financial sectors, which gave both the banks and designated firms greater freedoms to borrow from overseas without prudent limits tied to the capital base of the banks or to the capital structure of the firms. IMF publications released in September 1997 suggest short-term foreign loans rose in Indonesia by 160 per cent in 1995. Things started to change after a year of crisis. For example, the supreme body, the Financial Reform Board of South Korea announced in November 1998 that firms were required by the end of 1999 to have a debt-to-equity ratio of no more than 200 per cent: this is reported on the Internet. This rule means that firms could have only two dollars of loans for every dollar of equity, which would create a debt-to-asset of, at most, 0.67. At the time of the crisis, South Korean firms had as much as 7 dollars of loans for every dollar of equity. Press reports also suggest that South Korean firms in general had 7 dollars of debt for every dollar of share capital at the height of the crisis: as will be described later, this ratio for Malaysia and the USA was about the same at the time of the crisis, which suggests that there were some other variables at work in the case of Malaysia. Some countries such as Chile had passed prudential regulations that placed a limit for banks on foreign currency loans equivalent to no more than 25 per cent of the regulatory capital. Prudential banking rules of this kind, if present and implemented, would not have fostered the financial fragility. That would have prevented such weakness from destabilizing the economy and making it prone to financial crisis. Another source of the weakness prior to the crisis was the currency basket peg practised by these countries. Japan did not practise a basket peg, but was in effect intervening in the market quite frequently in the 1990s first as part of its policy to synchronize currency value to the G7 accord and second as a tool to support its trading policies. Continued interventions in the markets were

38

Liberalization and growth in Asia

made possible by this peg, bolstered by the healthy amount of reserves all these countries had built in the period running up to the crisis. In free-floating economies such as Australia, the currency adjustments are smooth as information hits the market, and slow adjustments are made. In a peg system, human intervention enlarges the volatility in the currencies. When export growth was slowing down in a free-float regime, the currency adjusts slowly. With basket peg, the volatility was high, and not smooth. Exports were beginning to weaken from as far back as October 1994 in Thailand. Generally the high export growth rates either became very small or turned negative in Malaysia, Indonesia and South Korea during a lengthy period of about 10 quarters prior to the onset of the crisis.13 The currency peg in these countries and the fixed exchange rates in many others ensured that the worsening current account statistics did not translate as lower currency values. Lower currency values have been registered with current account weaknesses in other countries with greater central bank independence: Australia, Canada and New Zealand. The Australian dollar went from close to A$1.00 yielding US$0.89 in 1993 to A$0.65 in 1996, a fall in value equal to 27 per cent.14 Such a smooth reaction was not possible under the managed peg. This led to the inevitable delayed effect of cumulative bad news. The simmering current account problems and the banking fragility in Thailand were pushed to the headlines by an 18-month drawn-out political drama in Thailand. This led analysts to closely re-examine the economic fundamentals of the country. They began to sing a different tune altogether about Asia from those similar to the one hitherto played by the World Bank, which in 1993 dubbed the Asian development experience a miracle made to occur by the moving hand of good governance.15 The July baht devaluation occurred and its contagion spread quickly to other economies between July 1997 and March 1998. Subsequent political uncertainties in Indonesia during March–May 1998 worsened the effects of the crisis. The Indonesian rupiah went from about R3500 to a US dollar prior to the crisis to about R8500 and then at the height of the political crisis to R20000 during a particular day in June 1998. It recovered to R7600 to a dollar by October 1998. Non-Performing Loans The obvious reaction to a sudden loss of control on the currency rate was a knee-jerk reaction of foreign short-term lenders to call off or curtail further lending to the countries affected. Information in Table 2.3 reveals statistics on that reaction in all cases. Both the banking and the private sector firms experienced sharp falls in the growth rates of foreign borrowing. There were also substantial declines in some cases. Soon the effect of the withdrawal or reductions in the further availability of loans or even disintermediation by

Asian financial markets: from crisis to recoveries

39

Table 2.4 Non-performing loans in Malaysia (as percentage of total outstanding loans)

Commercial banks Merchant banks Finance companies

1988–90*

1991–93

1994–96

1997

1998

24.67 18.43 27.77

14.33 6.87 14.80

5.70 8.08 10.97

3.60 1.70 4.70

3.30 3.60 5.00

Note: * This was just after a recession during 1986–88. Sources: Bank Negara Malaysia (1994b) and press reports.

depositors withdrawing their savings as a flight to safety or any combinations of these would lead to increases in bad debts. That is exactly what happened as is shown for one country in Table 2.4. These figures from Malaysia suggest that its non-performing loans were not substantial in 1997 and 1998. The high levels of bad loans in 1988–90 are from the economic recession that hit this economy during 1886–87. As the banks were coming out of that recession, the bad loans had still not been paid off as happened later. The high bad loans in 1992–93 are due to the aftereffects of the Gulf War in 1991. The financial crisis does not seem to have had as severe an effect as these two previous major external shocks. Nonperforming loans in the commercial banks are reported to be under 4 per cent of outstanding loans. Finance companies – there were 57 financial companies of which 8 of them were affiliated to major banks – had the highest levels of non-performing loans. International data sources give some further but sketchy statistics on this topic. Thailand’s top banks had the following levels of bad loans: total bad loans amounted to 4900 million baht in 1998. This is 20 per cent of the total loans of these banks. Before the onset of the crisis in July 1997, non-performing loans amounted to 8 per cent. In Indonesia, nonperforming loans were 15 per cent in state banks and 5 per cent in private banks during 1995. The next year witnessed a slight increase in these figures, but the crisis led to the closure of more than half the financial institutions when the currency, which initially went down from R2500 per US dollar to R3600, then depreciated severely to around R12000 in the month when the President of that country resigned on 20 May 1998! Little or no information is available on this topic for South Korea. But information available from South Korean Internet sources suggests a sudden jump in dishonoured cheques. The value of dishonoured cheques as a percentage of the value issued is as follows: under 8 per cent in 1992; 13 per cent over 1993–94; 15 per cent over 1995–98; and 23 per cent at the beginning

40

Liberalization and growth in Asia

of 1997 rising to 60 per cent by the middle of 1998. These statistics suggest the extreme fragility of the financial sector of that country. Indonesia’s dishonoured cheques must have been large as well. From about 5–10 per cent of the issued values in 1994–96, this statistic worsened to 15 per cent (in one month it went up to 19 per cent) in 1997. This declined to a 15 per cent level in 1998. Demand deposits in the Hong Kong banking system went down by 21 per cent following the crisis compared with the pre-crisis period. Savings deposits declined by 25 per cent during the crisis, which must have placed a huge strain on the banking sector to create credits. This and other information suggests that the monetary effect of the crisis has been a general weakening of the financial strength – increased banking fragility in other words – of the Asian countries. What is unique in the analysis is the kind of endemic nonperformance as is the case for Malaysia. A similar effect, perhaps not of the same magnitude as in Asia, would be expected even in a developed economy’s monetary sector during a financial crisis. This is not necessarily unique to Asia, though the severity may be less in more developed economies. For example, the American credit union bailout cost over US$300 billion. This amount is less than 5 per cent of GDP, but not so in the Asian cases where bailout of failed institutions amount to above 20 per cent of GDP, on average. But the important point is that the banking sector was already having severe bad loan problems for well over two years before the crisis. The crisis could not have come at a worse time. Information released in November 1998 by the IMF suggests that in the worst cases the bailout may cost about 20 per cent of GDP. Non-performing loans can be seen as the consequence of imprudent lending. It was made worse by the crisis. The effect on the banks later weakened the economics of businesses, which were unable to bear the high interest rate nor were able to secure credits for normal operations. The overall effect has been that the heavy reliance on foreign borrowing by the banking and the real sectors evaporated in 1998. Growth in foreign borrowing by banks declined by a quarter during the second half of 1997 at the worst point of the crisis. Even with the special reasons for borrowing abroad, it became difficult to attract such funds. The private sector, which had doubled and trebled foreign loans (for example, the Philippines) in the pre-crisis period had negative growth in foreign outstanding loans. Other statistics available from IBRD and IMF sources in 1999 suggest that even before the crisis hit these countries, the banking sectors in all the affected countries had severe fault lines. They had foreign currency loans that were too high, exposure to the property sector was too great (Thailand had 28 per cent of loans to this sector), related party lending rules were not strictly followed, and foreign currency exposures were not hedged since there was a belief that the high

Asian financial markets: from crisis to recoveries

41

level of reserves would be sufficient to ward off speculative attacks on the currencies. The overall effect of non-performing loans and the general weakness of the banking sector can be better evaluated by examining the revisions in the ratings of the financial strength of the banking system as is documented from IMF sources in Table 2.5. Table 2.5 Financial weakness rating following the crisis

China Indonesia Korea Malaysia Singapore Thailand

Mid-1996

End-1996

Mid-1997

End-1997

End-1998

D D D C+ B C+

D D D C/C+ B C+

D D D C/C+ B C+

D D D D+ C+/B D

D E E+ D B E+

Note: A (highest rating) to E (lowest rating) with the scale defined as the financial institutions not requiring support from shareholders, government and other institutions. Source:

Moody’s Investor Services.

China’s financial sector fragility has not been revealed as it was protected by its fixed exchange rate regime and was still on the export-led growth path without any significant declines at the time of the crisis. All other countries had their ratings downgraded as can be seen in the table. Even Singapore’s financial strength came under doubt. Its rating was downgraded in the second half of 1997. South Korea’s rating went down to E+ even though in 1997 it had been admitted to the OECD after three years of scrutiny about its suitability for membership. Malaysia was downgraded to D: the rating was moved one notch up in early 1999. Thailand has been worst hit losing its rank from C+ down to grade E. Thus, the crisis had sapped the financial strength of these countries as never before. These ratings of the financial sectors in the affected countries reveal the financial fragility in Asia. Crisis Impact on Exchange and Interest Rates Table 2.6 contains summary statistics on the interest rate and exchange rate experiences of selected countries. We also provide data on official reserves as a percentage of the GDP for various periods. It can be observed that there was significant weakening in all these factors. For example, China’s reserves dropped after the crisis, which is suggestive of an external weakening which

42

Liberalization and growth in Asia

is consistent with a still unreported decline in the country’s exports. In all the other countries, reserves have been built up during 1997 and 1998 to prevent further collapse of the ability of the economies to service imports at the increased post-crisis prices. The only exception is the Philippines, where the reserves declined substantially in 1997. In all the countries – with the notable exception of China, because of its fixed exchange rate – exchange rates declined substantially compared to their Table 2.6 Notable exchange rate declines and interest rate increases 1981–85

1991–96

– 5.90 3.20

– 8.60 5.22

11.00 9.60 10.04

29.00 8.64 11.17

20.00 7.92 11.03

Indonesia Reserve to GDP – Interest rate 10.40 Exchange rate 906.00

6.00 17.22 1744.00

6.00 17.60 2308.00

15.00 21.82 4650.00

33.00 55.95 7700.00

South Korea Reserve to GDP – Interest rate 10.30 Exchange rate 890.00

5.00 10.00 716.00

4.00 9.20 775.00

5.00 21.82 951.00

15.00 7.70 1395.00

China Reserve to GDP Interest rate Exchange rateb

1997

1998–99a

1986–90

Malaysia Reserve to GDP Interest rate Exchange rate

– 8.81 2.43

43.00 5.90 2.70

54.00 5.94 2.55

36.00 9.53 3.89

58.00 7.07 3.81

Thailand Reserve to GDP Interest rate Exchange rate

– 12.90 26.70

6.00 10.10 25.30

15.00 9.90 25.20

17.00 13.65 31.64

22.00 9.20 39.14

Notes: Reserve to GDP is a ratio of total reserves to GDP. Interest rate is annual average. Exchange rate is annual average. a Mid-year numbers. b Yuan per special drawing rights since it is more market-related. All other exchange rates are computed against one unit of US dollar. – Indicates data not available. Source: IMF International Financial Statistics (various reports).

Asian financial markets: from crisis to recoveries

43

long-term levels predicted by buoyant external conditions in 1991–96. The Thai currency went down to 39.14 compared with the pre-crisis level of 25.2 baht to one US dollar: a decline of 36 per cent in an economy that had the help of IMF support. For a US buyer, a dollar buys almost 49 per cent more ringgit in the aftermath of crisis: this is a case of no help from the IMF or a case of self-help. The Korean won declined by almost 44 per cent while Indonesia had the worst depreciation in the crisis, a 55 per cent decline against the dollar. The mid-1999 exchange rates were much improved compared to the mid-1998 rates. Exchange rates were Indonesia, R8500; South Korea, W1200; Malaysia, RM380 (fixed); Singapore, $1.74; Thailand baht 37. It can be noted that the exchange rates have recovered (except in the case of Malaysia and Indonesia) to levels nearer to those in mid-1997 before the crisis. It may be noted that by year 2004, the overshooting of the currency rates are recovering to levels reflective of more realistic levels underlying the fundamentals. The consequence of exchange rate decline was that it made future inflation higher. That translated immediately as high interest rates as is predicted by interest rate theories. Thai interest rates went up to a hefty 13.65 per cent in 1997 compared with 9.90 before the crisis; a 38 per cent increase. By mid1998, with the easing of monetary controls, interest rates have recovered to the pre-crisis levels in this country and the Philippines. That is not the case in other countries: the Indonesian interest rate for short-term borrowing went up to above 30 per cent! In early 1999, this came down to about 23 per cent, and in 2003, to about 15 per cent. In other countries, interest rates have declined to a level closer to the pre-crisis levels. In the still troubled Malaysia, statutory reserves were dramatically cut from 12 to 8.5 per cent in October 1998. This led to higher credit growth, which in turn led to a fall in interest rates. That helped to expand credits and bring down the interest rate to 7.07 per cent, which is still higher than the pre-crisis level of 5.54 per cent. The reader has seen a substantial amount of statistics on a proposed explanation for the severity of the financial crisis in 1997. A simple comparison between the 1997 Asian financial crisis and the 1994 Mexican (tequila) crisis suggests that there was merely a loss of confidence in the ability of the Mexican government to manage the economy when the native armed uprising showed signs of being successful in mounting a credible challenge to the then government (see Khalid and Kawai 2000). That confidence flap led to the tequila crisis of 1994 in Mexico. In the case of the Asian financial crisis of 1997, the sequence of macroeconomic events appears to be as follows: ●

Some economies had liberalized and secured a more or less open regime with fully open external conditions for currency and capital trading.

44

Liberalization and growth in Asia ●

●

●

●

Absence of prudent rule enforcement on exposure to short-term loans allowed their rapid build-up in the banking and in the real sector. The well-practised defence of basket-pegged currencies worked successfully over 1995 to mid-1997 and hid the impending problems from weakening exports. Political crises partly caused by connected lending led to runs on currencies starting with the baht, then the peso, then the ringgit, then the rupiah and then the won. Financial fragility revealed after the normal effects of currency declines led to a large number of financial institution failures, when repayment of foreign currency borrowing and non-performing loans to the real sector worked through the banking system.

The primary reason for the severity of the crisis appears to be the financial fragility which was already present and had emerged from failures to enforce prudent regulations on connected lending in almost all the countries; too much lending to the property sector; non-performing loans, etc. This theme will be taken up in the ensuing discussion in the next section.

6. ANALYSIS OF POLICY RESPONSES Policy responses16 to the Asian financial crisis included initial efforts by a country’s government and later assistance by international agencies and other nations. The major player in South Korea, Thailand and Indonesia was the IMF under the bailout programme (see Table 2.7). Malaysia, however, did not agree to a bailout and carried out their own policy agenda. In this section, we discuss, in detail, the policy responses to the crisis in individual countries, starting with Thailand, moving to Malaysia and finally, Indonesia. We also provide a table of events and policy responses (in chronological order) for each country. Policy Responses in Thailand Thailand, which was often called a ‘model’ for economic development by the IMF and the World Bank, was the first one to come under speculative currency attacks. Although the country saw the worst crisis of its history in July 1997, the currency crisis started as early as March 1997 when the Thai baht started depreciating. The first shock and sign of an approaching crisis was the collapse of the real estate market. The second signal (ignored by the authorities) was a sharp decline in export growth, especially in the electronics industry. These episodes coupled with a currency peg regime further accelerated the desire for short-term foreign debt.

Asian financial markets: from crisis to recoveries

45

Table 2.7 International community commitments in response to the Asian crisis (in billion US dollars)

International Monetary Fund World Bank Asian Development Bank Japan USA Singapore Malaysia Australia Other Total

Thailand

South Korea

Indonesia

4.0 1.5 1.2 4.0

21.0 10.2 4.0 10.0 5.0

11.2 6.5 3.5 5.0 3.0 5.0 1.0 1.0 6.1

6.6a 17.2

4.5b 54.7

42.3

Notes: a Group comprising of Australia, Hong Kong, Malaysia, Singapore, China, Indonesia and South Korea. b Group of Ten. Source: Internet reports.

The initial response was to defend the currency by raising interest rates and using foreign reserves. This effort resulted in a net loss of US$27 billion in spot and forward markets between March–June 1997 (EIU 1997). However, the confidence in the baht could not be restored instead the malaise spread to the whole financial system. When the collapse of the Thai baht became inevitable, the Ministry of Finance and the central bank decided to take some initial policy actions. At this point, the huge short-term loans that were moving out of the country caused the liquidity position of many banks and financial institutions to deteriorate rapidly. The Bank of Thailand (BOT), therefore, decided to merge the largest finance company, Finance One, with Thailand’s twelfth largest commercial bank, Thai Danu Bank. At the same time, the Finance Institutions Development Fund (FIDF) injected 40 billion Thai baht into Finance One. As a result, BOT credit to financial institutions increased from 2 per cent of GDP at the end of 1996 to 15 per cent in late 1997. The BOT also instructed some financial institutions with high exposure to property loans to increase their registered capital. The remaining finance companies were instructed to increase their debt cover and provisions against bad loans. However, these policies lacked sincerity as major shareholders of some non-performing finance companies were influential office bearers in the ruling political regime. In May, the newly merged Finance One/Thai Danu

46

Liberalization and growth in Asia

Bank collapsed resulting in a failure of the merger strategy and the whole financial system. In May 1997, the regime also introduced other measures to combat the approaching crisis. One of the measures was to limit offshore trading in baht. The government also established a 50 billion baht stock market rescue fund. It was decided that sixteen finance companies including Finance One were to be closed for 30 days and asked to come up with some merger plans or they would be closed for good. The BOT also announced a switch to a managed float exchange rate regime in 2 July 1997. However, due to continued speculative attacks on the currency, deteriorating conditions of the financial institutions and a weak central bank, these measures could not restore market confidence. Moreover, during this period, the country also witnessed some rapid changes in the administration, which further weakened the confidence. One of the questions raised on the initiatives of the government was the selection of 16 finance companies. As it became obvious at a later stage, the actual number of weak finance companies was much larger. It was also found later that during the initial 3–4 months of the crisis, the government had used about US$8 billion or 10 per cent of the country’s GDP through FIDF to rescue troubled finance companies. The level of foreign reserves at the Bank of Thailand went down to its lowest level and below the legal reserve level.17 When the situation got completely out of control and economic collapse became obvious, the government agreed to go for an IMF bailout plan. The IMF extended a huge sum of US$17.2 billion as stand-by credit, collected mainly from Asian countries, to support the balance of payments.18 The austerity programme also included US$2.7 billion contributed by the World Bank and the Asian Development Bank to enhance industrial competitiveness and improve capital markets. The IMF package was aimed at restoring market confidence, reducing current account deficits, reconstituting foreign reserves and containing inflation. The main policy measures to achieve the above stated objectives included the restructuring of the financial sector, fiscal adjustment and control of domestic credit. The austerity programme required Thailand to take certain measures that included an increase in the national value-added tax from 7 per cent to 10 per cent, 100 billion baht cut in fiscal spending (except education and health) in the 1997–98 budget, eliminating subsidies to the state companies, reducing inflation to 9.5 per cent in 1997 and 5 per cent in 1998 through tight monetary policy, lowering the current account deficit to 5 per cent in 1997 and 3 per cent in 1998, continuing the managed-float exchange-rate regime, maintaining reserves equal to, at least, three months’ imports which were calculated as US$23 billion in 1997 and US$25 billion in 1998 and suspending the practice of using inflationary financing to cover the losses of finance companies. By

Asian financial markets: from crisis to recoveries

47

December 1997, 56 of the 58 suspended finance companies were closed with guarantees issued to the creditors. These measures, however, failed to help Thailand out of the crisis or rebuild the confidence that the investors had lost in its financial market. Besides some political instability that delayed the implementation of the policies, the IMF was heavily criticized for experimenting with a hastily prepared policy package and then making frequent changes to it. Between November 1997 and December 1998, five Letters of Intent were issued making revisions in the earlier specified policies and adding new measures in view of the changing economic conditions of the country. For example, a Letter of Intent issued on 24 February 1998 changed the earlier strict requirement of achieving a fiscal surplus of 1 per cent of GDP (advised in the initial plan in August 1997) to a deficit of 2 per cent of GDP. This was further increased to 3 per cent of GDP in May 1998 (under a Third Letter of Intent). The critics of the IMF bailout package argue that it had prescribed a similar package to Asian countries which it had successfully experimented with in Latin America during the tequila crisis (or the 1994 Mexican peso crisis) ignoring the fact that the pre-crisis economic conditions in Thailand (as well as other Asian economies) were completely different from those in Latin American countries before the tequila crisis. The main cause of the Asian crisis was not high public debt but rather very high private debt. In fact most of the crisis-hit economies were either running a fiscal surplus or at least a balanced budget before the onset of the crisis. Probably, the tight fiscal (and/or monetary) policy was not advisable in view of the weak economic activity. Those who criticize the tight monetary policy as leading to a high interest rate, claim that such a policy would result in a massive liquidity shortage for the banking and corporate sector. The experts at the IMF and the World Bank took the view that a liberal monetary policy would contribute to the currency depreciation resulting in external net liabilities and eventually a financial distress. The question of choosing the right policy mix is a difficult one.19 The recent economic stability in most of the crisis-hit economies would lead one to believe in the IMF prescriptions. However, the important lesson is that the policy-makers should look carefully into the pre-crisis economic environment in a specific country and the underlying factors that may have led to the imbalances before designing and implementing any kind of structural or austerity programme. Any wrong move may lead to a disaster and make the recovery even more difficult. Policy Responses in Malaysia During the first half of 1990s, the Malaysian economy enjoyed very favourable conditions with a strong economic growth and relatively low

48

Liberalization and growth in Asia

inflation. The country had attracted a sizable amount of foreign direct investment and reduced its foreign debt to a moderate level which was estimated at US$45.2 billion or 42 per cent of GDP as of June 1997. The debt–service ratio of 5.5 per cent of exports was also low as compared to some other crisis-hit economies in the region. The banking system seemed sound with non-performing loans (NPLs) accounting for 3.6 per cent of total loans. Apparently, there was nothing wrong with the economic situation that could have predicted a crisis. Does that mean the economy got into trouble simply because of contagion? The answer may not be a straight ‘Yes’. The contagion may have partly contributed to the crisis but the main problem stems from the misunderstanding and mismanagement of the problem by the political leadership and the policy-makers. Not unlike some other crisis-hit economies, Malaysian economy also showed some signs of changes in the external sector which were not taken seriously by the policy-makers in the country as well as international agencies. One of these early signs was a decline in export growth. As stated earlier, all Southeast Asian countries experienced a decline in export growth in late 1995 or early 1996. The second important indicator was the excessive loan growth in the banking sector, much higher than the system could absorb without exposure to liquidity risks. Total loan growth was estimated to be above 30 per cent in early 1997. Most of this credit was extended to the non-tradable or less productive sector, especially to real estate. The loan-to-GDP ratio reached a high level of more than 150 per cent in early 1997. Policy-makers did not realize that the property boom had reached its peak and a collapse was imminent. The stock market also peaked during the same period. Market capitalization in the Kuala Lumpur Stock Exchange (KLSE) was estimated to be over 300 per cent of GDP in 1996. As stated above, Malaysia enjoyed strong growth during the first half of the 1990s. A stable exchange rate, with a narrow range of 2.36 to 2.51 ringgit against the dollar prevailed until mid-1997 when the Thai baht came under speculative attack. Initially, there was some depreciation of the ringgit, which brought the currency down from 2.48 against the dollar in March 1997 to 2.52 in June the same year. The speculative attack on the ringgit came in July 1997 and the currency fell to 2.57. A miscalculated initial response of defending the ringgit through massive foreign exchange market intervention, similar to what BOT did in Thailand, cost the Bank Negara Malaysia (BNM) a hefty US$1.5 billion, and attracted further trade by speculators. When this measure became too costly, the currency was left to market forces. As a result, by mid-July, the Bank Negara Malaysia lost about 8 billion dollars. Eventually, the ringgit collapsed to its lowest level of RM4.88 in early January 1998. This was a massive 50 per cent depreciation. The stock market showed a similar trend. Mass selling of stocks during the same period, July 1997 to January 1998,

Asian financial markets: from crisis to recoveries

49

particularly by international investors in equity forced the KLSE index to drop by more than 65 per cent. From over 1400 index points, it collapsed to below 400 points. The currency and stock price collapses left the investors with huge losses. A large number of businesses went bankrupt and some companies closed for good. At the same time, the real value of foreign debt obligation increased drastically due to a large depreciation of the ringgit. The political leadership started blaming currency speculators for this fall rather than taking some appropriate policy measure. The first measure to deal with the crisis was the establishment of a special RM60 billion fund in September 1997. The fund was established as a bailout to help selected Malaysians. Under the arrangement, the authorities allowed the United Engineers Malaysia (UEM) to undertake a reverse takeover of some of the heavily indebted companies. It has been reported that Employees Provident Fund (EPF) was used as the main source to buy such stocks. The immediate impact of such bailouts was a significant fall of over 20 per cent in stock market capitalization. (A few years later, the Hong Kong government did a similar bailout with similar consequences.) Like Thailand, Malaysia decided to defend the depreciating ringgit as the currency came under increasing attack. When an infusion of liquidity to support the ringgit failed to stabilize the currency, the Bank Negara Malaysia decided to enforce certain policies to reduce the current account deficits, contain inflation and restore soundness of the banking system. A combination of moderately tight monetary and fiscal policy was designed and implemented by the last quarter of 1997. The central bank raised the interbank rate from 7.55 per cent to 8.7 per cent by the end of 1997. Later, when the ringgit fell to its lowest level in January 1998, the rate was gradually increased to 11 per cent. To reduce the liquidity problem and non-performing loans in the banking system, the central bank reduced the classification of NPLs from six months in arrears to three months in arrears.20 At the same time, the government also introduced policies of fiscal restraint. Highlights of such fiscal measures included curtailing fiscal expenditure through restraining consumption spending and postponing some large investment projects such as dams, railroads, highways. These policies, however, did not work to restore the confidence and bring the economy out of recession.21 By mid-1998, it was clear that the initial policy response to the crisis achieved little success. The political leadership resisted an IMF bailout package similar to that implemented in Thailand, South Korea and Indonesia. But Malaysia, instead, decided to impose currency and capital controls, on 1 September 1998.22 The ringgit was pegged to the US dollar at 3.80, a very similar response to Hong Kong’s when the HK$ came under attack on that colony reverting to China some 10 years before. As in the case of Hong Kong, the fixed exchange rate is still in place in Malaysia.

50

Liberalization and growth in Asia

These measures could be considered a reversal of the liberalization policies Malaysia had pursued and implemented during the previous two decades. It is, however, interesting to note that the regional markets showed some stability in the weeks following 2 September 1998.23 Two possible interpretations are: first, that speculative attacks had eased and the currency and stock market had already stabilized as a result of IMF policies in neighbouring countries by the time capital controls were announced. This certainly diminished the perceived benefits of capital and currency controls. The second explanation is based on the contagion theory which suggests that the crisis originated in the Thai market but spread to the other regional economies because of strong trade linkages.24 As a flip side of the coin, one may expect positive spillover effects of the same contagion. Accordingly, capital control measures enforced by Malaysia restored confidence in the Malaysian market, and hence reduced the extent of further speculative attacks on the ringgit by easing the pressure coming from capital outflows, which helped the neighbouring countries to recover from the crisis. Even Indonesia, with its soaring political instability saw some increase in the value of its rupiah. On a final note, it is worth mentioning here that the IMF’s annual review of the Malaysian economy released on 10 September, 1999 acknowledged that capital control measures adopted by the authorities to deal with the financial crisis did help in securing early economic recovery. The capital controls provided a breathing space to the authorities to initiate and implement the financial sector restructuring and reforms. The IMF report further says: Malaysia’s strengths, which include limited external debt, a strong government budget position and a history of low inflation, should facilitate a Sustainable economic recovery.

and; A pegged exchange rate is more appropriate for Malaysia than a flexible rate. IMF also advised Malaysia to keep its exchange rate tied to the US dollar.

Policy Responses in Indonesia In the same way as in other Asian economies, some of the early signs of a possible collapse were completely ignored. The favourable conditions that prevailed in the region in the early 1990s helped Indonesia to attract large capital inflows equivalent to 4 per cent of GDP. Foreign creditors provided the financing through bank loans. By mid-1997, the outstanding debt in Indonesia reached US$59 billion of which 20 per cent was held by domestic banks, 67 per cent by corporations and the remaining 13 per cent was government debt. Two factors that led to increased vulnerability of Indonesian economy were

Asian financial markets: from crisis to recoveries

51

the lack of supervision and the short maturity of the above stated credits. Out of the total of US59 billion, US$35 billion was comprised of short-term credit under one-year maturity. The total foreign reserves by mid-1997 were only US$20 billion. This increased the foreign exchange exposure of the country. These problems were further aggravated by an overvalued currency, especially after 1995 when the US dollar appreciated against Japan’s yen and resulted in a sharp decline in non-oil exports. Export growth dropped from 26 per cent in 1991–92 to a mere 10 per cent in 1996–97. Financial fragility was another factor contributing to the economic downfall. It is a well-established fact that financial sector reforms in Indonesia were initiated only in the early 1980s, much later than many other regional economies.25 However, in contrast to other emerging economies, the liberalization process was much faster and lacked appropriate sequencing of policies. Moreover, the liberalization of the financial sector was not supplemented with the restructuring of the legal framework governing the financial institutions, including commercial banks: it had to be done by the IMF after the crisis. The liberalization process put the banking industry under relatively lax conditions both in lending and investment as well as reduced capitalization requirement.26 These relaxations and the lack of regulatory supervision further increased the risk exposure of the market participants. By November 1997, the Indonesian rupiah had lost about 25–30 per cent of its value against the US dollar. The Indonesian economy was further shaken by controversial policy proposals such as the establishment of a currency board, pegging the currency to the dollar and an IMF bailout. By January 1998, the rupiah had dropped substantially from its pre-crisis value against the dollar. Indonesia was probably the only country that decided not to defend its currency. The initial response to the currency contagion was much more appropriate than the policies undertaken in other crisis-hit economies. Rather than defending the currency, the central bank decided to first widen the trading band and eventually free-float the currency. The result was preservation of a sizable foreign exchange reserve of US$20 billion by mid-October 1997. At the same time interest rates were increased significantly and fiscal restraint was put in place by postponing some large investment projects. However, the announced policies lacked the sincerity on the part of the ruling elite. Fifteen of the projects that were announced to be postponed were given a green signal, a partial reversal of an earlier measure.27 The authorities were also unclear on the correct exchange rate regime policy to pursue. The proposal of a currency board was taken seriously but the IMF resisted and the policy was not implemented. The main reason behind this resistance was that the rapid switch in policies would increase the uncertainty and further diminish investor confidence. Finally, in mid-October, the IMF was called in to rescue the country. It

52

Liberalization and growth in Asia

suggested implementing the traditional tight fiscal and monetary policy package and maintaining a fiscal surplus of about 1 per cent of GDP. However, this policy prescription was not suitable as the economy was already facing contraction due to capital outflows. The tight fiscal policy gave a further blow to already weak investor confidence on the economic outlook by adding to the contraction of the economy.28 Under a tight monetary policy, overnight interbank rates were raised to almost three times the pre-crisis level but did little to stabilize the exchange rates since the large export sector needed capital to maintain its trade. However, the negative impact of such high interest rates was immediately felt by the banks and corporations.29 That derailed the economy. The second big mistake by the authorities under an IMF suggestion was the sudden closure of 16 banks as part of the financial sector restructuring. The investors’ confidence, which was already shaky, was completely lost. In the absence of any deposit insurance in Indonesia, this increased uncertainty occurred right where it counts in the banking sector, and eventually a bank run was perpetrated by the authorities! Some reports indicate a withdrawal of US$2 billion from the banking system during November and December 1997 (see for example, Radelet 1999, p. 8). At the same time the creditors to these banks decided to withdraw their loans which created more liquidity shortage to the banking sector. The situation was further aggravated by the reversal of the early decision to close 16 banks in order to keep open a few banks owned by close associates of the then President Suharto. Bank liquidity was further squeezed when Bank Indonesia instructed (under IMF advice) the increase of the capital adequacy ratio from 8 per cent to 9 per cent and allowed no forbearance.30 Bank Indonesia had to serve as the lender of last resort and ended up injecting about US$13 billion into the troubled banks between November 1997 and June 1998. These large credits were later heavily criticized by the IMF. The biased approach towards financial institutions owned by the ruling elites and close friends was the starting point of increasing uncertainty in the market. With most banks facing a liquidity squeeze and operating under the Indonesia Bank Restructuring Agency (IBRA), their normal lending activities were either minimized or substantially diminished. By the end of 1999, nonperforming loans had reached a level of 60–75 per cent. During late 1998 and early 1999, Bank Indonesia announced several plans for restructuring the banking system. Under strict recapitalization, banks with less than –25 per cent capital adequacy ratio (CAR) were to be closed. Accordingly, in March 1999, 38 banks were closed. The remaining 128 banks were subjected to recapitalization. The estimated cost of this recapitalization was US$40 billion or 29 per cent of GDP (see Radelet 1999, Table 3). Measures were also implemented under a corporate sector restructuring

Asian financial markets: from crisis to recoveries

53

plan. By mid-1998, Indonesian firms owed US$36 billion to foreign banks. An agreement was reached with a group of private creditors for debt restructuring with some guarantees provided by Bank Indonesia. Part of this agreement was to focus on providing a facility for the repayment of an estimated US$64 billion corporate debt through the establishment of the Indonesian Debt Restructuring Agency (INDRA). The efforts proved unsuccessful as Japanese banks, being the major creditors to the Indonesian corporate sector, did not show any willingness to offer any substantial debt relief. Policies for the short to medium term also included strengthening bank supervision and accelerating asset recovery. Fiscal discipline became another priority area. The focus in the medium term was fiscal sustainability. Policies were also suggested to reduce domestic and external borrowings. An analysis of Indonesian response to the crisis reveals that the internal problems did not allow the policy-makers to correct major macroeconomic imbalances and implement the policies advised by the experts from the IMF and other international agencies.

7.

A PROVISIONAL ANSWER AND CONCLUSIONS

The important issue that emerges from the details discussed in this chapter is the lessons to be learnt by emerging economies. For this, we revert to the original question. What are the causes and the consequential effects of the crisis on the countries analysed in this book? The identification of the main factors responsible for the crisis would help one to suggest policies to avoid or at least help reduce the impact of any future crisis. From the perspective of international economics, two main factors and a necessary condition can be identified as creating the crisis. The necessary condition, which is not the same as causation, was created in Indonesia, South Korea, Malaysia and Thailand through a greater degree of deregulation with respect to short-term cash flows into their banking and the real sector firms. This was done as part of a greater liberalization to attract capital of any kind to sustain the high growth rates of around 8.5 per cent per annum in the 1990s, precisely when the export sector, the backbone for the servicing of the foreign capital base, was steadily weakening. There are two causal factors for the currency decline: a weakening of the export sectors in these countries and the central bank’s attempts to keep the value of their exchange rates high through adopting managed floats of the currencies. The declining exports and the low profits of long-gestation investments in land and property-based investments – what an Indonesian economist (see Nasution 1983) called the land-based investments such as mega roads, mega infrastructure, mega industrial and even mega golf ranges –

54

Liberalization and growth in Asia

were inconsistent with the high exchange rates being maintained by the central bankers. More and more of the capital was being lent on the basis of connectedness of the borrowers to the governments in power, the big businesses, and often cross-border investments. In fact the idea of the relational lending was wrongly being pushed as the Asian way of doing business. The world found the quick fixes offered by this networked business facilitated by the triumvirate of the government, the business and the banks – call it quanzi loans – flouted all the basic prudent and governance rules of lending. The provision of implicit guarantee by the presence of government in the transactions (as pointed out in the Group of 22 Bankers’ report to Bill Clinton, the American President, in December 1998) was at the root of the problem. The effect of these multi-factor-led crises can be summed up in one phrase, increasing financial fragility. Increased financial fragility occurring within about a year of the crisis in all the countries affected by it led to economic slow-down, to recession, and then to recoveries after costing as much as about 20 per cent of the GDP of each of these countries. The social upheavals of these secondary effects on the economy, not to mention the political fallouts in all but Singapore, are sudden loss of employment for an increased number of workers and a general decline in the quality of the lives of the people in the near term of about one to three years. Banking fragility, which was at the root of this severe problem after a year of the crisis, is a more dramatic symptom of the financial fragility. This has become a byword after the crisis. The exchange rate instability over a quarter century of free floats of a few developed country currencies and the peggingcum-managed floats of many developed and developing countries provided the recipe necessary for increasing the severity of this crisis. As noted in an earlier section, banking failures have become more frequent, causing severe damage to the sustainability of growth in the developing countries. Exchange rate instability has become a fixture and speculators are trading 12 times the values of currency required to sustain the present level of world trade in merchandise (Bhagwati’s widgets; Bhagwati 1998). Globalization of financial flows – especially with short-term flow of portfolio funds seeking high returns within an accounting period across a global network of investments – translates in practice as endemic operational risk to the Asian banks and real sector firms. This is especially severe when central banks fail to adopt prudential limits to the external capital in the real and financial sectors. As would be expected, some countries such as South Korea have passed laws to limit wayward levels of borrowing by banks and real sector firms. We wish more countries would adopt this path. All three models of banking organizations have not been able to cope with the adverse effects of continuing financial crises in the last ten years as these crises are bringing severe retardation to bear on normal economic activities.

Asian financial markets: from crisis to recoveries

55

The American model with deposit insurance is evidently creating a moral hazard problem leading to episodes of failures when banks take the kind of imprudent investments knowing in advance that the government or the deposit insurers will rescue them from a crisis: recall the deposit insurance failure in America in the credit union bailout of the 1980s. Unfettered competition among atomized US banks has been good to customers in the US as the margin between deposits and lending narrowed the most under this model. Narrowed profits or bank failures from too small a margin would cause more banks to fail but this competitive banking model improves services to bank customers. The English model of banking with few large banks providing the bulk of deposit management has led to periodic failures, in this case more from the weaknesses in the government policies in respect of prudential lending practices of the monopolistic large banks. The third model, the mono-banking of the Communist era, is no longer a choice to be considered. Banking fragility weakens the ability of the banks to fulfil their functions efficiently after crisis. In both the developed and developing economies, the banking sector fulfils three key functions. These are (1) undertaking guarantees in financial transactions, an example being the letter of credit on which world trade depends heavily, (2) collecting small savings into large loans or maturity transformation and (3) providing the framework for efficient payments among parties undertaking financial transactions. In many countries, the level of bank lending to the non-financial sector is below 80 per cent of GDP. These functions cannot be taken over by the direct financial markets. In all the countries affected by the crisis, bank credits run at around 80 to 100 per cent of their GDP with direct market funds being a small portion of the total funds raised. Thus, banking fragility becomes worse in such countries given a heavier reliance on bank credits for sustaining the very high growth rates of these developing economies. One factor offered as an explanation for the crisis is financial liberalization. In Table 2.8, we list the beneficial effects of financial liberalization by deepening markets to support higher levels of economic activities in a fastgrowing economy. Financial deepening is seen to be a slow process that takes time. When financial liberalization was pursued vigorously, as in Malaysia and Singapore, the results were greater financial depth as can be seen in the table. This eventually helps to create viable direct financial markets. Money market depth in the less liberalized economies such as South Korea and Indonesia is shallower, about 50 per cent of GDP, than in the more liberalized ones where this ratio is closer to 100 per cent. The financial intermediation ratio (FIR), which is the ratio of assets in the financial system as a proportion of GDP, shows the same pattern over time. FIR is just above 100 per cent in less financially deep Indonesia compared with the ratio of over 200 per cent in the more developed Malaysia, for

Table 2.8

Greater financial depth to support economic growth South Korea

Financial Depth

56

Money market depth (M2/GDP) Financial intermediation ratio Capitalization ratio Sources:

Indonesia

Malaysia

Singapore

1976–80

1990s

1976–80

1990s

1976–80

1990s

1976–80

1990s

31.80

43.80

16.70

53.50

47.60

97.00

73.00

116.00

110.00

197.00

44.40

127.00

148.00

286.00

254.00

377.00

22.00

80.00

3.00

45.00

55.00

220.00

95.00

160.00

IMF International Financial Statistics and IFC publications. Figures computed by authors.

Asian financial markets: from crisis to recoveries

57

example. The capitalization ratios in these countries are also much higher than in slow growth countries such as Pakistan (statistics are reported in Chapter 8 on Pakistan in this volume). Thus, far from being the cause of disaster, financial liberalization supported the fast-growing economies to secure high output growth in the 1980s to 1996. It is the financial fragility that led to the crisis. A greater degree of financial openness along with a subservient central bank that failed to enforce fragility removing prudential regulations or monetary reforms (free floating currencies) have facilitated the onset of crisis. If the policy-makers had taken steps to remove or even manage the financial fragility well along with policies of liberalization, then the severity of the crisis would have been less pronounced. Internet releases on the top banks in the world provide information that suggests a strong oligopolistic banking structure in Australasia. Fourteen of the top 50 banks in the world are from Asia and Australia. Of these, 11 are Japanese banks. While the decentralized American banking structure has spawned about 7898 banking institutions serving the US economy (see Federal Reserve Bulletin, January 1996, p. 5) the model favoured in Asia is oligopolistic banking. The top few banks dominate the banking sector in all Asian countries and these promote very widespread featherbedding practices of depressing deposit rates, keeping high margins, engaging in connected lending, and generally favouring easier regulatory burdens on banks. Oligopolistic banking, where the top four to five banks will account for the majority of deposits, is a poor model. Strangely, this form of banking in one country (Australia) is called the Four Pillars, when it should be named the four monopolistic cousins. Compare this with the market share of 71.7 per cent of the deposits by America’s 7898 banks! Even the largest 800 bank holding companies there account for only 50.9 per cent of the deposits. In most Asian countries, a single savings bank will have more than 50 per cent of the deposits. An example of the monopolistic banking is the case of Singapore, at least till July 1998, when the POSBank with almost half the country’s deposits, was merged with the DBS bank, leading to one mega bank. Such top banks are even represented on the boards of the central banks, and thereby become privy to inside information of regulators in some countries. Outside the boardrooms, the top bankers network with the political and big business groups to facilitate anti-competitive practices in the industry. The command economies (like China) and the socialist economies (India, etc.) practise a very virulent form of lack of separation of responsibilities between the rule-makers, the rule implementers. The big businesses have thus produced a recipe on how to create weak banking systems with huge non-performing loans. These latter cases are documented elsewhere in the book, and should be blamed for promoting general weakness in managing the people who seek monopoly rent and wealth without serious and honest efforts. As long as

58

Liberalization and growth in Asia

financial intermediaries are likely to engage in a game of wresting more economic rent by seeking or working around the regulators’ often flawed idealized rules (see Kane 1977), no model will be foolproof or safe from manipulation. Looking at the 1997 Asian financial crisis after it had run its course over 24 months gives a different perspective from the one an observer might conclude in the midst of the crisis. One not sobering fact to arise from our analysis is that this crisis cost the most in terms of the rescue efforts as well as in the reduced growth perpetrated in the hitherto fast growth economies during the two years surrounding the crisis. But a sobering fact is that the more we come to know of the genesis of the crisis, the more it reveals the following stylized facts: ●

●

Pursuit of inappropriate policies by (a) relying on short-term domestic and foreign capital, (b) switching to long-gestation investment projects at the wrong time when (c) the export growth was declining and (d) central bank failure to enforce independent monetary and prudential processes, is the cause of the crisis. The root cause of the problem that made the crisis worse was an endemic financial fragility resulting from the pursuit of the above policies.

Financial liberalization provided greater depth and resilience to sustain a greater amount of economic activities that were taking place in the crisis-hit countries. Liberalization therefore provided a necessary but not a sufficient condition for the crisis to have the severity it had taken in just about 24 months after the fateful Thursday, 2 July 1997, when the Thai baht could not be stagemanaged any longer. The policies pursued under the tutelage of IMF and other institutions led to recoveries in all these economies (except Indonesia) by year 2000. However, the Iraq war in 2003 by the coalition of the willing31 and the worldwide anti-terrorism measures following the World Trade Center destruction by Middle Eastern terrorists have prevented these nations from building on the good economic recoveries already in place in their countries by 1999 and 2000. The financial crisis provided several long-lasting lessons to Asian and other countries.

NOTES 1. 2.

Some of the details of the pre-crisis performance of these countries will be discussed in country-specific analyses. There is a large literature available on the causes of the Asian crisis. See Aghevli (1999), Arndt and Hill (1999), Lauridsen (1998) and Kawai (1998) for a detailed discussion on this issue.

Asian financial markets: from crisis to recoveries 3.

4.

5.

6. 7.

8.

9.

10. 11.

12. 13.

59

The Thai central bank defended a weakening currency for a while. By mid-1997, when the Thai cabinet dithered about taking bold decisions to tackle its banking problem, a wrong signal was sent to the much more open financial markets. Confidence snapped and the currency declined. Both authors of this book were conducting interviews in the financial sector, and witnessed these events as they travelled to the region during March 1997 to May 1997 and met with senior officials and bankers. IMF Article 8 provides the guidelines for exchange rate management. Countries may choose to free float currencies: Australia chose this in October 1984 to solve its economic problem. A country could peg to a strong currency and maintain that peg when its currency comes under speculative attacks: Hong Kong did this in 1981 to escape the attack on its currency. China’s final agreement with Britain led to Hong Kong currency weakening. Thailand, among others, chose to basket-peg, which is also a peg but to the average currency exchange rate of the top 10–15 trading partners. Widespread banking failures were observed in the late 1920s and early 1930s followed soon after by the Great Depression of the 1930s and thereafter to a second human tragedy, World War II. The lessons learned from that Depression and the efforts to strengthen the financial sector in the developed countries saved them from experiencing severe bank failures in the post-war years. The Asian bankers failed to take a history lesson from that experience. Instead the central banks did not take steps to wipe out a particularly vicious form of government-cum-banking-cum-big business quanzi or connected lending. Lending practices under this ignored the basic consideration of project viability, which is one reason for the high levels of non-performing loans in all Asian banking systems. This figure is reported on the Internet under the BankWatch report on Asia, dated 29 October 1998. Trade in goods and services, as pointed out by Bhagwati (1997), is growth promoting in that there is a limit to the demands for goods and services. He has labelled free trade in money as not being in the same league for the simple reason that there is no satiation in the demand for money to place an automatic break. Instability could also come from domestically driven forces without cross-border transactions. With an appreciating currency in an economy with low interest rates, savers would redirect cash holdings to obtain speculative profits by pushing up asset prices. Because the real interest rates in Singapore had been very low since the mid-1980s, people’s savings were channelled to speculation in property and other assets markets, which weakened the Singapore currency during 1997–98. If they have huge foreign reserves to support their currencies, exchange rates may be even maintained at high levels in such economies. The build-up of huge portfolio investments in the Asia markets took place over 1988–93 as a result of many of the countries adopting new regulations easing entry and volume restrictions in the bond and share markets. For example, Malaysia liberalized its share market in 1989–91, which led to a huge increase in foreign activities. In 1993, the peak of this flow of short-term money, the Kuala Lumpur stock market yielded a 104 per cent return. The subsequent two years saw a correction by 35 per cent. One study (Asher et al. 1992) found that these measures are meant to reduce the cost of capital to almost zero, and in some cases to negative cost of capital. With such incentives, any normally unprofitable investments could be turned around to become profitable. Much has been said about too much debt being taken in the name of development. The banking sector taking too much debt has been at the root of the problem. (Rowley, Anthony, ‘Lehman puts regional banks problem loans at US$1,200 billion’, Business Times, 19 October 1998.) As at 2003, the situation has changed moderately, but is still of concern for some countries. The reader may refer to Khalid and Kawai (2003) for a definition of contagion and some empirical evidence for it in Asia. That the export sector was weakening was not widely publicized in the press. In the case of Malaysia, current account deficits were growing fast as far back as 1993, but the capital flow to the financial and real sector offset the dangers of the weakening in the trade sector, a false sense of security widely given coverage by the local press and in official discussions during the 1990s.

60 14.

15.

16. 17. 18. 19. 20.

21. 22.

23. 24. 25. 26.

27. 28. 29. 30. 31.

Liberalization and growth in Asia The Australian dollar touched a record low of US$0.49 in 2001 before appreciating significantly and touching a record level of US$0.74 in early December 2003. This is largely attributed to global depreciation of the US dollar, to the high base interest rate while inflation has touched a low of about 2.4 per cent in Australia. A closer examination of the miracles performed by the so-called wise political sages turned out to be good neoclassical macroeconomic management. Political elites across the Asia Pacific rim had to deliver economic growth to impoverished masses in the face of the attraction Asia had for Communist propaganda of the 1960–89 period. For two interesting accounts of the transformation of the Asian economies, see Campos and Root (1996) and Chowdhury and Islam (1996): also see a review article by Ariff (1997). For more detailed coverage of the policy responses see Khalid (1999c). According to Lauridsen (1998), under a 1940 statute, the legal requirement is that total reserves should be equivalent of the value of total currency in circulation. Table 2.7 shows the contribution of different countries as well as international organizations in the bailout fund. For more detailed discussion on IMF policies, see Goldstein (1998), Khatkhate (1998), Perry and Leipziger (1999), Radelet (1998, 1999) and Xu and Ling (1998). There is some scepticism on this policy. Some statistics show that the percentage of NPLs as a ratio of total loans went down after the crisis. This seems unlikely given the severity of the situation. One explanation of this episode is that BNM, during 1998, reversed the policy and gradually extended the classification of arrears from three months to one year. There is no proof to support this argument, though. A recent unpublished study at the Universiti Putra Malaysia suggests that the share prices of banking stocks declined substantially when the regulation was changed from three to six months. When the rule was reversed several months later to three month in arrears, the bank shares recovered the losses. The details of events in Malaysian case are provided in Jomo (1998a, 1998b, 1998c) and Wade (1998). It is important to note here that the capital control measures were to control short-term capital only. Capital movement in FDI, transaction for trade in goods and services, interests, profits and dividends of long-term capital and current account do not come under these control measures. This issue has been discussed in detail elsewhere in this book. See John Williamson (2000) for a discussion on costs and benefits of capital controls. These details are discussed in a separate chapter on Indonesia (Chapter 5) in this book. The benefits of financial liberalization are not questionable. The argument focuses on the appropriate sequencing of such policies. Although there is no consensus on what should be the optimal sequencing, using models and a gradual approach in liberalizing the financial sector is preferred in the literature. There is sufficient discussion in the media to prove that these 15 projects were owned by Suharto’s family. The IMF changed their tight fiscal policy stance several months later after realizing the initial mistake. The damage had, however, been done. The details of currency crisis and policy responses in Indonesia may be found in Soesastro and Basri (1998), Nasution (1997), and Pincus and Ramli (1998). This policy was also changed in January 1998 by allowing forbearance and reducing capital adequacy ratio. The term refers to the invasion of Iraq by a military force mandated by 30 UN members who were willing participants. These participants bypassed a long-practised full UN Security Council approval for declaring war on a country: there was only one such war before, in the case of the Korean War in 1953–54.

3.

1.

China: a command economy responding well to market signals for a long while now INTRODUCTION

China, which was under the iron grip of Communist central planning from 1949, took cautious efforts 30 years later to move from a command economy model towards a transition market economy. Its multitiered prices and exchange rates have been unified, the mono-banking system replaced with a separate central bank along with new state banks. The financial sector has been expanded to include specialized commercial banks and non-bank financial institutions while efforts were made for a while to discipline government finance. Growth has been around 8 per cent during the years after 1998 with inflation, on average, in single digits. Some measures were taken in the aftermath of the Asian financial crisis to strengthen the financial sector and the regulatory structure. The currency has shown stability since 1997 when Hong Kong with its huge foreign exchange reserves became part of China. Further pro-growth policies are needed to transform the economy into a fully market economy model. In view of its success, China’s cautious reform process is often touted as a model for former command economies to make the transition towards becoming market economies. It is debatable, however, whether a one-party authoritarian rule is a necessary recipe for success in the short and long run, which opens a political dimension to any discussion on liberalization and growth. This chapter therefore examines an interesting case of great relevance to the 20-odd transition economies. It is relevant to North Korea and Vietnam for example, in the Asian region and also for Eastern Europe or even Cuba. We examine the economic and financial structure of the country in the next section. Both sectors are still burdened within the public-ownership mode, but the structural reforms within the public ownership scheme have created private-sector-based competition in small and medium enterprises as well as the wholesale importation of multinational involvements mostly in the trade sector in cosmetically free trade zones. Section 3 provides the more interesting details on the financial sector reforms undertaken. The impacts of these 61

62

Liberalization and growth in Asia

reforms are measured in the following section before concluding the chapter with a short discussion on future prospects. Its trinity of challenges are: how to be a respected member of the WTO; how to bring in currency reforms; and what structural reforms are needed to corporations, away from the stateownership entrenched in shareholding.

2.

ECONOMIC AND FINANCIAL STRUCTURE

The economy of traditional China was squarely based on rural economic activities completely dependent on agriculture based on the individual peasant families. The agriculture sector was dependent on traditional technology comprising human effort, animal power and natural fertilizer. It was only in the early 1900s that China realized the need for modern technology and allowed domestic and foreign investments in industrial and commercial enterprises. After the Communists drove the Nationalists to Taiwan in a bloody civil war, the People’s Republic of China (PRC) was established in 1949 and the Chinese Communist Party decided to rely heavily on the Soviet model of economic structures and development strategies. The end result of adopting a centralization model was the transformation of the pattern of ownership from private sector to public sector, a weakness that has led to an inefficient state sector over 50 years from which the country is still trying to extricate itself in the twenty-first century. By 1956, almost all the assets, including foreign ones, were transferred to the public sector in one way or the other. A mono-banking system was established as the circulatory system for domestic payments with the heart of the system being at the State Council – certainly not the will of the marketplace – while the Bank of China with its overseas offices became the sole repository of foreign transactions. These measures of collectivization of agriculture and nationalization of industry to some extent legitimized the political regime to govern the Chinese economy as a system of mandatory central planning orders. The Party assumed full control over the economy and its policies by the dictates of the People’s Congress that met once in three years to rubber-stamp the decision put to them by an entrenched bureaucracy-cum-rulers. Those members of the central bureaucracy, who live a life of protection in Beijing, were supposed to execute the will of the Party so expressed at the meeting. This was in reality the central planning, where, after the decision by the Congress, the state exercised its planning function primarily through mandatory procurements and allocation of key agricultural and industrial products by holding up rigid price controls on major goods. There was no place for market prices nor for the will of the economic agents to be expressed through market prices. To ensure that economic agents had no freedom, the means of production was

China

63

taken in trust by the state itself. How could economic agents express their choices if they could not own the very means that could give them the choices!? This system created huge public enterprises with the highest level of inefficiency. The international press often reports of 28000 central government-owned enterprises together with another 300000 provincial and city government-owned firms controlling this vast economy: this excludes the military-owned firms. Most of the government resources were allocated to finance these enterprises. The government realized the inefficiencies associated with the Soviet model but made only cosmetic changes without giving up controls over the economy till the passing away of the founder of Communist China, Mao Zedong. The only visible change that occurred during a short space of time over 1971–75 was a slight increase of state investment in agriculture inputs such as machinery and fertilizer with heavy industry still being the major recipient of state investment. The result was a closed economy, which hoped to grow from internal demand with minimal external openness. The reader may see the sharp contrast of this with the economies described as open ones elsewhere in the book. By 1994, China initiated policies to curtail the loss-making state sector through privatization and sale of assets. Given that some of these corporations are not so easy to dispose of given the obligations that they have for the welfare of the retired employees, China has been reluctant to make the kind of clean-slate sales that East German firms were subjected to in the 1990s. Reforms will come slowly to curtail the drag that these state enterprises are putting on the budget. After gaining control of the mainland in 1949 and up till 1975, the Communists pursued a policy of socialist economic development – as it is more correctly described – by pursuing a system of political commands to manage the economy. Given its lack of capital and technology, the push for prosperity had to be based on self-reliance and complete control of central planners. During the initial trial reform during 1977–80, a policy of opening up trade and investment was put in place. Since then, the leadership and policy-makers have made efforts to gradually relax central planning by decentralizing economic decision making, and eliminating or at least reducing the gap between the two-tiered pricing systems. These steps stabilized exchange rates, eliminated the black market for foreign exchange and reduced slightly the dependence of state enterprises on government subsidies as well as from the financial sector. The detailed analysis of these reforms is described later in the chapter. Nonetheless, the overall success of these reforms relative to some other Central and Eastern European countries is quite obvious, and is often used to illustrate the idea that China’s grip on one-party rule is the root cause of this success. Of course, that is not the case. Why did other one-party statist model come to naught? GDP grew at an annual rate of 6.7 per cent

64

Liberalization and growth in Asia

during the period 1971–80 compared with an earlier growth rate of between 3 to 6 per cent. But growth went into double digits for most of the years when more reforms, especially overseas capital and later technology, came Chinabound during 1983–2002 with a slight slowdown in 1997–99. Lest the readers have a biased view on the state sector, it must be stated that the speed of reforms to the state sector has picked up since Zao Ziyang became the Premier, and especially since the days of the great flood in 1998–99.1 About 1000 very large enterprises consisting of 878 industrial enterprises and 122 service-sector firms are reserved to be developed into future large firms. The official line is that these firms are needed to compete with foreign firms when China eventually adopts full reforms. The remaining small and medium enterprises are to be reformed as follows. A huge number of third-category firms will be sold off in outright privatization. The promising ones with profitability will be permitted to become joint venture non-state enterprises, and sold off. Firms that could be established as public corporations owned by employees with state majority ownership will become shareholder cooperatives. Some progress has been made in this regard as can be judged by the burgeoning stock-exchange-listed firms since 1987. Thus, a future is envisaged still with three classes of state-owned firms in the non-public goods production sectors: the number of firms will be small, but their significance will still be potent. By any means this scheme, even if it works to improve efficiency in the restructuring stage, will leave the most significant part of the economy in the ownership of the state. South Korea needed only 36 chaebols (not state-owned but with great influence on the state) to bring the great Korean economy to its knees in 1992–97 through their profligate behaviour in capital resource allocation (see Chapters 2 and 6) and state–chaebol clandestine relationships. Efforts are being taken to reduce the manning levels of state enterprises to raise efficiency. To alleviate total loss of income, redundant workers are given half pay and sent home on leave. We proceed now to give a snapshot of the reforms. 2.1

Economic Performance

China developed a huge dependence on the external sector for capital and technology but eschewed domestic real sector, foreign exchange and financial sector openness, all three of which, along with fiscal reforms, were postponed. Table 3.1 shows statistics on socio-economic improvements during the last 42 years. From the time of the Tiananmen Square event2 right up to 1997, China continued to enjoy high economic growth averaging above 9 per cent, though the growth slowed down slightly from 1996 onward to 7.3 per cent per annum in 2001. The per capita income increased from US$306 per annum in 1981–90

Table 3.1

Basic economic and social indicators of development in China, 1960–2002

Indicators

65

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

National Accounts GDP Growth (%) Per capita GDP (US$) Private consumption/GDP Government consumption/GDP

– – – –

– – – –

9.35 306.00 51.63 13.24

12.02 451.00 46.55 12.82

8.26 757.00 47.19 12.16

8.00 847.00 48.02 13.10

7.30 927.00 46.57 13.21

– 963.00 47.10 13.50

Financial Indicators (%) Gross domestic savings/GDP Fixed capital formation/GDP Inflation (per annum) M2/GDP Fiscal balance/GDP Trade balance/GDP Current account balance/GDP Total trade/GDP Debt service/GDP Foreign reserves/imports

– – – – – – – – – –

32.50 30.20 1.40 – – – – – – –

34.40 28.66 7.50 57.68 –0.93 –0.80 –0.10 21.74 – 41.02

41.30 33.70 40.10 97.84 –2.37 1.09 0.85 37.14 10.10 42.35

40.50 34.98 1.96 133.24 –1.93 3.83 2.46 37.05 9.90 88.84

38.90 36.51 0.40 152.15 –3.10 3.19 1.90 43.94 9.30 73.56

38.50 37.33 0.70 158.60 –4.44 2.86 1.46 42.78 7.90 87.11

39.40 41.10 0.80 182.42 –3.03 3.57 2.86 50.18 – 97.03

– 2.29

– 1.84

2.40 1.49

2.58 1.37

3.06 0.61

3.10 0.82

3.60 0.77

4.00 0.60

Social Indicators Unemployment rate (%) Population growth (%)

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

66

Liberalization and growth in Asia

to US$963 per annum in 2002 (be cautious in interpreting this figure as it includes the huge GDP of Hong Kong after its takeover). Private and government consumption are steady as a ratio to GDP of around 48 per cent and 13 per cent, respectively. The reforms that were initiated during the 1991–95 period did give a boost to domestic saving to GDP ratio when it increased from 34 per cent in 1981–90 to an average of 40 per cent since then. Investment has shown gradual increase over this period and was 41 per cent of the GDP in 2002. The main success of the regime was to control inflation which at one point was moving around 60–70 per cent per annum. Although the civil service and state enterprises were being downsized, the government expenditure increased by 18 per cent and the budget deficits accounted for 3.03 per cent of the GDP in 2002. Due to a tight monetary policy, money supply (M2) growth declined to 11 per cent in 1998 from 26 per cent in 1997. The M2 grew at 18 per cent in 2002. With domestic demand having abated, government is pursuing a Keynesian type expansion by printing money and investing in upgrading infrastructure to keep the unemployment down as well as to absorb the potential laid off workers from state enterprises. These trends are depicted in Figure 3.1. The high growth performance stated above is partly due to high growth in the export sector, which enjoyed a record high level of 97 per cent in 1994 but 60

Growth rates

50

Real GDP CPI M2

40 30 20 10 0 –10 1961

1966

1971

1976

1981

1986

1991

1996

2001

Note: No data available from 1961–78. The whole time period is, however, used to preserve the consistency with other graphs in this chapter.

Figure 3.1

Growth rates of real GDP, CPI and M2, China: 1961–2002

China

67

declined later and has averaged around 13 per cent since then with 2002 registering 22 per cent growth in exports. Under China’s accounting system, output is counted as sold once inventoried: high levels of inventories have built up with a slow-down in the traded sector, but the unsold inventories are giving false high growth statistics. Merchandise imports experienced an average growth of 12 per cent since 1995 with 21 per cent growth in imports registered in 2002. Overall, China enjoys a trade surplus of 3.6 per cent of GDP and had a current account surplus of 2.9 per cent of GDP in 2002. The impact of reforms in the foreign exchange market is visible by an increase in reserve to imports ratio of 42 per cent in 1990–95 to 97 per cent in 2002. The country is very successful in attracting foreign direct investment (FDI). FDI registered a growth of 30 per cent per annum in 2001 with US$49 billion received in that year. This is 4 per cent of the Chinese GDP and makes China the second largest recipient of FDI among all countries, and first among the 126 developing countries. On social indicators, China’s unemployment rate has ranged between 3–4 per cent during the last decade. During 1995–97 a total of 3 million workers were laid off in the state sector. Population growth is reduced to 0.6 per cent. This is due to China’s very strict ‘one-child’ policy which is subject to criticism on various grounds including issues of human rights. In general, China’s economy has shown steady progress over the last two decades ever since the second phase of reforms was initiated. Later events such as taking possession of Hong Kong in 1997 which came with huge international reserves contributed significantly in high and stable economic growth since 1997. China’s membership to the WTO in 2001 has further improved the prospects of economic growth in China.

3.

LIBERALIZATION

Chow (1987) split the pre-reform periods into five sub-periods. The years 1949–52 are used as a period of recovery from civil war. No major economic change took place during this period except land reforms, whereby the land was distributed from the rich landowners to the farmers, and then this right was soon taken away by the establishment of collective farms. The second period covered 1953–57 when the government introduced its first five-year plan, à la Soviet model as stated earlier. The years 1958–61 was the period of the Great Leap Forward when Mao and his planners wanted to create a Pandora-style accelerated economic growth to unattainable levels by public exhortation. These policies without a set of incentives for economic agents eventually resulted in a great failure, and economic activities declined. The fourth period, 1962–65, witnessed economic readjustment through the

68

Liberalization and growth in Asia

introduction of more liberal economic policies, which led to some recovery. Finally, the well-publicized Cultural Revolution of 1965–75 led to economic disaster. The country was effectively taken over by the near-religious zeal of the young wanting to purge the superstitions, as they termed them, of the old China and purge the capitalist opportunists. Till Deng Xiaoping overthrew the presumed successors to Mao,3 and initiated limited farm ownership in the late 1970s, nothing significant happened. The factors that led to economic reforms in China were not related to the economic crisis of the same degree as in some central European countries. Even with the negative effects of policies such as the Great Leap Forward and Cultural Revolution, which led to depression and famine in China, the country managed to maintain an average growth rate of about 6 per cent per annum between 1958 to 1970. Price controls in place ensured relatively low inflation and virtually no external debt was incurred. Macroeconomic instability was not the reason for initiating reforms in China. The impetus for reforms was the growing discontentment with the system, which had spread to the rural areas, the power base of the party. The televised pictures of a prosperous West following the opening to the West in 1976 created yearnings for reforms. Even the neighbours, long considered as less elevated than China, seemed to have some of the prosperity which was absent in the sterile planned economy. The other major reasons for policy change towards gradual economic reforms and liberalization were the higher growth performance of East Asia during 1965–79 relative to China’s declining growth over the same period, the decline of the Soviet Union’s political supremacy in Asia, meagre progress in technological development and somewhat reduced tension between China and the United States, which was pursuing a policy of vigorous opposition to Russia. Although the reform process was relatively slower and more gradual – a reason why we like to label it cautious – than in some other countries in East Asia and Eastern Europe, the result was more encouraging. Relative to some Eastern European countries, reforms in China became more successful. The estimated growth registered was about 10 per cent during the sixth plan, 1981–85, with both agriculture and industries registering double-digit growth, largely attributed to the introduction of private incentives to farmers to produce and sell for their own account. The overall sectoral relationship between consumer goods and producer goods and between agriculture and industrial goods improved. The standard of living and real incomes increased compared to the pre-reform period, 1949–77. The initial reforms were of a short-term nature basically to tackle the problems of economic crisis of 1975–76, but the authorities recognized the potential of longer-term reforms to strengthen Communist controls even as Communism was disappearing along with the statues and walls coming down in Europe.

China

69

Reform would bring in major changes to the existing infrastructure and planning, but would create prosperity for the masses. This experience of adopting a gradual economic liberalization could be studied under several phases. The first phase covered the period 1978–84, during which reforms were oriented to recover from the 1975–76 crisis of leadership and of the accumulated effects of the Cultural Revolution. The policies designed and implemented in this phase were of a short-term nature emphasizing their trials to test a new incentive system for agricultural production, allowing market-based operations in price determination and relaxing restrictions imposed on individuals’ decision making in both the agriculture and industrial sectors. Another interesting and rather bold measure in this phase was the decision to break the isolation from the world. The government established special economic zones as a means of attracting foreign investment and technology: private sector incentives were permitted to operate in these areas while these were not permitted in the domestic sector. The second phase spanned 1984–88 with the focus on the urban industrial sector. Policies implemented were about reforms to the pricing, taxation and wage systems in the urban areas. An important aspect was the establishment of a central bank. This led to reforms to depository institutions. This saw important financial sector reforms implemented to sop up the increased savings from the real sector returning to market-oriented economic activities. The third phase started in the middle of 1988 to 1991, which focused on correcting the negative impacts of certain policies implemented in the first two phases. As a result, the authorities were able to stabilize price volatility. The fourth phase started in 1992 with the intention of accelerating the reform process and opening up to the world. Broader policies were designed and implemented leading to more reforms in the financial sector, introducing a more appropriate legal framework, restructuring the role and the functions of the government and social sector reforms. Major economic and financial sector reforms are summarized in Table 3.2. 3.1

Economic Liberalization

The economic reforms were focused on four areas, namely: the fiscal sector, the state-owned enterprises, pricing structure and the external sector. The first two were aimed to streamline public spending and reduce the burden of financing loss-making state enterprises. Pricing reforms were required to deal with high episodes of inflation and external sector reforms to promote the export sector and attract foreign investment. In the pre-reform era, fiscal policy had no role in macroeconomic management. In a centralized system, the main objective remained administering allocation of scarce resources by central planners. The tax system was of

70

Table 3.2

Liberalization and growth in Asia

Major financial sector reforms in China: 1980–2002 Liberalization policies implemented

1980

Enterprises allowed to issue corporate bonds Foreign exchange certificates issued

1981

State council approved issue of government bonds

1984

People’s Bank of China established as the central bank of China Specialized banks established to engage in commercial banking activities Government issued security trading regulations

1985

Regulations governing foreign banks and joint Chinese foreign banks in SEZ announced; Shenzhen Foreign Exchange Swap Centre opened

1986

Commercial banks established at the provincial level All banks are allowed to engage in foreign exchange transactions Shanghai Foreign Exchange Swap Centre opened ICBC Shanghai created the secondary over-the-counter market

1987

Two universal banks established and permitted to compete with existing banks in all forms of businesses RCC and UCC established under the supervision of ICBC and ABC

1988

State council approved secondary market for government bonds in 61 cities

1989

Commercial banks expand their foreign exchange operations

1990

Shanghai and Shenzhen stock exchanges started

1991

PBC started using security companies as underwriters

1992

Foreign banks are allowed to open more branches in Guangzhou, Dalian, Tianjin, and the SEZs MOF and SCRES issued new accounting system for shareholding enterprises. State Council opened 28 inland cities and 14 coastal cities to foreign trade and investment; these cities are granted preferential policies Rules and regulations governing the joint stock companies announced. MOF issued new accounting system for foreign-funded projects

China

71

PBC announced the flotation of foreign currency bonds in the domestic market PBC appointed 7 accounting firms in Hong Kong to audit accounts of 35 enterprises that have applied for listing in Shenzhen and Shanghai markets The National Foreign Exchange Adjustment Centre opened in Beijing; the centre is fully computerized with participants from 42 local swap centres NSC established to formulate rules and regulations governing the securities markets in PRC Securities and Supervision Administration Committee established to supervise and regulate the securities industry 1993

BIS standard PBC issued 16 provisions to regulate activities in interbank markets Chinese residents are allowed to take ¥6000 abroad A cap on swap market rates imposed The Beijing Financial Market is replaced with the newlyestablished Beijing financial centre Regulations on transaction in foreign exchange swap markets introduced State Administration for Exchange Control allowed trading of foreign currencies by local individuals in Guangzhou and Shenzhen provinces Provisional regulations on the management of stock issuance and trade issued Provisional regulations on the registration and management of futures market issued by the State Administration of Industry and Commerce Fully computerized NETS for trading of stocks and bonds became operational Interest rates increases: 1.8% on term deposits 0.8% on working capital loans From 11% to 14.06% for 5-year T-bonds From 10% to 12.52% on 3-year T-bonds The cap on swap market rate removed New accounting system implemented Steps taken to address high inflation

1994

First nationwide interbank foreign exchange market set up in Shanghai. Continued overleaf

72

Table 3.2

Liberalization and growth in Asia

Continued Liberalization policies implemented

1994

Conditional current account convertibility of RMB established by removing some restrictions on foreign exchange transactions under current account A new exchange system implemented unifying the exchange rate determined in the interbank market. NEITS became operational, linking 12 major cities with plans for it to be expanded to 8 more cities Foreign Exchange Trading System starts operation Three policy banks established, namely, State Development Bank, Export–Import Bank, and Agricultural Credit Bank to take over policy lending Commercial banks adopted asset–liability ratio management on risk management and a system to identify and assess NPLs

1995

Rules for commercial banks established to seek profits and ensure safety net and liquidity Zhongyin Trust and Investment Company closed under new regulations for insolvent financial institutions. Many other banks and non-bank financial institutions were later closed under the same regulation

1996

New Foreign Exchange Control Ordinance promulgated which allowed RMB to be convertible for trade-related account transactions and lifted restriction on repatriation of profits and dividends by foreign investors (full current account convertibility) Centralized inter-bank market established. China Inter-Bank Offered Rate initiated

1997

Inter-bank bond market established in China

1998

Quota control on credit abolished Major steps proposed to restructure and regulate the financial sector in the aftermath of Asian financial crisis Special Treasury bonds worth RMB270 billion yuan issued for re-capitalization of state-owned commercial banks China Insurance Regulatory Commission established

1998

Four Asset Management created to take over from big four banks problem assets worth RMB1.3 trillion (in book value)

China

73

1997–99

State-sector reforms; new tax codes and administrative reforms; new codes of commercial laws enacted; serious efforts being taken to reduce the state-owned enterprises with three aims; some of them will be developed to become very large profitable enterprises to face the competition from international firms; some will be corporatized and listed, and owned by workers and the state; the rest will be privatized

2001

China joins the World Trade Organization

2002

Commercial banks adopted a five-category loan classification standard, prudential accounting practice and operational information disclosure system

Sources: Goldie-Scott (1995); Tseng et al. (1994); Bell et al. (1993); Ho (1998); websites.

little use in the absence of individual and enterprise income tax, with all enterprise profits being transferred to the state. The reform process has brought major changes in the tax system. These include the introduction of enterprise taxation through the Contract Responsibility System (CRS)4 in the 1980s; unifying the taxation of all foreign-funded and domestic enterprises in 1991; introduction of unified corporation tax, value-added tax (VAT) on production, capital gains tax (CGT) on property and stock transactions; consumption tax on luxury items, business tax for services; and reduction in income tax.5 Curtailing fiscal deficits was the second focus of fiscal reforms which had two objectives. One was establishing fiscal discipline by creating a mechanism where resources are efficiently allocated and distributed. These objectives were partly related to the distribution of revenues between provinces and the central government and the state and non-state sector. To improve the efficiency of tax collection and distribution between the centre and the provinces, the government abolished the contract-based intergovernmental revenue system. The National Tax Service (NTS) to collect all central and shared taxes was introduced in 1992. Later, in 1994, a Budget Law was implemented to improve the budgetary procedures and government administration. The second objective was the reduction or complete removal of subsidies, especially to loss-making state-owned enterprises. The process in this direction is slow but some progress has been made. These policies will be discussed in detail later in this chapter. The state-owned enterprises (SOEs), which constituted about 80 per cent of the enterprises in China, had no autonomy until the reforms were initiated. All major decisions on production, pricing and investment were within

74

Liberalization and growth in Asia

government control. Surplus funds had to be transferred to the state budget and losses and investment were dependent on subsidies and funding from state budget. Hence, one of the main concerns of these reforms was to give greater autonomy to the SOEs. The first set of measures were taken by introducing the Bankruptcy Law of 1988 and Enterprise Law of 1988 with the objective of making SOEs accountable and provide them with gradual autonomy. Later, in 1992, China Securities Regulatory Commission (CSRC) was established and in 1993 the Company Law was introduced aimed at giving maximum legal support and introducing incentives to public ownership and also to attract foreign investment. The introduction of Provisional Regulations on the Enlargement of Autonomy of State Industrial Enterprises in 1994 was to provide further autonomy to the SOEs. Reforms were also aimed at protecting the rights of the labour force by establishing a labour contract system in 1986, the introduction of an unemployment insurance scheme, and providing housing benefits to the employees. Besides weaknesses in the design and formulation of policy that failed to cover the overall systematic framework within which enterprise economy should operate, especially during the early stage of the reform process, one cannot ignore the improvement in the efficiency of SOEs that has contributed to rapid economic growth. The government also took some bold measures to reform other sectors of the economy which are directly or indirectly linked to the operation and performance of state enterprises. For example, the price controls on certain essential items until 1991 resulted in huge state enterprise losses. Price liberalization that took place as early as 1992 has had positive impacts on the performance of SOEs. Thus our analysis suggests that China has made a good deal of progress in enterprise reforms, though a lot more is needed to convert the system into a completely market-based economy. The major objectives of external sector reforms were to break the isolation the country placed on itself and to open the economy to the rest of the world to boost foreign trade and investment. It may be interesting to note here that China’s open to the world policy started in early 1970, much earlier than the actual economic reforms were initiated. At the initial stage, China was only interested in trade relations without allowing any foreign investment. With the package of overall economic reforms in 1978, they encouraged foreign enterprises to invest in China both for export goods and encouraged capital to bring new technology with them. Efforts have also been made to provide protection to foreign investors by invoking a proper legal framework. Passing legislation in this regard helped: the Joint Venture Law and Foreign Enterprise Law of 1979. The rights and interests of foreign investors were also protected by the 1982 revision to the constitution. A major step in this regard was the designation of open economic zones (OEZs) that promoted trade and foreign investment in these designated areas

China

75

without the same firms given access to the interior of the country. The government adopted new regulations in 1980 to establish four special zones in Guangdong (Shantou and Shenzhen) and Fujian (Zhuhai and Xiamen) provinces. A special economic zone (SEZ) administration was also established to manage these zones. This administration was authorized to draw up development plans, organize their implementation, examine and approve investment projects, deal with the registration of such enterprises, issue licences and land-use permits, coordinate working relations among the different ministries to reduce the bureaucratic bottlenecks for them and provide legal protection to the investors. Certain tax and other benefits were also provided to attract foreign investors. Another related development aimed at accelerating foreign investment was the establishment of economic and technological development zones (ETDZs) in fourteen coastal cities, which included Tianjin, Shanghai and Guangzhou, all of which offered economic incentives to foreign investors similar to those of SEZs. Table 3.3 shows the performance of these special zones. These two sets of incentives were the reasons for the large-scale movement of foreign capital to China.6 Of course, the very much advertised market of a billion people was not there given the low incomes and an absence of a sizable middle class. One report estimated that the middle class was about 70 million compared with another poor country, India, with a corresponding 220 million. These policies worked well to substantially improve the growth of commodity trade and foreign investment in China.7 As at 1998, China was the eleventh largest exporting economy and second largest host country of foreign investment. 3.2

Financial Liberalization

The pace of financial liberalization was slow, experimental and only taken gradually, in some instances, not covering the whole country. The liberalization process that had started as early as 1978 did not give sufficient coverage to financial sector needs until the mid-1990s. However, the pace of the reforms process changed significantly due to changing economic conditions in Asia and as part of the prerequisites in China’s bid to become a member of the World Trade Organization (WTO). The remainder of this section details the development of and the reform process undertaken in the financial sector over a period of about 20 years. Monetary policy In the pre-reform period, the main instrument of the monetary policy was a credit plan and a cash plan. Due to price rigidities, the demand for currency was highly correlated with cash incomes with excess supply of money having no impact on prices or balance of payments. Under a mono-banking system,

Table 3.3

Performance of special export zones in China Shenzhen

Zhuhai

Shantou

Xiamen

Hainan

76

Number of signed contracts for FDI

1980 1985 1990 1994

142.0 605.0 602.0 2221.0

– 117.0 386.0 516.0

– 109.0 174.0 547.0

– – – 692.0

– – – 802.0

Contracted volume of FDI (million US$)

1980 1985 1990 1994

219.0 975.0 516.0 2831.0

– 131.0 283.0 1023.0

– 17.0 148.0 1312.0

– – – 1865.0

– – – 1225.0

Actualized foreign investment (million US$)

1980 1985 1990 1994

2.7 32.4 47.7 1730.0

– 7.3 9.6 763.0

– 0.8 8.4 774.0

– – – 1242.0

– – – 1289.0

Export trade (million US$)

1980 1984 1990 1994

– 265.0 2573.0 –

– 11.0 456.0 1488.0

– 4.5 420.0 2202.0

– – – 5651.0

– – – 987.0

Source:

Chan (1998).

China

77

the credit plan was the only instrument to achieve monetary targets and it served as a loanable fund plan. After 1978, the credit plan alone was not enough to achieve the target due to increasing financial transactions within the system and also an increased number of financial and non-financial institutions in the economy. It was this delinking that had led to the mushrooming of illegal money dealing and credit groups that lay at the root of the reforms to the financial system. Had the Communists ignored this development, these unlicensed activities could have generated huge illegal holdings as had happened in Russia. The credit plan also got separated from the loanable fund plan. The reform process brought gradual openness in the monetary policy as well by allowing other instruments such as bank lending, reserve requirements and interest rates to be used while controlling money supply. As a result, the reforms helped change the monetary policy mechanism from direct to a mixed to direct and indirect controls. The credit plan was used to set targets for assets and liabilities of the financial institutions, the central bank’s monetary base and for lending. The plan had a bottom-up approach where targets for next year’s deposits and lending were planned at the branch level of the People’s Bank of China (PBC), the mono-bank. The head office of the PBC would then announce the national credit plan after taking into consideration the prevailing economic environment and future movement of basic macroeconomic variables. The ceilings for total lending and investment lending set at the national level were then disaggregated for each branch. The loanable funds were controlled by using other means, PBC lending to specialized banks being one of the main post-reform policy instruments. This instrument helped these specialized banks to manage their overall liquidity through short-term credits to meet their credit targets in case of shortage of deposits. Later in 1998 the quota control on credit was abolished to meet the needs of an increasing number and variety of financial institutions and financing channels. A number of indirect instruments were introduced as part of the money supply control mechanism such as interest rates, open market operations, reserve requirements, central banking lending and rediscount policy. The reserve requirement is the second most important tool of monetary policy. Banks are required to have 13 per cent of their domestic currency deposits as reserves with the PBC, among the highest levels in the world. Demand and time deposits of specialized banks, universal banks, rural credit cooperatives, urban credit cooperatives, and trust and investment companies are subject to this regulation while deposits of fiscal and interbank transfers are exempted. Interest rate is another policy instrument used by the authorities.8 The open market operations were initiated as a policy instrument with the development of money markets. However, PBC lacked the knowledge and experience in dealing in what was still not a well functioning money market.

78

Liberalization and growth in Asia

It will take some time for the domestic bond market to develop to full scale to support the open market operations. With the opening up of the financial sector, the interest rate has also been used recently to provide a supporting role in controlling money supply. But the rate is not completely determined by market forces, and may not yet serve the purpose at this point. Only continued reform will help to resolve these issues. However, the most fundamental problem, which needs immediate attention, is the question of central bank independence. Even with a separate role for the PBC, the major policy decisions are still taken at the State Council level and by the Ministry of Finance. Finally, the PBC provides resources to finance fiscal deficits. Unless deficits are reduced to a reasonable level and the domestic bond market is fully developed, this function of the PBC necessarily will and must continue. Till then, the PBC will not be able to function as a monetary authority, a role assigned to the PBC as the central bank in a future market economy. The last but not the least important argument of monetary policy is the regulatory framework governing financial institutions. China introduced bank laws in 1994. The prudential regulations were implemented only in 1995 requiring banks to observe capital adequacy ratios, liquidity ratios and limitations to exposure to risk. Some major developments have taken place in the last five years to restructure the regulatory framework for financial institutions. Once this framework is put in place and tested successfully without any state intervention, it will create an environment for smooth functioning of financial institutions and significant reduction in market risks. The monetary policy has passed one test successfully by reducing inflation to single digits. The monetary policy, along with other macroeconomic policies, also came under test during the Asian financial crisis when many countries in the region suffered losses in economic growth whereas China was completely spared from any negative effects of it. The banking sector Since the Communists took over China and until 1978, the banking system followed the Soviet model. The People’s Bank of China as the single financial institution had the sole responsibility to provide credit to public enterprises. After the establishment of the PBC, all private banks inherited from the previous system were gradually merged into the PBC. The PBC operated directly under the State Council. Hence, it emerged as the mono-bank in 1955 with an extensive nationwide branch network. Under this system the head office would receive deposits of all branches and then issue compulsory plan targets of loans to the branches. The branches were obliged to follow these targets. The main drawback of the system was that most funds would be controlled or used by the state budget leaving limited scope for credit expansion. Therefore, the PBC served as a supplier of funds to the SOEs, with

China

79

neither prices nor the demand for funds playing any role in determining credit. The first phase of reforms in the depository institutions were initiated in 1978 and continued till 1984. The authorities reinstated the status of Agriculture Bank of China, and Bank of China in 1979. The People’s Construction Bank of China was turned into an independent financial institution still under government ownership. Further reforms were initiated during the period of 1978–84; the State Administration Bureau of Foreign Exchange was started to administer the foreign exchange; commercial banking businesses went to the Industrial and Commercial Bank of China. By 1984, the PBC was transformed into the central bank of China. Commercial banking activities were transferred to newly established specialized banks mentioned above. Specialized banks for rural/agriculture, for imports, exports, and foreign exchange, for fixed investment, and for industrial and commercial activities emerged, still belonging to the government! These measures were implemented to meet the increased demand for credits as a result of privatization and decentralization, which led to growth, which in turn created demand for credit and securities from the residents. The second phase of banking sector reforms took place during the period 1984–94. At the very early stage of liberalization, the authorities realized that the four specialized banks were not able to cope with the diversified needs for financial services. The private sector demand for credit increased substantially due to increased wealth created by fifteen years of more open economic activities. Therefore, a decision was made to increase the number of banks and expand the activities of financial institutions. Besides the existing large specialized banks, some small banks such as the Bank of Communications, China Everbright Bank, the Shenzhen Development Bank and the Shenzhen Merchant Bank were approved, all of which still belonged to the government. Incentives were provided to establish finance companies and units for rural and urban credit operations. The period also witnessed the opening of branches and representative offices of foreign institutions, securities markets and securities companies. The other important development in the banking sector was the interbank market that operated at the municipal and provincial levels. In 1997, the first privately-owned bank was given a licence to operate from one branch in a major city. The third phase of the reform was initiated in 1994 and still continues. In 1994 three policy banks, namely, the State Development Bank of China, the Agricultural Development Bank of China and the Export–Import Bank of China, were established. These policy banks are given responsibility to make loans according to the government policies, a function that was originally assigned to the specialized banks. This move was to help specialized banks to operate on a purely commercial basis since commercial lending is now

80

Liberalization and growth in Asia

separated from policy lending. This also helped the state-owned commercial banks to operate more efficiently. Since 1998, these banks reduced the number of branches by 45000 through either closure or merger and had a staff reduction of 240000. During the same period these banks paid RMB500 billion yuan in taxes to state revenues. In 2001, the four state-owned banks registered a profit of RMB23 billion yuan and wrote off RMB61.7 billion yaun worth of bad loans. By 1993, PBC had 2550 branches in China with RMB1017 billion yuan of assets. The four specialized banks, namely, Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, and People’s Construction Bank of China had 123161 branches and RMB4457 billion yuan assets. Besides these banks, the banking system has six universal banks, three development banks (China Investment Bank, Guangdong Development Bank and Shenzhen Development Bank) and three housing saving banks. The country also has 52763 branches of rural credit cooperatives (RCC) and 4011 branches of urban credit cooperatives (UCCs), which collect deposits and extend credits to rural and urban households and enterprises, respectively. The system also comprises 69 foreign deposit-taking banks and four foreign joint venture banks and finance companies.9 By 2001, China had established 10 joint stock commercial banks whereas 2200 urban credit cooperatives have been reorganized into 109 city commercial banks. The rural credit cooperatives have been de-linked from the Agricultural Bank of China, one of the four specialized banks. Three new rural cooperative banks have been established. Foreign exchange transactions are managed by the Bank of China with over 200 overseas branches. This bank is solely responsible for handling trade-related foreign exchange and international settlements and remittances from overseas Chinese. It has offices in many foreign countries in Europe and Southeast Asia. Thus, ownership has not changed, but specialization alone is taking place. Foreign banks were also allowed to open branches in China as part of the open-door policy initiated in 1979. The authorities adopted a restricted provision and the only banks allowed in were the ones from industrialized countries with international banking experience. Moreover, the reciprocity principle followed in international banking, as is clear from this gesture, would also give PRC access to operate overseas. In 1979, the Export–Import Bank of Japan became the first bank to establish a representative office in Beijing. In April 1985, the PBC announced Regulations Governing Foreign Banks and Joint Chinese-Foreign Banks in SEZs. Accordingly, foreign banks were allowed to operate in certain SEZs, and to deal with foreign exchange districts. The State Council allowed foreign banks and joint venture companies to operate in SEZs.10 By June 2002, China had 181 operational entities of foreign banks with 147 foreign bank branches. Total assets of foreign banks

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81

amount to US$37.2 billion. Foreign exchange loans issued by foreign banks account for 20 per cent of the aggregate foreign exchange loans issued by financial institutions in China. These measures gave overseas access to Chinese banks as well. By the end of 2001, Chinese financial institutions had established 90 branches and representative offices in the overseas market with total assets of US$122.7 billion. Although the reform process is slow and gradual and the central bank still has a dominant role in allocating and transferring funds between provinces, the commercial banks have emerged from a mono-bank to a more diversified and presumably competing banking system. As regards the administrative set-up in the reformed system, the specialized banks are independent to supervise their branches. However, this administration is weak due to insufficient resources, frequent intervention from local governments and the regulation of the local PBC branches (Huang 1998). The reforms allow banks to retain part of their profits for development and staff benefits. With a system of relatively fixed interest rates and without a responsibility for bad loans, banks seems to be engaged in attracting loans by taking high risks. This was evident in 1999 with the collapse of about 40 investment houses, of which the most notable one was that of the Guangdong International Trust and Investment Corporation (GITIC) which lost US$60 billion as reported in Internet publications.11 Reforms in non-bank financial institutions The liberalization of the non-bank financial institutions (NBFIs) started as early as 1978 with the establishment of the Trust and Investment Company (TIC), RCC and other institutions engaged in leasing, insurance and securities transactions. The China International Trust and Investment Corporation (CITIC) started operations in 1979. It engages in raising funds from foreign sources to finance enterprises through loans and equity participation. CITIC is a holding company with diverse interests in production, technology, finance, trade and services. The basic function of RCCs, which work under the supervision of the Agricultural Bank, is to collect idle funds in rural areas and extend loans as well as provide advisory services to rural businesses and residents with financial problems. Similarly, UCCs operate under the supervision of the PBC and are independent legal entities. They provide services to collectives and private industrial and commercial enterprises by taking deposits, extending loans, undertaking settlement and remittances. The total assets of RCCs increased from RMB95.57 billion in 1985 to RMB299.95 billion in 1990, about 42 per cent per annum growth. Similarly, total assets of UCCs increased from RMB3.19 billion in 1987 to RMB28.42 billion in 1990. Total assets of TICs improved from RMB23.89 billion in 1986 to RMB77.44 billion in 1989.

82

Liberalization and growth in Asia

The CITICs enjoyed an increase in their assets from an estimated RMB8.03 billion in 1986 to RMB33.78 billion in 1990. There were about 260 CITICs prior to the 1999 collapse of about 40 of them, one of which, GITIC, was among the biggest.12 Reforms also improved the status of operations of insurance companies. China Insurance Regulatory Commission was formed in 1998 to supervise and monitor the activities of the insurance companies. At the end of June 2002, China had five state-owned insurance companies, 15 joint stock insurance companies, 19 Chinese–foreign joint ventures and 14 fully foreign-funded insurance companies. Reforms also helped to establish insurance intermediaries such as insurance brokers, agencies and assessors. Interest rate reforms During the central planning era, interest rates on deposits were considered a kind of exploitation and hence were never given any importance. With the iron rice bowl of Maoist rule, little was needed to be saved, and none would have to live on retirement from interest income, a scourge of the decadent capitalist system. So, the story line about exploitation was most fitting. In the postreform period, this attitude towards interest rates changed gradually and some importance was being placed on them and related policies. It was realized when inflation was rampant after reforms, the real interest was not enough to attract any deposits. Although the interest rate on a one-year fixed saving deposit was raised from 3.24 per cent in 1978 to 13.14 per cent in 1990, there were several episodes of real negative interest rates during a span of 12 years. Similarly, in the pre-reform period, interest rates on short-term loans used to be higher than those of medium and short-term loans! So much for market economy of capital. Interest rate reforms brought cost, term and risk considerations. While setting up interest rates and rates for medium and longterm loans, these were set higher than short-term loans. The financial institutions have been allowed since 1996 to set their own interest rates within a 30 per cent band around a base rate set by the authorities. Another major development was that the specialized banks adopted different interest rates for different enterprises depending on these enterprise demands for credit and speed of capital turnover, which is the beginning of risk consideration for lending activities. These measures helped give a boost to domestic saving and also provided a profitable environment for lending institutions. As depicted in Figure 3.2, the spread between the lending and deposit rates has increased over time, given the fact that real interest rates have moved into positive numbers since 1996. Money market development The primary market for securities started in 1981 with the first issue of

China

9.00

4 ER IR Spread

3.5 3

7.00

2.5

6.00

2

5.00

1.5

4.00

1

3.00

0.5

2.00

0

1.00

–0.5

Exchange rate

8.00

Interest rate spread

10.00

83

0.00 –1 1961 1966 1971 1976 1981 1986 1991 1996 2001 Figure 3.2 Exchange rate movement and interest rate spread, China: 1961–2002 treasury bonds sold by the government to the enterprises and individuals. During 1988–90, the authorities developed a secondary market for securities. During the same period, government established the National Electronic Trading System (STAQ) in Beijing. In 1991, the Ministry of Finance changed the administrative placement of the bond system to marketing through underwriting by financial institutions. The basic reason for establishing the securities market was the change of focus from inflationary financing to bond financing. In the past, the government had adopted the policy of printing money (and unsterilized currency inflows) to finance consistent fiscal deficits, which had resulted in rising inflation. Since the early 1990s, the focus has changed to finance the deficits through bond financing. Accordingly, it was decided to take measures to develop money and capital markets to sell short- and long-term Treasury bonds. In 1990, the government initiated the issuance of such bonds underwritten by financial institutions. In 1997, the first interbank bond market was established, allowing commercial banks and some other financial institutions to trade in repo and spot transactions of government securities and financial bonds issued by policy banks. By the end of June 2002, the interbank bond market registered a turnover of RMB10.7 trillion. Another important institution is the interbank market. This is one of the most important sources of lending and borrowing among banks and other

84

Liberalization and growth in Asia

financial institutions. Prior to the reforms, China had a system of vertical allocation of credit from the State Council through the central bank. Under this arrangement, banks with surplus funds would hold onto them while banks with shortages were not given access to credits. Though some efforts were made to ease the credit allocation as early as 1979, it was only during 1983–85 that this system was transformed to a horizontal allocation of funds across banks and industrial sectors. In 1986, the PBC issued a notice on Provisional Regulation on Management of Banks in the PRC under which the interbank market was formally established and all financial institutions were given the right to handle interbank borrowing and lending. Branches with temporary excess of funds would lend to those branches in need of funds. In 1990, the PBC issued Provisional Measures on the Management of Interbank Business. These markets were established in economically and financially advanced cities with the restriction of one market in each of these cities. The PBC supervises the activities and operations of these markets. In January 1996, a centralized interbank market was established and the China Inter-Bank Offered Rate (CHIBOR) was initiated. As a result of these measures, the interbank market has shown steady development during the last five years. By the end of June 2002, this market reached an accumulative turnover of RMB3.4 trillion. Capital market development Securities institutions provide long-term capital financing. Under the central government’s aim of increasing the channels and proportion of direct financing, these institutions were developed at a fast pace. Securities exchanges were initiated in 1990–91 in Shanghai and Shenzhen allowing trading in government and enterprise bonds and shares of joint stock companies. This was only done after about four years of experimental trading with Western instruments such as shares and bonds in two cities, Shenzhen and Shanghai. In 1992, the policies were further relaxed to allow foreigners to participate in this trading, which led to the creation of A and B class instruments. To further boost investors’ confidence, the China Securities Regulatory Commission was established in 1992 to oversee and supervise the development of the securities industry. The National Security Law was implemented. These measures helped to boost the stock market and as a result, the number of shares listed rose from 15 to 113 by mid-1993 with the combined capitalization estimated at under 10 per cent of the GDP. In 1998, these two exchanges had almost 350 stocks traded. By the end of 2002, China had 109 securities firms and 15 fund management companies with a net asset value of above RMB100 billion. During the same time, the capital market had 1197 listed companies with a total market capitalization of RMB4.65 trillion and negotiable equity value of RMB1.53 trillion. The

China

85

domestic and overseas securities market has helped to raise RMB827 billion since 1991. Foreign exchange market The People’s Bank of China is responsible for any external foreign transactions including foreign exchange and international settlements of traderelated transactions and remittances from overseas Chinese businesses. China experienced various reform arrangements in the foreign exchange market. Before reforms were initiated, it was normal for there to be several exchange rates for trade transactions between the foreign trade corporations (FTCs) and domestic enterprises. The authorities established a single exchange rate in 1981 for the international settlement of trade transactions that were done below the official exchange rate. The official exchange rate was devalued in later years and eventually the exchange rate was unified in 1984. But capital and current account controls are still in place so that the system is still a fixed one. A dual exchange rate system re-emerged in 1986 and was maintained until 1993. Under this system, there was an official exchange rate that was subject to periodic adjustments and a local market determined rate set in the foreign exchange adjustment centres (FEACs) or swap centres. A third rate was a parallel market (or black market) determined by the usual demand for foreign exchange. The official exchange rate was pegged to the US dollar. The yuan was devalued by 21 per cent in 1989; 9 per cent in 1990; and 14 per cent in 1994. The second rate was set at a relatively depreciated level as compared to the official rate. This system required the domestic enterprises and FTCs to surrender their export receipts at the official exchange rate and receive retention quotas against them. These enterprises were then permitted to trade these retention quotas at the swap centres. Initially, the scheme was restricted to foreign-funded projects only, but later in 1988 all enterprises with foreign exchange retention quotas were allowed to trade in the swap centres. Gradual liberalization removed controls on the determination of swap market exchange rates and, by 1991, all residents were allowed to sell foreign exchange at the swap rate at the designated bank branches. However, the purchase of exchange was subject to approval by the State Administration of Exchange Control. As regards individual earnings, earnings of individuals working abroad were required to be repatriated but allowed to be maintained in foreign currency accounts within domestic banks. The same rule applied to remittances. Foreigners were issued foreign exchange certificates denominated in yuan, against any foreign currency brought in and could be used for domestic transactions and up to 50 per cent could be reconverted at the official exchange rate. For capital transactions, SAEC had the responsibility to monitor the country’s external borrowing. All medium and long-term commercial borrowings were subject to SAEC approval. Foreign direct investments were

86

Liberalization and growth in Asia

subject to approval by the Ministry of Foreign Trade and Economic Cooperation. In 1994, the government again unified the exchange rate set at the prevailing swap market rate and abolished the retention system. It decided that the renminbi, also known as the yuan, was to be the only legal tender in China effective 1 January 1994. According to the new rules, domestic residents were required to sell their foreign exchange receipts from abroad to designated financial institutions. The new system also abolished the need for prior approval of the purchase of foreign exchange for trade and trade-related transactions. Businesses involved in trade and with relevant documents were allowed to purchase foreign exchange from any designated financial institution. The unified exchange rate is determined at the interbank market and is a managed float system with a ±3 per cent movement in renminbi allowed against the US dollar. Another major reform was the establishment of the China Foreign Exchange Trading System (CFETS) in Shanghai, effective 1 April 1994. This is an electronic system for foreign exchange trading. An institution, to trade in foreign exchange, is required to be a member of CFETS. The current account was made fully convertible in December 1996 while capital is being changed to fully convertible gradually. These measures helped to stabilize the currency. From 1994 to 1998, the currency had been managed at a very stable range of 8.7–8.3 per US dollar. Despite all expectations of a devaluation of the yuan, since 1999, China has been able to maintain currency stability along with reducing inflation to single digits. Even the 1997 Asian crisis did not leave any negative effects on the Chinese currency. This was partly achieved by Hong Kong’s merger with China which came with one of the highest levels of foreign reserves in the world and which helped to stabilize the yuan. These trends are verifiable by referring back to Figure 3.2 and numbers reported in Table 3.4. A long-term issue of great significance has started to be put on the table since October 2003. With the world’s largest foreign reserves built up from two major sharp devaluations in the first half of the 1990s, the undervaluation of China’s currency is seen by well-informed people as the main culprit for severe current account imbalances between China and several key nations. The promise made several years earlier to reform the currency regime was unilaterally withdrawn in 1999: the excuse given then was that the Asian financial crisis has prevented China from freeing the currency. This issue has come to the forefront as it also did in the early 1980s when a similar build-up of reserves by Japan and South Korea led to the Plaza Accord of the 1983–84. The Chinese authorities fail to see this build-up in the same light, preferring to say that the currency is correctly valued at its fixed rate. This issue will become a major challenge for China. Freeing the exchange rate will drive the

Table 3.4

Growth of financial and capital market indicators for China (annual averages)

87

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

Exchange rate (% change)

–

–4.74

12.68

13.17

–0.18

0.00

–0.02

0.00

Interest rates Bank rate Deposit rate Base lending rate

– – –

– 0.50 0.50

0.79 7.30 8.00

9.00 9.61 10.26

– 4.28 7.36

3.24 2.25 5.85

3.24 2.25 5.85

2.70 1.98 5.31

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

88

Liberalization and growth in Asia

current fixed rate up about 30 per cent above its present level, which has consequences for the competitiveness of China and other countries. China’s membership to WTO: a major development The process of China’s entry to the WTO started in the mid-1980s. China’s accession process was one of several which began under the GATT but concluded under the WTO. In her desire to become part of the world trade forum, China has made significant commitments under the WTO charter. Between 1992 and 2000, the average import customs duty was reduced from 45 per cent to 17.5 per cent. This includes a reduction from 43 per cent to 17 per cent on industrial products and from 36 per cent to 18 per cent on basic products including raw materials and farm products. The government has already lowered import custom duties to zero for nearly 75 per cent of all imported products (Sinopolis.com 2001). In the agriculture sector, China promises to cut tariffs from an average level of 31.5 per cent to 17.4 per cent. China has also pledged to eliminate export subsidies. It plans to gradually eliminate quantitative restrictions and cut the tariff rates from an average of 24.6 per cent to 9.4 per cent by 2005 in the industrial sector products. During the same period plans are to remove tariffs on telecommunication equipment, semiconductors, computer equipment, and other information technology products. In the services sector, China has pledged to open its telecommunications, financial services, distributions and other service industries to foreign service providers. It has also promised to implement its trade policy uniformly to all countries and make this and other such policies more transparent (Adhikari and Yang 2002). The signs are there. In 2000 China’s service trade reached US$66.46 billion, a fifteen-fold increase between 1982 to 2000 and ranked tenth in the world. Tourism is the main contributor to this performance (Shantong 2002). The impact of WTO membership on China will not be immediate and extensive. It will, however, allow China to gradually abolish all types of protectionism of domestic industry. A recent study predicted that China’s entry to WTO will increase its share in the global garment market from 18 per cent to 44 per cent, in the textile market from 5 per cent to 8 per cent, for metals from 3.5 per cent to 5 per cent and for other products from 5 per cent to 10 per cent (Sinopolis.com 2001). Agriculture, in contrast, is expected to suffer some losses. The Development Research Centre of the Chinese State Council predicted that about 9.6 million people would leave agriculture within 10 years. At the same time, China’s farm products will be exposed to more competition with similar foreign products (Jianrong 2002). Overall, telecommunications and automobiles are believed to be the main sectors to reap the benefits of WTO membership.13 While the WTO does not directly address human rights issues, it will

China

89

accelerate the opening of the Chinese economy and the liberalization of Chinese society. The Chinese free market reforms and opening of foreign trade and investment would put enormous pressure on the political regime to implement policies of economic and political freedom and the rule of law. This will also force China to abandon the use of child and prison labour. At the same time, the opening up to foreign investment and privatization of domestic industry will also help to address the environmental issues and pollution control technology. If these policies are placed in a timely manner and with sincerity, China is expected to emerge a major market economy in the years to come.

4.

ASSESSMENT OF LIBERALIZATION

As discussed in the previous section, China has taken major steps toward economic and financial sector liberalization since 1996. The measures taken during this period may partly be attributed to precautionary moves in view of the significant economic declines observed in fairly newly developed economies in Asia in the aftermath of the Asian financial crisis and may partly be linked to China’s successful bid to become a member of the WTO. Whatever the case may be, these measures have helped the economy to curtail rising inflation, achieve monetary management, encourage domestic saving, create an environment suitable for domestic and foreign investment and provide currency stability. The official foreign exchange reserves have increased to 10 months of import coverage. Between 1997 and 2001, M1 and M2 grew at an annual rate of 14.5 and 14.8 per cent. During the same time total lending increased to RMB6 trillion. Figure 3.3 depicts the changes in the M1 and M2 and the foreign reserves to imports ratio which indicate the improvement in monetary management and foreign reserve over a period of 30 years. Table 3.5 uses another set of indicators to evaluate the impact of liberalization policies on the Chinese economy (data prior to 1981 are not available). The positive impact is visible by a substantial increase in M3 to GDP ratio from a level of 69 per cent in the 1980s to 170 per cent in 2002. Although complete statistics on private sector participation on credit extension are not available, the number for the year 2002 shows that the private sector was able to extend the bulk of the total domestic credit. Domestic investment (as a ratio to GDP) increased from 28 per cent in the 1980s to 41 per cent in 2002. This ratio is on a par with some of the newly developed Asian economies covered in this book. China was able to attract huge amounts of foreign direct investment which was recorded at 4 per cent of GDP in 2002 but maintained an average of 3.7 per cent since the 1990s. The development of the domestic money market helped to rely more on domestic borrowing as a source of

Liberalization and growth in Asia

70

Growth rate

60

120 M2 M1 FR/IMP

50

100 80

40 60 30 20 10

40

Foreign reserves to imports

90

20

0 0 1961 1966 1971 1976 1981 1986 1991 1996 2001 Note: No data available from 1961–78. The whole time period is, however, used to preserve the consistency with other graphs in this chapter.

Figure 3.3 Foreign reserves to import ratios and growth rates of M1 and M2, China: 1961–2002 financing fiscal deficits. This is evident with a decline observed in foreign borrowings.

5.

CONCLUSION AND FUTURE PROSPECTS

China has initiated major economic liberalization policies only since 1979. It did this very cleverly in two ways; by experimentation and by retaining the command structures at the top without real decentralization. This is in direct contrast to the big-bang approach advocated by Ivy League scholars and experimented within Eastern Europe’s transitional economies with serious disruptions. China’s reform process was gradual but consistent with learning from small-scale applications and gradual extensions.14 Given the political, economic and social environments that prevailed for many years prior to 1979 and the subsequent economic chaos of the type unleashed by big-bang reform approaches in Russia for instance, the achievements of China are commendable despite criticisms in some quarters that China’s reforms are not widespread.15 However, it is not clear if such slow process of reforms could

Table 3.5

Indicators of financial and capital market depth in China (percentage annual averages)

91

1981–90

1991–95

1996–2000

2000

2001

2002

Money depth (M3/GDP)

68.55

95.09

122.81

138.39

146.85

170.10

Intermediation depth FIR (total/GDP = DC/GDP) FIR (private/GDP)

71.07 –

95.18 –

117.31 –

132.87 –

136.77 –

170.32 155.56

Capital accumulation GFCF/GDP FDI (net)/GDP FDI (inflow)/GDP

28.66 – –

33.70 4.38 3.88

34.98 4.58 4.36

36.51 3.64 3.56

37.33 4.29 3.71

41.00 4.19 3.99

– –

– –

1.59 –

2.92 –0.01

2.60 0.04

3.12 –0.09

Indebtedness Domestic borrowing/GDP Foreign borrowing/GDP

Notes: M2 = currency + quasi money. M3 = M2 + other deposits. FIR: financial intermediation ratio. FIR (total) = claims on public and private sector (total credit). FIR (private) = claims on private sector. GFCF: gross fixed capital formation. FDI: foreign direct investment. DC: domestic credit. Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

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Liberalization and growth in Asia

have also worked in other emerging economies in Eastern Europe, where the economies had greater social development and also higher industrial development. The progress China has made so far is visible with the continuing interest of domestic and foreign investors. The international banks are still lending, though the country has built up huge loans at the state level from multilateral lending and international development assistance: see Ariff (1998c). China has recorded very high growth rates simply because of pent-up demand and the release of the entrepreneurial energy of its people. It is now the world’s tenth largest trading nation in terms of value traded although its share in world trade is not large. It is still a recipient of the largest foreign direct investment among developing countries because it is also the largest country with seemingly huge potential markets for multinationals from countries with near satiated demands for goods and services. These multinationals are still waiting for the emergence of a reasonable-sized middle class, the important structure needed before the kind of goods that they are good at producing are demanded. China’s accession to the WTO will put more pressure on the regime to put a more transparent system of an open-door policy with a well-defined regulatory structure in place that can protect the right of ownership and provide a safe environment for domestic and foreign investors. During the 1997–98 financial crisis that affected most Asian economies, China managed its current and capital accounts ably to avoid major setbacks from the contagion effect. That was possible because of the fences still in place in the form of controls on capital and currencies, not because of its innate economic efficiency. Many, in 1999, were speculating that China would eventually bow down to the pressure and devalue the yuan in the year 2000. However, that did not happen. In fact, Chinese currency has shown remarkable stability since 1998. China has not come fully unshackled from a mindset of central planning even though it pretends otherwise in official meetings and press briefings that such a rebirth is taking place. The sudden release of energies of the people given choices for the first time in 1977–79 after thirty years of repressed central planning led to enthusiastic independent economic actions not supervised by the central planners. That produced the release of energies of a hardworking people as never before. That could not last forever without serious reforms to bring in real competition by changing ownership rules and of freedom of entry into economic activities. There is also the need for development in the forms of legal rights, independent judiciary, central banks, a professional civil service, military, police, and so on for a real return to a market economy model. China hopes to achieve all this in an experimental fashion while keeping the Party’s control on the country. Only time can tell if this is a compatible mixture of aims.

China

93

NOTES 1.

2.

3. 4. 5. 6. 7.

8. 9. 10. 11. 12. 13. 14. 15.

The financial press reported in late 1998 that China’s mass media widely reported the anger of the Premier as he witnessed the disintegration of concrete dams, built to withstand flood water, as the river levels rose in several places. It appears that the contractors and provincial cadres in charge of building dams were lax on enforcing strict standards of dam construction. It took a flood to reveal to the rulers in Beijing the extent of corruption that had permeated state-directed activities. Strenuous moves to reform the state sector were taken since the new Premier took control. The Tiananmen Square event, as it is euphemistically referred to by the world, refers to the event during the night of 4 June 1989, when the student uprising was violently put down: Deng was then the Chairman of the committee in charge of the PLA. Students had taken control of Tiananmen Square, and they had some limited support from a clandestine workers’ movement. China’s cabinet took a decision after an emergency meeting of the Council on the eve of the crackdown when the Premier Li Peng gave a speech that the student uprising was against the state and would be brought to an end at any cost. During the next few months, all those who took part were tried, some executed, and others imprisoned. There is no consensus on how many died, and China treats the event as a closed matter. This episode is well documented in the literature on the Gang of Four, one of whom was the widow of Mao himself, who was tried and sentenced to be executed only to die of cancer. The CRS required the tax payment according to a negotiated tax contract rather than a standardized tax schedule. For further details on these taxes, see EIU (1995, p. 16). As stated in the previous section, China was the second largest recipient of the foreign direct investment in the developing world. Despite these efforts, 1986 witnessed a sharp decline in foreign investment in China, basically due to declining profits. Some explanations for this decline in profits include low productivity, lack of motivation in the workforce, rapidly rising costs, especially office space and accommodation, excessive bureaucratic bottlenecks and most important, foreign exchange controls. Some measures were taken to improve the situation in 1986 under the ‘Twenty-two Articles’. The interest rate reforms have been discussed in section 3.2. The numbers are obtained from Tseng et al. (1994, table 3, page 13). Initially, these banks were allowed to take deposits and make loans in local currency. However, later PBC withdrew this allowance to protect the domestic banking industry from competition. A May 1999 report in the South China Post describes the judicial finding that assets to the equivalent of 17 cents in a dollar have been recovered. Please refer to chapter 5 of Dipchand et al. (1994) for these numbers. For further details on China’s membership of WTO, refer to F. Khalid (2003). For example, stock exchanges were only established after several years of experimentation of capitalist-style trading that took place in two cities before the official establishment of the stock exchange in Shenzhen and Shanghai. Mikhail Gorbechev, the architect of reforms in the Soviet Union, was asked about the failed Russian reforms in a television interview broadcast by the SBC network in May, 1999 in Australia. He said that he, when he was then the equivalent of a President, was planning for a slow reform over about fifteen years under great painful changes. Only such a route, he said, would have been successful. Perhaps he is right in this regard.

4. 1.

India: more than a decade of liberalization, yet not fast enough INTRODUCTION

This country experienced three decades of violence and civil disorder, despite the non-violence doctrine of the Mohandas Gandhi, prior to gaining independence in August 1947. The independence also led to further civil unrest with millions of people moving between a partitioned India and Pakistan, which event engendered a bitter cold war between these two neighbours which still persists. In this respect, India shared as birth pangs, some of the vicious human tragedies that also occurred in other countries: South Korea in 1954, Taiwan in 1949. Unlike these two countries, however, the effect on the Indian people was to resolve not to adopt significant market opening measures to ensure long-term growth prospects. Given the country’s large population base, seen as a protected market for goods and services, it followed precisely the opposite strategy to that adopted by market openers by designing and aggressively pursuing an import substitution policy mix putting reliance on home-grown industrial capacity, which later mushroomed into becoming a highly regulated economy with little external economy or investment relations with the rest of the world. This cryptic view of development may be harsh but the truth was hidden by India’s half a century of avowed public relations stand about being open to the rest of the world. There are even more serious drawbacks from the widespread corruption which has pervaded all aspects of ordinary Indian life today. Do other poor countries have to travel this same path? As an example, take the case of South Korea, whose external trade amounts to 79 per cent of its GDP in 2002, it created prosperity from an outward oriented economic vision. Yet, South Korea was a poorer country than India in 1954! The corresponding trade-to-GDP ratio for India is 29 per cent, a mere third that of South Korea. This reflects clearly the extent to which India pursued the wrong policy of inward growth strategy thereby generating only a 3.5 per cent long-term growth while South Korea harnessed a 9 per cent growth rate and aggressively grew an external economy to become rich enough to be the twenty-fifth member of the Organization of Economic Co-operation and Development, the OECD, and the fourteenth largest economy.1 Things started to change for India in 1990, when, spurred by the 94

India

95

experience of high growth in ASEAN and East Asian economies, significant brave steps were taken by India’s political elites to bring in more liberal policies. Though the pace of reforms slowed with the coming to power of a conservative religion-based party in 1997 and also from the impacts of nowremoved trade sanctions imposed on India for testing five atomic bombs, the expectations are that there is only one way to go forward for this country. That is, to continue adopting further reforms, and that sooner rather than later.

2.

ECONOMIC AND FINANCIAL SECTORS: AN OVERVIEW

Examining the contemporary development experience of India is a useful exercise for a number of reasons given the newly-found desire to adopt critical reforms needed to move this economy to a higher growth path than in the past. By some accounts, the size of this economy is described as being large enough to be the fifth largest modern economy in the world.2 By the same measure, China would be the second, and Japan the third largest economies. Adoption of a liberal policy mix by a pioneer modernizer normally leads to more or less a domino effect on others in the neighbourhood adopting changes broadly similar to the pioneer country. For example, the excellent growth paths established in the 1960s by four of Asia’s newly industrializing economies (Hong Kong, South Korea, Taiwan and Singapore) led to the adoption of market opening measures by a number of Southeast Asian countries in the 1970s. These reforming economies registered growth rates of close to 8 per cent in the 1980s. China’s experimentation with liberal policies in the 1980s also influenced several East Asian economies. Vietnam tried to mimic China’s path at transforming a command economy to respond to market signals, and thereby hope to achieve some measure of development not experienced before. 2.1

Economic Performance

In much the same way, India’s adoption of liberal policies in the late 1980s has begun to nudge other countries in the neighbourhood to consider and, in some cases, such as Bangladesh, successfully adopt new policies. The long-term growth experience of the South Asian economies in the pre-reform period has been significantly below the world average. The very low 3-4 per cent income growth over 1970–90 in the South Asian region is markedly inadequate to bring sufficient improvements to the quality of lives for the peoples of the region. This is particularly so given a high population growth rate of 1.67 per cent, high youth dependency rate of around 40 per cent, and per capita income

96

Liberalization and growth in Asia

that would place the South Asian countries among the low-income countries. Countries such as South Korea, Taiwan and others that started as low-income ones but moved out of that grouping by adopting relevant liberal policies achieved double the Indian rates of growth to bring in prosperity to their peoples.3 India started the post-war age of hope with massive problems. To start with, it was a poor country unable to feed all its people. Population growth was closer to 3.5 per cent immediately after World War II. In 2002 its population had edged above a billion, growing at a more moderate rate of 1.68 per cent. Most of the population is concentrated in the northern belt, which is relatively more industrialized than the less heavily populated south, which is largely an agricultural belt with a mountainous and dry interior. Its GDP of about R16700 billion4 at current prices is the fifth largest economy in Asia. Per capita income of R18000 or just below US$500 puts it among the low-income category in the world: South Korea has 20 times that per capita. However, per capita income has grown steadily at 3.7 per cent per year since the mid-1970s: even though the GDP growth has increased in the 1990s, growth in the 1980s was 3.8 per cent. Nevertheless, the growth rates in the 1980s and in the 1990s are well above the population growth rate, which provides some hope of income levels to rise in the future: see Table 4.1. The reader will note from Table 4.1 as well as Figure 4.1, the historical growth rates. Economic growth on the other hand has been more robust in the 35.00 30.00

Growth rates

25.00

Real GDP CPI M2

20.00 15.00 10.00 5.00 0.00 –5.00

–10.00 1961 Figure 4.1

1966

1971

1976

1981

1986

1991

1996

2001

Growth rates of real GDP, CPI and M2, India: 1961–2002

Table 4.1

Basic economic and social indicators of development in India

97

National accounts GDP growth (%) Per capita GDP (US$) Private consumption/GDP Government consumption/GDP Financial indicators (%) Gross domestic savings/GDP Fixed capital formation/GDP Inflation (per annum) M2/GDP Fiscal balance/GDP Trade balance/GDP Current account balance/GDP Total trade/GDP Debt/exports Debt/GDP Foreign reserves/imports Social indicators Population growth (%)

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

4.11 97.82 78.69 8.25

3.06 167.70 73.18 9.25

4.72 314.56 69.20 11.13

6.71 348.37 79.65 13.24

5.73 441.20 65.23 11.94

4.20 467.23 64.60 12.57

5.49 478.20 65.02 12.85

4.40 – – –

– 14.80 6.36 22.40 –4.15 – – 10.08 – – 16.01

22.30 16.98 8.16 30.23 –4.29 – – 12.52 – – 34.09

21.90 20.78 8.88 42.11 –7.43 –2.26 –1.77 14.69 754.52 47.89 22.32

23.10 27.00 12.29 54.23 –6.68 –1.70 –1.46 24.39 611.34 59.83 41.85

24.10 21.90 7.61 50.34 –5.14 –2.42 –1.10 24.67 443.50 51.43 49.48

23.40 21.90 4.01 55.57 –5.17 –2.60 –0.90 28.34 401.01 55.30 54.71

24.00 21.70 3.69 58.22 –4.70 –2.60 0.30 – – 57.31 –

24.50 23.90 4.39 – –7.40 – 0.60 – – – –

2.31

2.27

2.15

2.38

1.68

1.57

1.54

–

Sources: IMF International Financial Statistics (CD-ROM), World Development Report (various issues) and Asian Development Outlook (various issues); Ariff and Khalid (2000).

98

Liberalization and growth in Asia

1990s, following a good measure of financial and a limited amount of real sector reforms undertaken since 1988. The average GDP growth of 4.5 per cent in the 1990s is well above the long-term growth rate of well under 3.5 per cent. Growth since 1994 has improved closer to the 8 per cent level, a level that matched those of the fast growing ASEAN economies. Growth rates in 2000–02 have regressed to below 5 per cent, partly due to poor rainfall and its effect on agriculture and industrial outputs.5 With consumption falling from a high of about 90 per cent of GDP in the 1950s to the current 65 per cent, the savings (and investments) rate has increased from a mere 10 per cent of GDP in 1950 to the 1997 figure of around 24 per cent. Government consumption has been held down at about 10–12 per cent throughout the period. This is a direct result of the failure to undertake tax reforms6 to improve sources of revenue, with which far-reaching infrastructure investments could have been undertaken in almost all such areas as roads, rail, ports, power and telecommunications: tax reforms were announced in February 1998 effective from 1999, which would have impacts later, as there are no signs of improvement in fiscal deficits. The poor state of the infrastructure has been a dampener for foreign capital flows into the currently more open real sector after the reforms. The country’s trade with the rest of the world is also among the lowest: imports and exports as a percentage of GDP are a mere 29 per cent compared with the same figure of 16 per cent in the 1980s. The corresponding numbers for South Korea are 79 and 68.8 per cent of GDP while for Malaysia, they are 90 and 214 per cent of GDP. India has suffered and continues to experience persistent trade and current account deficits, which led to serious weakening of the local currency prior to the 1992 exchange rate and monetary reforms. These exchange rate reforms managed to slash the instability by half. The annual rate of depreciation of currency during the pre-reform period was 14 per cent per annum. With more capital inflows, the current accounts may improve, but still the weakness of the trade sector is a cause for worry in this economy. The exchange rate has begun to improve following the adoption of further reforms in 1998. A glance at the social indicators in Table 4.1 reaffirms the lack of genuine development in India. The literacy rate has been improving, but not as well as has been achieved by Southeast Asian economies. Illiteracy is still about 40 per cent compared with a 15 per cent level in China, Indonesia and Malaysia (ADB 1997a, 1997b). Education receives a low level of funding at about 2 per cent of government budget compared with the double digit levels in South Korea or Taiwan. Education-related expenditure in the ASEAN countries is closer to 20 per cent of the budget. However, Indian enrolment rates in primary schools have gone up from a low of 68 per cent of the relevant population in 1965 to the current 94 per cent. This trend, if continued, will lead to better educational statistics for this country.

India

99

Expenditure on health is also very low at less than 2 per cent of the budget. Data available elsewhere (ADB 1997a) suggest that the average life expectancy of 61 years compares not unfavourably with 68 years in China or the 71 years in Korea. Infant mortality in India, though having improved from a low of 150 per 1000 live births 30 years ago, is currently at 80. Comparative statistics are: South Korea 11; Malaysia 13; and China 30. This is partly a reflection of the lack of health infrastructure, particularly potable water, and poor provision of public-health-enhancing facilities. There are no signs that other measures of social indicators not reported here are improving either. From this brief background, the reader will appreciate that this chapter covers one of the two important cases (India and China together) for a study of liberalization. India and China account for perhaps two-thirds of the Asian population. In the next section, we provide a quick review of the economic and financial structure of this large economy that has recently taken hesitant but strong steps to reform its rule-bound economy which has been relatively more closed than open. The effects from the greater degree of financial and real sector reforms since 1988 are identified and explained in some detail in section 3. The last section describes the prospect for the future. We describe very little of the import substitution policies of the 1950–87 period, which produced some desirable outcomes despite seriously putting the economy in a low growth path. The benefit was that it helped to build domestic industrial capacity to serve a large population. Rather, we pay more attention to the recent reforms especially in the financial sector. The reforms in the real and the financial sectors have led to some beneficial results to alleviate capital constraints, a perennial growth problem for all countries. A significant feature of the Indian economy is that it has developed a reasonably modern economy based on monetary exchange away from the past rural-based economy that it was some 50 years ago. The structure of the economy can now be described by examining the statistics in Table 4.2. The structure of the economy has changed significantly over the four decades since 1955. The agriculture sector has declined to about 31 per cent share of the economy compared with its earlier dominance of a share closer to 60 per cent. Table 4.2 Structure of the Indian economy over 40 years of inward growth (% of GDP)

1960 2000 Sources:

Industries

Services

20 27

33 40

Agriculture Exports 46 31

4 10

Investment

Savings

16 24

14 28

IMF International Financial Statistics; World Bank, World Development Reports.

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Liberalization and growth in Asia

The rural population has also declined over the years as almost 30 per cent of the population now live in urban areas compared with half that in the 1950s. However, the agricultural sector is able to produce more, so that the country has reached the grain sufficiency that it was unable to obtain right up to the end of the 1970s. In this respect India (and China) have developed their agricultural sectors while achieving sufficient diversification of the economy away from agriculture. For example, the proportion of primary goods in 1970 Indian exports was almost 60 per cent compared with the 1994 figure of about 40 per cent. That is a significant improvement with industrial goods growing to 60 per cent of exports. This figure is still not as high as that achieved by Malaysia in just 20 years with more outward looking liberal policies. It exported primary goods made up of 94 per cent of exports in 1970 compared to 29 per cent in 1995. The service sector increased in size only marginally, showing a lack of development of the tertiary sector. Growth of this sector is very high in other countries, in fact closer to 50 per cent, but it has been accomplished by a far greater degree of industrial activity. Industrial output has grown faster in India merely as a testament of the import substitution policies followed during the 1956–87 era. The GDP share increased to almost 30 per cent in 1998 compared with the 20 per cent in the earlier period. This is one of the great boasts of this country in that it was able to build an industrial output capacity, while having a very low savings rate, so that at the close of the twentieth century, it was among the top ten or so economies of the world in terms of industrial capacity. It is capable, given capital and higher technology, of retooling itself very quickly given its accumulation of a trained technical workforce – another boast is called for here: it has the third largest technicalscientific workforce in the world – and the basic industrial structures in place. Another significant feature is the great stride it has made to garner savings. In the 1950s, consumption was as high as 90 per cent so that it hardly had sufficient resources left over for investments. Over the years, and very slowly without too much dependence on external capital flows just as South Korea did, the gross investment rate has been pushed up to the level of 23 per cent of GDP in 1996 (South Korea achieved a higher rate given its larger external sector). This is a level about 5 per cent higher than the world average, yet not as high as the 30–40 per cent investment rates achieved by the fast track economies such as China, Malaysia and Thailand. Of course, the over-dependence of the latter two countries on external capital flows had destabilized them quite seriously during the 1997–98 Asian financial crisis. But India, without that great an exposure to foreign capital, remained relatively unscathed from this crisis. The export sector has changed dramatically. About 58 per cent of total exports were manufactured goods in 1995 compared with their smaller proportion in earlier years. Even though it

India

101

does not have as many manufactured outputs in exports as South Korea – 92 per cent in 1995 – India has managed to diversify its exports towards higher value added ones. Non-textile and non-labour intensive export items constituted two-thirds of the exports of this country in the 1990s compared with only a third in 1965. Great changes also took place during the same period and helped change the structure of the financial sector as well. Financial activities in India are conducted within some 300 institutions (and 10000 quasi-finance traditional finance organizations) employing almost one million workers. The financial system is fairly large and complex, stretching over six central bank planning regions spread over the whole country. The bulk of financial activities are carried out in Bombay in the western region but the centres in Delhi, Gauhati, Kanpur, Calcutta, Hyderabad, Ahmedabad, Madras and Bangalore also play crucial roles. The banks, the share markets, insurance sector and mutual funds (unit trusts and chit funds) and the government bond markets are reasonably developed. Starting in 1991, India has been taking steps to create a market-based callmoney market and a bill rediscounting market also with repo auctions. Lack of competition has restrained their growth, as there are few competitors in these markets. There is also an increasingly thriving foreign exchange market developing very fast as a result of the floating of the currency and lifting most exchange controls which became effective in June 1994. Apart from these spot markets, India has not much activity in specialized futures markets (e.g. warrants, stock options, swaps, etc.) of any significance. With permission being granted in late 1999 to write cross-currency options, first steps have been taken to create viable futures markets for hedging purposes. The Finance Minister in his 1994–95 speech to the parliament in February 1994, said: The Government attaches high priority to reforms of the capital markets aimed at creating an efficient and competitive capital market.

This is a continuing policy still. The reforms of the 1990s reflect that sentiment. The euphoria for more reforms in the 10 years of liberalization, which started in 1992, had not been evident at all in the previous 41 years. 2.2

Financial Markets and Development

The structure of the financial sector underwent a great many changes over the period before the 1988–97 reforms. While China started to close down all capitalist institutions in 1950 as undesirable after they drove the nationalists out of the mainland in 1949, India was pursuing a policy of nationalization that led to similar structural effects. The financial sector was put in a bind in both countries.

102

Liberalization and growth in Asia

The Communists disbanded the central bank, and set about creating a monobanking system with the People’s Bank of China subsuming all the functions of the banking sector. India started to nationalize the largely private-sectormanaged banks into a few large government banks, for example the Reserve Bank of India. It established the Reserve Bank of India (RBI) to co-ordinate their nationalization and control plans. There were three bouts of nationalization, one immediately after independence in 1949 with the nationalization of the Imperial Bank of India, a second bout in 1969 and a third one in 1980. Fourteen banks were nationalized during the second round with eight more in March 1980. The structural result was that Indian banks moved from the private to the government sector, and under government controls, as in China, the banks provided the payment function and failed to develop the wherewithal to assess and price investment risks. Both countries had bad loans and they failed to create a quality banking system as delegated monitors to assess and manage investment risk. Add to these, connected lending practices and preferential rates for special groups, and you have the recipe for an inefficient banking sector. The resulting structure was a mix of nationalized banks (this does not include the RBI) and a few private banks in India. Soon, there were 22 large nationalized banks owned and operated by the government, 29 domestic origin banks owned as joint stock private companies and 24 foreign-origin banks. The nationalized banks accounted for about 55 per cent of all retail banking activities in the late 1980s (Sercu and Uppal 1995). These banks also had the largest network of branches, 61 per cent of the 61000 branches in the country. In short, the financial sector became structured as follows. A central bank supervised the institutions, which were (1) commercial banks, (2) specialized banks, (3) mutual credit organizations and (4) informal financing enterprises. A securities exchange body (the SEBI) was enlarged and given powers to supervise the direct capital markets and unit trusts. The insurance commission supervised the risk management enterprises. Notable characteristics of the financial sector can now be described. The State Bank of India and its affiliates dominate the financial sector. To that add 10 large nationalized banks and a further 12 specialized banks for long-term loans, so that we have the central government effectively controlling the financial sector. Also to be taken into account were the Unit Trust of India (UTI) and the Insurance Corporation of India (ICI), the only two bodies permitted to operate as government-owned companies in those two areas, then the extent of the state’s involvement in the financial sector can be described as somewhat pervasive. Since 1994, reforms have been put in place under which these two have been broken up into several bodies while new licences have been granted for newer entities. It is a miracle how the much less powerful 29 privately owned commercial banks and the 24 foreign origin banks managed

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103

to retain a 40 per cent share of the market in the 1990s! The fact that the private banks existed especially in the major urban areas perhaps provided a sort of trench line beyond which the state dominated banking sector would not dare move. This augured well for India as it provided a semblance of competition that preserved some degree of market influence in the financial sector even under the widespread dominance of the public sector banks. When Indonesia’s banking system was practically run by the state up to about 1988, the private sector lost ground and managed to account for a mere 20 per cent of the deposits. What was worse in Indonesia was that the inefficiency in managing the banks was more prevalent even in the private sector banks until widespread banking reforms began to turn the situation around to a position that, in 1996, 80 per cent of deposits were in the private sector banks. With the state rescue of banks that were in trouble in 1998–99, it is now reversed again. This is not so in India. The stock exchanges in India, 23 of them altogether, were all operated privately (the primary one being the Bombay Stock Exchange), developing on the private sector model over many decades, became important institutions as sources of direct capital for major corporations. More will be said of the roles of the capital market in a later section. However, indirect market financial institutions were placed under increasing control of the state, thus stifling the proper working of the financial markets to serve intermediation roles as well as pricing efficiency. These restrictions have been slowly lifted since 1988. In summary, it can be said that there were severe suppressive policies in the Indian financial sector. There were very high reserve requirements (at one time as high as 45 per cent of deposits), which helped to channel deposits into the central bank. There were 20 different schedules of interest rates. By controlling the minimum and the maximum rates, the regulators were able to subsidize some activities more than others in pervasive programmes of directing credits to certain economic activities. Readers would recall that this is a widespread practice in developing countries to, hopefully, fast-track growth. In all countries covered in this book, such efforts distorted market pricing of profitable investments, which led to poor investment decisions in the long run. Instead of fast tracking growth, capital resources got wasted. Finally, there existed multiple exchange rates while capital controls were in force to prevent other than approved capital outflows: this was slowly removed with permission given to corporations to sell shares in the developed capital markets as ADR and GDR placements since early 1990s. With capital outflow controls, international capital was reluctant to come in even for investing in the real sector first, because there were serious controls on the exchange rates needed for business and second, because there was no permission until the 1991 reforms for foreigners to own 100 per cent of a firm. Most of these controls would be steadily rolled back starting from about 1988.

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From our discussion to this point, it is perhaps correct to describe the structure of the Indian economy as one that worked under pervasive controls designed to foster corruption under a maze of regulations. Where there are too many rules, there is opportunity to make a quick buck! As a result, the government machinery, which is supposed to be efficient, could not be so, hence it failed to deliver a sufficiently high growth in incomes to bring prosperity to the people. No thanks to the import substitution policies, the economy became inward oriented. But that process produced a surprisingly perverse benefit. It led to the slow but steady improvements in industrial outputs as domestic firms clambered to produce goods and services to serve a huge, growing population. Hence, this largely agricultural economy with 90 per cent of the people living in the rural sector in the 1940s slowly underwent change to become a large industrial economy though without a sufficiently developed services sector. The export sector has diversified especially since 1989, towards more value added products. Urbanization has increased to a level today so that almost three out of ten persons live in urban areas. The financial sector has been pervasively suppressed though the presence of 53 vibrant private-sector-owned commercial banks gave some competition to the state banks to prevent them from taking over the whole system. Thus, the financial sector did not deteriorate to the level seen in some countries such as China and Vietnam, where any semblance of a modern financial system was removed under their Marxist-Leninist total state controls until 1995, when financial sector reforms began. The liberalization that started in India in the early 1990s has led to farreaching changes to the financial structures in particular. The economic structure put in place by the import substitution policies is still holding together, and its participants are in fact fighting to preserve the monopolistic and oligopolistic practices intact in order – they financed a right-leaning government to come to power – to shut out competition to continue to earn economic rents. When the full impact of the reforms in the real sector that started in 1984 in a modest way get under way, the structure of the real sector is likely to change in the near future as happened in other countries as well. So will the financial sector with bold reforms under way since 1994.

3.

LIBERALIZATION

3.1

Economic Liberalization

Pricing reforms Consistent with received wisdom in development literature, India started the reforms in the real sector. In post-reform India, domestic and foreign

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investments are permitted in all sectors in any part of the country with the removal of the law that had, since 1956, reserved a large segment of the economy as the government’s own investment domain. The first Prime Minister Nehru’s enthusiasm for building industrial capacity had no bounds – he equated it to building temples – it was a way for the bureaucrats to steal the rights from the private sector to run these things for themselves as part of the state. These days, after the reforms, the areas reserved for the governmentonly investments remain only in defence, certain metals and mineral production and rail transport. The approval procedures for licences have been redesigned to bypass the corrupt bureaucracy. Conditions for automatic approvals are clearly spelt so that the Reserve Bank of India in Bombay can approve (1) investments in 36 priority industries and also give approval for 51 per cent foreign equity ownership; (2) export-oriented activities located in the export processing zones with 100 per cent foreign equity and (3) foreign technology transfer agreements valued at R10 million (US$275000) or royalties of up to 5 per cent for domestic sales and 8 per cent for exports. Other investment proposals may be made to and approvals obtained from the Indian foreign missions. The applications are then processed either by the Secretariat for Industrial Approvals or Foreign Investment Promotion Board in Delhi. Soon after the changes to regulations, the time taken for approving a bank to operate in India was a mere 69 days, reflecting the impact of liberalization on the efficiency of the approval process. To understand the extent of reforms that have been undertaken, it is necessary to look at the historical circumstance of liberalization. The genesis of controls started back in 1956 but the impetus for reforms was only evident in the late 1980s. The 1980s witnessed a period of stagflation in the world – low growth with falling commodity and asset prices – as the more developed countries emerged, weakened, after two oil price shocks of 1972 and 1979. A period of slow or no growth in the developed economies led to a sudden collapse of fast growth in the developing countries around the mid-1980s. Several such Asian economies from Japan to Indonesia made substantial price reducing reforms to regain competitiveness, which led to substantial growth from about 1987 to 1996 in these reformed countries. It was not so for India, which not only did not have the political will to challenge the entrenched protective sentiments of the industrialists running cartel-like markets but also it was experiencing insurgencies in several parts during a period of short-lived, weak central governments. India under this condition of political uncertainty and still holding on to the old inward-looking policies began to come to grips with the inadequacy of past policies to handle a worsening economic situation in the second half of the 1980s. When the short-lived government of a young leader7 created sufficient consensus to at least think about badly needed reforms during 1985–87, a

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window of opportunity for reforms opened. That was the situation in the late 1980s. It is interesting to hark back to the time when India took a decision to implement controls in order to get the public sector to be the engine of growth. The seed for the restrictive policies is contained in a 1956 parliamentary speech, taken from Yong and Rao 1995, made by the grandfather of the young assassinated leader urging the Indians to reform: in a country under-developed as ours, we cannot progress except by State initiative … by enlarging the State sector

This was not a speech by a Communist, but a man of great vision and conviction in freedom. That policy was endorsed in 1956 as the now famous (or infamous!) Industrial Resolution Policy. Only 3 per cent of the state budget was then allocated for public enterprises in 1956. By 1991, this had been expanded resolutely until 37.6 per cent of the state’s capital expenditure was absorbed by the mostly loss-making 246 central government public enterprises. These enterprises were making no more than 2–3 per cent profits per year. The GDP share of the public sector increased from a mere 14 per cent of the GDP in 1970 to almost 25 per cent in 1990. Of course there are worse examples, perhaps China or Russia? The GDP share of the public sector in China in the mid-1970s was 90 per cent! The entry of public enterprises in the production of non-public goods was mandated through laws that reserved certain economic activities – initially covering munitions, basic engineering goods, machinery, telecommunications, energy, among others – to be undertaken only by public enterprises. The original list was expanded when other policy objectives, for example agricultural development, dictated additional activities to be added to the restricted list. Even the so-called unrestricted items needed licences for the imports of foreign inputs, be it capital or material inputs to production. This led to the rule by bureaucracy, a very corrupt bureaucracy,8 which bred inefficiency in addition to exacting a high price in the form of corruption money given to obtain even normal approvals for licences. As the restrictive policies began to slow down economic growth, there were limited attempts to tinker at the fringes of the controls without removing the restrictive list. The number of people employed by the public enterprises increased to 2.2 million in the 246 enterprises while the entire civil service employed only 4 million to serve a population close to a billion. In addition to these firms, there were 823 state-level enterprises similarly making losses and forming a network of inefficient producers under political patronage. The total capital expenditure in these enterprises amounted to a mere 2.9 per cent in 1951 on five enterprises: in 1990, this became 37.3 per cent of the total budget. A good measure of the entrenchment of the public sector in the non-public goods

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sector may be judged by the following statistics. Public enterprise shares in the late 1980s GDP were 33 per cent (manufacturing), 90 per cent (utilities), 50 per cent (transport and telecommunications), 40 per cent (finance, banking and insurance) and 47 per cent (services other than administration and defence). An evaluation of the public sector firms was made in early 1990. A decision was made to sell off inefficient ones and to keep the ones that could be turned around to make profits through greater decentralization of management and corporatization. By the mid-1990s, a substantial proportion had been sold as a start on a long road to divesting the public sector enterprises. There was an attempt in the second half of the 1980s to permit limited entry of foreign firms with promises of special approvals for higher than 49 per cent foreign ownership. This was still inadequate compared with the higher foreign ownership levels offered in the ASEAN economies some 4 hours’ flight time away. These initiatives were sporadic and did not lead to any favourable responses under the endemic political crisis years during 1986–88. The real sector reforms began to release some energy in the domestic economy as a result of the cumulative effects of these limited reforms in the real sector. These are not examined in detail here. However, the new government that came into power in 1991 acted on a series of reports it and the previous government had commissioned on liberalization. After the assassination of the reform-minded young leader Rajiv Gandhi, the new government carried out many systematic reforms in the real and the financial sectors. There were three major highlights of these reforms. First, they introduced decentralized approval powers to the foreign embassies and the central bank for most foreign investment applications while the state governments were given more power to compete for investments. Second, the restricted list was abolished (except in defence, administration and essentials) thus leaving almost the entire economy open to entry by non-government domestic and foreign investors. The reader will note this openness is dramatically different from the policy of entry to only special zones of many countries. Third, a number of far-reaching financial reforms were implemented, removing most of the restrictions on financial resource flows into and out of India. Years of pursuit of bad policies led to the economy slowly sliding into a morass. Figure 4.2 provides summary information on reserves and other financial variables. The worst crisis occurred in 1991. Foreign reserves were almost depleted, the savings rate had plummeted in 1989 to 7 per cent, the current account deficits were close to danger levels and the budget deficits also went to a dangerous level closer to 10 per cent of the budget. The remedy that amazingly saved the country was a 23 per cent devaluation of the currency and subsequent financial reforms put in place. The IMF lent money and provided support for this reform. These measures eased the situation slowly until the country regained a reasonable level of economic health by the end of

Liberalization and growth in Asia

30.00 25.00

Growth rate

20.00

80.00 M2 M1 FR/IMP

15.00

70.00 60.00 50.00

10.00 40.00 5.00 0.00

30.00

–5.00

20.00

–10.00

10.00

–15.00 1961 1966 1971 1976 1981 1986 1991 1996 2001

Foreign reserves to imports

108

0.00

Figure 4.2 Foreign reserves to imports ratio and growth rates of M1 and M2, India: 1961–2002 1992.9 Just out of the woods, a brave set of reforms were put in by the Rao government that set the road to greater reforms yet to come. India has not faced similar problems of current account deficits in the years since that event. External sector policies Further exchange rate reforms came in two stages. In late 1991, the restrictions on a large range of items previously not permitted as imports were removed. Among them was a restriction on import of gold. There was a fear of Indians spending their savings in buying gold, and successive governments have imposed restrictions on import of gold, thus making a profitable arbitrage for those who dared to bribe the customs to bring in illegal gold imports. With the removal of this restriction, there was a sudden increase in the inflow of gold imports, and the premium that was paid by Indians for gold soon disappeared as the markets equalized the prices inside and outside the country. More restrictions on imports were removed during the years 1993–94. Finally, all restrictions for currency convertibility on producers were removed in March 1993 thus making a substantial change in the external sector. Exporters and those sending remittances to India could do so freely. For individuals wishing to go on tours and for education, liberal approvals were given for foreign exchange. But for other purposes, controls on the non-production sector remained. In July 1994, the currency became fully convertible, satisfying

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Article 8 of the IMF. Capital accounts were liberalized. There are still controls on capital accounts of the non-exporting domestic firms. Foreign direct investment in all industries except those in the negative list is now possible: the negative list is now reduced to a small list of seven activities. This effectively removed almost all restrictions on foreign and domestic firms’ entry into the industrial sector. Automatic approvals are possible for investments with 51 per cent foreign ownership in high priority sectors such as energy production, telecommunications and others. A Foreign Investment Promotion Board has been set up to expedite and follow up on such investments. Available statistics show some improvements as well as some bad effects of the harsh policies implemented to avert a major financial crisis. One obvious bad effect was inflation following the current account liberalization in 1993–94. The inflation rate went very high as a result of devaluation of the currency. However, by 1996 inflation had been brought to a manageable 9.2 per cent level. There were large declines in the monetary markets for the same reasons. But foreign direct investments increased by leaps and bounds. By the end of 1996, before a slowdown took place in anticipation of restrictions by the conservative government that was expected to come to power in the following year, FDI had increased from about US$100 million to close to US$3000 million. Trade deficits of about 2 per cent in 1993 declined steadily to –1 per cent by 1995 before increasing in 1996: trade deficits settled at just above 2 per cent of GDP right till 2002. 3.2

Financial Liberalization

Substantial financial reforms were put in place as alluded to in the previous discussion. The reforms covered wide-ranging areas and have been introduced since 1989. See Table 4.3 for a detailed summary. They are still ongoing. For example, the Reserve Bank of India announced in November 1998 further easing of restrictions on domestic firms issuing securities in foreign markets. The year 1999 witnessed tax incentives coming into effect for all. In 1999, steps were taken to introduce derivative trading: the reintroduction of ‘Badla’ contracts was in line with this policy. Government finance Because of the over-extension of the financing by government to both provide capital and offset the losses incurred by the public enterprises, there has been a persistent loss of controls in managing the government’s finances. This has been made worse by the absence of any meaningful tax reforms. The tax reforms implemented since 1994 have produced some favourable results, but the real reforms came only in 1998. The revenues are always far short of the

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Table 4.3 Major economic and financial sector reforms in India, 1956–2002 Date of reforms

Liberalization policies implemented

Genesis of controls 1956 Industrial Policy Resolution under which the state sector was required to create industrial capacity by designating a large number of activities as the reserved areas for the state to operate 1949, 1967, 1982 Nationalization of Reserve Bank of India and Imperial Bank of India Establishment of State Bank of India Further nationalization of more banks in the 1960s Nationalization of all insurance companies and establishment of a single large insurance corporation to take them over Establishment of specialized banks and of the Unit Trust of India Liberalization 1980s

Limited reforms to address periodic problems in the management of the economy; no reforms taken to break out of the controls that were already in place Restrictions on certain imports were relaxed to ease constraints on private sector’s ability to respond to changing international competitiveness

1988–89

Following the initial success of limited reforms in 1988–89, the system of reserving certain sectors for investments by the state was dismantled

1991–97

The reservation list was abolished and all entry restrictions ended so that local and foreign investors could enter any sector; only a few defence-related and certain metal manufactures and rails were still kept by the government for strategic reasons

1998–2002

Reforms to exchange rates, financial institutions, tax reductions and capital flows

Real sector reforms

Export processing zones where any foreign enterprise could produce and own 100 per cent of the firms

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In other parts of India, 51 per cent ownership permitted Approvals were standardized; for foreigners, approvals could be obtained through the central bank and from a special investment promotion board set up for that purpose In 1998, further easing of controls on foreign companies In 2000, further liberalization to facilitate the setting up of free trade zones in different parts of the country Board of Approvals for Export Processing Zones established to provide one-stop approvals for special economic zones Banking and financial reforms

Statutory liquidity ratio reduced from high of 25% to 2.5% while the total reserve reduced to 10% by 1998. As of 2002, the CRR ratio was 5.0% Interest rates slabs reduced from 20 to 3 by 1989–90. Further reduced to a single slab with no restriction on lending rate; minimum deposit rate is still in force Prudential norms improved by supervision standards for bad debt provisioning and for risk-weighting the exposure to risky loans Capital adequacy of minimum of 4% by March 1993 and 8% by March 1996 introduced and implemented Maximum support for state-owned banks in recapitalization stipulated when the state-owned banks undertook to improve efficiency Private sector could buy up to 10% voting rights in state banks to inject slow privatization into them Stricter reporting requirements on non-performing assets from 1998 Restrictions on branching lifted as well as restrictions for entry into the sector; repatriation of profits needs no approval from mid-1998 More private sector banks are licensed to operate in the country since 1999; two foreign banks permitted were Morgan Guaranty and JP Morgan To create liquidity and market indicators, new rules put in place to encourage short-term money instruments, including forward contracts, repos and swaps in mid-2000 Continued overleaf

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Table 4.3 Continued Date of reforms

Liberalization policies implemented In 2002 more reforms to interest rate and bank deposits, reserve ratios made More reforms on several aspects of financial sector introduced in 2002

Capital market reforms

Current and capital account reforms

Auction on treasury bills and government securities started in 1992 The supervisory capacity of the regulator (SEBI) strengthened to reform the capital markets Capital Issues Act repealed. SEBI relaxed issue conditions and permitted issues to be marketed after approvals Listed companies were permitted to have access to international capital markets Monopoly by the one mutual fund company broken with entry of many more Over-the-counter exchange established to create a screentraded computer-assisted operation; this is expected to become the model Foreign ownership restrictions relaxed a little National Stock Exchange starts trading on derivatives in mid-2000 Book-building rules introduced to improve capital market pricing in 2000; IPO issue regulations modernized in 2000 In 2000 SEBI becomes the sole share market regulator and IRDA for insurance matters India operated a fixed exchange rate regime despite most countries choosing managed floats in the late 1970s and early 1980s; during this phase, India’s currency depreciated at an annual rate of about 10% 1991 currency crisis led to a 23% devaluation of the currency 1993 Foreign exchange controls on producers and individuals were slowly relaxed 1994 Currency was free-floated satisfying the IMF article 8 conditions Capital controls on producers substantially removed

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Exchange controls on individuals eased for travel and education Further easing of capital controls shelved in the face of the 1997 Asian financial crisis Insurance sector is the next one to be reformed; limited reforms being introduced in this sector by easing entry barriers Tax reforms

After a period of tinkering with the tax structure and tax administration, broad-based reforms were passed into law in 1997 and 1998; this is expected to bring in widespread benefits. Further reductions to corporate and personal tax rates made in 2001

Sources: Reserve Bank of India publications and Ariff (1996).

expenses. Part of the shortfall is offset by the official development assistance from the developed countries while the rest has to be offset by domestic or foreign borrowing. India had consistently run a 3 per cent saving to investment gap. It was filled by foreign loans (which were 4.4 per cent of the 1996 GDP for example). Foreign loans stand at 24 per cent of GDP, a level much more sober than is found in many developed and developing countries: many financially weakened economies have debt rates of about 50 or more per cent of GDP. Indonesia and Vietnam each have loans of more than a year’s GDP. India has also resorted to public sector borrowing that has led to the ballooning of the domestic debt to about 20 per cent of the GDP. In addition, the country also has international debt taken under multilateral lending for development. Direct capital and money markets The stock markets have a long history since these markets developed over a long time. In 1996, the share markets were capitalized at about 48 per cent of GDP. The stock exchanges are served and managed by around 4000 brokers and 20000 sub-brokers, who are equivalent to the dealers in a modern market. These statistics indicate a higher level of development of the stock markets, all of which have been in the private sector. India’s capital market is a very large one among the 53 emerging markets in the world. Most emerging share markets are capitalized at about 20 per cent of GDP. The stock markets are situated in several major Indian cities and are not integrated in so far as there are no integrated trading procedures and communication links similar to, for example, the associated exchanges in Australia. There are 23 separate exchanges with the Bombay exchange accounting for two-thirds or more of

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the trading volume and value. A national integrated stock exchange with screen trading and automated operation is developing fast. There are some 12000 stocks listed and traded. Of these, the exchanges in Bombay, Calcutta and Delhi account for more than 50 per cent of the listing. Trading is more intense in Bombay. The exchanges at Kanpur, Ahmedabad and Madras are also active and large. Recent good performance provides important descriptive statistics on the Bombay Stock Exchange. The total capitalization of all the world’s 53 emerging markets in 1996 was about US$1900 billion. India’s stock market ranks among the top 10 with a capitalization of US$150 billion in 2002. This high capitalization to GDP makes the share market a far deeper market than most of the emerging markets. The Bombay exchange may be counted as being among the top six following South Korea, Taiwan, Mexico, Thailand and Malaysia. The value traded in Bombay is 3.5 per cent of the average of the 30 top markets of the world in the 1990s (IFC reports). The stock market has provided an average yield of about 38 per cent during 1988 to 2003. But its risk is also high, about 40 per cent standard deviation of returns per annum. In terms of price–earnings ratio, the Bombay market is about a third higher in risk than a typical market average for the world. Therefore the coefficient of variation of 1.05 for India compares favourably with most developed markets (which have average coefficients of 0.90) as well as the developing markets (which have average coefficient of 1.7). The average price–earnings ratio in the 1990s of 25 to 33 makes the Bombay market in recent years about onethird times more risky than the world average (IFC reports). India’s bond market is not well developed though the government bond issues are traded within the financial institutions. There is a potentially large private market to be made with R2700 billion worth of government bonds. There is also a tax-exempt bond mutual fund scheme with government securities. The capital market was still not international enough to attract foreign capital inflows. This changed in 1995–96 when much of the disinvestment in Southeast Asia led to large capital flows into the Indian markets. This is in a sense not comforting as markets such as those in Karachi and Bombay that liberalized faster went through speculative capital inflows, which, when withdrawn, destabilized the ability of these markets to provide steady streams of financing. While Indian companies can access foreign markets for funds, likewise, foreign companies can invest in the Indian financial institutions as well as by obtaining licences to run financial institutions. This is designed to improve efficiency while also making it a lot cheaper to trade in the market. An overthe-counter (OTC) market has been in operation since mid-1994, giving access to smaller firms to list their shares: since then, small firms have another access through the automated national exchange, which started growing very fast

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since 2000 as large numbers of newer firms are listing in the screen-traded exchange. Eventually, this screen-based trading system is expected to unify the exchanges. These and other reforms on capital adequacy for brokers, greater and more frequent disclosures, etc. are expected to provide opportunities for this large capital market in that region to develop into a financial centre for that time zone in the future. Under the planned mixed economy model with a large role reserved for the public sector to develop the economy, resources had to be directed towards the government sector. The state engaged in active interventions in the economy (World Bank 1989; 1990). This meant a greater role for the government in the monetary economy of the country. From as far back as the 1950s, the central bank imposed a high liquidity requirement on the banking system. Almost 47 per cent of the deposits in the banking system ended up as reserves with the central bank in the form of bank deposits and holding of government securities by the banks. This was unlike the situation in Malaysia, which followed a policy of commercializing the rural sector to improve the incomes of the rural population, but did not use reserve requirements, instead, issued huge domestic debts to be bought by the financial institutions. But in most other economies this ratio was seldom above 18 per cent of deposits. In addition, the government also depended on deficit budgets for decades as a stimulus for growth, and that led to excessive money growth with high inflation. Exchange rate policy was the leading candidate for reform when the serious crisis occurred in 1991. Reforms to the multiple exchange rates and controls on producers and individuals were lifted after a massive devaluation of the rupee by 23 per cent in 1991. Steps soon followed to unify the multiple exchange rates into one in 1992. By March 1993, further reforms were put in place to remove restrictions on producers holding foreign exchange. The managed exchange rate adopted against a basket of currencies has led to greater stability of currency. The exchange rate in early 2004 was R41 = US$1.00, a gain of 3 per cent per year on the average over three years: see Table 4.4. With those significant reforms, the real sector was able to conduct foreign exchange transactions to acquire capital and technology as well as improve trading with the rest of the world without having to obtain permission. In July 1994, all remaining controls on foreign exchange were removed thus restoring India’s external account to satisfy the stipulation of IMF Article 8. But this new policy came very much later than other more liberalized economies. In contrast, the various Southeast Asian countries had reformed their exchange rate regulations by switching to managed float of their currencies between 10 and 18 years earlier. Restrictions on individuals holding foreign exchange for travel and education were relaxed while maintaining controls on others. Similarly, reforms to capital controls have been shelved in view of the 1997–98 Asian financial crisis.

Table 4.4

Growth of financial and capital market indicators for India (annual averages)

116

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

Exchange rates (% change) Share price returns

5.15 1.39

0.54 4.58

8.41 24.31

15.41 36.31

6.82 7.27

4.38 11.22

4.99 –24.53

3.02 –6.36

Interest rates Bank rate Call money rate Commercial lending rate

4.25 4.53 –

8.20 8.68 4.45

10.00 10.06 16.50

12.00 13.18 16.65

9.20 3.27 13.63

8.00 – 12.29

6.50 – 12.08

6.25 – 11.92

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

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Interest rate reforms The banking system was designed to serve the demands of credit targeting by the government to achieve sufficient growth in outputs in the agricultural and industrial sectors. This meant two things, massive redirection of deposits to the reserve bank to make it available for the government and second, interest rate controls. The reserve ratios on deposits were kept high and government ownership of banks became dominant to achieve the first objective. To achieve the second objective, a system of maximum and minimum levels was designed in order to control interest rates. At a time before the interest reforms in 1992, there were twenty different schedules of interest rates: the Appendix to this chapter provides summary information on interest rates when the 20 slabs were standardized in 1991 and again in 1993. Subsequent deregulations removed these restrictions. A series of reforms to free interest rate controls have been taken since 1991. The 20 slabs of interest rates were reduced to 3 in 1991. The minimum deposit rate was reduced by 3 per cent and the maximum interest rate for bank advances was reduced by 4 per cent. Thus, the market was expected to adjust its offered rates to depositors. But there were no improvements as the controls continued to be binding. It was when all controls on lending rates were removed that interest rates started to respond to market forces. In the early phase of removing the lending restrictions, interest rates went up. Since 1993, the lending rates have been coming down especially with inflation coming down steadily to a much lower level, which is well below the double-digit inflation in the years before the reforms: inflation in year 2002 was 4.39 per cent. Auction of 91-day Treasury bills and government securities commenced in 1993. This led to new developments in that this provided broad indications of the base rates, the risk free rates, all determined in the open market. The credit creation of the banking system can now be examined. The high liquidity ratios dampened the money multiplier function of the banking system since at the prevailing high reserve rate, the money multiplier could be in the region of three to four times the deposit rates unlike the 9 to 10 times possible with easier reserve ratios. Liberalization of the reserve requirements to the 1998 level of about 11 per cent led to greater credit creation under a market based credit system now in force. Demand deposit almost doubled over 1991–97 as did also the time deposits. Time deposits grew at a rate of 17 per cent per annum compared with half that rate in the pre-reform periods. The growth rate in demand deposits averaged 12.6 per cent, which is also about double the rate in the pre-reform periods. Interest rate reforms led to easier credit creation to support private sector activities. In 1998, the total domestic credits in the non-financial sector amounted to about 55 per cent of GDP compared with the pre-reform ratio, which was below 50 per cent. In

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addition, reforms made foreign capital available to corporations and banks through more access to the international capital markets for funds. The GDP share of foreign credits to the private sector is about 8 per cent in 1998 compared with the pre-reform ratio of 1.4 per cent. Thus, interest rate reforms, reductions in the bank reserve ratios and relaxation of controls on access to capital sources have all combined to make available more credits to the private sector. It can also be noted that the bank spread of 2.88 per cent in the pre-reform period has widened a little in the post-reform period. This is as it should be to strengthen the ability of the financial institutions to obtain higher profits at the time when more stringent capital adequacy rules are being imposed. This would have the effect of making the banks more profitable, and hence more able to also modernize more speedily. Reforms to bring in competition by lifting restrictions on interest rates would result in new realignments among the banks as efficiency will become the criterion for survival, eventually leading to more mergers and takeovers. With the reforms of (a) the financial sectors and (b) more openness in current and capital accounts, India’s interest rate regime is likely to become more responsive to international forces as capital flows are beginning to take place both ways. Structural changes are already evident bringing along with them changes to the process of price determination in the financial system. For example, seven new banks have been licensed in the private sector. Concentrating mostly in the metropolitan areas and therefore catering to the large industrial customers, the new banks are expected to increase competition in the more profitable market segments. With the managed-floating rupee since 1994, international effects on the currency are quite evident in making the currency respond to economic fundamentals. This has been an important reason why the rupee did not overshoot following the Asian financial crisis during June 1997 to May 1998. Competition and creation of more liquid and varied financial intermediation will come next to integrate India’s monetary economy with the rest of the world. Central bank and depository institutions India’s financial system at the time of independence was designed to cater to the demands of international commerce and, to a limited extent, the demands of what has come to be termed the ‘big boys’, the elites of the society as well as the large trading and manufacturing houses (Chhipa 1987; Sarkar 1988). The Reserve Bank of India and the Imperial Bank of India were both nationalized in 1949. These acts were only the first of far greater interventions in the financial system to come in later years. Intervention in the financial sector was legitimized and sold to the public to usher in ‘mass banking’ with its emphasis on reaching the average citizen, which meant the rural sector

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where 90 per cent of the population lived. Special banks for industrial financing were formed in 1948 (the Industrial Finance Corporation of India – IFCI), 1955 (the Industrial Credit and Investment Corporation of India – ICICI) and 1964 (the Industrial Development Bank of India – IDBI). In later years, two more specialized banks respectively, one for agriculture financing (National Bank for Agriculture and Rural Development – NABARD) and another for international trade (EXIMBANK) were set up. In September 1956, 245 life insurance companies were taken over to form the Life Insurance Corporation of India. The State Bank of India, SBI, was licensed in 1955, as a means to bring mass banking to the whole country with the aim of providing access to deposit facilities and credits to a larger base of depositors and creditors. These institutions expanded very fast as did the banks affiliated to the SBI. Currently, the SBI and its affiliates account for about a fifth of the retail banking activities. These four and the General Insurance Corporation (GIC) formed in 1971, played critical roles in their respective financing areas. Other specialized financial institutions listed in the table were progressively set up as demands for focused financial intermediation grew. All financial institutions are licensed by the central government agencies, and therefore India’s financial system is similar to that non-American model found in most Commonwealth countries. Banks were divided into two groups namely the more significant public-sector banks and the also increasingly important private-sector banks. The more dominant public-sector banks number about 224, and have a large number of branches throughout the country in year 2002. Of the public-sector banks, 196 are regional rural and co-operative banks accounting for slightly more than one-seventh of the deposits. The private-sector banks, numbering 53, contribute to about a third of banking activities. The Indian Overseas Bank and certain others have about 120 branch operations in foreign countries to facilitate international transactions. The number of branches increased from 8321 in 1969 to some 61000 branches by the year 2000. Branches increased very fast at an annual rate of 10.4 per cent. About 23 and 50 per cent of branches are respectively in the rural and semi-urban areas. The remaining 27 per cent of the branches are in the metropolitan areas. Branching to spread the network to the whole country has been a signal success of the plan to introduce mass banking. In the category of specialized banks, there are thirteen institutions at the national level for development, trade, agricultural, etc. At a lower level still in the same category, there is a network of 18 state financial corporations and 26 state industrial development corporations to finance small to medium enterprises. The third category comprises non-banking financial companies, which have registered a phenomenal growth as these were new organizations that catered to a growing demand for new services. For instance, a major

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Liberalization and growth in Asia

player in this category is the Unit Trust of India (UTI). As a ratio of gross financial savings of households, deposits in these non-banking institutions amounts to 8 per cent, which is considered a large portion taking into account the stage of development of the economy. Informal financing enterprises, the fourth category, include traditional Nidhis, chit funds and money-lending enterprises, which are traditional informal sources of financing for commercial enterprises. Several organized exchanges for money, bills, bonds and stocks were created. This group includes potentially the fastest-growing financial institutions. All these institutions and markets come under the central bank, the Reserve Bank of India (RBI). The RBI has direct responsibility for the licensing and supervision of financial institutions in general with responsibility for the smooth functioning of the entire financial system. In the pre-reform years of 1949–88, the RBI played a critical role in implementing policies to support the diversion of financial resources to the central government to carry out the targeted credit programmes to home-grow industrial capacity and to expand the agricultural outputs. These days, the RBI is more concerned about deregulating, and returning the financial sector to respond to market forces while of course being the guardian for maintaining macroeconomic stability. It has also attracted some of the best and able minds in the country.10 The banking reforms took place during 1992–94. The aims of these reforms were to introduce greater transparency to improve investor protection, enhance efficiency and improve competition to upgrade the standard of customer services. After 25 years of targeted mobilization of savings, the country managed to bring banking services increasingly to the rural sector. Through that strategy it managed to improve the savings rate of the country from a mere 10 per cent of GDP in 1950 to about 24 per cent by the end of the 1980s. With foreign capital coming in easily with reforms to the capital account for producers, the gross savings rate has gone closer to about 27 per cent in 1998. Rural residents have ready access to banking services with one branch serving 21000 rural residents in the 1990s compared to one per 425000 in 1969! Today there is one branch per 16000 urban residents. Rural bank deposits have increased to 14 per cent of the total deposits from a mere 3 per cent in 1969. Targeted credit policy to improve investments in the rural areas appears to have worked. About 13 per cent of the total credit is also given to rural residents.11 It should also be pointed out that 25 per cent of the domestic savings are channelled through the commercial banks, that is the public-sector, rural and private banks of India. All banks are now required to extend credits to priority sectors, namely agriculture, small-scale industries and small businesses, at concessionary interest rates. Up till 1990, this directive applied to only the public-sector banks but with deregulation this rule has been extended to private-sector banks

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as an advisory guideline. In addition, 1 per cent of credits are required to be made to the weaker sections – the scheduled caste persons – of the society at a concessionary interest rate. The wide-ranging reforms put in place between 1994–99 covered the entire financial sector, which has been identified as a key element in the overall restructuring of the economic system. The government-owned banking sector, which still dominates the sector, is now under pressure to improve operational efficiency to compete with new entrants, and to come under increased scrutiny on prudential norms. More private banks are now being licensed to offer the badly needed competition to improve customer services. Some of the major reform measures undertaken were included in Table 4.3. Control on branching has been removed. Capital adequacy has been increased to 8 per cent effective from 1996. The reserve ratio has been reduced to 10 per cent. During 1997, when there was a temporary pressure on the undervalued rupee, the reserve ratio was raised by a 2 per cent margin to dampen liquidity. Restrictions on expansion and lending operations have been relaxed. Money and exchange markets Development of a vibrant money market was long delayed again because of the controlled financial system. However, as a prelude to some degree of market-based determination of base interest rate, a money brokerage firm was licensed in 1988; a discount house was also licensed. The latter was set up by the central bank contributing R10000 million capital. It trades in 91-day and 364-day Treasury bills, and also rediscounts commercial bills. It deals in overnight call money instruments and also rediscounts bills of up to 14 days’ maturity. Market building activities arising from these reforms improved money market liquidity. At the same time, this market enables the discovery of going market rates for very short-term money market instruments. In a sense, these actions at reforms are similar to those Japan undertook in its money markets in 1984, when short-dated Gensaki (equivalent to a Treasury bill) financial instruments were approved by Japan’s central bank for trading among the financial institutions also to reveal short-term interest rates. An important new trend with the reforms in India is the large increase in the issue of commercial papers particularly by companies with good credit rating. Banks are subscribing to these papers in a large way thus creating liquidity in short-dated risky money instruments. From October 1993, maximum maturity for such instruments was raised from 6 months to 1 year and the eligibility norms for companies issuing papers have been further liberalized. India has followed a fixed–adjustable exchange rate regime, which, when adjusted frequently by the authorities, reflected the market rates quite closely. Indian rupee declined systematically against the dollar over the decades except in 1985, 1987 and 1997 when it rose by small amounts. The real rate of interest

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Liberalization and growth in Asia

was 6.5 per cent (relative to much lower real deposit rates in the United States). However, the high demand for foreign exchange on account of the deficits in funds to the tune of 3.6 per cent of GDP, the need for foreign debt servicing, and the generally lower productivity levels (figures not available) drove the rupee down over years. The average depreciation of the rupee against the dollar was some 10.6 per cent per year over the decade to 1991. In ten years, the currency declined in value by half. Depreciation halved to about 4 per cent during 1992–99. The partial free-float of the rupee in March 1993 sent it to its all-time low as it corrected the past misalignment with the market and partly also on account of the current account crisis just prior to that reform. Since 1996, this depreciation has slowed, and the rupee started to appreciate from about 1998. Another often-quoted problem at the root of the inflation, and hence the depreciation of the currency, was the high level of monetary expansion caused by the Keynesian deficit budgeting for years under the import substituting policies. The rupee declined by some 19.66 per cent in 1993, but subseqently stabilized against the dollar. Contrary to expectations before the reforms, the rupee held steady against the dollar, and on several occasions in the second half of the 1990s the RBI had to intervene to keep the rupee from appreciating. One report said that the RBI spent US$1000 million protecting the rupee in the first half of 1994: see RBI reports. RBI interventions have occurred whenever inflows through portfolio investments and export receivables surged. As part of exchange rate reforms, authorized dealers in foreign exchange have now been permitted to write cross-currency options to provide customers with a hedge on their foreign exchange exposure. The rupee has stabilized against most world currencies, and has slightly appreciated against the US dollar, given the open current and capital accounts, against the dollar, and was not expected to appreciate. On the other hand, the experience on exchange rate management in other countries suggests that unless productivity improves in the economy along with a low inflation rate with high external reserve to support the currency, it is unlikely that the currency can halt the downward moves. But, the depreciation of the currency since 1993 has been about 1.4 per cent, which is a vast improvement. The RBI is pursuing a monetary policy based on sterilizing the inflationary effect through foreign exchange swap operation. This is also helpful. On the development of liquid and deep money markets, the experiment has already started with call money markets and bills discounting introduced in 1987. There is need for competition in this area as more players are licensed. The floating of the rupee in June 1993 and the 1994 removal of most capital controls put India on a par with the successful newly industrializing economies that introduced such reforms as far back as the late 1970s as did Singapore and Malaysia and, in the early 1980s, Taiwan. Further impetus has

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been provided recently through the creation of speedy automatic approvals for investments introduced in 1994 to bypass the deadeningly slow bureaucracy. This and other measures brought in from 1993–99 have contributed to faster processing of the foreign investments applications. Tax incentives that will provide the pull factor needed to bring foreign investments have been put in place, which is partly the reason for the substantial increase in FDI. Very few statistics are revealed on the quantity and variety of the foreign exchange markets, the money markets, the bond and debentures market, etc. not to mention the feasibility of the advent of futures markets. After a debate in 1999, a series of reforms led to a slow introduction of financial futures instruments, starting with the reintroduction of the ‘badla’ contracts (the Indian version of a forward market in shares) in 1997. Currency exposures can now be hedged via over-the-counter options and in forward markets. Derivative markets are being introduced to manage price risk. 3.2

Impacts of Liberalization

The 1991 financial crisis brought India to the brink of bankruptcy that would have required inviting the IMF to rescue the economy. The important reform steps taken to avert that disaster have been described in the earlier sections. The list of significant reforms is included in Table 4.3. As the reader can note, there is a consistent speeding of the reforms in the 1990s until the coming into power of a nationalist conservative Hindu party (BJP) in 1997. Much of the impetus for reforms was still kept on track to some extent by an astute new finance minister bent on bringing India to a level of openness needed for the economy to grow sufficiently. That government was defeated in a general election and the new government that took office in 2004 has also adopted a slow-phased reform strategy to fend off the opposition to bolder reforms. These reforms were instrumental in slowly bringing the economy away from the slow growth of over 40 years. The reforms very deftly implemented by a succession of three able economists and political leaders saved the country by placing it on a path towards recovery and hopefully higher growth. The detailed effects of these policy changes have been amply discussed in earlier sub-sections. The reforms led to a momentum for growth being achieved over 1989–99. By all indications, the economy is now being slowly returned to the private sector incentives even though government ownership of key industries and of the financial institutions still continues. There is need for the real sector reforms to take deeper roots to compel the still dominant government firms to improve their efficiency levels. Financial deepening The statistics in Table 4.5 refer to measures of financial deepening. These

Table 4.5

Indicators of financial and capital market depth in India (percentage annual averages)

124

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

Money depth (M3/GDP)

25.41

35.74

51.32

62.39

55.66

61.88

64.38

Intermediation depth FIR (total)/GDP (=DC/GDP) FIR (private)/GDP

24.80 10.26

32.77 17.69

50.14 25.90

57.80 28.85

48.37 25.38

52.97 28.82

54.25 28.86

Capital accumulation GFCF/GDP FDI (net)/GDP FDI (inflow)/GDP

14.80 – –

16.98 – –

20.78 – –

27.00 – 0.37

21.89 0.65 0.62

21.85 0.57 0.49

21.66 – –

– –

– –

6.85 0.63

6.14 0.55

5.02 0.10

5.02 0.03

4.62 0.08

Indebtedness Domestic borrowing/GDP Foreign borrowing/GDP

Notes: M2 = currency + quasi money. M3 = M2 + other deposits. FIR: financial intermediation ratio. Claims on public and private sector (total credit), on private sector (private). GFCF: gross fixed capital formation. FDI: foreign direct investment (net). FDI (In): foreign direct investment (inflow). DC: domestic credit. Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

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125

statistics are computed over the pre-reform and post-reform periods. Even though the financial system was generally increasingly closed with very high levels of interest rates suppression, somehow the financial system managed to attain some depth not likely to be seen in similarly placed economies. Part of the reason for this was the guidance that the central bank provided as it had a clear vision of what to achieve in the way of developing a financial system to accommodate industrial and agricultural developments that were being promoted.12 Money market depth was very low by the standards achieved by the more open economies such as Malaysia. Money market depth improved from around 30 per cent of the GDP in the 1960s to 64 per cent of GDP in 2001. The total intermediation ratio improved from around 70 to 110 per cent. As is likely to be recalled by the reader, government’s intermediation ratio grew faster than that of the private sector. This is an expected result given the farreaching controls put in to divert resources to the state to undertake economic activities in the real sector. A notable achievement on financial depth is the gradual improvement in the gross capital formation as a percentage of the GDP. This statistic showed the greatest gain from 18 per cent in the mid-1970s (recall that this was a mere 10 per cent in 1950) to a peak of 27 per cent in the mid-1990s, but declined to around 22 per cent in 2001. The investment rate was stuck during the 1970s and 1980s in the region of 18–22 per cent. Since the reforms over the period 1993–2000, the ratio has improved by a good 5 percentage points. This is largely due to the reforms making it possible for the producer sector to get finance from foreign sources. Foreign-sourced capital is 8 per cent of the 1997 GDP. Borrowing both from inside India and outside is coming down with better management of the debt issue. Also, as of 2003, the credit rating of India is far better than is the case of many Asian countries because of the caution in this regard. Thus, the fifth largest economy in the world has finally taken the needed reforms to lift the suppression that was placed on its financial sector. Meanwhile, the inefficiency in the producer segment is still there from a long period of controls as well as from the entry of the state in several non-public goods areas. The real sector reforms will take some time to work their way through the economy. Impacts on foreign capital flows Indian firms obtained private foreign sources of capital as soon as reforms permitted them to raise capital outside the country. These sources grew steadily from just about US$208 million in 1991 to the 1997 high of US$3351 million.13 Attempts to get FDI to inject not just capital but also technology and market network have been therefore reasonably successful. The FDI has increased from just about several million in the pre-reform period to a few

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Liberalization and growth in Asia

billions in the late 1990s, and has kept in phase in 2001 and 2002 as judged from press reports: official statistics are yet available, but a figure of close to 6 billion is quoted in the press. It averaged about US$72 million before the reforms. It is above US$3billion in the years after 1997: in 2003, state budget sources place this at about US$6000 billion. That represents an exceptional growth not very much different from the experience of China, when it started permitting foreign owned firms to operate in coastal areas in the 1980s. In addition, the portfolio investments have grown even more aggressively from the 1991 figure of US$8 million to the 1997 figure of US$2960 million. Obviously, foreign producers and investors are favourably disposed to investing in the large now open money and capital markets that this country represents. It is often remarked that the size of the middle class of about 220 million people in this country would make it an attractive consumer market for most of the 38000 multinational firms from the developed countries. Meanwhile, the economy’s capacity to mobilize larger savings (about 26 per cent of GDP in 1998) for domestic investments would be an added attraction for the multinationals to look for potential joint venture partners.

4.

FUTURE PROSPECTS

This case has been an interesting one in this study about Asian liberalization and growth. It holds relevant lessons for large economies in Asia, Africa and South America. A large economy that this case represents is interesting in that it used the state resources to develop a huge industrial sector while also gearing up the agricultural sector to produce more to attain self-sufficiency in grain outputs to feed a huge population of 1032 million in 2002. The import substitution strategy for securing development was originally meant to cover few sectors going by the deeds of the founding father of this country. But it eventually engulfed the entire economy as those outside the restricted lists could not obtain the foreign capital, technology nor the markets because of the fixed exchange rate regime adopted by the country, which also prevented the more efficient producers from accessing foreign resources. It took the simmering problems in the late 1980s and the near financial bankruptcy in 1991 to prod the elites to dismantle the controls that had grown over the years. As was noted elsewhere in this chapter, the state sector expanded into areas they were not equipped to manage, and this drained almost 40 per cent of the government budget each year to support the 246 central government enterprises and close to about 823 state-owned enterprises. These enterprises were planned to be sold off very fast and, some opponents would claim not fast enough, to inject cash into the state and efficiency into production. However, the BJP government put that on slow track: the new Congress

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government has other priorities. The sealed bid auction adopted by India for this purpose is admirably transparent, worthy of emulation by others in the few cases of privatization sales. But not worthy of praise is the behind-the-scenes manoeuvring by politicians at the time of award decision to obtain variation to the sealed bids, and through that process, as reported in the press, still continue corrupting the entire system of sales. The very same corruption has created a black economy equal to the size of the reported economy. One has just to visit shopping complexes in cities to see the purchasing power of the ordinary citizens loaded with money, a good part of which is suspected to come from the underground economy. It is still a highly regulated economy that has driven almost half its real activities underground. With the controls removed particularly on most of the capital items and all controls on the current accounts for the domestic producers, the Indian firms are now free to modernize, find new markets, and to improve productivity therefrom. The real sector has shown a good deal of adeptness at this as shown by the readiness to become more international in approach since 1992. Export growth responded well in double digits prior to the coming into power of the conservative government in 1998 with a platform to stop greater openness to foreign capital. Despite that rhetoric, more capital resources have been secured from abroad even after this government came to power, while FDI commitments were increasing right up until the explosion of India’s atomic devices, then missiles and then air force and ground force actions against the Pakistani positions in Kashmir. Then there was a terrorist attempt to bomb the Parliament in Delhi in 2002. These events have led to heightened security as if the September 11 event is not enough. Surprisingly at the urging of the USA, both Pakistan and India are making large-scale efforts to build bridges in their relations soured by 52 years of cold war between them. This situation was made worse by the coming into power of the ultra-national religion-based political party in 1996. Meanwhile, modernizing forces are looking forward to the continuation of further reforms – except perhaps in privatization (because of the entrenched debate on this issue) – with the coming into power of the more socialist-leaning Congress Party in June 2004. Till a resolution is achieved by India and Pakistan coming to terms with each other on the question of border disputes – progress in that is surprisingly fast in 2003/04 – as well as them coming to terms with the world to stop making more nuclear bombs, prospects for fast-track development are very slim. It was the desire also to catch up with the fast growing Asia that led to the widespread reforms we examined. Depending solely on the domestic expansion of economic activities will certainly recast India in the same slow growth mould as before. To break away from that Indian rate of growth, the country has to grow an external economy perhaps twice the size of the current one. India needs the world and the nationalist conservatives don’t see that

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Liberalization and growth in Asia

blatant truth. All the reforms that were taken will be to no avail if more reforms and greater openness to the rest of the world – this includes India’s neighbours – are not secured quickly to build on the momentum for growth. A Humpty Dumpty that fell and broke may not be put together by all the soldiers, so the saying goes! Membership of the WTO alone is insufficient when a developing country like India is not likely to welcome greater trade and financial dealings with other countries plus greater market opening by shedding the web of 50 years of rule-making to control freedom of economic activities even within the country. Political forces unleashed by nationalist and religious fervour over 1996–2004 of the BJP coalition government are serving as the warnings for outside capital and technology against coming into India even after 10 years of great openings already evident up to the year 2003. Since the coming back to power of the Congress government in 2004, a balanced growth strategy to include rural reforms has come to the fore, and this may presage a different strategy for growth during the next five years at least. However, the momentum for reform is well entrenched since the pros perity brought on by the limited reforms has become a tangible proof that this path is the correct one to follow for any government. It is the pace of liberalization that is under debate, not whether liberalization should be pursued.

NOTES 1.

South Korea also started its development from a position of a low-income poor country status. But its strategic choice of policy mix made a big difference compared with the choice made by India’s modernizing elites. As a result, Korea’s growth rate was closer to 9 per cent while that of India was 3.5 per cent. Korea became a member of the rich OECD club in 1997. It is also quite paradoxical that Korea experienced its worst crisis in its development history precisely because of the over-exposure to too much short-term external capital that began to dominate its finances in the 1990s. India should avoid this excess to prevent a similar exposure to private-sector-led collapse from taking too much short-term foreign debt to fasttracking growth. 2. The World Bank (1989) ranks countries by converting gross domestic products equivalent in purchasing power of the income levels of countries. This ranking would have us believe that India is the fifth largest economy. The Indian economy, if the GDP is measured in US dollar exchange rates, may be ranked to be among the largest 25 economies. 3. The arithmetic of development is strikingly simple. A growth rate of 3.5 per cent will double incomes in 20 years whereas it would take only seven years to double income if the growth rate is 10 per cent per annum. Thus, China almost trebled its income in half the time taken by slow-growing economies just to double their incomes. Of course part of the reason for China’s spectacular growth over 1984–98 is also the release of people’s enthusiasm unshackled from the controls of the Maoist era. Two other reasons are the FDI flows augmented by ethnic Chinese capital from Southeast Asia. 4. Using the 1999 exchange rate of R42.5 to US$1.00, India’s GDP is roughly US$390 billion in nominal terms and US$1700 billion in PPP equivalent. 5. India’s growth rate needs careful interpretation. In the years 2002–04, the agricultural production increased by 26 per cent mainly due to the good rainfalls in those years. When

India

6.

7.

8.

9.

10. 11.

12.

13.

129

prolonged droughts reduce agricultural output, the decline in this predominant sector may provide a false signal of industrial output growth. Corporate tax reforms were undertaken in the mid-1990s in India followed by income tax reforms taking place in 1998–99. All other countries (except China) covered in this book made significant fiscal reforms 15 to 20 years earlier to reduce the government budget by returning some of their economic activities to the private sector or by increasing revenues through a diversification of the tax base. That young leader was Rajiv Gandhi, assassinated in May 1991. A new government that came to power soon after that fateful event started the path towards liberalization. Some reforms are still continuing. A conservative government that came to power in 1997 for a brief period, and then ran the country from 1998–2004 did not deliver on the election promises to slow down the pace of reforms. On a visit to this country in 1997, an event that took place amazed the writer at the level of corruption. A foreign Indian visiting India decided to enrich himself through night burglaries. He stole jewellery from houses in a rich village. A village vigilante force caught the man and ensured custody in a police jail. The next morning the villagers found to their dismay that the officer in charge of the police station had freed the burglar. The burglar paid a huge bribe, took his passport and left the country! Much of the credit for saving India from collapse must be given to Manmohan Singh, a professor of economics in Delhi University and a one-time World Bank executive, who worked as the Finance Minister in the Rao government. How that man managed the Indian Crisis is a case worth studying in crisis management. In June 2004, he was elected the Prime Minister of the newly-elected government. We have met during study visits and in conference venues the very able men who are at the helm of managing the economy. The disparity between rural deposit and credit in the United States was at the root of demands for state bank licensing in the United States. This led to decentralized banking whereby states were given the right to approve branching within the state. This led to drastic consequences, which also led to the growth of bank holding companies to overcome the licensing limitations. The Glass–Steagal Act, which decentralized US banking, was amended only in 1994 to permit inter-state branching. Despite criticism of the Indian Civil Service as one mired in corruption, credit must be given to a core of dedicated officers. Some of them are found in key institutions such as the Central Bank. We had the benefit of meeting some of them. These officers have made a difference to the system by excelling in the task assigned. So, it is not surprising that the financial institutions under government control had often attracted the better officers as a matter of tradition. Even outside, one finds brave efforts being made to stifle corruption by top civil servants. The reporting system for FDI varies from country to country. China reports memorandum figures, that is, the promised figure signed in agreements. India reports the actual repatriated flows. As a rule, actual commitments can run from as low as 15 per cent to 70 per cent of the memorandum amount. Hence, the Indian figures for comparison with other countries must be multiplied at least by a factor of 2.5 to get the memorandum figures comparable with those reported for several other countries (e.g. Russia and China).

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Liberalization and growth in Asia

Appendix A record of bad interest rate management history (%) Category

As at 1 March 1993

As at 2 September 1993

Bank deposits Domestic term deposits Non-resident rupee accounts Savings deposits

Not exceeding 11.00 13.00 6.00

Not exceeding 10.00 12.00a,b 5.00a

Bank credit (non-exports) Up to and including Rs7500 Over Rs7500 to Rs 15000 Over Rs15000 to Rs25000 Over Rs25000 to Rs50000 Over Rs50000 to Rs200 000 Over Rs200000 (minimum)

11.50 13.50 13.50 16.50 16.50 17.00

12.00 12.00 12.00 15.00 15.00 15.00

0 13.00

0 13.00

13.00 13.00 13.00 15.00

13.00 13.00 13.00 15.00

17.00 22.00 17.00

15.00 20.00 15.00

6.50

6.50

4.00

4.00

15.00 15.00

15.00 15.00

Export credit (rupee) Credit on duty receivables Pre-shipment credit 180-day Post-shipment credit Demand bills Usance bills (46–90 days) Credit for govt incentives Pre-shipment (181–270 days)c Post-shipment credit Usance bills (91–180 days) Beyond 6-month shipment Other export credit (min.) Post-shipment export credit (US$, demand bills for transit period + grace period of up to 6 months from shipment date) DRI advances Term loans (agriculture, SSI and transport up to 2 vehicled Over Rs25000 to Rs200000 Over Rs200000 (min.)

Notes: a Effective date 1 July 1993. b NRE interest rate reduced to 11 per cent wef 12 October 1993. c With prior approval of Reserve Bank of India. d Effective 12 October 1993, structure of lending rates same for working, and long-term capital.

5.

1.

Indonesia: liberalization amidst exchange rate and now growing political stability INTRODUCTION

Continued political uncertainty was an entrenched state of affairs in Indonesia at the time of writing this chapter but it achieved some stability in 2004. Instability was true five years and two elections after the fateful resignation in May 1998 of General Suharto, who led the New Order government from 1966. He came to power after a bitter civil war stage-managed to pre-empt the likelihood of the Communist Party of Indonesia coming to power at that time. On the economic front, Indonesia underwent massive changes over 33 years as the structure of the economy was slowly changed from one that exported primary products in 1970 to one that could export 40 per cent non-oil manufactured exports in the 1990s. This dramatic change in the production structure of the economy could not have been achieved without a careful crafting and implementation of liberalization policies to improve the performance of the economy. Indonesia, which is the fifth most populous country in the world – a population of 210 million – managed to acquire some level of industrial capacity despite two critical weaknesses. It is a widely scattered country with hundreds of islands with a land area of 1905000 sq km with an insufficiently developed infrastructure and a scarcity of trained workforce, made worse by a failure to build schools and universities, resulting in endemic low productivity. Added to this is a second factor, the need for foreign capital to sustain a high economic growth to keep pace with the growing labour force. With these weaknesses, the currency had to give way several times to keep export competitiveness, and also to draw foreign capital to finance moves towards becoming a diversified economy. The result was a vicious circle of exchange instability shortly after each time the economy was put on the right path through reforms. Now the genie of political risk continues, and is likely to continue for many more years. After almost four years of a government elected with a free election, the government was unable to establish credibility. This led to the election in 2004, which resulted in a decisive win 131

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Liberalization and growth in Asia

for a new government with the election to office of a President with almost a two-thirds majority. Thus, has ushered a new era of stable government. This chapter documents the liberal policies put into action during a span of 40 years to 2004, which were destroyed by the sudden withdrawal of the guiding hands of authoritarianism in a poor and fragmented society. Of course, these reforms were speeded up again over 1998–2004 under the guidance of the IMF. The next section examines the structure of the economy, with special emphasis on the structure of the commercial banking. The details of the steps taken to stabilize this large economy and the consequences for policies are examined in section 3. We examine the circumstances that warranted the policies, and the effects of these policies. Special attention is paid to the policy impacts from financial liberalization: see sub-section 3.3. In the last section of the chapter, the reader will find a discussion of the experience of the Indonesian economy right up to the time of the baht crisis of 1997, and the chaotic years that followed.

2.

THE STRUCTURE OF THE ECONOMY AND THE FINANCIAL SECTOR

Table 5.1 provides a summary of socio-economic development in Indonesia since 1960. The Indonesian economy grew at an average growth rate of between 6 and 8 per cent per annum over the three decades following 1967, before going into the negative region for two years in 1998–99 and achieving very slow growth since then. Figure 5.1 provides a plot of the growth path and related statistics. The growth was the highest during 1990–96, which was secured on the back of too much short-term debt in the banking sector supporting long-term investments in the non-traded sector, which in fact led to Indonesia going into crisis along with four other neighbours. During the period of very good growth, per capita income grew by 4.7 per cent, which is very close to the growth in such exceptional cases as Malaysia and Singapore. Over the 1965–94 period, Indonesian per capita income changed from a base of 5.2 per cent to 13.2 per cent of US per capita (ADB 1998a). This is rapid progress in increasing wealth, about two-fifths the rise secured by a more politically stable Malaysia for example. As the economy had restructured as an exporter of non-oil and manufactured goods, consumption fell from its high of 87 per cent of GDP in the 1960s to about 67 per cent, progress comparable to slightly more than those achieved by large export-based economies. During this period, the government consumption was held steady at about 8–10 per cent of GDP falling towards 8 per cent after 1994, only to fall further after 1997. Fiscal balance as a percentage of GDP shows that the budget deficit was well under the 3 per cent mark widely considered as prudent even in the early

Indonesia

133

100.00 Real GDP CPI/100 M2

Growth rates

80.00 60.00 40.00 20.00 0.00 –20.00 1961 Figure 5.1

1966

1971

1976

1981

1986

1991

1996

2001

Growth rates of real GDP, CPI and M2, Indonesia: 1961–2002

phase over 1970–82. For a brief few years in 1991–95, the budget was in surplus by 0.5 per cent. This gave way after the crisis. The financial structure of the economy also provides interesting characteristics. The current account was persistently in the red until 1990. Since then it has gone into positive territory, and with the huge competitiveness in exports, it has been sustained there even after the crisis. In the early period of restructuring, capital goods imports and dependence on imports in general weakened the current account: the country imported more, by 2.7 per cent of GDP in the 1970s and 1.7 per cent in the 1980s. The current account improved to positive figures in the 1990s till 1994 but it deteriorated to –3.7 and –4 per cent in 1995 and 1996 respectively. The trade structure was becoming unfavourable along with the same patterns of weakening witnessed in the region as exports began to decline from about mid-1995. However, with the economy on full throttle openness by the IMF restructuring actions, trade has now increased to 75 per cent of GDP as of 2004. This placed heavy strains on the ability of the central bank to manage the currency on a band. The band was steadily increased to 12 per cent indicating the weakening resolve of the Bank Indonesia with less foreign exchange resources to defend the slow devaluation that started in late 1995. The 1997 Asian crisis gave a huge push to this trend, and the managed float was abandoned in August 1997 with disastrous consequences for the current account. The exchange rate overshot hugely, and the current account problem

Table 5.1

Basic economic and social indicators of development in Indonesia, 1961–2002

National accounts GDP growth (%) Per capita GDP (US$) Private consumption/GDP Government consumption/GDP 134

Financial indicators (%) Gross domestic savings/GDP Fixed capital formation/GDP Inflation (per annum) M2/GDP Fiscal balance/GDP Trade balance/GDP Current account balance/GDP Total trade/GDP Debt/exports Debt/GDP Foreign reserves/imports

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

3.72 – 87.32 8.72

8.00 254.36 67.51 10.16

5.51 551.56 58.01 10.23

7.13 853.71 57.41 8.72

1.02 819.94 66.69 6.76

4.90 723.20 67.71 7.08

3.32 676.35 67.02 7.43

3.70 819.00 70.70 8.20

– – 210.57 – – – – 25.36 – – –

22.60 19.80 17.48 15.44 –2.74 6.60 –1.20 40.64 – – 23.50

31.50 30.30 8.61 24.90 –1.44 5.01 –3.05 47.57 154.39 36.98 22.58

38.10 34.30 8.92 43.97 0.50 4.34 –2.28 53.15 132.53 36.16 26.58

27.40 23.10 19.44 57.07 –1.20 11.56 1.61 64.27 239.10 – 47.46

25.60 16.10 4.52 58.41 –1.20 16.45 5.25 62.94 194.00 – 58.51

24.90 17.40 12.02 56.68 –2.80 15.62 4.75 74.10 205.90 – 57.14

21.10 14.30 11.46 54.90 -1.70 13.40 4.20 73.66 – – –

Social indicators Unemployment rate (%) Expenditure on education (% of budget) Expenditure on health (% of budget) Expenditure on defence (% of budget) Population growth (%)

–

2.50

2.70

4.70

7.90

6.10

8.10

9.10

–

7.44

9.23

10.00

7.90

5.37

5.00

6.45

–

1.94

2.17

3.33

2.89

1.75

1.33

1.57

– 2.57

5.43 2.14

5.12 1.98

8.19 1.65

5.32 1.57

5.21 1.47

6.03 1.20

7.84 1.20

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

135

136

Liberalization and growth in Asia

then became a nightmare in 1998. The cash flows from the IMF rescue were keeping up the current accounts after August 1998. The IMF has returned the economy to a manageable stability, which has led to (a) improved reserves, and (b) a current account surplus. The IMF was about to end its mission in early 2004 with a scheme agreed to pay back the loans taken. Figure 5.2 provides the impact of these reforms on the reserve position of the country. Domestic savings were 22.6 per cent of GDP in 1971–80 against the actual capital formation of in the region of 21 per cent. The structural change suggested by these statistics can be seen in subsequent years. The savings rate increased continually to 38.2 per cent (largely the result of banking reforms), as did the fixed capital formation. This growth was achieved at the tremendous cost of high inflation and high interest rates to sustain a level of investment far in excess of what could be achieved without capital inflows. These inflows were courted from the first acts of liberalization by establishing the Foreign Exchange Bourse in 1967 to trade currencies and the laws passed in the same year to encourage capital and technology flow. Only the government or government-connected banks were licensed to do the lucrative currency trading. The high inflation rate of 17.49 per cent (average) per annum in the 1970s was brought to manageable levels of single digits in the subsequent periods. 120.00

6.00 4.00

80.00 60.00 40.00

2.00 0.00 –2.00

Interest rate spread

Exchange rate

100.00

8.00 ER IR Spread

–4.00 20.00

–6.00

–8.00 0.00 1961 1966 1971 1976 1981 1986 1991 1996 2001 Note:

There are no data available prior to 1966.

Figure 5.2 Exchange rate movement and interest rate spread, Indonesia: 1961–2002

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137

The Asian financial crisis reintroduced inflation, made worse by the civil disorder during 1997–99: in 1999 the rate was 54 per cent. Managing the inflation at the single digit level, while maintaining high growth under high interest rates to attract borrowed capital, over such a long period was the result of careful liberalization policies that addressed macroeconomic structural weaknesses. Lending interest rates were close to 20 per cent per annum during most of the period, which underlines the structural feature of the economy dependent on external funds flow both to support sovereign debt as well as to support private sector investments. Following the crisis, interest rates soared, but have since levelled down: the government bond yield has halved to about 10 per cent by 2004. There was a substantial restructuring in the money markets. Till 1984, there were no instruments in the money market with which the central bank could monitor the market rates. As a result, the money market structure was one where there were very few instruments to trade. Broad money to GDP was a mere 16.1 per cent in the 1970s. However, the structure of the money market changed dramatically after the introduction of SBIs (central bank acceptance bills) and SBPUs (commercial papers). The ratio changed to 52.5 per cent by 1996. Money growth has been managed very well to keep the inflation and exchange rates manageable. Despite these remarkable improvements, the money market depth was not sufficient to conduct monetary policies; hence the central bank resorted largely to interventions in the banking sector to conduct its policy implementation. Interest rate controls continued to be maintained. It was decontrolled only in 1993, when the central bank adopted a system of bids for SBI based on market rates. Thus, the structure of the monetary sector changed quite a lot in the period following 1984 and later in 1993. The social structure of the society also changed dramatically given the spillover effects of continued growth during 33 years. Wealth created remained at the top: the top 20 per cent of households retained 40.7 per cent of income while the bottom 20 had a meagre 8.7 per cent. Even Bangladesh had a slightly better wealth distribution! The financial crisis pushed the bottom half of the population below the poverty line, and that was the main cause of the political unrest with widespread poverty as more and more of the population got hurt by the collapsing economy. As can be seen in Table 5.1, the unemployment rate fell steadily – till just before and during the crisis, in recent years – as did also population growth rates. The decline in population growth was significant, having fallen from 2.14 per cent in 1971–80 to 1.20 per cent by 2002. With continued development, the government spent more money on health, which led to a higher survival rate (from 41.2 years to 63 years in 1993; infant mortality fell from 128 to 56) while education also received higher budget allocation.1 The literacy rate improved to 16 per cent

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Liberalization and growth in Asia

from the 1970 figure of close to three times that number. More women found employment in the formal sector. Exchange rate management has been disastrous. There were five episodes of large devaluations. The devaluations ranged from 10 to 50 per cent during 1971 to 1986: the value of the rupiah in 1996 was one-sixth the value of US$1.00 equal to rupiah 415 fixed in 1971 at the time of the rupiah’s peg to the dollar. The currency lost 76 per cent of its value in August 1997 following the contagion of the baht crisis and the dramatic resignation of the government during student unrest in 1998. Large devaluations were needed to bring the economy back to sustainable levels each time the problem assumed near-crisis proportions in 1971, 1978, 1982 and 1986. The 1997–98 crisis brought in the IMF to help restructure the economy burdened by a huge capital outflow and a bankrupt banking system. With greater liberal policies implemented since 1997 by the IMF, the economy responded sufficiently rigorously so much so that the exchange rate appreciated by a good 15 per cent to settle at about rupiah 8000 = US$1.00 by 2003. The second factor that created instability was largely Indonesia’s high consumption and low savings. Given its low level of capacity to mobilize savings, Indonesia depended heavily on imported capital throughout the period of graduating the economy from a primary producer to a manufactured goods producer by the end of 1989. To attract the capital inflows to achieve this status, it had to keep its real interest rates high, which partly explains why interest rates were largely controlled right up to 1992.2 A high real interest rate had to be maintained to attract capital in the face of the post-1982 substantial declines in oil-based revenues as the result of declines in world oil prices. The decision to move away from oil dependence was made in the late 1970s (oilrelated revenue provided 80 per cent of the state revenues then) when the oil prices were still on the rise. Two correct reform responses were implemented to improve the capacity to mobilize savings by liberalizing the financial sector – some say liberalized too much – with improved competition and improving the fiscal health by reforming the taxation policies.3 The banking and fiscal reforms were implemented in the early 1980s, which led to improvements in savings mobilization, both local and foreign, while the fiscal health also improved. The latter led to a reduction in the demand for capital from government, even though the private sector was not motivated to be prudent given the freedom they got in 1988 to raise foreign-currency loans in Indonesia or from overseas, a critically flawed policy since this created incentives for residents to undertake currency risks. Despite carefully structured reforms in the real, monetary, banking and fiscal sectors, the heavy dependence by the private sector on foreign shortterm capital flows and the government that financed off-budget expenses by

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139

borrowing from the Paris Club continued to create instability after each period of reforms. The private sector borrowing started to build up especially after 1989 when domestic firms started to invest heavily in (1) infrastructure projects and (2) luxury investments in golf courses, hotels, resorts, and others. Consequently, the private sector borrowing in foreign currencies increased substantially: this was similar to the Australian experience in the late 1980s. In 1997, this ballooned to a massive amount of loans, which, combined with the already existing public sector debt, brought Indonesia to a dangerous level of debt in 1997.4 Total debt increased from US$66.9 billion in 1990 to US$131.4 billion in 1997 prior to the baht crisis. Even with a healthy economy, debt coming close to 70 per cent of the GDP was not sustainable over any definition of affordability. The final outcome was dramatic and predictable. The exchange rate could not be defended in the face of a massive withdrawal of funds mostly by the locals when the 1997 baht crisis spread to Indonesia in September 1997. Political unrest made the crisis worse in May 1998 following the election of the president to a fifth term which brought demonstrators to the street. Soon, the rupiah lost 76 per cent of its value. The IMF moved in with a restructuring and rescue plan, and negotiations dragged on for the first half of 1998: in the case of South Korea, the negotiations were completed within four months. Carefully structured liberal reforms, often not effectively implemented in this country, could not overcome the persistent exchange rate instability even in this interesting case. When the weakest link gave way in August 1997 and once again in May 1998, years of gains from liberal policies of Indonesia were decidedly lost within two years. The economy is estimated to have lost 15 per cent of GDP during 1998/99 and the recovery to any modest growth was not foreseen before the year 2001 (the actual growth in that year was slightly above 3 per cent). Growth returned slowly as the political situation improved, and was around 6.5 per cent in 2003. In summary, the Indonesian economic transformation is noteworthy as is also its collapse under political unrest. A largely primary producer in the 1960s successfully adopted expansionary policies that helped it to emerge as a diversified economy with significant industrial capacity. A measure of the success of the policies right up to about 1993 is the manner in which each episode of instability was managed by implementing liberal policies that helped the economy to steer back to normalcy after a short period of heightened crisis four times over. It is currently going through its worst period of financial instability aggravated by political uncertainty. The progress achieved during the 32 years to 1996 has often been highlighted by the reduction in poverty in this populous country. The percentage of the population living below the poverty line declined from a high of 60 per cent in 1960 to under 10 per cent in 1996 (see Nasution 1998a): this has

140

Liberalization and growth in Asia

significantly increased in 1998 as a result of the crisis. As will be documented later, the Indonesian currency experienced its worst currency overshooting in 1998, and it would take some three more years before growth would hover above the negative region as recovery set in with improved terms of trade with the overshooting of the currency. This is the price, it appears, that the country paid for neglecting prudential supervision of the financial sector so that it became less than robust, and so-called deregulation that permitted the capital structure of firms to weaken so badly that each dollar of shareholders’ funds supported about five dollars of debt burden, as a result of which the financial sector was ripe for the crisis and the political crisis worsened the situation in May 1998. Additionally, the exchange rate liberalization that permitted firms to borrow locally in foreign currency as well as from foreign sources provided incentives to investors, both individuals and producers alike, to place huge currency deposits in the expatriate financial centres in foreign countries. The structure of the financial sector had gone through rapid changes. In the 1960s, the structure changed slightly when foreign banks and joint venture banks were permitted to make a market in the Foreign Exchange Bourse. Otherwise, the banks were mostly private-sector owned. Following its 1984–86 liberalization, the banking sector changed dramatically with the entry of large numbers of banks and non-bank financial institutions. At this period there was also more specialization with the licensing of specialized development and other banks. The rapid growth in banking and in non-bank financial institutions helped the economy as Indonesia extended its manufacturing and export capabilities. The 1997 crisis had seriously reduced the capacity of the financial sector as the overshooting exchange rate wiped out most of the assets of the financial institutions. It was reported that most banks would fall within the category of defaulting. There was restructuring imposed on the economy from the end of 1998 to year 2003. It was expected that the government would require the banks to renegotiate their private loans with the bilateral parties involved: this they did, and the banks are now recapitalized under new or previous owners. Some help was extended in the form of restructuring funds to domestic depositors. Beyond that, the banking sector has been seriously damaged by the crisis, and restored to operation with massive government bailout, then recapitalization, and in some cases, the banks were bought by foreign banks.

3.

LIBERALIZATION

Indonesian society emerged from a continual state of civil disorder from 1939 to 1964 with its independence movement (1939–47), leading to a period of unifying the diverse nation of 26 ethnic groups under one language. Then it

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141

had to grapple with the aborted Communist coup in 1965. Thus, at the start of its reform process at the end of the 1960s, Indonesia had only one strength. It had been woven into a nation by its vitriolic founders, Soekarno and his team mate Hatta. The country was among the poorest, and the period of civil strife had left basic infrastructure destroyed or unattended. It was the discovery of oil that came as a saviour for Indonesia. At least it provided some foreign exchange to engineer growth through reforms. This it did during the early period when oil prices soared thus giving huge revenues to the government. The Indonesian liberalization can be grouped under four episodes, after which the 1997 Asian crisis necessitated a fifth episode of IMF-type market opening and restructuring of the economy. ●

●

●

●

●

1966–70: Foreign sector liberalization: The reforms were aimed at stabilizing the economy by bringing the inflation (112 per cent) down and to obtain foreign capital for investments and for foreign exchange needs to support the imports. 1970–78: Directed credit to diversify the economy led to high inflation. To contain this, the central bank took over foreign exchange transaction and pegged the currency at 415 rupiah to one US dollar. 1978–82: With falling oil prices and therefore falling oil revenues, reforms needed to revamp the financial sector on a more competitive basis by deregulation and private sector incentives. To address the fall in government revenues, the targeted credits were eased off slowly and tax reforms improved revenues. 1982–92: Genuine reforms to restructure the economy on a balanced basis. Reforms improved macroeconomic stability from 1984, and led to a period of 10 years of exchange rate stability after 1986. (There were no significant reforms till 1998 under the IMF.) 1997–2002: IMF-led reforms to open current and capital accounts, break-up of barriers to entry, prudential reforms and monetary reforms along with of course free floated rupiah.

These reforms addressed the periodic instability that arose from its underdeveloped status at the starting point. Reasonable success was achieved in that the real income grew by average rates of about 7.5 per cent per annum despite the less developed starting point. The inherent instability, which arose from the need to be competitive in the face of stiff competition from the regional players, was managed periodically without getting out of control. However, the 1997 currency crisis which followed on from the baht crisis and the May 1998 political crisis led to loss of control, and the economy has become mired since 1997 into severe instability. The IMF has restructured the economy, which has led to reasonable currency stability, current account surpluses for

142

Liberalization and growth in Asia

four years, and reserves running at about US$50 billion in 2003. Prudential supervision is being centralized in a new body. The details of the successful reforms are examined below. 3.1

Economic Reforms

The highlights of the economic reforms to be described later are summarized as key statistics in Table 5.2. As can be seen, the 1970s and early 1980s have had some success with reforms. Much of the growth from liberalization took place from the mid-1980s to 1996. What were the bases on which Indonesia managed to diversify its economy and obtain the substantial improvements in all the variables included in the table? For this to be fully understood, one needs to examine the four sets of reforms that the policy-makers put in place over the years. Reforms I The New Order government that emerged after the worst civil unrest of 1965 had to manage the economy to find jobs for the huge unemployed labour force. The exchange rate had to be managed to bring in expatriated capital. To these ends, three reforms were put into place: a banking reform; a capital account opening for foreign capital; and measures to ease inflation. The banking reforms introduced currency trading in the Foreign Exchange Bourse, where foreign banks and joint venture banks were permitted to take part. This stabilized the black market for currencies, and encouraged repatriation of capital as well as helping to improve confidence. Indonesians were among the first to provide capital account openness to foreign capitalist in 1970, way ahead of many others. This was designed to attract skills, technology and capital to Indonesia. These reforms had the intended effects. The exchange rate stabilized, foreign capital inflow essentially to primary processing industries surged. Inflation, which reached 112 per cent in 1967, abated to 8.8 per cent by 1970 while GDP, which was growing at the moribund rate of 2.25 per cent before, jumped to 6.65 per cent in 1970. Exports jumped by 64 per cent over the period. Thus, the macroeconomy was stabilized within five years of the most severe civil disorder that gripped the country. A solid foundation was made to experiment with more reforms. Reforms II The next set of reforms were more ambitious. These aimed to develop indigenous manufacturing capacity away from the heavy dependence on manufactured imports that drained foreign exchange – recall that the current account deficit was –3.7 per cent – and away from the over-dependence on oil,

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143

which provided 80 per cent of government revenues. With the high-priced oil providing the revenues, Indonesia could well afford to practise what South Korea and Taiwan had also done to home-grow manufacturing capacity. One thing that was missing in Indonesia was the well-educated high quality labour that is essential to home-grow manufacturing capacity; the immigration policy also did not encourage large-scale injection of skills. The capital provided as targeted credits to desired firms in preferred industries failed to create any viable industries after about ten years (Woo 1995). Meanwhile, the oil prices were softening in the closing years of the 1970s presaging a need to review the targeted credits policy. The exchange rate was pegged to the US dollar. These reforms had one desirable effect. Inflation from the effects of directed credits was brought down from 33.7 per cent at one time to 6.7 per cent. The price for that were two sharp devaluations of 10 and 50 per cent in 1971 and 1978 respectively. Reforms III With the failure of the targeted credits to home-grow manufacturing capacity during a period of fast declining oil prices, Indonesia had to adopt more comprehensive reforms rather than take less bold steps like the previous ones. But this was postponed in favour of an urgent need to stabilize the exchange rates. The peg to the US dollar was abandoned in favour of a less rigid management. In its place, a managed basket peg was put in place using the trading partner currency weights. This was implemented in November 1978 with a huge devaluation of 50 per cent. Malaysia and Singapore had adopted a basket peg in September of the same year, and the then favoured policy was to adopt this method of management. The current account now returned to a more market-determined exchange management supposed to redress the exchange rate instability that had built over the years. Over-investment in the non-traded sector was curtailed. Protected industries with a preferential exchange rate had to adjust to market discipline. Overall, the inflation declined to 7.2 per cent by 1979 and export surged by 50.2 per cent. Some degree of diversification began to emerge as the economy moved to diversified exports. Reforms IV The long-postponed comprehensive reform had to be undertaken now as the oil income declined fast from 1982 on. Revenues were declining, and diversification was beginning to occur. The comprehensive reforms took fourfold directions: banking reforms and capital market reforms to improve mobilization of capital; reforms to encourage foreign direct investments; tax reforms to improve revenues through a point-of-production tax on producers; and strengthening monetary management of the economy. These reforms were

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Liberalization and growth in Asia

more financial in nature, and will be described in the next sub-section. The effects of these reforms were to turn the economy towards a stable path for the longest period over 1983–93. In fact there was only a small devaluation (by Indonesian standards) of 31.6 per cent in 1986. A small fiscal surplus resulted; current accounts improved; exchange rates appreciated slightly; and the foreign capital surge to Indonesia was the largest in the region excepting China. Suffering and recovery after crisis Following the contagion from the baht crisis in May 1997, the weaknesses in the Indonesian economy and the political system began to surface. With the full foreign exchange openness available to producers and individuals, the private sector began to take too much debt. The banks were borrowing short, often in foreign currencies, and lending the money to firms that undertook land-based investments in the non-traded sector (hotels, resorts, condominiums, shopping malls, etc.). Often the borrowing was done directly with foreign banks or even foreign firms. Thus, the public debt, which was under control, now had new debt multiplying soon in the private sector. The contagion from the 1997 Asian crisis hugely destabilized the Indonesian economy. There was an attempt to control the private sector loans when a Foreign Currency Co-ordinating Committee was set up to control the private sector bad-debt problem in 1991: but the attempt did not seem to have had any effect. If it did, it was temporary. Since the currency turned out to be the major factor in destabilizing the country, its impact on interest rates and exchange rates is depicted in Figure 5.3. The IMF rescue plan has led to a reasonable success. The exchange rate regime changed to free float in August 1997; by 2003, the volatility has subsided to a lower level. The central bank was made autonomous to pursue stabilization policies.5 The weakest link in the reform process had given way, and the effect was to unravel the gains that accrued to Indonesian society over 33 years of carefully executed reforms. 3.2

Financial Liberalization

The individual reforms to bring in the financial (and economic) transformation of this country are summarized in Table 5.2. The important financial reforms will be discussed under several sub-headings below. The reader will recall that the earlier section included a brief discussion of the economic reforms. Exchange rate policies Indonesia, like most other countries during the Bretton Woods period, was in a fixed exchange regime. It changed in 1971 when it switched to pegging

Indonesia

80.00

Growth rate

70.00 60.00

80.00 M2 M1 FR/IMP

70.00 60.00 50.00

50.00 40.00 40.00 30.00 20.00 10.00

30.00 20.00

Foreign reserves to imports

90.00

145

10.00

0.00 0.00 1961 1966 1971 1976 1981 1986 1991 1996 2001 Figure 5.3 Foreign reserves to imports ratio and growth rates of M1 and M2, Indonesia: 1961–2002 against the US dollar. A basket peg was put in place from 1978 to July 1997: see also Figure 5.2 mentioned in section 5.2 of this chapter. The intervention band was increased from 2 to 12 per cent during 1991–96 in the face of worsening current accounts. During the 33 years of exchange rate management, constant devaluations of exchange rates returned the economy to stability and competitiveness: in 1971 (10 per cent devaluation); in 1978 (50 per cent); in 1983 (40 per cent); in 1986 (31.6 per cent). These episodes turned the economy around each time helping to reduce inflation, and ensuring surges in exports. Indonesia had persistent exchange rate instability caused, in our opinion, by its low factor productivity, which in turn is largely dependent on the education and skills of the labour force apart from the technology employed in the secondary sector. The exports were largely composed of labour-intensive outputs of intermediate goods and semi-processed manufactures: only 16 per cent of the 40 per cent of exports were non-labour intensive. Sixty per cent of the exports were primary goods. However, with the more comprehensive reforms carefully put in place during 1984–88, the economy achieved a good degree of stability. Exchange rates stabilized and even appreciated a little; inflation was a modest 7–8 per cent; government budget was in the black; and there was large capital inflow. But then the current account began to deteriorate from late 1995 along with several Southeast Asian economies, prompting more frantic attempts to

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Liberalization and growth in Asia

Table 5.2 Major economic and financial reforms in Indonesia (1952–2002) Liberalization policies implemented Prior to first reform 1952 1965

First reform 1966–69 1967

1969

Second reform 1971–78 1970

Jakarta Stock Exchange reopened; Dutch firms nationalized Economic stabilization to reduce inflation and ease exchange controls Laws passed to encourage investments – local and foreign Economic stabilization Legalized private trade in foreign exchange through Foreign Exchange Bourse New Bank Act permits foreign exchange by foreign banks and joint venture banks Approved local banks permitted to trade in foreign exchange (bank devisas) Non-oil exporting capacity Foreign investment laws to ease entry of foreign capital, technology and skill, especially for primary sector capital-intensive activities

1971

Peg rupiah to US$ at 415 rupiah after a 10% devaluation; exchange rates unified to two, one for all transactions and 10% lower for essential items Central Bank takes over foreign exchange transactions; Foreign Exchange Bourse almost abolished Major policy of directed credits to preferred firms to create industrial capacity

1970–76

Danareksa established to distribute National Investment Certificate in unit trusts

1977

First local firm listed on the Jakarta Exchange

1978

With the aim of making Indonesia competitive for non-oil exporting, the rupiah devalued by 50% in November 1978

Indonesia

147

Third reform 1978–82 1978

Towards non-oil export capacity and foreign investments Exchange liberalization; basket peg to trading partners’ currencies Special exchange rate for foreign capital and central bank takes a swap to cover the risk Directed credits over 1970–82 failure; reduced directed credits

Fourth reform 1982–92 1982–83

Banking and FDI reforms Banking reforms introduced easing entry of non-state banks and non-bank financial institutions to mobilize savings and expand credits to support non-oil based expansion

1983

Real sector liberalization with tariff reduction, entry of foreign firms

1984–85

Monetary policy instruments: SBI (bank bills) and SBPU (commercial papers) introduced to create money markets for monetary intervention Repos and CDs introduced later to improve liquidity in money markets

1987–88

Capital market reforms to ease listing requirements, lift price limits, entry of more brokers and easing of foreign share ownership to 49%

1986–89

Tax reforms to strengthen public finance; introduced point of production value-added tax; reduced personal tax since collection was not easy

1988

October: Public sector banks allowed to place up to 50% in commercial banks Banks authorized to issue foreign exchange loans in domestic markets and individuals were permitted to deposit in any currency (at devisas)

Crisis after reforms 1991 Adopted prudential regulations; restricted CAMEL and related party lending to improve quality of commercial banking Continued overleaf

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Liberalization and growth in Asia

Table 5.2 Continued Liberalization policies implemented 1991

To cap surge in private sector borrowing, committee formed to control foreign borrowing by private sector firms

1992

Stock exchange privatized in August; reorganized

1993

Interest rate now determined by market forces in SBI market Between 1992–97, exchange rate intervention band widened to 12%

1995

Controls on finance company lending; no new licence; borrowing to net worth restricted to 15 times (domestic) and 5 times (foreign)

1997

August: Abandoned peg as Thai baht crisis spread; rupiah crisis; abandoned basket peg

1998–99

Rupiah rescue with help from Australia, Japan and Singapore failed Indonesia accepts IMF restructuring and rescue plan Lifted controls on interest rates by letting market rates determine SBI tenders

2000

IMF rescue plan after losing control of exchange rate devaluation Bank restructuring agency (IBRA) set up to take over bad bank loans to recapitalize the banks; the financial crisis led to all except 30 of over 300 banks collapsing. Import relief for service sector introduced

2001

Inflation had come down with central bank focus on credit control, and monetary targeting to gain control of the economy. Year-on-year inflation running at 76% brought down to less than 20%. Monetary target set at moderate level of 4–6%; Bank Indonesia adopted guidelines for better management of risk; supervision is planned to pass to a new body, Financial Services Supervision Institution

2002

A target for non-performing loans set at 5% for 2003; inflation targeting has been revised down to single digit Blueprint for financial system revealed; scripless and

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149

automated trading of SBIs; other trading innovations introduced across the financial system for improving efficiency Six pillars of banking system developed for Indonesia for discussion in 2003 A target set for the cessation of IMF activities by end 2003 with negotiated payments of loans 2004 Sources:

Agreement signed to cease IMF activities Bank Indonesia reports; Asian Development Bank reports; Nasution 1998c.

counter exchange rate declines. Then came the baht crisis, which spread to the rupiah in August 1997. Soon after, a political crisis relating to news of the fifth term for the president increased the country’s troubles. The result was a market devaluation, in fact an overshooting of the currency by 75 per cent. An IMF rescue plan started in mid-1998, and growth was then expected to decline till 2001 before any positive growth could be had. However, the economy grew by about 3 per cent in 2001, and has since grown faster. By 2001, the exchange rate had started to recover, which was 20 per cent improved compared with the previous year. However, with the Bali Bombing incident in October 2002, the economy, already suffering from the September 11 incident, hit a bad track and the worldwide slowdown of economic activities. Bali has since recovered its attraction to worldwide tourism: tourism has recovered to about 70 per cent of the 2001 level by year 2004. Interest rate policies If there was a macro-finance variable that was most managed, it was the interest rate. It was set administratively or by some intervention of the central bank throughout the period till 1993. Prior to the serious attempt at banking reforms in 1984, the interest rate was largely determined by the government banks, which dominated the deposits as they accounted for about 80 per cent of them. Deposit interest rates were very low even though lending rates were very high, having always hovered above 15 per cent with a huge spread. Even in the more stable 1990s, lending rates were in the region of 18.9 per cent (1995) to 25.2 per cent (1991): it is about 12 per cent in mid-2004. These high rates had to be maintained to sustain the huge capital flow needed to bankroll industrial development in the 1970s and 1980s and land-based developments in the 1990s. The main reason for the high interest rate was its control. With the abandonment in 1993 of the band within which the SBI bids had to be made, interest rates were largely market determined. The SBI discount provided the floor for interest rates. After this reform, interest rates began to

Table 5.3

Growth of financial and capital market indicators for Indonesia (annual averages)

Exchange rates (% change) Share price returns 150

Interest rates Discount rate Call money rate T-bill rate

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

– –

6.20 –

11.93 –

4.07 –

51.64 2.09

7.21 –9.11

21.84 –17.87

–9.25 11.55

0.00 0.00 2.10

0.00 7.96 11.10

1.88 13.17 13.81

13.44 11.79 17.34

18.96 27.69 22.92

14.53 10.32 12.50

17.62 15.03 15.48

12.93 13.54 15.50

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

Indonesia

151

move away from around 20 per cent towards 17 per cent during 1993–96. By 2002, call money rate has come down to about 13 per cent. Table 5.3 provides a summary of these trends. Another reason for the high interest rate in earlier years was the expectation among foreign exchange traders that the real interest rate was low because of inflation. This reason (International Fisher Effect) is perhaps the more important one since there were expectations of built-in devaluations periodically. A third reason for high interest was the relative under-development of the money markets to signal a going rate in a competitive situation. It was not till the mid1980s that sufficient instruments were available to determine the going rates for money: the SBIs issued by the central bank and the SBPUs introduced by the private sector to raise short-term money. Later on repurchase agreements (repos) and negotiable certificates of deposit (NCDs) were introduced. These increased the depth of the market, and the base interest rates began to emerge from the late 1980s. This process has helped the central bank, which uses these instruments increasingly to conduct monetary interventions. Monetary policy and the central bank Monetary policy was conducted using the reserve ratios and interventions in the commercial banking sector as a matter of expediency given the lack of a liquid market for monetary interventions. This was the state of affairs till the second half of the 1980s. With the advent of the SBI as the instrument of intervention, things began to change slowly as the liquidity in that instrument began to build. In addition to these, the central bank engaged in foreign exchange sterilization and swaps to manage the exchange rates as required during the peg with the US dollar (1971–78) and under the basket-peg regime later. There is a difference of opinion about the efficacy of the intervention. One opinion is that the interventions were ineffective as the clout to demand compliance by the banking sector was not available to the central bank. That is an extreme view, in our opinion. The more moderate position is that the authorities had conflicting demands placed on them because of the targeted credit policies that were in effect till 1983. With that abandoned, they had less conflict. Over the years, certain conglomerates who had the ears of the politically connected groups could and did get away from supervision as happened in a number of cases made public in the 1990s. An example is the case of a private bank which had a related party loan exposure amounting to 60 per cent of the base capital! This sort of escape from basic norms could not happen without the complicity of the central bank. This diminished the ability to conduct unfettered prudential supervision as well as damaging the ability to intervene decisively in a number of serious situations. Nevertheless, it must be stated that the considerable good results that came about from major policy implementations, no doubt within

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constrained situations, must have come about from reasonably competent policy execution. The central bank took the initiative first in 1970 to introduce an exchange rate clearing house to obtain market rates for the exchange rates. That was a success till the adoption of the peg to the US dollar, when foreign exchange transactions were abrogated to the central bank. With the adoption of the basket peg and later reforms to the capital accounts, foreign exchange was returned to the banking sector with sterilization intervention within the central bank. Prudential regulations adopted with the 1984 banking laws helped to reform the banking sector somewhat. Related party borrowing was restricted while a revised form of the CAMEL system (a system of assessing the capital as advocated by the International Bank for Settlements) was put in place to improve prudential regulations. Competition increased, deposit mobilization and deposit rates improved. There was large-scale movement of deposits to private sector banks. In 1983, 80 per cent of the deposits were in government banks. By 1989, the private banks had 80 per cent of the banking system deposits. This was a dramatic turnaround. Service quality improved, and the network of branches improved throughout the country. So did also the proliferation of bad (Kane, the renowned banking scholar based in Boston College, would call it ‘zombie’) banks with little expertise but licensed to take in public savings and to lend. Seriously thought-through reforms and restructuring efforts in the banking sector under IMF advice have led to a good foundation being laid for future recovery of the banking sector. The IBRA has failed to deliver the stability it promised; it is about to be closed down in the year 2004 if current demands materialize soon. Capital markets The Dutch colonialists had developed a vibrant capital market for trading commodity-related capital, bonds and loans. This fell into disuse during the war years and until 1952, when it was revived mostly for the purpose of nationalizing the Dutch firms, and then distributing the shares to locals. Nothing much happened till 1977, when it was revived again to distribute national certificates in unit trust shares. In that year the first local company was listed: that was just about a dozen years before China. Growth was incremental till the comprehensive reforms were made. The capital market was looked at favourably as the place to privatize public sector firms and plans were put together to study its feasibility in the 1980s. Three significant reforms in capital markets were made. Capital from abroad could be obtained from 1988 onwards. In that same year, listing requirements were eased, more brokerage licences were issued, and ownership of 49 per cent shareholding by foreigners was approved. At end-1989, there

Indonesia

153

were 57 firms listed compared with 214 in 1994 and about 255 in 1997. Capitalization improved from rupiah 434 billion in 1988 to rupiah 104 trillion in 1994! This brought in foreign capital inflow. Volume improved, and prices surged. More companies sought listing on the market. These improvements continued to develop the capital market as listing improved to over 200 companies. The basic premise of the reform was that a private-sector managed bourse will do a better job than a government managed exchange. This is a lesson still not yet learned by transition economies such as China, where the exchange is managed by bureaucrats but with most modern technology at their disposal. The next reform was the privatization of the exchange when the government ceased control of it, vesting it as a private limited company self-regulated by member companies. The trading system was automated in line with the regional practices in neighbouring countries. This 1992 reform was the most telling in that the Jakarta stock market significantly improved its attraction as Indonesia’s major market. The total listing as at 1998 was 283. After privatization, traded value increased from about rupiah 7 billion to about 25 billion. Foreign interest in traded value dominated by a factor of 7 :2. Prior to the currency crisis, the market was capitalized at 45 per cent of GDP compared with 3 per cent in the 1970s. Summary The foregoing discussion, though brief, described the importance of financial reforms to stabilize the economy as it periodically lost competitiveness. Exchange rate reforms and interventions appear to have become a permanent feature of the financial reforms in Indonesia. Next in importance was the need to keep interest rates under control till exchange rate stability was achieved in the early 1990s. Interest rate decontrol was the last of the reforms put in place. The comprehensive package of banking, monetary, tax and exchange rate reforms during 1982–88 was noteworthy in that these reforms actually returned the economy to a level of stability not seen hitherto. However, bigger forces, particularly political forces and excessive short-term debt financing land-based development in the 1990s, led to a massive overshoot of the currency when the baht contagion and then the political unrest worsened the stability that the Indonesians thought was in their grasp. Indonesia spent the years 1998–2000 recovering from these shocks. The weakest two links in the reform process – political oligarchy and financial fragility in firms and banks – led to the awful outcomes unexpected by any observers. Well into the year of the crisis in 1998, the administration thought that Indonesia would bounce back as it was presumably on a good path to stability! Events proved otherwise, and the IMF spent all of 1998–2004 reforming the economy.

154

3.3

Liberalization and growth in Asia

Financial Liberalization Effects

Macroeconomic effects The overall impact was a rapid growth in income over the 32 years. With an average rate of growth of about 7.5 per cent during most of the period, Indonesia emerged out of its position as an impoverished nation with 60 per cent living below the poverty line in 1970. International sources showed the steady decline in this one key statistic till it went below 10 per cent in 1998. As is the case with the South Korean experience of almost 10 per cent growth, which lifted that country from its lowly status in the 1960s, the liberal policies pursued in Indonesia lifted the economy to become reasonably developed. Inflation, which was above 112 per cent in 1967, was brought down steadily to around 15 per cent during the 1970s and 1980s. With the more comprehensive reforms taking effect in the late 1980s, inflation was brought down to single digits during 1990–96. Government revenues from a diversified economy kept phase with new development needs. Revenues grew ahead of the growth rates. Money market growth rates were steady as the central bank developed incentives for the financial sector to develop new instruments. The growth was sufficient to enable some monetary interventions to be done through the market as well as letting these new markets reveal market rates. Foreign direct investments started to flow especially after 1986. Next to China, Indonesia attracted the most capital inflows. On exchange and interest rates Exchange rate policy was a crucial component in the policy mix in this case. From as early as 1967, managing the exchange rate was a critical element to maintain its competitiveness as well as, through a high interest rate policy, to attract inflow of capital. Part of the reason for the exchange rate instability was the inclination of the producers and individuals alike to taking capital out and depositing in foreign currency whenever there were hints of uncertainty. This was facilitated by pretty open capital and current accounts as well as two specific actions namely to let the firms borrow directly from overseas and for loans to be opened in foreign currencies within the country. This was as if the central bank was encouraging people to switch to and fro to foreign currencies, thus undermining the confidence in the currency of the country. The exchange rate, which, under the peg to the US dollar was fixed at rupiah 415, slowly depreciated to the 1996 rate of rupiah 2383. At the height of the political crisis in May–June 1998, the rupiah reached a low of 17000 to a dollar. By the start of 1999, it had recovered to around 7500 to a dollar: it was rupiah 8500 in mid2004. This rapid decline was due to the need to realign the economy to gain competitiveness several times. It can be seen that the rate of depreciation was

Indonesia

155

the highest during 1981–90. The rate of decline slowed considerably in the first seven years of the 1990s. Interest rates were maintained at very high levels, in double digits, throughout the period. With the interest rate liberalization in 1993, the spread between the deposit and lending rate narrowed to about 3 per cent in subsequent years before the crisis – during the crisis it widened by 9 per cent. The spread remained high during the rest of the period for 1999–2001. The lending rate was close to 20 per cent while the deposit rates were below the lending rates by a margin of about 6–8 per cent during most of these years. The money market rate, however, was closer to 10 per cent. This created incentives for firms to borrow in the short end of the market as the difference between the short and long rates was very large. However, with better liquidity in years 2003–04, the spread has narrowed to about 4 per cent or even less at times. The statistics in Table 5.4 underscore the importance of external capital inflows as a result of the mid-1980s reforms. From an average of about US$250 million to US$600 million in the early years, foreign direct investments increased fivefold during 1991–94. Since then, they doubled again during the years prior to the crisis. The total flow in the 1991–97 period amounts to a US$23 billion injection of capital representing an average of 15 per cent of the GDP. Next to China, this is the largest flow of foreign direct investments. Portfolio investment also increased particularly after 1992 following the privatization of the stock exchange and capital market reforms to permit foreign entry. Gross fixed capital formation improved over the years from the low of 20.7 per cent during 1976–80 to the high of 36.1 per cent of GDP in 1996: this fell marginally during 1997–99. This was the nexus for growth. Most of this improvement was due to the financial liberalization that attracted capital into Indonesia as the economy diversified into manufacturing over 1978–96. The FDI as percentage of GDP also shows this massive dependence on foreign capital. Just like the Korean firms which began to borrow from abroad after 1996 and thus built up too much debt in the corporations, so did Indonesia although its government managed its side of the finances more carefully. Tests of financial liberalization (Ariff 1996, p. 335) showed that the openness indicator of the economy improved to 0.681 during this period. This suggested a level of financial liberalization equivalent to that of Thailand though not as high as Malaysia with its openness indicator of 1.00. Thus, the financial reforms strengthened the financial sector to manage the high growth economy. Overdependence of firms on short-term and foreign currency loans at the time of worsening trade had the potential to destabilize the economy in ways unknown to the economic managers. That was the key reason for the collapse of the economy. The reader should recall that the bottom 20 per cent of the population was receiving less than 9 per cent of the GDP compared with

Table 5.4

Indicators of financial and capital market depth in Indonesia (percentage annual averages) 1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

–

32.14

46.43

58.79

64.89

62.31

–

Intermediation depth FIR (total)/GDP (=DC/GDP) FIR (private)/GDP

16.39 16.72

21.33 22.39

48.96 49.23

60.80 42.35

66.50 21.58

60.94 20.46

– –

Capital accumulation GFCF/GDP FDI (net)/GDP FDI (inflow)/GDP

19.80 – –

30.30 – 0.44

34.30 – 1.41

23.10 – –0.09

16.10 – –2.99

17.40 – –2.26

14.30 – –

0.08 0.08

0.27 0.27

– –

– –

– –

0.84 0.84

– –

Money depth (M3/GDP)

156

Indebtedness Domestic borrowing/GDP Foreign borrowing/GDP Notes: M2 = M3 = FIR: GFCF: FDI: FDI (In): DC:

currency + quasi money. M2 + other deposits. financial intermediation ratio; claims on public and private sector (total credit), on private sector (private). gross fixed capital formation. foreign direct investment (net). foreign direct investment (inflow). domestic credit.

Sources: IMF, International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

Indonesia

157

the top 20 receiving around 40.7 per cent. When the currency induced economic decline during August 1997 to April 1998 pushed a large segment of the population below the poverty line, it created the mob riots that brought about the political demise of a pro-reform regime on 20 May 1998. The question asked is ‘Is it the financial crisis that led to the Indonesian economic decline?’

4.

ASSESSMENT AND FUTURE PROSPECTS

The market had assessed the worth of an Indonesian economy burdened with too much short-term debt in the 1990s. The 1997 Asian financial crisis and the May 1998 political crisis had revealed the danger of short-term money financing long-term investments. Without a credible wealth distribution, the danger of a fast slide into poverty was unanticipated by the ruling elites. It also revealed the lack of implementation of prudential regulations, which led to far too many instances of misdemeanour in the financial dealings of large conglomerates, some of whom simply abused their close relationship with the political power centres. This has set back many years of wellearned gains. In fact, the years 1998–2002 had become years of decline and a painful road back to a mere 4–5 per cent growth, which is insufficient to even provide enough jobs for new entrants in the labour force. Over 1998–2003, the IMF has done a satisfactory job of restructuring to lay the foundation for recovery with political risk brought down by a move away from confrontation politics and the return of a strong mandate in the July 2004 general election. The Indonesian economy had persistent instability during its development stage. The authorities were able to maintain control by using the exchange rate management to absorb other inefficiencies. Fundamental reforms to improve factor productivity had not been carried out and must now be undertaken, starting with improved standards of general educational achievement and vocational skills. This reform can only be secured in the long run, but action must start soon. This is the key to improving labour productivity, which in turn will take the pressure off for huge devaluation to perennially redress a loss of competitiveness. Higher labour productivity, which would help increase the labour share of a growing economy, along with capital inputs should alleviate the persistent problems of this economy. Finally, the central banking authorities must seize the new freedom they had won to engineer an efficient intermediation market by improving prudential regulations. Much of what will happen is pretty uncertain as the IMF moves are very slow in the face of political events moving fast in this vast country of islands spread over such a vast area of the Indian Ocean, from India on the west and the South China Sea in the north.

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NOTES 1.

2.

3.

4.

5.

Indonesia did not spend as much as did other similarly fast developing countries. The initial step in this direction was taken as sekolah pondok (‘school in the hut’ literally) in the 1960s, from which it has not been accelerated to the levels of modernization found, for example, in Malaysia or South Korea. In this respect, Indonesia has many things in common with South Korea, which too had greater demand for capital but it mobilized savings locally by establishing a balanced budget at a very early phase of its economic development. Next, it lowered input costs by controlling wages for a long period of time. Other policies pursued enabled Korea to overcome its capital inadequacy right up to the early 1990s, when massive short-term borrowing, also coupled with a political crisis, led to the Korean won losing 75 per cent of its value. Comments in 1999 in the international press suggest that private bank licences were granted without too much care for a country with very little banking expertise. This led to too many inefficient banks making imprudent loans without the careful oversight of an independent central bank. The total debt of US$131 billion consisted of about 50 per cent medium-to-long term debt. Of the 50 per cent which was short-term debt, US$49 billion was borrowed from banks: of this, US$19.7 billion had a term of one year. The total debt was about two-thirds the GDP value! The external and local short-term debt amounted to US$34.7 billion in 1997, about 32 per cent of the GDP (Nasution 1998c). In one of the author’s (Ariff) meetings with the officials of Bank Indonesia in September 1998, this phenomenon was very apparent. Everyone was aware of the epochal change that had been brought on the Bank. The restructuring of the bad loan banks is being pursued professionally, unlike in the earlier period, when high officials were transferred for pushing through actions consistent with prudential regulations. If this new-found freedom is cherished and improved on, it will be the financial sector that will benefit.

6.

1.

South Korea: a case of capital account liberalization, growth collapse and reforms to recovery INTRODUCTION

The Republic of Korea (South Korea) is situated in the southern part of the Korean Peninsula, which is to the north-east of China and to the west of Japan. South Korea has a population of 46 million within a small land mass since most of the land was kept by North Korea at the partition in 1955. Its development efforts started in the 1960s from the basement, so to speak, as a low-income country, but graduated to the middle-income within 20 years and then to upper-middle income status by the end of 1990. A very significant feature of the Korean development experience is that South Korea experienced continuous growth from 1960 to 1997 with only one short-lived recession in 1981. The economy grew steadily at an annual average rate of about 8.5 per cent then. That aside, the Korean experience is also unique in development literature in that this high level of continued growth was based on one-sided openness to take advantage of the post-war trade liberalization of the developed and developing countries to which South Korea sent its exports. Japan had secured growth for a long time in much the same manner a short while earlier without a simultaneous easing of entry barriers into the domestic economy. An important fact is also that the 1997–98 Asian financial crisis affected South Korea’s output very severely in 1998 with GDP declining 7.8 per cent, the largest ever decline. As a result of this massive shock to the economy a year after it opened its capital account fully in 1996, it had increased debt levels by 67 per cent (US$55.3 billion) over just two years. Under the restructuring efforts of the IMF, South Korea rapidly adopted the kind of reforms that it had shunned during the high-growth period to recover control of the economy.1 Thus, this analysis brings to the fore the need for balanced reforms as an important lesson from this case. Korea’s economic development is based on an earlier experience followed by Japan, and is different from the later approaches of the potential tigers in that they relied excessively on foreign capital and technology. The strategy followed was to turn to industrial restructuring to make the economy an 159

160

Liberalization and growth in Asia

industry-based production machine, and then develop through reaching out to the rest of the world as a newly industrializing economy just as Hong Kong, Singapore and Taiwan were pursuing similar policies at about the same time. The achievement of sustained high growth had done many good things to the Korean people. The quality of life improved significantly for Koreans as a result of the successful economic development. Life expectancy has improved by almost 20 years since 1965. Infant mortality rate declined to 11 per 1000 births over the same period. Poverty and illiteracy have been reduced to nil in this country while education received a large share, about one-fifth, of the government budget: similar figures are true for other fast developing countries. A symptom of a developed economy is that most of the population (84 per cent) live and work in cities and the capital city is home for one out of three Koreans. South Korea was admitted to the OECD group of developed countries in 1997 after three years of careful analysis to ensure that it would have the kind of institutional framework required of a member. The per capita income, which was 9 per cent of the US income in 1965, improved to 48.8 per cent in 1995. This rate of improvement has not been matched by any except the city economies of Hong Kong and Singapore, both of which have the revenue of a country but not the land mass of one typical country to spread the expenditure, hence having a distinct advantage not available to South Korea, indeed to most countries.2

2.

ECONOMIC AND FINANCIAL SECTORS: AN OVERVIEW

South Korea, with a middle-sized population, has a very large economy essentially built on external-oriented liberalization to turn the country into an industrialized economy. To move the economy from its dependence on the export of light manufactured goods, efforts were made to restructure the economy towards high-value-added manufacturing since 1970 and they paid off well. With some serious strains, the restructuring has been a success, judged with hindsight. The share of primary produce in exports was 35.2 per cent of all exports in 1975 compared to the share of 8.1 per cent in 2002. Similarly, the share of the scale-incentive electronics exports increased from almost nothing to about 50 per cent of the manufactured exports over the same period. South Korea’s trade amounts to 67 per cent of the GDP. This suggests the extent of restructuring from light manufactured goods to highvalue-added manufacturing during 1987–2002 has been a successful experiment. Manufacturing is the mainstay of the economy now with services and agriculture (about 10 per cent) taking a lesser share of the economy.

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161

Almost four-fifths of the population lives in urban enclaves, working in the industries. 2.1

Economic Development

Typical of such an external oriented economy, private consumption declined from the high of 67.4 per cent of GDP during 1971–80 to about 50 per cent in 1997. Government consumption was held down at about 10 per cent during those 27 years. With near fiscal balance during the same period, the trade sector provided a strong source for the expansion of the economy while at the same time the savings generated were directed to investments in the private sector. Gross domestic savings increased from 22.3 per cent over the years to the 1995 high of 35.1 per cent.3 This and the healthy external sources for funds – which were possible when firms were permitted to borrow from outside in the 1980s – enabled a higher rate of fixed capital formation by securing more funds than were available domestically. The country, caught up in the Cold War politics of the 1950s, was divided with the agriculturally productive part of the land going to North Korea, which still adheres to Communism. With very few natural resources except a large population base, and ravaged by civil war (the Korean War killed two million), it can be argued that South Korea’s dire preconditions provided the proper environment for a government-directed development programme with an authoritarian character. South Korea modernized and reformed its domestic economy but adopted a one-sided openness to the rest of the world to take advantage of the post-war opening that was occurring in all developed countries and in some early reforming developing countries. After the careful implementation of the development strategy during the first two economic plan periods over 1961–70, South Korea saw a quick transformation of its economy, one that was based on exports of light manufactured goods to the rest of the world. This strategy based on creating competitive small-tomedium enterprises, paid off handsomely with the economy registering an 8.4 per cent growth per annum during the 1960s: see Figure 6.1 for a plot of the history. That period of growth absorbed the unemployed labour pool and importantly legitimized the development efforts directed from the top by governments that could only be called authoritarian. See Table 6.1 for details. The population growth was fairly high in the 1970s – 1.69 per cent – but the growing economy absorbed the expanding workforce. With prudent government consumption at 10.2 per cent of GDP, there were large savings of 23.6 per cent of GDP.4 The external trade terms were very good as South Korea was the second country to put faith in export-led development, and its external sector provided more funds for the expanding economy. With import

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Liberalization and growth in Asia

80.00 Real GDP CPI M2

70.00

Growth rates

60.00 50.00 40.00 30.00 20.00 10.00 0.00 –10.00 –20.00 1961

1966

1971

1976

1981

1986

1991

1996

2001

Figure 6.1 Growth rates of real GDP, CPI and M2, South Korea: 1961–2002 substitution policy of the earlier years, South Korea saw a huge foreign capital build-up. In 1962, it decided to rely no more on foreign direct investment and stuck to that decision till 1997. Inflation during this period was very high averaging 16 per cent: the rest of the world also experienced high inflation during the 1970s and 1980s. Inflation in Korea abated from the double-digits figure of about 16 per cent to the year 2002 figure of 2.2 per cent. The 1970s saw the restructuring of the economy towards a reliance on heavy and chemical industries that heralded the HCI era. This scheme was not exactly similar to the one in India led by the Oxford economists but in the Korean case it was without the huge economic base of a large country. The cash-rich Indonesia followed a similar policy to generate an internal capacity for production through low-interest capital support to selected industries: Indonesia was then earning huge cash from its oil exports. Investment in heavy industries was actively supported by the Korean government to produce highvalue-added exports, not import substitution. Though the switch to a HCI economy required a number of liberal policies, these policies were implemented only internally and the Korean economy opened at best only modestly to the rest of the world. The next phase in the 1980s witnessed a series of reforms to redress the strains of the move to restructure the economy. It started after the 1980 economic recession, Korea’s first recession since 1956. In the rest of this

South Korea

163

chapter, the reader will find extensive details of the reforms undertaken in this period. The upshot of this was that the economy was put on an even keel very quickly, and reforms started to yield favourable results. This is a period when serious efforts were made to timetable a sequence of financial reforms to open the economy to the rest of the world. The average on all indicators improved. One example is the massive decline in bank discount rate to as low as 5 per cent and another is the decline in inflation to a single digit that headed towards 5 per cent. Soon came a different concern. The admission of South Korea as a member of the OECD was expected to herald an era of development. There was a large degree of closedness in the financial sector as well as the real sector that had helped to protect the domestic enterprises. These were not going to be sustained. Besides, the citizens were demanding a greater share of the wealth placed in the companies under various forms of protection of the industries. Greater transparency in the management of the economy and the corporate sector was needed. Political transformation began to occur. The events connected with these demands led to political changes in the 1990s. During that very period of such severe political strains came the Asian currency crisis, which crippled the Korean economy in 1997–98. The outcome was a series of reforms to make South Korea adopt balanced reforms to open its sectors to the external economies, now under the tutelage of the IMF team of experts. The economy recovered by 1999 and a lot of reforms were put in place to free this economy from rigidities such as the dominance of production by large cartels (some 36 chaebols controlled by rich families creating political patronage), barriers to entry in financial sectors, etc. The results were astounding. The recovery has placed South Korea back on track, only diminished by the continuing advantage for small-goods manufacture that China poses with its controlled exchange rates. The economic transformation over the 1960–97 period required a series of changes to the structure of the economy as well as the financial sector. This will be examined in the next section. The impact of the reforms on the social conditions in South Korea is now described. As noted earlier, it managed to increase its per capita income at a steady rate so that it improved dramatically to the 1997 figure relative to the US of almost 50 per cent. This general improvement in the income level was also achieved with moderate inflation except in the 1970s. Thus, the benefit of this can be seen in improved socioeconomic indicators. Korea is one of the few countries with safe drinking water both in the cities and in the rural areas. It has a 99 per cent literacy rate, and the standard of education has been improved, with about a quarter of the government budget going towards education. Life expectancy improved from 49 in the 1950s to 74.9 in the 1990s for females and 46 and 67.3 for males. Infant mortality declined from 115 per 100 in the 1950s to the present 11.

Table 6.1

Basic economic and social indicators of development in South Korea

164

1961–70

1971–80

1981–90

1991–95 1996–2000

2000

National accounts GDP growth (%) Per capita GDP (US$) Private consumption/GDP Government consumption/GDP

8.46 155.00 79.75 10.73

7.49 867.00 67.56 10.18

8.66 3153.00 57.07 10.56

7.47 8341.00 53.55 10.32

5.06 9408.00 56.04 10.33

9.33 9761.00 57.31 10.05

Financial indicators (%) Gross domestic savings/GDP Fixed capital formation/GDP Inflation (per annum) M2/GDP Fiscal balance/GDP Trade balance/GDP Current account balance/GDP Total trade/GDP Debt/exports Debt/GDP Foreign reserves/imports

– 18.48 – 18.94 –0.65 – – 28.66 108.98 7.37 32.09

22.30 27.51 16.48 32.74 –1.72 – – 67.54 49.95 13.55 15.58

32.00 30.17 6.39 36.15 –0.84 0.40 0.73 67.72 39.61 13.64 12.75

35.30 36.97 6.21 40.05 –0.18 –0.76 –1.30 57.64 36.45 10.20 19.16

33.70 31.57 4.00 58.61 –1.80 4.05 3.05 76.78 14.40 – 35.34

32.40 28.39 2.25 79.13 1.30 3.66 2.65 86.53 10.90 – 49.76

2001

2002

3.10 6.35 9025.00 10006.00 59.14 60.17 10.37 10.56

30.20 26.96 4.06 84.77 1.30 3.16 1.93 82.21 13.90 – 60.02

29.30 26.74 2.77 87.01 3.80 2.97 1.28 78.59 9.40 – 65.70

Social indicators Unemployment rate (%) Expenditure on education (% of budget) Expenditure on defence (% of budget) Population growth (%)

–

–

1.84

–

15.91

18.89

1.69

1.18

2.70

–

5.00

4.10

3.78

3.11

18.92

19.00

14.52

18.10

16.20

1.01

0.95

17.70 0.90

16.40 0.70

15.60 0.60

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues).

165

166

Liberalization and growth in Asia

These social statistics would justify placing South Korea among the top five developing countries to have achieved remarkable socio-economic improvement through an external-oriented development strategy while also achieving a degree of domestic ownership of the means of production unparalleled in East Asia with the exception of Japan. 2.2

Financial Market Development

The financial structure of the economy also underwent substantial changes. We discuss here the structure of the budgets and of the financial sector. The financial structure was based from the beginning on the restricted model, which relied upon a limited number of financial institutions providing the basic and some specialized financial functions. Foreign banks were permitted to enter but not the foreign manufacturers. Domestic banking was expanded, but the foreign banks permitted into South Korea could not expand their network because of branching limits. Some degree of import protection was put into effect right up to the mid-1980s, the key reason being that the infant industries nurtured under the policy loan (i.e. the term used for government directed bank loans) regime needed protection for a period of time: this was legitimate under the then GATT rules. The external balance of the economy suffered severely: the trade deficit averaged –6.3 per cent and the current account declined to –5.6 per cent of the GDP. Inflation shot up to 17 per cent and the interest rate for borrowers was the highest during this 10-year period at 13.7 per cent. There was over-investment in the heavy industries, and capital was redirected at the expense of the more competitive small-to-medium enterprises. Unofficial finance enterprises sprouted all over the country to meet the capital needs of the latter. The banks that were told to direct policy loans had not much left to give to the other more productive sectors. This laid the basis for the birth of a new entity, the nonbank financial institutions to meet credit needs. Nevertheless the average economic growth was yet again 8.4 per cent during the 1970–79 period. This costly but timely switch to high-value added production paid off later. The Bank of Korea (BOK), the central bank, was not independent of the government till it was restructured in 1997–98 following the IMF intervention. During most of the period, the government was able to influence the financial sector through its control of the BOK as well as having shareholdings in the key deposit-taking institutions shown at the next level. The commercial banks were mostly owned by the government and they had the most influence in the market till the reforms of the mid-1980s. There were a large number of foreign banks – about 80 in the 1990s – but they operated under restrictions on branching at least until the late 1980s. This meant that the government-owned commercial banks tended to dominate domestic financial transactions. The

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167

specialized banks were also owned by the government, and these were instrumental in targeting financing to priority areas during the economic restructuring of the country. As part of the reforms in the 1980s to create institutions to cater for the demand for funds for the small-to-medium enterprises, the non-bank financial institutions, (NBFIs), were licensed. These formed the third category of financial institutions. The capital market was reorganized and that constituted an important source of fund-raising for the larger enterprises. By the end of 1987, South Korea’s share market became the second largest in Asia next to that of Japan. Broadly, the financial reform in the 1960–79 period was extensive within the domestic economy: see Table 6.2, a summary of reforms. The banking structure was expanded, and special banks were licensed to cater to the needs of newly emerging special situations as the economy was being restructured towards high value-added production. Foreign banks – some 70 of them – were permitted to support the economic linkages that were occurring as trade expanded. By 1979, total trade had become almost 35 per cent of GDP. This is also consistent with the financial institutions following trade theory in the banking literature. The creation of special banks helped to target investment to preferred industries, which built huge over-capacity on the back of capital subsidies and import protection.

3.

LIBERALIZATION

Liberalization could be described as cautiously advancing one-sided reforms till 1994. From 1995 liberal reforms were made under the behest of OECD till mid-1997 and thereafter by the IMF restructuring schemes. Liberal policies were implemented during 1960–97 to the extent consistent with the aim of developing the economy through exports of manufactured goods and services. The reader will find that South Korea took advantage of the external openness in the developed and some developing countries and reciprocated by opening its economy as little as possible to other countries. Next, it adopted a policy of balanced government budget and reliance on internal funds as much as possible; the large external trade providing a steady injection of funds for expansion. Therefore, the main reason for reforms of the financial sector was to enable the sector to cope with the greater fund needs for a fast-growth situation and to facilitate capital formation. While domestic financial reforms gained speed steadily on account of the sustained income growth, reforms to the financial sector was aimed at keeping abreast of the internationalization of the Korean economy. Thus, from 1961 on, several specialized deposit money banks (DMBs) were licensed, the first being the Industrial Bank of Korea. There were a total of six specialized

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Table 6.2 Major economic and financial sector reforms in South Korea (1961–2002) Liberalization policy implemented 1961

Industrial Bank of Korea to finance small and medium enterprises

1962

Fisheries Credit Bank Cooperatives; 85% foreign investment, so policy reversed

1963

Citizens National Bank to provide small loans to firms and households

1967

Korea Long Term Credit Bank to finance capital for the manufacturing firms Korea Housing Bank to finance housing loans

1969

Export–Import Bank of Korea to finance exports and imports of Korean firms

1974

National investment laws to develop and support heavy and chemical industries

1976

Credit guarantee laws to help policy loan firms with inadequate collateral

1979

Industrial restructuring through heavy industries had created over-investment, and there were imbalances in the economy. To address these concerns, a 20% devaluation of currency was made

1980

The peg with US$ was abandoned in favour of a managed exchange rate To fight inflation from the unproductive policy loans, wage setting was introduced along with control on interest rates and reduced government budget

1981

Tax reforms were made. Among them, the special tax treatment of key industries was substantially reduced. But 100% depreciation permitted to reduce shock Laws to assist credit and banking sector of the livestock co-operative sector National housing policy laws to help workers obtain state-built housing

1982

Most preferential interest rates abolished or reduced. But

South Korea

169

interest rate control on long-term securities were put in place 1984

Major change: certain financial intermediaries permitted to set interest rate but lending only within a certain range; so, no decontrol of interest rates

1983–85

Banking reforms: government divested its share in major commercial banks; barriers to entry relaxed; additional commercial banks, finance companies, mutual savings companies

1986

Industrial promotion laws replaced with industrial development laws

1984–88

For the first time, major import liberalization; liberalization ratio improved from 80% to 95%. Average tariff on imports reduced from 24% to 18% (1998: to 7%) Capital account still controlled for fear of flight; but foreign borrowing for capital and materials liberalized

1988 (Dec)

Further decontrol of interest rates for long-term but not short-term nor for deposit rates

1989

Laws to control major shareholdings in companies; 12.4% individual holdings brought down to 2.25% by 1995

1985–89

Because of the effects of the policy loans that affected the banks throughout the early 1980s, non-performing loans shot up to 10.5% in 1985–86; to reduce this, BOK lent 1700 billion won low interest loans to the banks and made a subsidy of 189 billion; this led to inflation of 9% and to a real estate boom; by 1989, NPL reduced to 5.9%

1988–89

Further financial reforms with more commercial bank licensing, entry to NBFIs outside the capital city permitted

1990 (March)

Major switch to ‘market exchange rate’ based on the previous day’s average exchange rate (August 1997 free float in the face of the Asian crisis)

1996 (July)

Capital account freed for the first time

1997 (Sept)

Onset of currency crisis; IMF invited; fully floating currency Large-scale reforms under IMF restructuring scheme started (see text) Continued overleaf

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Liberalization and growth in Asia

Table 6.2 Continued Liberalization policy implemented Industry reforms were two-pronged. First, the entry barriers were lifted to improve competition 1997–99

The free float of the currency was continued. Although the currency did not recover completely, it has settled at about 30% lower than the level before the crisis; this made Korean exports in durable markets very competitive Capital account openness was continued as well; this facilitated the sale of assets to help the economy recover speedily in 1998–99. Capital shortage of the type that plagued this economy in earlier years was eased

2000

The power of the chaebols, which came from their dominance of the economy, was eroded with anti-cartel laws supported by pointed reforms to break up that dominance Korea adopted laws to limit the firms on how much loans can be taken; a time schedule was adopted to reduce the high debt–equity levels to no more than a level considered safe for the economy. Those with levels higher were given time to bring the debt levels down

1998–2002

Entry barriers in the financial sector were slowly removed The IMF-led reforms restored this economy to health again; economy grew by 6.5% per annum over 2000–02. Its only weakness is that, like many other economies, its exports are not competitive with those of China with an undervalued fixed currency

Sources: Bank of Korea reports; IMF announcements in 1998 and Reuter’s reports.

DMBs, four NBFIs and six other fund-related institutions. The Korean Stock Exchange (KSE) was expanded to cater to the fast developing economy. In 1980, there were 352 firms listed with a value of 2.421 trillion won: by 1992, the heyday of the stock market boom, there were 688 firms with a capitalization of 84.712 trillion won. That represents a phenomenal growth of 31 per cent per annum. The bond market was also expanded though not at the same speed. During the same period, corporate bond value increased to

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171

32.7 trillion won from 2070 issues. The value of government bonds also increased to 32.5 trillion won. Overall, the capital market reforms made it possible for firms to take good advantage of the growth potential in the economy. 3.1

Economic Reforms

The South Korean economy at the end of 1996 – prior to the crisis – was the second largest economy in East Asia with a gross domestic product of 376 trillion won or US$454 billion. This also represented a progress to the uppermiddle income status among the nations. This level of growth was reached after a series of far-reaching reforms that successfully moved the economy from the status of a low-income country in 1960. The four stages of reforms Opening to the World, 1960s South Korea had become a divided and poor country in the 1950s largely because of the Cold War conflict. To secure growth and to move towards the status of higher income country, South Korea adopted a strategy of planned changes through industrialization. The security needs of the country were taken care of by the American security umbrella. South Korea marshalled its domestic resources to manufacture consumer goods produced with labour-intensive methods. It therefore based its expansion on exporting its light manufactured goods all over the world, particularly to the developed markets. South Korea was the second country after Japan to do this. It paid off very well, and led to a level of prosperity, which became threatened when other countries notably Hong Kong and Taiwan (as well as some Central American countries) started to compete in the same export markets. When the first oil shock hit the economy in 1972, it became clear that the country needed to move to higher value-added manufacturing to avoid becoming non-competitive with more entrants into the consumer light manufacturing route to development. Ambition towards heavy industries, 1970–79 This led to a slow restructuring of the economy towards reliance on heavy industries. This was labelled the HCI policy, for heavy and chemical industries policy. This required some degree of protection. So, tariffs were increased for some sectors. An ambitious programme of reforms in other sectors followed. Foreign financial institutions were permitted during this period, but these were restricted to operating as single entities without branching permits. Most of these banks came from the countries to which South Korea was exporting its manufactured goods or importing materials. But the economic policy pursued was to enable the heavy industry firms to become profitable as soon as possible. This was done through

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Liberalization and growth in Asia

preferential treatment of the national priority firms and through cheaper policy loans to enable capital investment. As this expansion continued, the second oil shock occurred in 1978. The after-effect of subsidizing these heavy industries began to take a toll in other parts of the economy. The strains led to a major recession in 1980. Reckoning costs and reforms, 1980–91 The next 12 years saw a gradual phasing out of the subsidies to the heavy industries, and redressing the damages to financial institutions and small-to-medium businesses. First, industry specific incentives were phased out slowly, import restrictions on domestic firms were lifted, and limited financial liberalization was set in motion, the last being the outcome of pressure and the Plaza Accord. While the reforms were taking the protection off the heavy industries, the government ensured that the heavy industries that had become burdened did not get wiped out. The government’s National Investment Fund was set up using the pension fund balances, banks also participated. Initially, the import liberalization ratio had declined to 40 per cent, but it was permitted to go up to 57 per cent in 1980 just to sustain the protection needed for the heavy industries soon after the second oil shock. The peg to the US dollar was abandoned and a flexible exchange rate introduced in 1980. Soon after, the interest rate came under control, wage formation was returned to wage settlement schemes and dividends were reduced. As a result, the current account deficit was cut by 60 per cent in 1982 while inflation declined from 25 per cent to 7 per cent. Tax reforms made in 1981 reduced the special tax treatment to the supported industries. Depreciation was permitted at 100 per cent to reduce the shock from withdrawal of financial support. The supported industries came under a threeyear rationalization plan to make them efficient. When the economy began to respond by 1983, further opening to the rest of the world was made in the forms of gradual reduction of tariffs from 95 per cent in 1984 to 18 per cent by 1988 and later to 7 per cent by 1998. This introduced competition gradually, and the crisis of the type that plagued Indonesia with similar policy loan withdrawal had been, by 1998, avoided by South Korea. Move to balanced reforms, 1990s There followed several financial reforms that will be examined later. However, the reforms of the three periods to prepare for the changeover to an industrial economy were more or less completed by 1991. What remained to be done was to bring in reforms in the financial sector and to create a balanced norm for reforms needed for a more mature economy by the end of 1990. This came in the 1990s, which led to (1) a market average exchange rate and (2) capital account opening in 1996 and (3) planned liberalization of interest rates thereafter.

South Korea

173

After signing the Restructuring Scheme agreement with the IMF, South Korea took extensive reforms that covered all aspects of the economy, except perhaps the agricultural sector. Barriers to entry were removed in both the industrial and financial sectors that in earlier periods had promoted cartel-like behaviour as well as large firms influencing policies using their dominance of the economy. The influence of chaebols has been waning since 2001 because of laws that restrict their behaviour. The reforms have prepared the economy to have efficiency and openness that were lacking in earlier periods. 3.2

Financial Liberalization

The postponement of extensive financial reforms by the adoption of basic reforms to support the economic restructuring in the real sector has been seen by some observers as the best way to insulate a fast growing economy from external shock. It is also consistent with the widely-held view that financial opening must come at the end of other reforms. This is interesting in that such sentiment is now being expressed as a desirable theoretical position by some economists after twenty years of financial crises in several developing economies. The capital account was tightly controlled for fear of capital flight since more capital was needed by the heavy industries. But the foreign exchange needs for capital and material requirements were made readily available. Between 1981–83, the government started divesting its shareholdings in commercial banks. The entry barriers to the sector were eased and more banks were licensed during 1988–89 while entry barriers to NBFIs outside Seoul were scrapped. Limited reforms to interest rates were started in 1984 for the first time, about a quarter century after planned growth was put in motion, very unlike Indonesia. Certain financial intermediaries were permitted to set their own interest rates within a broad band. When the market gained some experience with this reform in interest rates, most banks were permitted in 1988 to set their rates for RPs (repurchase agreements). However, the short-term deposit interest rate was still fixed. That mattered significantly to depositors, whose interest rates were still fixed. Corporate trust account interest rates were decontrolled only in 1987. These measures were meant to open the financial sector to become more efficient, and to ride the bad policy loan effects that kept dragging the economy in the early 1980s. With a limited opening of the capital market to foreign investment, the KSE – Korea Stock Exchange – experienced a boom in 1986–89. This helped the banks to raise equity to overcome the lingering effects on them from their participation in the failed policy loans to heavy industries. As a result of these reforms to overcome the negative effects of

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Liberalization and growth in Asia

the policy loans scheme, the economy recovered and registered an average growth rate of 10.4 per cent during 1985–91. These two favourable events acted as precursors for major financial reforms that would be planned for the 1990s. With these structural reforms in place, one would imagine that Korea had a more open economy. But there were several institutional barriers that would prevent the extent of opening one would have expected at every stage of the economic development. This continued to be an irritant in bilateral negotiations of trading countries. Major economic and financial sector reforms are summarized in Table 6.2. Exchange rate policies South Korea adopted a cautious policy of exchange rate reforms. The won was pegged to the US dollar right up to 1979. A switch was made in 1980 to a managed float regime. The weight on US dollar was large on account of South Korea’s large trade with the USA. This was adopted only after the 1979 devaluation of 20 per cent. The exchange rate was fixed at 484 won to a dollar during 1974–79. After the managed float, it declined to 659.9 won to a dollar, a decline of 36 per cent. The managed float along with the imposition of controls on the non-corporate sector foreign transactions kept the managed float working for a while. The exchange rate worsened to 890 by 1985, but improved thereafter following the recovery of the economy: see Figure 6.2 for a plot of the exchange rate and interest rate history. The first of the reforms was the adoption of the market-average-rate system to manage the foreign exchange. Recall that a managed float was put in place in 1980 after abandoning the peg to the US dollar. Under the new system the day’s exchange rate was set at the average of the last day’s exchange rate. This was implemented from March 1990. South Korea is the only country in the region covered in this book that moved from basket managed float to a quasifree float based on market average. It is reported that the volatility in the real exchange rate declined substantially after this reform. This is one reason why the currency crisis of 1997 was not from the exchange rate but from too many short-term loans taken by the industries. When the Asian crisis hit the exchange rate in September 1997, the exchange rate was left completely to market forces, thus it is fully floated. In the following year, the capital account was fully opened under the IMF instruction. With the financial and real sector reforms in the 1980s, the economy started to perform better, registering a high growth of 7 per cent in 1981 after the 1980 recession. By the middle of the 1980s, the managed float had led to an overvaluation of the won. Pressure began to mount especially from the United States for more realistic exchange rates. After prolonged efforts, South Korea accepted a return to a more market determined exchange rate. This was

South Korea

14.00

5.00 ER IR Spread

Exchange rate

12.00

4.00 3.00

10.00 2.00 8.00 1.00 6.00 4.00 2.00

0.00

Interest rate spread

16.00

175

–1.00

–2.00 0.00 1961 1966 1971 1976 1981 1986 1991 1996 2001 Note:

Data on interest rate spread are not available from 1961–80.

Figure 6.2 Exchange rate movement and interest rate spread, South Korea: 1961–2002 reluctantly done only in March 1990 and the so-called market-average exchange rate management was adopted. The result was actually a decline in exchange rate by 5 per cent in 1990. The improvements in exchange rate over 1985-89 under the managed float was making South Korea less competitive, and the depreciation was welcome relief. Under the market-average exchange rate system, the exchange with the US dollar was set within a range of the weighted average of the inter-bank rates on the previous day. That base rate was used to set the exchange rate with other currencies. This had the effect of returning the exchange rate, though still managed within a band, nearer to a market-based system. This was only abandoned in 1997 because of the Asian currency crisis. The exchange rate freedom achieved was not matched with capital account freedom. The capital account was still tightly controlled. But the exchange rate was allowed to be set freely in the market with little intervention within an ever-expanding band. South Korea is continuing, as at year 2004, with the free float even though there is pressure to return to some form of management of the currency. Compared to most countries, South Korea had adopted very cautious exchange rate management right up to the time when it considered that the real sector had most of its problems sorted out and by keeping the capital account

176

Liberalization and growth in Asia

still closed. Since the economy was based on the trade sector playing the more important role, it made sense to reduce exchange rate uncertainties within a band. There is merit in this cautious approach. It is difficult to fault the logic of limited reforms in the light of the heavy toll the more reformed Asian economies had to pay while the exchange rates of the Asian economies that did not adopt exchange rate reforms did not suffer exchange rate declines. The adoption of cautious external open condition for the real sector and the preservation of strict controls on individuals wanting foreign currencies helped traders during the light manufacturing era (1960s) and the heavy industry era (post-1970s). The exchange rate management of South Korea differed quite significantly from those adopted by the ASEAN countries. ASEAN countries moved to managed exchange rates very early in the 1970s, and also adopted full capital control opening to attract foreign direct investment. Even the non-corporate sector had free access to foreign exchange. Most ASEAN economies adopted a form of managed exchange rates. Since the trade flows in the ASEAN countries are based on foreign direct investments from several countries, the trade-weighted exchange rate management was markedly different from that of South Korea. Its trade-weight with the USA was quite high – recall the pressure from the United States for freeing the exchange rate during the 1985 Plaza Accord – because of South Korea’s large trade dependence with the USA in the earlier period. The volatility of the exchange rate declined substantially in the period 1990–96 when the exchange rate was determined under the market exchange rate system.5 However, when the capital account was freed in July 1996, it set in motion some powerful forces that would lead to a huge flight of funds in the fourth quarter of 1997 leading to a 75 per cent decline in exchange rate, and a major recession in 1998. But in the period 1996–97, the fund flow into South Korea had accelerated after the capital account opening. When the crisis started in July 1997 in Thailand, the open capital account along with the market exchange rate system could not stem the outflow resulting in a 75 per cent devaluation of the won within a six-month period. Interest rate policies The World Bank in 1989 praised South Korea’s liberalization as exemplary for its economic growth. But this is not exactly correct. While domestic liberalization helped to create the kind of favourable conditions to support the economic expansion, the external economy had been kept under control to a large extent. Among these, the important ones were the control of interest rates on deposits throughout the period and the limited lifting of interest rates for producers since 1991–92. Control on interest rates has been a binding feature of the economic management of South Korea during the entire period of this

South Korea

177

study. It is with the entry of the IMF restructuring that interest rates have been freed after the Asian crisis. There are three features that can be identified on interest rate policy. First is the desire of the authorities to make capital as cheap as possible as a prop to develop real-sector capacity during the restructuring period towards a heavy industry focus. Policy loans channelled through the largely governmentowned financial institutions prior to 1986 ensured that the priority sectors received capital at low interest rates or there were some forms of favourable treatment, one of which was the setting up of the promotion fund to protect the heavy industries when the policy loans were removed by 1982. Thus, interest rate had to be suppressed, and in some periods set at favourable rates as policy loans. For example, to overcome the huge increase in the non-performing loans from the policy loan era, banks were given 1.7 trillion won loans (about 2 per cent of the GDP at that time) at 3 per cent annual interest when the government bonds were yielding about 13 per cent. The second feature of the interest rate management is the continued control of deposit rates for bank deposits throughout the period. Till the mid-1980s, deposit rates were not permitted to be set by market forces for the corporate sector. Corporate sector interest rates were freed first in 1984, when the rates for repos (repurchase agreements, thus not applicable to individual depositors) were permitted to be determined by market forces. At that same time, longterm interest rates for borrowers were also permitted to be set competitively. The third feature of interest rates was the suppression of them in the deposit sector. For instance, the deposit rates remained fixed at 10 per cent during 1985–92. This had the positive effect of attracting deposits, but had the adverse effect of borrowing costs going up whenever the local rates were higher than rates in world markets. With world interest rates coming down in the late 1980s and early 1990s, the fixed interest rates were further lowered for bank deposits. Interest rate suppression, thus, has been a prevalent feature in South Korea throughout different macroeconomic situations till 1997–98, when interest rates were freed. Monetary policy The central bank of an economy with more or less balanced current account, government budget, and no or limited foreign capital has very little else to manage except the credit growth to support the expansion of an economy growing at a high rate of about 8.4 per cent. Thus, monetary management was reduced to one of managing sufficient expansion of credits to meet the demand of an expanding economy. M2 grew at about three times the rate of growth of the economy. The average M2 growth rate was 22 per cent during 1971–96. In the fund-starved period of the 1960s, the credit growth was an excessive 61 per cent.

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Liberalization and growth in Asia

This rate of growth is very large, and it explains the inherent inflationary tendency in the economy except during the periods when inflation was brought down. Compared with the low inflation of East Asian economies with lower growth in monetary expansion – 15 per cent – South Korea’s policy of high credit expansion was consistent with the need for more funds to support a high-growth economy. This is particularly interesting since Korean firms could not access foreign funds till about 1987. South Korea received official development assistance, ODA, right till 1976. The total assistance over 1955 to 1975 amounted to 403 billion won. South Korea has not been getting development aid since 1976. Hence, during the period of economic restructuring towards heavy industries, sufficient credit creation was critical for sustaining the planned high growth. Central banking Central bank functions are carried out by the Bank of Korea. But, unlike in most other economies, the government plays a key role in guiding and controlling the way the central banking function is executed. As with the interest rate policy designed to support real sector restructuring programmes, so is it with the central bank. The BOK functioned as the executor of government policies. Its role was to assist the policy-makers to bring about a desired level of economic activities through interventionist policies, far from the non-interventionist stance advocated by monetarists. It is useful to examine banking policy to grasp the importance of the way policies are made conjointly with the government. There are three bodies involved in central bank-related decisions. The first body is the Economic Planning Board under the Ministry of Finance, which works closely with the Korea Development Institute (a think tank) to formulate economic policies. That policy mix is decided at the next level of the ministries of the government. The central bank’s policy-making body, the Monetary Board, then considers the policy mix: as the chairperson of the Board, the Minister of Finance, has significant influence in the final outcome of the policy. Therefore, the final decision is in fact made by the Minister and the BOK just executes the policy mix already formulated. Thus, the actions to be taken by the central bank are determined by the government through this three-tiered system of decision-making. The central bank, far from being independent to pursue stable economic growth with price stability, functions very differently. For example, the policy loan decision having been made in the early 1970s, it was the Bank of Korea’s job to implement actions to ensure that the policy loans are made to the heavy industries in pursuit of restructuring. If a particular industry had to be saved (for example a shipping company or a bank) from bankruptcy, the BOK would make funds available to tide the industry over for a period of

South Korea

179

time. This is an interventionist central bank to aid the broader planned economy. The Monetary Board of the BOK was a platform for making national policies. Far from being independent, the central bank is an instrument to ensure that monetary policies consistent with the national economic plan are formulated and put in place. Thus, cross-policy consistency is ensured through this form of central banking organization in South Korea. The nature of the central banking is therefore vastly different. This explains how South Korea had managed to delay several norms of financial liberalization normally seen in other OECD economies as they reformed their economies. The end result was economic growth based on a restructured economy that had by 1996 become an industrialized economy with an upper-middle income. Reforms under the IMF directives had eroded the power of the BOK. The central bank is a lot more independent, and is more able to function now as a guardian of the economy to manage inflation, target credit growth independent of the government desires, but in line with the dictates of industrial activities. Capital markets Capital market development was the most striking in that the asset growth of listed companies was very high, 31 per cent per annum. The capital market reform is noteworthy also in that the reforms were directed more in the domestic economy. Reforms to open the capital market to the rest of the world were delayed as long as possible, in fact till the late 1980s. Domestic capital market reforms were aimed at achieving capital formation to reduce the high level of debt in Korean firms. This took the form of organizing the market rapidly to provide a clearing house for the listing of good quality firms on the exchange. These firms could then raise capital and reduce their dependence on bank debt. The second aim of developing the capital market was to ensure that, with the rise of large shareholding across other firms, the undue control of the chaebols of the economy could be reduced. A brief summary of key capital market developments during 1980 to 1997 is useful. The number of listed firms grew from 352 in 1980 to the present number of about 800. The bond market also increased its listed bonds at face value of 1649 billion won to close to 35000 billion won. The Treasury issues have also grown substantially. Traded value in shares is moderate at US$450 million traded value per firm per year, which is about the level in Tokyo, but about a third less than that in the New York stock market. Share market capitalization is about 55 per cent of GDP, which is a lot less than those found in markets such as Japan (91 per cent), Thailand (96 per cent), etc. The importance of the capital market may be judged by one indicator. An average of 25 per cent of the capital needs was raised through the organized capital markets. This ratio is far higher than is the case with most countries

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Liberalization and growth in Asia

studied in this book, the exception being Malaysia, where the capital market, much more open to the outside world than the KSE, provided about 45 per cent at some times. More and more firms were listed on the exchange. In fact, the number doubled in ten years. The depth of the market increased from a mere 6.9 per cent of GDP to about 35 per cent in 1996: after the collapse following the crisis, it was a mere 12 per cent. As a comparison, examine the ratio in China. After 20 years of capital market development in China, the depth of China’s regulated market is still under 30 per cent. South Korea also developed a viable public debt market. The corporate bond market has attained a high rate of growth. From its base of just 1.7 trillion won, the corporate bond market grew at a very high rate of 27 per cent per annum. The Treasury bond market also grew in steps. South Korea’s bond market is reputed to have developed faster than most bond markets in developing Asia. The share market was used as a tool to broaden the share ownership structure of firms, particularly the non-chaebols, in order to lessen the control of the economy by the chaebols.6 At times by forcing divestment across broader share ownership, the government was able to bring these firms to more diversified ownership. From a high of 12.4 per cent individual ownership in the 1980s, the ratio has been brought down to about 4 per cent in the 1990s. With the 1987 reforms to investment banking the cost of going public was brought down, which led an upsurge in listing activities. The institutional impediment to issuing stocks priced higher than the par value was removed in 1986. As a result, 47 companies got listed in one year in 1987. 3.3

Financial Liberalization Effects

Macroeconomic effects South Korea’s development experiment is one of cautious reforms in all aspects except the domestic sector to strengthen competition in all sectors to gain productivity. As far as possible, the financial sector and in the external sector, reforms were put off as long as they could be, which conforms to the scholarly advice given these days after the 1997–98 crisis. Reforms aimed at reaching out to the rest of the world were made in order to expand by exporting; foreign firms were not given free entry to prevent competition to the domestic firms. This paid off very well during most of the development period. The important indicators are summarized in Table 6.3. Output growth in GDP has been phenomenal and continuous. Inflation, which was high at one period, was brought down significantly. Government revenues grew rapidly so that the government had no problem on the fiscal side. Monetary expansion kept phase with the income growth. Trade balance

Table 6.3

Growth of financial and capital market indicators for South Korea (annual averages)

181

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

Exchange rates (% change) Share price returns

20.67 –

7.31 –

1.82 25.33

1.80 5.87

9.97 3.78

–4.87 –8.67

14.15 –21.73

–3.09 32.20

Interest rates Discount rate Call money rate T-bill rate Time deposit rate Base lending rate

18.92 0.00 – 4.56 0.00

13.70 7.91 – 16.17 1.80

6.70 12.16 14.59 10.14 11.05

–1.30 –0.76 10.17 40.05 52.72

3.05 4.05 8.68 58.61 77.11

2.65 3.66 9.00 79.13 98.86

2.50 4.69 7.05 5.79 7.71

2.50 4.21 6.56 4.95 6.77

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

182

Liberalization and growth in Asia

was more or less restored whenever there was any misalignment. Overall, there was an orderly transformation of the economy towards the status of an upper-middle income economy. On exchange and interest rates Exchange rates were pegged to the US dollar till 1980. There followed a period of managed float, which gave way to the market-average exchange management in 1990. Interest rates have been fixed throughout the period for depositors. Limited interest rate reforms permitted the long-term lending rates to be determined by the market only in the 1980s. In 1987, firms were permitted to borrow from overseas through foreign-currency denominated borrowing. The exchange rate depreciated during the 1960s by 17 per cent per annum during the period of peg to the US dollar. In the next period of managed float, the won depreciated by only 4 per cent per annum over the 1970s although in the subsequent period till 1989, the depreciation was only 3 per cent per annum. During the market average exchange management period, the currency declined by 11 per cent per annum. The Asian crisis sent the won down by 75 per cent within a year from September 1997, before it started to recover with the assistance of the IMF. In hindsight, it appears that currency instability was prevalent both during the hard peg as well as during the marketaverage regimes. The exchange rate for the Korean won has settled around won 1300 = US$1.00 under the free float in force since July 1997. The interest rate story is quite different. Through a dogged policy of not returning the deposit rates to be determined by market forces, South Korea managed to keep the bank deposit rates steady. The high interest rates in the 1970s and the 1980s were partly due to the policy loan scheme, which made debt cheap for the heavy industries, which meant that the interest rates for the rest of the economy had to be high. Deposit rates were managed right up to 1991. But the borrowing rates for the firms were to some extent liberalized in steady steps for long-term loans starting from 1984–87. 3.4

Indicators of Financial Liberalization

Table 6.4 provides a summary of financial liberalization ratios over the 1976–96 period. It is evident from the figures in it that the public sector did not create expanding claims on itself except in the middle of the policy loan period: claims against government were 24.9 per cent of GDP. Over the remaining period, 1981 to 1992, this ratio was kept very low, which permitted the private sector to access more credits. The claims on the private sector went up from 18 per cent of GDP in 1961–70 to 107 per cent of GDP by 2002, an almost sixfold increase, on borrowing by the private sector. The financial

Table 6.4

Indicators of financial and capital market depth in South Korea (percentage annual averages)

183

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

Money depth (M3/GDP)

22.60

39.00

42.22

52.72

77.11

98.86

106.07

108.30

Intermediation depth FIR (total)/GDP (=DC/GDP) FIR (private)/GDP

21.67 17.90

39.48 35.50

53.31 49.24

57.11 56.34

77.34 75.27

91.92 89.82

99.00 96.63

108.22 106.89

Capital accumulation GFCF/GDP FDI (net)/GDP FDI (inflow)/GDP

18.48 – –

27.51 – –

30.17 0.66 0.30

36.97 0.79 0.27

31.57 2.50 1.41

28.39 3.09 2.01

26.96 1.39 0.83

26.74 0.97 0.41

– –

0.53 1.18

0.56 0.27

0.31 –0.13

– –

– –

– –

– –

Indebtedness Domestic borrowing/GDP Foreign borrowing/GDP Notes: M2 = M3 = FIR: GFCF: FDI: FDI (inflow): DC:

currency + quasi money. M2 + other deposits. financial intermediation ratio; claims on public and private sector (total credit), on private sector (private). gross fixed capital formation. foreign direct investment (net). foreign direct investment (inflow). domestic credit.

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

184

Liberalization and growth in Asia

sector had developed sufficient depth thanks to these reforms so that it managed to create a doubling of funds to the private sector. This indicates the favourable effect of financial liberalization. Without these reforms, it is difficult to see how the real sector demands for credits would have been met without rekindling a dash for credit and thus exorbitant interest rates. On the other hand, capital formation was steadily held up except during the period of severe strains following the 1981 recession. The gross fixed capital formation was held steadily at above 31 per cent of GDP during the rest of the period with a slight decline after the Asian financial crisis. This rate of growth in capital formation was quite extraordinary for a country which had shut out foreign direct investment till 1991 and had permitted very little borrowing in foreign currencies till 1996. Portfolio investment jumped eightfold in the period following reforms in 1991. Thus, the ability of the economy to provide large injections of gross fixed capital formation throughout the period can only be accounted for as coming from a set of capital controls in place, which prevented capital outflows, and from the ability of the domestic financial sector to generate sufficient credits for a fast-growing economy. Some observers have also suggested that the no-name bank accounts facilitated large-scale hiding of money, which then found its way as available resources. Capital controls were in place for individual transactions throughout the period till the middle of 1996. Producers had limited freedom in transacting in foreign currencies except for acquisition of capital and materials. But in the 1980s, limited permission was given to firms to invest overseas. This led to a certain amount of investment outflow from 1985; the investments by the banks have turned out to be bad as South Korea has very little banking expertise to make their investments profitable. Portfolio investment into the country was not permitted till 1991, when FDI started, multiplying eightfold in the next year. In the two years between 1991–92, South Korea received more foreign investment than in the 25 years previous to that date, thanks to the reform that permitted limited foreign borrowing. But this was nothing compared with FDI accounting for 82 per cent of investments in 1962, the year when South Korea decided to go solo with domestic capital and shut foreign investments from ever rising to dominant levels. In 2002, FDI inflow constituted 0.41 per cent of the GDP after peaking in the year 2000 at 2.01 per cent. Even with capital controls lifted, there is very little FDI inflow into this economy. In summing up, it is quite fair to describe South Korea’s liberalization as one that did not make capital account opening a centrepiece of its reforms. Instead it delayed this aspect right till July 1996, when both foreign and domestic firms were able to have near full freedom to move capital. Much of the development in the previous era was achieved with dependence on domestic capital and very little FDI came to South Korea. A year after the reforms to the capital account came the financial crisis. That crisis happened

South Korea

185

during a period of political turmoil, which started modestly as an investigation of huge ill-gotten gains by a former president, connected with bribe giving and taking between the government and the chaebols. But long before the political crisis following this revelation in 1997 came to an end, the banking system was in near disarray from bad loans, and from the effects of too much borrowing by corporations during the 1994–97 period.7 However, over the 1954–96 period, it is the choice of the industrial policy based export-led growth that led to the gains South Korea made as we described in these pages. To gain an idea of how important the external sector is for the country, the reader is requested to refer to Figure 6.3. In that sense, it is a unique development case in that, with almost no capital account opening and with interest rate reforms delayed as long as possible, South Korea managed to grow at the real rate of about 8.5 per cent per annum over a lengthy period of time.

4.

ASSESSMENT AND FUTURE PROSPECTS

The Korean economy has absorbed excessive foreign short-term capital since 1996 when the capital account reforms removed all restrictions on foreign borrowing while at the same time lifting restrictions on domestic firms putting

70.00

Growth rates

60.00

70.00 M2 M1 FR/IMP

60.00

50.00

50.00

40.00

40.00

30.00 20.00 10.00

30.00 20.00

0.00 –10.00 –20.00 1961 1966 1971 1976 1981 1986 1991 1996 2001

Foreign reserves to imports

80.00

10.00 0.00

Figure 6.3 Foreign reserves to imports ratio and growth rates of M1 and M2, South Korea: 1961–2002

186

Liberalization and growth in Asia

capital in other countries. This led to a huge build-up of borrowed capital in the banking sector, which helped the government and the private sector to continue its earlier established fast-track growth in income. This had the seeds of its own destruction when the debt in the capital structure became too high at seven dollars against a dollar of equity. When the baht crisis led to the re-examination of the financial soundness of the Asia Pacific economies, the Korean won declined dramatically losing about 76 per cent of its value within three months. The rest is history. The IMF was invited in to assist in restructuring the financial sector. Along with the IMF, monopolistic practices of the big businesses have been curtailed by the government elected in 1997. This process of major reforms will lead to significant changes in the structure of the economy in the future. The banking system, which was the worst hit, is also likely to undergo even greater change in structure and management. These developments are taking place while South Korea is expected to experience a few years of lowered economic growth relative to the close-to-10 per cent growth it had prior to the crisis. A reexamination of this case a few years later may reveal that the reforms being put in place will enable the economy to manage a growth of about 5–6 per cent in the near future. Assessing the longer-term prospects is fraught with danger since one impact of the Asian financial crisis should be a more cautious business investment practice. That will depend when and how much confidence will return to the economies in the region. However, after the biggest ever decline of 7.8 per cent in GDP in the last quarter of 1998, the Korean economy is again showing strong signs of recovery (6.5 per cent average over 2000–02), and has surpassed that rate in 2003. That is not surprising since South Korea had often shown a strong resolve to work recoveries from near-disaster crises time and again before.

NOTES 1.

The main culprit of South Korea’s trouble was the huge build-up of debt in corporations steadily over the 1990s. Debt of US$40 billion in 1991 has ballooned to US$112 billion by 1997: by 1999, the debt had soared to US$160 billion. That is an annual growth of 22 per cent. The high risk from high debt to equity and the resultant interest services, even before the crisis hit, had reached breaking point. 2. See Asian Development Bank (1997b). These city-based economies have per capita income equal to three-quarters of that of the United States. Given the status of a country of city-based economies such as Luxembourg, Monaco, etc., these states collect revenue as a country though they lack the land mass to spread the revenue as development expenditure. This makes cities inherently more efficient and rich. 3. Following the 1997 Asian currency crisis, this has changed dramatically as is discussed in Chapter 2 and in Chapter 11. 4. This very high savings rate in the 1960s is a remarkable feature of the Korean experience. From the start of the planned growth, it made the planners rely on internal capital formation. For a number of reasons – one being the capital-rich Japan next door – South Korea was not

South Korea

187

prepared to welcome foreign capital right up to 1996, just before its admission to the OECD. In subsequent years, domestic savings was insufficient to meet the higher capital needs of a more technology-intensive production. However, given South Korea’s reluctance to allow foreign ownership of domestic production, insufficient savings to meet the higher investment demands led to persistent high interest rates in this economy. This was a price the country paid for keeping FDI as low as possible in the pre-1997 era. 5. Studies have shown that the variability in exchange rate was the lowest in the 1990–96 period. The standard deviation of the rate of change in exchange rate declined by more than half in this market-average exchange rate period. 6. It is reported in recent years that the top 50 chaebols produce 85 per cent of the GDP. Of these, the five biggest ones have been the targets of reform by different governments depending on how a particular government felt towards a given set of chaebol families. Hence there is a political dimension to this policy as well. 7. The average debt ratio was running around 400 to 500 per cent of equity before the September 1997 currency crisis. With a sharp currency decline, this ballooned to as much as 700 per cent of equity! As was discussed in the previous chapter, South Korea’s crisis was a disaster waiting to happen because of this excessive short-term borrowing and bad banking management.

7. 1.

Malaysia: liberalization with exchange and capital controls INTRODUCTION

Malaysia is increasingly seen as an example to emulate by similarly placed small-to-medium economies to achieve socio-economic development via rapid pro-growth reforms in the economic and financial sectors. This country also aims to progress towards a developed nation status by year 2020.1 It has a good-sized, almost 25 million, educated population in a resource-rich land with good infrastructures,2 which portends well for her to secure similar high income growth of the past in the face of competition from larger countries with several times her population and cheaper labour costs. The reader will find in the next section an introduction to historical development. That overview indicates that markets, when opened to the rest of the world, could assist in securing high-income growth. That phenomenon associated with reforms helped to raise the status of this country to the current middle-income category. The key reforms undertaken to secure that high growth are presented chronologically in section 3 to give the reader a feel for the kind of reforms a country undertook to secure high growth. Some current challenges to reforms and growth are discussed in the final section of the chapter: that relates especially to the aftermath of the 1998 decision to introduce controls on current and capital accounts as well as domesticdemand-based stimulus to secure growth.

2.

ECONOMIC AND FINANCIAL SECTORS: AN OVERVIEW

Malaysia can be described as a resource-rich small-to-medium sized country supporting a population of almost 25 million within a total land area of 330000 sq km, 59 per cent of which is virgin forest plus 14 per cent in agriculture. Like relative-sized countries such as Sri Lanka, Thailand, Taiwan and South Korea, it had a reasonable level of modernization prior to its new path to recently achieved high growth. This favourable precondition of having pro-growth inclinations among the elites helped to attract industrial activities 188

Malaysia

189

from more developed countries when policy changes signalled were chosen appropriately as pro-growth and market-friendly. Situated in the pathway of two fast growth areas namely East Asia, with the world’s two largest economies of Japan and China, as one growth area, on the western Pacific and North America on the eastern Pacific, this country could partake in the growth of these two regions by identifying itself as a resource-rich country with modern skills and infrastructure to attract manufacturing activities as long as its comparative advantage was superior. That is exactly what it did after a period of experimentation with primaryproduce-led growth in the immediate post-war era till 1976. The result was astounding: per capita income, which was 10 per cent of the US income in 1957, improved to 30 per cent in the 1990s. While the primary produce, rubber and tin, made up 80 per cent of exports in 1960, the country’s successful industrialization enabled it to export manufactured items, which accounted for 75 per cent of all exports by 1996: manufacturing constituted 32 per cent of output in 2003. These vital statistics summarize the progress of this Asian economy with potent lessons for other developing countries. Consider the experiment with capital and exchange rate controls to combat the ill-effects of the 1997–98 financial crisis. Other crisis-hit countries spent huge resources, mostly from the IMF, to regain economic stability while Malaysia managed to restore stability with a non-traditional recourse to controls. Her bold and controversial stand on currency speculation as the source of the crisis has sharply focused attention on one major source of economic instability in the post-Bretton Woods world since 1973. During the fixed-exchange rate era with the US dollar pegged to gold during 1946–73, most of the currency trade arose from trade in goods/services. But this has not applied since 1973 – currency trade has grown from US$300 billion then to the present US$1950 billion – with speculative currency trade accounting for six times more currencies being traded than to support goods trade (and even central banking) activities. Malaysia’s economy developed as a primary producer of tin and rubber over a century of colonial rule. The high world demand for commodities during 1957–76 led to prosperity in rural areas in the critical formative years over the immediate post-independent period. This was a lucky experience because unlike several other countries, which developed fast through urbanbased industrial activities, this country created prosperity in the rural sector through commercial agriculture before developing the urban sector. At the beginning of 1970, primary produces constituted 95 per cent of the country’s exports.3 With independence in August 1957 from British colonial rule, the initial policy mix pursued by the political elites was designed to improve the general well-being of the rural population, which held a disproportionate electoral

190

Liberalization and growth in Asia

voting pool of almost three-quarters. For the newly elected governments, capturing the rural vote to remain in power was a significant political strategy for survival against the Communist subversion and threat in the countryside. Also a majority of indigenous peoples of the country, popularized since the 1970s as the bumiputra or the ‘sons of the soil’, lived in rural areas, 60 per cent in fact, in 1960 compared to 24 per cent in 2002. Rural improvement policies were also consistent with pro-growth advocacy. The international development institutions were extolling the wisdom of pursuing natural-resourcesbased development programmes for the less developed countries. The pursuit of this twin policy of rural improvement to improve incomes of indigenous peoples was financed by a huge public expenditure based on debt. Policy change was very evident in the 1980s, when the commodity-boom ended for good (it appeared) in 1983. Sixty-three per cent of the total 1981–85 government budget was financed by sovereign debt, roughly half foreign and half domestic. In the light of what is considered a prudent level of public debt, less than half of that would be considered dangerous. A debt servicing ratio of 4 per cent in the 1970s increased to 16 per cent by then. That was still not dangerous because of a healthy external sector. But the currency exchange rate deteriorated along with the fall in demand for primary products: the currency, which was then at RM2.18 to a US dollar, depreciated by 12 per cent. Most neighbouring countries were already adopting newer approaches to restructure their economies in the line of what the four ‘tiger’ economies (Hong Kong, South Korea, Singapore and Taiwan) had done in the 1960s to secure sustainable economic growth on export-based labour-intensive economic activities. Adoption of export-led growth has, since 1983–84, become the basis of the transformation of the economy. Manufactured outputs increased rapidly to 34 per cent of GDP. Industrial outputs make up threequarters of exports. Per capita GDP doubled although the population growth did not fall significantly. This success spawned the current vision of becoming a developed nation by the year 2020. 2.1

Economic Performance

The overall performance of the country is described by the statistics summarized in Table 7.1. The average annual economic growth over 40 years is reported to be 6.5 per cent by the central bank literature: the reader may refer to Figure 7.1 to get an idea of the historical growth rate.4 The per capita income increased from RM675 in 1959 to about RM11500, which represents a continuous 7.75 per cent growth per annum in local currency. As stated earlier, per capita GDP in US dollars relative to the US per capita income improved threefold. This level of general income growth in a developing country is considered very good in development circles.

Malaysia

35.00

191

Real GDP CPI M2

30.00 25.00 Growth rate

20.00 15.00 10.00 5.00 0.00 –5.00 –10.00 1961 Figure 7.1

1966

1971

1976

1981

1986

1991

1996

2001

Growth rates of real GDP, CPI and M2, Malaysia: 1961–2002

These statistics suggest a 6.30 per cent growth in the industrial era, which is not too far off the 8.00 per cent growth during the commodity-based era. Per capita income grew at 7.75 per cent (7.6 per cent in US dollar terms). As the economy developed a respectable export sector, private and government consumption went down significantly suggesting the ability to fund higher investment and the return of the economy to private sector activities. Private consumption is 45 per cent and government consumption is 8.46 per cent of GDP. Improvements in financial indicators suggest that inflation had been kept low throughout the period through a tight monetary policy while the monetization as measured by the M2 to GDP ratio accelerated from 43.6 per cent to 103 per cent in 2003. Securitization as represented by total assets in banks of 11 per cent increased to over 100 per cent of GDP. These are notable achievements considering that the money and inter-bank markets were almost non-existent as late as 1963. Fiscal balance had been achieved by a moderately high tax regime with good collection experience as well. Returning the economic activities more and more to the private sector to achieve many of the aims of the government policies has helped to prevent massive concentration of wealth that is characteristic of many economies at this stage. This was supplemented by credit targeting implemented in the late 1970s to improve the financial conditions of the indigenous people.5 The external account was managed well given the competitiveness of the

Table 7.1

Basic economic and social indicators of development in Malaysia

National accounts GDP growth (%) Per capita GDP (US$) Private consumption/GDP Government consumption/GDP 192

Financial indicators (%) Gross domestic savings/GDP Fixed capital formation/GDP Inflation (per annum) M2/GDP Fiscal balance/GDP Trade balance/GDP Current account balance/GDP Total trade/GDP Debt/exports Debt/GDP Foreign reserves/imports

1961–70

1971–80

1981–90

1991–95 1996–2000

2000

2001

2002

6.40 315.00 64.48 10.38

8.30 794.00 54.61 8.93

6.03 1688.00 51.03 10.60

9.47 2379.00 49.36 7.91

4.89 2735.00 43.39 7.59

8.30 2974.00 42.43 8.03

0.40 3093.00 45.06 8.43

4.20 3232.00 44.23 8.41

24.20 15.50 0.93 29.44 –4.10 – – 91.29 69.47 32.37 33.87

30.40 24.39 5.98 43.60 –6.78 – – 89.11 99.39 46.09 46.78

33.17 30.53 3.25 63.65 –8.17 10.26 –2.86 113.10 137.97 81.60 36.31

35.60 39.14 3.97 76.73 0.10 3.60 –9.40 158.93 69.26 56.38 51.16

24.00 31.99 3.14 98.53 – 22.90 6.93 197.32 – 35.60 44.95

47.10 25.61 1.54 101.68 –5.80 30.10 12.27 217.57 36.60 37.00 39.53

42.20 24.93 1.42 106.78 –5.50 26.26 10.41 229.28 41.60 – 43.11

41.80 23.23 1.81 102.08 –5.60 19.10 7.60 214.48 39.00 46.00 49.34

Social indicators Literacy rate (%) Unemployment rate (%) Expenditure on education (% of budget) Expenditure on health (% of budget) Population growth (%)

– –

46.00 –

70.00 3.40

83.00 –

84.00 –

86.00 3.10

86.00 3.60

87.00 3.50

–

21.98

19.10

20.90

22.00

23.00

23.00

24.00

6.53 2.81

4.89 2.83

5.60 2.69

5.80 2.40

5.90 2.40

5.90 2.20

6.00 2.10

– 2.51

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

193

194

Liberalization and growth in Asia

export sector in commodities and later in manufacturing. However, this balance was lost in the 1990s as capital imports increased substantially with the expansion of infrastructure and commercial-cum-tourism-related property development during the first half of the 1990s, exactly at the wrong time when the export growth, the mainstay of the restructured economy, started to decline significantly with China emerging as the competitor for consumer goods manufacturing. Much of the foreign investment flows that financed these longgestation projects were withdrawn suddenly in 1997–98, precipitating the financial crisis, which first hit South Korea, then Thailand, spreading over the next six months to several countries as the contagion spread. In February 1998, this crisis led even to the hedge-fund crisis that almost unbalanced the US financial market (the Federal Reserve chairman averted this potential event by cutting the interest rates in time). Unlike what can be observed very often in other developing countries at the same stage of development, the rural sector in this economy has good roads, water, electricity and telecommunications as well as good transport facilities. The cities have grown with well-developed housing and industrial areas with schools, sporting facilities, etc. Rural out-migration increased as urbanization grew from about 47 to 75 per cent of the population. The World Bank upgraded the status of the country from middle to upper-middle income category. Funding for education amounted to 24 per cent of government budgets throughout the 1980s right up to 2004, almost the same as South Korea, which helps to produce a trained workforce relevant for an increasingly industrialized economy. Illiteracy has declined to below 10 per cent of the population while poverty has been reduced to 8.1 per cent of the population. Infant mortality declined to the current 9 deaths among under five-year-olds while life expectancy was 73 years in 2003. 2.2

Financial Markets and Development

In 2002 there were ten anchor banks, which are bank-holding companies with a large number of banks, finance companies and investment banks under them, delivering effective payment and intermediation.6 The non-bank financial institutions consist of very special institutions with large assets (the Employees Provident Fund Board, the National Savings Bank, Pilgrim Fund Board) and the following specialized financing entities; 13 leasing companies, 7 development banks, about 60 property and unit trusts, 4 housing finance units and 59 insurance companies. These non-bank financial intermediaries provide insurance, broking and discounting activities. The banks and nonbank financial institutions are supervised by the central bank, Bank Negara Malaysia (BNM) – monetary management of the economy is vested in this body as well. Supervision of financial markets comes under the Securities

Malaysia

195

Commission (SC). These financial markets include money markets, the bond, and share markets as well as futures markets. BNM took over the currencyproducing function in 1967 after the currency board was abolished. BNM used to formulate all financial policies (in consultation with the Finance Ministry) and deliver regulations: in March 1993, the SC was formed to take over the supervision of capital and derivative markets, and matters relating to merger and takeover activities of all firms. The SC is responsible for the orderly development of the stock, bond and futures exchanges while ensuring investors’ protection in those direct capital markets. The Kuala Lumpur Stock Exchange (KLSE) is the sole share market, which has about 800 companies listed in two boards.7 There are several futures markets for money, interest rates, commodity futures and stock index futures. In summary, it can be said that Malaysia modernized its infrastructure across the whole country as well as pulling the rural sector away from poverty because of incomes policy and development of rural sector and the indigenous population. Forty-five years of moderate and continuous development – unlike in low-income, low-growth economies in the region – has been founded upon broad-based agricultural and industrial policies as well as programmes to provide the infrastructure to support an industrializing economy. This was aided by financial market reforms to mobilize capital and financial know-how. Institution building in the financial sector became important and liberalization policies pursed aggressively enabled financial sector development. These strong points made this country a preferred location for multinational production and marketing up until 1997. Since then and with the continuing shift of manufacturing to East Asia and elsewhere, newer policy initiatives are being experimented with.

3.

LIBERALIZATION

The financial sector was built from scratch. As a BNM report says: the possibilities for effective monetary management were rather limited in the beginning [in early 1960s] because the financial system which serves as the transmission mechanism for policy was relatively underdeveloped. (Bank Negara Malaysia 1994a, p. 449)

In the late 1950s, when development efforts in this newly independent country were being mooted, there was a civil war being fought with the Communists, who had gone into the jungles to continue the war to capture power through armed struggle. Another feature was that the newly empowered elites had to eradicate rural poverty, which was the basis of the Communist propaganda. The parliamentary democracy put in place then also empowered rural people

196

Liberalization and growth in Asia

with a large voting pool. A third feature was that a majority of the rural population, almost all of them indigenous people, was already in commercial agriculture. These realities led to the formulation of a policy mix aimed at rural development as a means of removing the attraction of Communism while the same policy was seen as assisting in improving the incomes of the people, the bumiputra, who held the voting pool. Thus, the liberalization policies to be discussed in this section were determined by the political realities of the time. When the commodity boom ended in 1983 continuation of the dominant bumiputra preference ownership had to be slowly reduced to attract foreign capital-cum-technology resulting in industrial export-led focus. Full-scale liberalization in the financial sector to mobilize resources needed for industrialization ensued. With the hollowingout of Southeast Asia in 1994 onwards as a manufacturing hub, temporary efforts to redirect capital to land-based long-gestation infrastructure investments led to foreign capital leaving this economy (and other neighbouring economies) suddenly in 1997–98. It struck as the baht crisis in July 1997, and wreaked havoc in several economies including Malaysia. The imposition of currency-cum-capital controls in October 1998, and implementation of a number of financial reforms along with expansionary economic policy helped to stabilize the economy.8 3.1

Sources of Reforms

The banking infrastructure was built slowly. It took 45 years to create over 2000 bank branches from a base of 111 branches, almost all of which were branches of foreign banks. Financial institution building and capacity to improve intermediation efficiently was essential both in the agriculture-andmining-led as well as manufacturing-led phases of economic expansion. The exchange and interest rate instability hit all economic activities in the wake of the US decision in August 1971 to abandon its commitment to the fixed exchange rate system. Financial reform policies were needed to contain the effects of this event. That and the 1972 first oil price increase, which led to the world recession of 1975–76, led to economic recession. The second oil price hike in 1978–79 led the world to a period of stagflation, low or no growth with high inflation, which also called for further reforms. These led to Malaysia being pushed to pro-growth liberal policies to secure growth in the next twenty years. Financial liberalization had to be far-reaching to support the move towards greater reliance on manufacturing and export-led growth. The experiences of several countries in these aspects were not uniform. For example, South Korea and Taiwan followed this path with few financial reforms whereas Malaysia followed this reform path with a substantial dose of liberal policies in the

Malaysia

197

financial sector as will be seen later in this section. In this regard, the desire to develop the financial markets as a major financial centre for the region was part of the reason, although the reforms opened the door for huge capital resources to flow in to support the industrialization efforts. Just prior to the financial crisis, the share market was capitalized at 323 per cent of GDP. When foreign owners sold share scrips in ringgit and then converted the proceeds to foreign currencies, chiefly the US dollar, the ringgit had to give way although all other fundamentals were not as bad in this economy as were the cases in South Korea, the Philippines and Thailand. By the end of 1997, the capitalization declined to a mere 136 per cent of GDP. The prices drifted further in the next year as more scrips were sold, and then converted to ringgit. It is this sort of short-term money that the capital controls of 1998 were meant to stabilize. 3.2

Financial Liberalization

The individual reforms to bring in the financial (and economic) transformation of this country are summarized in Table 7.2. The important financial reforms will be discussed under several sub-headings below. The reader will recall that the last section included a brief discussion on economic reforms. Financial reforms may be grouped into three distinct phases over the 45-year period. During the colonial period, Malaysia developed private-sector-based financial institutions to facilitate international trade in commodity exchange and for the import of finished goods, mainly from the United Kingdom. There were no inter-bank markets in Malaysia, but the foreign banks, which controlled the financial system in the 1950s, used the London inter-bank markets to transact daily. There were also no capital markets in Malaysia. The share market was located in Singapore serving two places, but Singapore was not part of Malaysia except for a three-year period over 1963 to 1965. In this period there were more banks, more branches, more finance companies, more insurance companies, etc. Another feature of this period was the development of money markets to trade short-dated securities, which revealed the market rates of interest, etc. Discount houses were established, merchant banks introduced securitization expertise to list more companies on the exchange, longer-dated securities were introduced and a capital market was established in 1960, which became the Kuala Lumpur Stock Exchange in June 1973. In fact almost all institutions were modernized and expanded. The only exception was the delayed establishment of the securities commission, the formation of which occurred in March 1993. 1973–98 The early to late 1970s formed the heyday of commodity boom. With the

198

Liberalization and growth in Asia

Table 7.2 Major economic and financial sector reforms in Malaysia, 1958–2002 Liberalization policies implemented 1958

Economic Incentives Law: international capital and dividend allowed

1959

Central bank formed with an Act of Parliament, Bank Negara Malaysia Act (Foreign-origin banks dominated the economy; no money or capital markets)

1960

Stock trading started in Kuala Lumpur in addition to Singapore

1963

Establishment of discount houses from which money market and inter-bank activities could be developed through market-related signals Treasury bill issued by the central bank to get market interest rates

1967

Currency issuing power transferred to BNM from the regional currency board

1969

Treasury bonds issued by BNM to get the base rates from market bids

1970

Establishment of merchant banks

1971

Finance companies, which had a dominant position in lending comes under Banking Act, therefore under central bank supervision Commercial banks permitted to issue fixed deposits up to 36 months

1972

Commercial banks permitted to issue fixed deposits up to 60 months To induce institutions to lend to bumiputra economic activities, a Credit Guarantee Corporation of Malaysia, CGCM, set up as a private institution

Jun 1973

Exchange rate no longer fixed; most restrictions taken off Capital market trading converted to ringgit as a genuine step to localization

1973

Currency convertibility with Brunei and Singapore ends in May; ringgit floated in June 1973

Malaysia

199

1975

Selective credit line to bumiputra economic activities comes into force: of the increases, 20% in loans, 10% in agri-loans, 25% in manufacturing loans and 10% in housing loans

Sep 1978

Exchange rate fully liberalized; a basket peg to trade-weighted currency

1978–79

Up to this period, BNM set the interest rates in consultation with the major institutions; that is prior to 1978, interest rate was controlled First move to free interest rates: commercial banks could set interest rates for deposits, a year later also for lending

1978

Interest controls introduced in lending and deposit markets (removed in 1991)

1979

Industrial Bank of Malaysia formed to finance loans exceeding 7 years Merchant banks brought under the definition of Banking Act

1980s

Rationalization of the regulations to make the commercial banks diversify into securities and other activities as separate accounting units

1983

Islamic banking with profit sharing instead of fixed interest introduced

1985

CAGAMAS bonds introduced to finance housing credit market

1986

A number of cooperative finance companies and some banks failed; central bank rescues them, and passes laws to bring them under banking supervision A new banking act (BAFIA) passed to consolidate all amendments

1985–86

Recession: easing of monetary controls to stimulate investments

1986

Real sector reforms to permit greater ownership by foreign companies Tax reforms introduced to stimulate economic activities Continued overleaf

200

Liberalization and growth in Asia

Table 7.2 Continued Liberalization policies implemented 1987

Current account surplus RM6.6 billion (or about 4% of GDP) results from reforms to the real economy and the pursuit of low interest policy to stimulate the economy Current account goes into deficit of RM0.9 billion and continues to be in deficit

1989

Mutual double listing of capital securities in Singapore and Malaysia ceased

1990

Capital market reforms: eased entry barriers to broking; more mutual funds; foreign share ownership limit increased to 49% (high volatility in share market) International Offshore Financial Centre in free-traded Labuan established

Oct 1990 1988–91

Interest rate differential very high, large capital flows into Malaysia; private sector loans increased by 23% per annum mostly for non-traded investments

1989–May 1996 12 upward revisions of statutory reserve ratios to contain overlending to the private sector; but by that time baht crisis had taken root Tariff reduction on further items, 600 more (AFTA initiative) 1993

Swaps were controlled by limiting this to only US$2 million per day per customer with an upper limit of US$5 million on all non-traded foreign exchange transactions

1989–92

Money market operation by government stopped (this took liquidity down further as government placed deposits with BNM)

Apr 1990

Curbs on consumer credits for vehicles (75%-only rule) and credit cards (RM24000 annual income; age limit 21; and 10% minimum repayment Excess funds of pension body, EPFB (in 1993 this was RM10.9 billion) put in BNM to reduce credit expansion

1991–92

1992

Issue of BN Bills to absorb further liquidity

Malaysia

201

1993 1994

Two-tier regulatory system inaugurated to improve soundness of banking; by end 1997, 18 (11 banks, 3 finance companies and 4 merchant banks) qualified as these had 2% higher capital adequacy ratios; incentives given to the first tier institutions

Aug 1997

Defended the ringgit, lost reserves; abandoned managed float; ringgit free floated

1997–98

Several interventions in the market to arrest the free fall in the stock market and in the ringgit; ringgit fell to RM4.16 per US$ due to offshore speculation; all failed

Aug 1998

Fixed exchange rate at RM3.80 effective October, 1998; short-term foreign capital withdrawal limits announced; ringgit banned from trading outside the country

Feb 1999

Internal trading of ringgit within a local free market; stringent limits on individuals’ use of foreign currency imposed

Aug 1999

More easing of controls on real sector firms so much so that they are able to secure foreign exchange freely still with approval required; individuals permitted to take out for specified purposes such as education and travel, not for investment outside 1. Funds established to buy off non-performing loans (Danaharta) and inject equity (Danamodal) to rescue the banking system from collapse from nonperforming loans in excess of 12% of loan book in the credit system 2. The weakened deposit institutions are being consolidated by consensus under the direction of the Bank Negara Malaysia into better capitalized smaller core groups of banks. The earlier idea of six core group banking institutions is now being amended to ten groups

Nov 1999

A general election held in November returned the government to power for five years

Jan 2000

Speculation is rife suggesting controls may be lifted in early 2000 (Wall Street Journal, 9 January 2000) Continued overleaf

202

Liberalization and growth in Asia

Table 7.2 Continued Liberalization policies implemented Apr 2001

Deposit-taking institutions merged into ten anchor banks encouraged by the central bank guidance initiated in 1998 as future financial sector reforms to strengthen the banks and to improve management practices to face foreign bank entry from 2005

Mar 2002

Notice has been given of reforms to share-broking firms. Banks have been given permission to buy non-bank financial institutions

Sources:

Bank Negara Malaysia; Asian Development Bank reports; the Internet.

wealth accumulated after a period of 17 years of fairly good growth right up to 1996 – despite the fact that this country did not follow the more successful examples of manufacturing of South Korea, Taiwan and Hong Kong – there were calls to introduce interventionist policies particularly to direct credits to certain segments. This found expression as interventions in the interest rate markets, preferential credit allocation for the bumiputra and other preferences. This came at the wrong time since the 1975–76 world recession prevented these policies from being pursued vigorously. By the time the 1970s came to an end, the commodity boom was gone and in the early 1980s the world was again in stagflation. The recession came in 1985–86. The combined effect of these adverse events was that the interventionist policies could only be pursued vigorously for a short while over 1975–79. With fast growth that came later, these interventionist policies were considered to be minor irritants in the light of the larger growth taking place for everyone, including the indigenous producers. Far-reaching reforms had to be put in place to move the economy to provide momentum for growth. Thus, by starting on the road to industrialization, substantial real sector and financial sector reforms had to be undertaken while also deflating the public sector through privatization of inefficient public goods providers. In short, the call was to return to the market mechanism. The government reduced its expenditure, and privatized widely to improve efficiency. All forms of government-delivered goods were returned to the private sector – no doubt still maintaining a network of financial controls of related companies under political party controls – in roads, airlines, ports, power, water and telecommunications. Industrial land development was taken seriously to locate industries in five different parts of the country to spread

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203

development regionally. Where there was future growth, an attempt was made to latch onto that growth by forming growth triangles. The financial sector went through liberalization. June 1978 saw the removal of all forms of exchange controls except in the form of a basket-pegging management of the currency. Capital controls were no longer applied to domestic firms and individuals. The capital market was opened to foreign transactions so much so that this share market became the main attraction in Asia for international short-term money. The Bank Act of 1973 was consolidated in 1986 with better prudential regulations. A two-tiered system was put in place from 1994 to segregate the weaker institutions from the sound ones: 18 of the some 90 major institutions qualified to become stronger and bigger – the intent of this reform was to get the public to read it as safer – banking institutions. Similar progress was made in introducing prudential regulations, though considered in the light of the post-crisis information on this aspect, these were not sufficient guarantees of safety nor were these implemented fully or strictly. There began a persistent flow of capital into Malaysia due to the combined effect of (1) low inflation in the 1990s; (2) therefore low domestic interest rates and large interest rate differential with many countries; and (3) the very open financial condition.9 The central bank tried to mop up liquidity to stem credit expansion, but it was not successful. The excessive credit available found its way into the non-tradable sector with the result that the private sector was overladen with too much investment of borrowed money in the longerterm infrastructure and property investments. The capital goods import requirements of these investments also widened the current account deficits to an all-time high in the period 1994–96. The high-priced share market attracted so much world attention that in 1993 the funds raised in the capital markets amounted to the same level as all the loans made available by the banking system! The capital market continued to provide 25 per cent of the funds instead of the 3–10 per cent, which was the norm in most periods without the overpricing of the asset markets in the 1990s. The cost of funds therefore went down for public companies, making it possible for private sector firms to undertake long-term projects in the non-tradable sector. This worsened the current account, which, given the continued managed float of the exchange at about RM2.50 to 2.60 to a dollar, could not be sustained for long. An examination of Figure 7.2 reveals that the reserve position for this economy was very healthy throughout the period of growth except during two severe economic (1996–97) and financial (1997–98) crises. July 1997 to October 1998 The baht crisis, that was how it was perceived then, exposed the weakness of

Liberalization and growth in Asia

50.00 40.00 30.00 Growth rate

20.00

M2 M1 FR/IMP

80 70 60 50

10.00 40 0.00

–10.00 –20.00 –30.00

30 20

Foreign reserves to imports

204

10

–40.00 0 1961 1966 1971 1976 1981 1986 1991 1996 2001 Figure 7.2 Foreign reserves to imports ratio and growth rates of M1 and M2, Malaysia: 1961–2002 the Philippines economy first, then the Indonesian economy as well as the Malaysian economy. During the two months over June–July 1997, the steps taken by the authorities under the then Acting Prime Minister did not lead to any amelioration of the situation. When the Prime Minister resumed work after two months of recuperation, the crisis had become worse. More and more individuals were taking their savings out of the country to place them in hard currencies or simply keeping the ringgit outside the country! His further failure to take early decisive steps to bolster investor confidence led to further falls in the exchange rate and, along with it, the stock market collapsed. The stock market plummeted below the 1000 index value, when the government’s attempt to intervene in the market led to further falls after a short rebound.10 Continued selling of shares and conversion to foreign currencies weakened the ringgit to an all-time low of RM4.76 to the dollar during the first half of 1998. Every rebound in the share market led to further sales of the shares, and soon further conversion of ringgit into hard currencies. The fall was relentless. While this was happening, IMF’s attempt to rescue Indonesia and South Korea did not lead to any quick resolution of the currency problem. The March 1998 election which led to a fifth term for Indonesian President Suharto provoked political unrest and riots. Parliament was seized by students in much the same manner as the Tiananmen reformists occupied the square in Beijing. The IMF, faced with the Indonesian President’s reluctance to accept the terms

Malaysia

205

of IMF intervention, postponed corrective actions amidst this turmoil, and this had a telling effect on all the currencies in the region. Meanwhile, opposition to the IMF path to reform grew louder. In mid-1998, a number of influential scholars (Krugman and Bhagwati included)11 supported exchange rate control as the last-ditch effort to stem the crisis. The beleaguered leaders in Malaysia took the slimmest of hope in the new minority consensus on controls, and implemented exchange rate and capital controls effective from September 1998. Consequently, the large-scale trading in the ringgit came to a stop in Singapore and elsewhere to the delight of the policy makers in Kuala Lumpur. The exchange rate soon improved to just below RM3.90 to the dollar by end-September 1998 and the interest rates began to decline below 10 per cent. Thus, one of the more liberal policy regimes was stopped in its track by the 1997 Asian financial crisis. There was widespread scepticism, when the idea of capital controls and fixed exchange rates was discussed as to whether these controls could achieve the conditions needed for openness with the rest of the world while achieving the long-term development aim of becoming a developed nation.12 Controls appear to be favoured by the view of the government on currency speculation and the government leaders’ stand that currency speculation is not a necessary economic activity for development. Nevertheless, it must be admitted, their action to bring in controls from October 1998 stopped the runaway depreciation of the currency at least for the time being. Interest rates halved to about 7 per cent within a month of the announcement. Further easing of the credits is on the cards. The statutory reserve was reduced to 8.5 per cent in November 1998 from the earlier 12 per cent, with a promise of more relaxation to come. The export sector has registered high growth and its financing needs may be satisfied now with cheaper money. That could well become the leading edge of the recovery for this country. 3.3

Exchange and interest rate policies

In Table 7.3 is given a summary of statistics on the exchange and interest rates. Compared with most developing countries, the exchange rate experience of Malaysia could be said to be one that others could emulate. The credit for this goes to a very conscious knee-jerk policy stand on inflation by the central bank. Throughout the period, if nothing else, the BNM had not hesitated to take actions to stem inflation at any sign of it threatening growth. With inflation under control, and enjoying good commodity prices while successfully restructuring the economy towards industrialization, the stable currency exchange rate provided a steadying factor for investment capital to come to Malaysia in a proportion larger than the size of the economy. Severe currency

Table 7.3

Growth of financial and capital market indicators for Malaysia (annual averages)

Exchange rates (% change per annum) 206

Interest rates Discount rate Call money rate T-bill rate Time deposit rate Base lending rate

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

0.06

–0.77

3.43

–0.26

6.99

–5.07

–3.54

8.18

4.66 1.07 – – –

4.17 3.38 2.90 2.80 3.90

4.73 5.90 4.60 7.00 9.20

6.20 6.56 6.12 6.61 8.35

– 5.82 5.21 6.17 8.62

– 2.66 2.86 3.36 6.77

– 2.79 2.80 3.40 6.70

– 2.73 2.70 3.20 6.40

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

Malaysia

207

depreciation occurred only during the 1997 Asian financial crisis. From the period of liberalization in the late 1970s, this country attracted liberal doses of FDI every year right up to 1996, just prior to the crisis. The average flow of foreign direct investments amounted to US$4.5 billion per year: over 1990–96, the accumulated amount would have been 35 per cent of the GDP assuming recovery by year 2002. But recovery did take place from year 2000, and so the prediction of a longer period for recovery did not materialize. 1959–73 With fixed exchange rate during this period, the Malaysian currency – then called the dollar – was pegged to the pound sterling. Very small changes to the rate were made in line with the parity conditions prevailing. Just prior to the breakdown of the fixed rate system in mid-1971, the currency lost value due to the commodity price inflation. It went right up to 3.60 units per US dollar. The newly formed central bank increased the reserves from 3.5 per cent to 5 per cent to stem the credit expansion and to bring down inflation. Again in 1972, the ratio was raised to 8.5 per cent (and 2.5 per cent for finance companies). The oil price hike came in 1972. A new currency, the ringgit meant for only Malaysia (leaving Brunei and Singapore to keep the dollar designation) was introduced in June 1973 with most exchange rate controls removed. 1974–79 With the world recession in 1975–76, the combined effect of the policies led to a reduction in inflation from a high of 12 per cent to single digits. Thus, the first attempt to contain inflation in the late 1960s led to success in the middle of the 1970s. With the second oil price shock in 1978, more financial liberalization was undertaken. A notable change was relaxing the controls on interest rates. Controls were introduced in pursuit of lowering the interest costs during the phase of commodity-led growth. The same policy was consistent with the credit and equity targeting policies of the mid-1970s. Interest rate controls were removed slowly over two years. This led to capital flows that gave some advantage. 1980–89 This period was known for slow growth, which culminated in economic recession over 1986–87. The exchange rate was maintained, under a managed float system, at about RM2.35 during the slow growth period. With the economy recovering in 1987, there was a very large inflow of capital from outside. Along with that came the potential for high inflation. The BNM maintained low real interest rates which helped to ease the exchange rate upward a little but did not lead to inflation. In this regard, the 1986 current

208

Liberalization and growth in Asia

account surplus was a great help. The current account deficits in the years up to 1990 were not large, which also helped to keep the exchange rate stable though a shade higher than the rate in the first half of the 1980s. 1989–96 This period saw a continued high interest margin with other countries. This stimulated large capital flows into the country. The BNM revised the reserve ratios 12 times till the reserve ratio was 12.5 per cent in 1996. Further corrective actions taken did not tighten the loose credit conditions, which led to excessive credit expansion in the private sector. For instance, lending to the private sector increased by 23 per cent over four years compared to 12 per cent in the previous period ending in 1992 when the lending rate remained below 10 per cent. However, this was well below the 60 per cent credit growth reported in South Korea and Thailand. Economic growth was in excess of 8 per cent. This had the potential for inflation, but the credit controls and tightening of credits kept it below 5.7 per cent during most of the period. 1997–2002 With the onset of the Asian financial crisis, interest rates soared, as did inflation. During the 16 months from the onset of the crisis, interest rates soared to double-digits, almost 12 per cent at one time. With the easing of credit controls (and deficit budgets) to introduce an expansionary policy to revive the economy in mid-1998, interest rates began to reverse, and settled below 10 per cent. But the ringgit started to decline till in June 1998, it depreciated to the maximum of 76 per cent compared with the levels before the crisis. This led to the implementation of currency fixing at RM3.80 to the US dollar and capital controls, which was to prevent withdrawals of short-term money. Withdrawals of funds within 12 months of their entry were penalized by the loss of earned profits. This was relaxed in two stages: first the withdrawal period was reduced to six months with loss of interest; later in 2000, withdrawals were permitted provided half the gains were forfeited. Further relaxations were implemented in 2002. At no time were restrictions severe enough to impede trade-related withdrawals or even individuals wanting to travel for educational puposes or on important family matters. Interest rates were maintained at low levels throughout the study period. Except during the 1979–85 period, when the lending rate was a shade above 10 per cent, borrowing costs to firms became the lowest in the 1990s, when the lending rate was 8.3 per cent, a rate that could not be achieved in less open financial markets such as those in South Korea and Indonesia. This low capital cost was the product of high domestic savings and high foreign capital flows. In the 1990s, this factor dulled the firms by encouraging them to take

Malaysia

6.00

ER IR Spread

5.00

209

6.00 5.00

4.00 3.00 2.00

3.00 2.00 1.00

Interest rate spread

Exchange rate

4.00

0.00 1.00

–1.00

0.00 –2.00 1961 1966 1971 1976 1981 1986 1991 1996 2001 Note: Data for interest rate spread are not available from 1961–76.

Figure 7.3 Exchange rate movement and interest rate spread, Malaysia: 1961–2002 low-profit long-term investments at a time when the export sector was registering sustained declines, from 1991 onwards. This led to further borrowing by the private sector as no one anticipated that a systemic crisis was developing in the region with (1) declining export growth; (2) too many shortterm loans in banks and firms and worse; and (3) increasing non-performing loans in a relaxed supervisory regime (see Figure 7.3). 3.4

Financial Institutional Development

At the time of forming the central bank in 1959, there were 26 commercial banks of which 18 were foreign banks, with 111 branches. Total assets of the commercial banks was M$1.1 billion, about 11 per cent of GDP. In 1996, there were 37 banks, all of which were locally incorporated even though 16 of them had foreign affiliations. The total assets in 1996 amounted to almost 100 per cent of GDP. In the beginning, the foreign banks held most of the deposits in the country, and transacted with London inter-bank markets as the currency was fixed to the pound sterling. All this changed dramatically over the years through financial institutional reforms and diversification to support a developing economy. Unlike what

210

Liberalization and growth in Asia

happened in the command and socialist economies in East and South Asia, the banking sector remained in the private sector. Government bought shares in some leading banks such as the Maybank, but no nationalization of the type found in other countries ever occurred. During the 1960s to mid-1970s, attention was focused on building a variety of financial institutions. Thus, entry barriers were eased and more banks, finance companies, merchant banks, Islamic banks, a savings bank, and development banks were licensed. Finance companies (i.e. the credit unions) were later consolidated into fewer firms. The number of branches also increased to about 1200 of which the local banks had preference accounting for 85 per cent of branches. By the mid1990s there were thriving money markets in Malaysia along with robust capital markets helping to raise about 25 per cent of capital needs of the economy. Apart from structural changes, regulations governing the sector were rapidly changed and modernized. The Bank Act 1973 was meant to apply to commercial banks. Other deposit-taking institutions such as the finance companies, Islamic banks, and merchant banks were brought under the purview of the banking laws in the 1970s. With more industry-based development, three new regulations came into effect. An omnibus act to cover deposit taking and non-bank financial institutions was passed into law in 1986. In 1989, notice was given that banks would be required to take steps to incorporate under the local laws from 1994 as enshrined in the new banking act. The two-tier regulatory system was implemented in 1994, which by 1997 led to 18 sound banks, finance companies and merchant banks qualifying with higher capital ratios than the rest. There were savings cooperatives, which were outside the banking laws, as are still such large asset-based institutions as the Industrial Bank, the pension fund (EPF), the Tabong Haji and the Savings Bank. The poor management of the co-operative savings units led to a massive bail-out in the early 1980s, and also led to a few banking failures: now credit unions are under BNM supervision. Though most relevant institutions come under the prudential regulations of the BNM, exempting some is not seen as prudent. As described in section 2, banking consolidation to strengthen the capital management of banks led to all the deposit-taking institutions being merged into 10 anchor banks in 2001. This exercise took three years of consultations and negotiations among the affected parties. 3.5

Financial and Capital Markets

Pertinent statistics on financial and capital markets suggest the steady growth in activities and depth of these markets in parallel with the underlying economic activities. It has been remarked in an earlier section that the

Malaysia

211

financial markets were developed from scratch in this country. The inter-bank markets started in 1967 with the establishment of the discount houses, which traded short-dated monetary instruments after buying them wholesale at the time of issue. This led to the beginning of an active discount market. Treasury bills and bonds were introduced later. The freeing of exchange controls led to active trading of the local currency both in the spot and forward markets. Capital market development started in 1960 with the trading in Kuala Lumpur of the dual listed stocks and bonds in Singapore. The real impetus came only when the ringgit was adopted in June 1973 as the Malaysian currency and Kuala Lumpur traded the shares in the local currency. The dual listing arrangement with the Singapore stock exchange worked both ways in the earlier period. With the development of the local market, more and more firms continued to restrict listing to the local market even though the more established firms were actively traded in both markets. The dual-listing coming to an end in 1989, along with other reforms, made the local market extremely attractive to foreign portfolio investments. Liquidity surged very high and the market gained substantial growth in all aspects. The total traded volume in 1993 represented the cumulative total volume of the past 20 years! The market yield in that year was an enormous 104 per cent in this, the fourteenth largest market. This made foreign interest in the local market a very significant destabilizing force. Since the withdrawal of foreign interest in the market starting in 1994, the market drifted down to lower levels, and was also badly affected by the currency crisis. The structure of the capital market changed rapidly in the late 1980s and 1990s. The number of firms listed almost doubled in the period and capitalization soared with high-priced stocks: in 1999, there were 702 firms. The bond market also expanded with two rating companies providing rating services. To these were added a few derivative securities. Interest-rate derivatives were added soon in 1995 followed by the offer of stock index futures on a 100-stock based index in December 1995. Plans were afoot at that time to include options markets. With the crisis affecting the market sentiments, some of these plans have been put on hold. The share market bore the worst effects of the financial crisis. The immediate effect of the currency crisis – worsened by the exposure of this market to foreign and local individuals holding a large portion of the market – led to the collapse of the share market. It plummeted by almost 80 per cent, and languished between 350 to 500 index values for almost three years. Only in 2000 did it recover to a level about half way to the point it was at the onset of the crisis. The exit of foreign portfolio investors, especially in the face of strong capital controls on portfolio flows, meant that the market was deprived of the demand push, which was a basic reason for this market’s attraction for both foreign and local investors.13

212

Liberalization and growth in Asia

Credible reforms to liberalize the financial sector were also noteworthy features of development experience. Not only did the reforms help to build a financial institutional framework from scratch, they also helped to build a diversified financial structure that delivered the capital at a low interest rate to assist the development process. In the 1990s, there were too much capital flows into the country because of this very openness. Attempts by the central bank to mop up the liquidity to prevent the private sector taking on too many imprudent investments failed. This failure at the time of worsening current account deterioration weakened the exchange rate, which was held artificially high by the basket pegging in place since 1978. When the policy responses did not restore the confidence of the investors, both local and short-term fund owners withdrew their funds to safer currencies, and the exchange rate went on a free-fall that exhausted the ability of the country to sustain the shock. The adoption in October 1998 of a fixed exchange and capital controls on shortterm cash inflows reversed one aspect of the liberal policies in the financial sector on its track. It has nevertheless brought in some stability after 12 months of instability. Would it deliver the long-term needs of an economy dependent on the external sector for development?

4.

EFFECTS OF LIBERALIZATION

4.1

Macroeconomic Effects

The growth rates in the key financial indicators of the economy are very impressive except in the case of the very wide variation in trade since the 1990s. The economic growth rate was sustained within the long-term trend of about 8 per cent in the 1970s and 7 per cent in the 1980s despite world recessions in 1975–76 and stagflation in the first half of the 1980s. Growth has been impressive in the 1990s at above 7.80 per cent suggesting a long-term path of 8 per cent. Since 1998 growth has been re-established at a potential rate of about 5 per cent in the short run while experimentation is underway on strategic changes in policy following the 1997 crisis and the September 11 event, which has led to far-reaching economic ill-effects. Growth in FDI flows was almost four times the economic growth rates suggesting the increasing dependence of this economy on foreign capital, which was endemic to the Southeast Asian region: this has been slowing down since 1995 as exports were declining. Between 1991–96, a total of US$47 billion in FDI was invested. This does not include the private sector borrowing from foreign sources and the portfolio flows to the equity and bond markets, both of which received substantial foreign activities. An important consequence, which could not be sustained in the long run, was the high investment

Malaysia

213

rate in this economy. In most years over 1990–96, investment rates were close to or above 42 per cent of the GDP. These rates of growth in the investment and economic activities were achieved without a substantial rise in the inflation rate as well as in interest rates. As noted earlier, inflation control has been pursued by the central bank. Only in 1996 did inflation go above 5 per cent, whereas it remained below that figure throughout the 21 years covered by the data. This is not a mean achievement even within Southeast Asia. The other countries in the region, with the notable exception of Singapore, had inflation twice or three times the rate in Malaysia. This aspect of financial and monetary management deserves further study as it may hold important lessons for development economics policy. The BNM has had a signal success in this regard despite being faulted in others. The fiscal health of the economy is also seen by the high growth rates in public finance. This grew at the highest rate of 22.13 per cent during the commodity boom period and during the 1990s with the average growth rate of 11.7 per cent. This was achieved by the twin policy of privatization and tax reforms. By privatizing more and more firms, public goods production was moved to the private sector, and this also provided more money since the losses of public sector firms were no longer getting budget supports. The tax reforms, which reduced personal tax and corporate tax, led to higher growth in government revenues. This aspect also deserves further study since many newly emerging economies have to tackle the problem of how to divest lossmaking public enterprises while reducing tax rates without losing a hold on public finance. Monetary growth was running ahead of income growth in some periods as for example during the 1975–80 period, when government borrowing peaked as the commodity prices declined while the rural development programmes were nearing their peak as well. Comments made earlier in the section on exchange rate management would suggest that this was due to the persistent high liquidity in the banking sector, a consequence of the financial liberalization that led to capital inflows. Repeated attempts to manage the liquidity kept these figures from getting out of control and from affecting the inflation controls. But the monetary growth was high in the 1990s as the central bank was grappling with the task of reducing credit expansion in that period. Its attempts led to inflation being kept down but failed to curb high capital usage in the non-traded sector. Not curbing the private sector investment into non-tradable production areas destabilized the fine balance they achieved in managing inflation. The overall impact of financial liberalization on the financial sector was very widespread. Despite the central bank’s concern about the need to control inflation, which meant that monetary growth was discouraged throughout the

214

Liberalization and growth in Asia

period, the ratio of M2 to GDP doubled over the period. This reflected the growth in economic activities over the years. This ratio went up from 0.48 (48 per cent) in the five years over 1976–80 to close to 0.90 during 1993–97. Money growth, as explained in an earlier section, was kept low to discourage huge expansion in the private sector demand for credits. The financial intermediation ratio (FIR) also doubled over the period reflecting the public’s willingness to hold assets in the organized financial sector. It also reflects the development of institutions that could facilitate the holding of assets in such institutions. This ratio was already high, 63.98 per cent of GDP in 1980, improved to 118.8 per cent. This level of intermediation is very close to the values of developed countries. That could very well be a reflection of greater commercialization of economic activities over the years and the liberal policies that encouraged competition. The impacts of financial policies can be seen in Table 7.4. The FIR for the public sector shows less growth from 0.74 in 1976–80 to 1.00 in 1993 and 0.70 in 1995. This decline in intermediation ratio in the post1994 period is a reflection of the changes in the structure of the government finance as the economy was gradually slowing down with declines in trade sector occurring from 1992. The private sector’s FIR kept increasing very fast from the 1976–80 average of 1.17 to 2.79 in 1995. In fact, there was a buildup of too much debt as firms switched to land-based investment projects to offset the loss from falling exports. In this, the encouragement of high-priced hotels, road works, condominiums, and resorts became fashionable in the mid1990s. Obviously assets and/or liabilities were fast being built up in the private sector. That is consistent with the trends shown in other statistics. A statistic of particular interest is the increase in the FDI flows, which must have increased intermediation in the real sector. FDI as a percentage of GDP increased fourfold in one year in this period. Growth in fixed capital formation was high in the 1990s. From the trend average suggested by the low figure in 1981–90 of 30.53 per cent of GDP, capital formation went up almost to 40 per cent in 1991–95. These figures therefore are consistent with the 1990s growth being part of a greater private-sector-led expansion. However, these figures were to decline by a large margin once the baht crisis started affecting the economy in 1997. Overall, the effects of financial liberalization on the financial sector have been salutary. It expanded in numbers, quality, and in the provision of new financial products. Further, financial deepening can be described as having doubled over the 20 years since concerted efforts to institute a greater degree of financial reforms were established after 1976. A close examination of the information in Table 7.4 indicates that there have been substantial capital inflows in the form of FDI over the years in Malaysia. On a per capita basis, FDI flow to this country is perhaps the largest

Table 7.4

Indicators of financial and capital market depth in Malaysia (annual averages)

215

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

Intermediation depth FIR (total)/GDP (=DC/GDP) FIR (private)/GDP

12.39 12.56

27.66 25.09

63.98 55.43

80.13 72.29

115.80 101.00

117.99 108.45

113.43 102.65

118.80 108.95

Capital accumulation GFCF/GDP FDI (net)/GDP FDI (inflow)/GDP

15.50 – –

24.39 – –

30.53 3.81 3.81

39.14 10.10 10.10

31.99 7.45 6.96

25.61 9.22 6.75

24.93 8.40 5.47

23.23 1.17 0.79

2.99 0.41

4.84 1.68

6.45 2.05

– –

1.10 –0.12

1.80 0.97

– –

– –

Indebtedness Domestic borrowing/GDP Foreign borrowing/GDP Notes: M2 = FIR: GFCF: FDI: DC:

currency + quasi money. financial intermediation ratio; claims on public sector (public), on private sector (private); the total (total). gross fixed capital formation. foreign direct investment. domestic credit.

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

216

Liberalization and growth in Asia

in the region with the exception of Singapore. Current and capital account opening was put in place prior to 1975, long before the worst effects of the commodity price declines started to bite and also long before other Southeast Asian countries took steps to attract foreign capital. However, it was not till the mid-1980s that foreign majority ownership was permitted, and this led to the fast acceleration of investments in the manufacturing and energy sectors. The cumulative total investment in the real sector is said to have given multinational firms a strong presence in this economy given the easing of restrictions on ownership and openness in financial transactions. These statistics underscore the importance of external capital inflows as a result of financial openness from the mid-1970s. In some years FDI constituted close to 10 per cent of the GDP as in 1992 and 1993. Gross national savings running at about 33 per cent of the GDP should be added to these flows thus leading to about 40 per cent capital formation in the real sector in several good years. This rate of investment was sustainable – given the tight rein on inflation – and high demand for exports. Once the exports declined, especially in the 1990s, the capital flows were maintained for use in building huge investments in the non-traded sector of shopping complexes, recreational facilities, mega infrastructure projects, all of which would only give low returns, not the kind that foreign money is after. The low returns were inconsistent with foreign capital requirements. Something had to give way once the currency started to weaken. Part of the weakness was due to the high portfolio investments in the capital markets and in the banks borrowing from abroad. These were short-term in nature, and liquidation of assets led to sale of currency, which further weakened the currency as it happened during the 12 fateful months during 1997–98. This led to reversion to fixing the currency and the withdrawal of the open financial conditions that prevailed over more than two decades.

5.

ASSESSMENT AND FUTURE PROSPECTS

The progress made over about 45 years of development activities in Malaysia had two important outcomes. It lifted the well-being of the people of this country. A primary producing country successfully restructured on its way, most observers agreed in 1996, to becoming a newly industrializing economy in the not too distant future. That this was achieved while pursuing limited credit and capital targeting to improve the social status of the majority of the population is notable when many countries (e.g. USA, Fiji, Ghana), unlike Malaysia which used market-based incentives, set up government organizations to achieve the same results. Another feature is the successful experience with containing inflation while maintaining high growth. This

Malaysia

217

is a special feature of this case study and there are lessons to be learned from it. With the return to a fixed exchange rate and therefore the remaining capital controls,14 many observers are sceptical about how this small economy could remain relevant to the powerful capital movers, which augmented the local resources that led to the successful development and restructuring of the economy. Export competitiveness has improved as a result of the recent realignment of currencies in the region. This country has an upper middleincome level of development, which means that the level of social and infrastructure development is more advanced than in other countries of the same size or even larger emerging economies. Perhaps this is a competitive advantage in that investment in such a place is likely to be more profitable to the international capitalists. We leave the future to be determined by the interplay of competitive forces, which could well be favourable to this economy even after the crisis since it has the kind of attractions that many in the neighbourhood are lacking. One key actor is the purchasing power parity of the ringgit. It is an attractive 268 per cent of a US dollar, which goes against the dire predictions based on the nominal GDP in US dollar market exchange rate. If the favoured twin-policy – a mix of an industry-based economy growing on both exports and domestically-sourced demand – bears good outcomes, it is very likely that this economy will be able to establish a growth rate of 5–8 per cent with its strong established position as an exporter of durables and also its huge capacity to invest at levels higher than 35 per cent of GDP.

NOTES 1. 2.

3. 4. 5.

6.

This country has adopted a vision of reaching the developed country status by that year as an official strategic goal to motivate all actors in the economy. Among similar-sized countries, Malaysia achieved significant income growth though Taiwan did achieve greater growth of 10.5 per cent. Malaysia is made up of two separated land areas across the South China Sea: Peninsular Malaysia, which has 40 per cent of the total land with 80 per cent population; East Malaysia with 60 per cent land, has 20 per cent of the population. The sources for much of the statistics are (a) ADB (1997b) Emerging Asia: Changes and Challenges and (b) Bank Negara Malaysia (1994a) Money and Banking in Malaysia. See Bank Negara Malaysia (1994a) ‘Preface’ to the fourth edition. The outright advantage in the capital market was interest rates set at about 2 percentage points below market rate. In the real sector, there were some advantages in the form of a discount for the bids by indigenous contractors in much the same way as Black contractors were treated in the USA. A third preference was in the allocation of new shares; 30 per cent of new shares were compulsorily allocated; indigenous population accounted for two-thirds of the total. Other schemes targeted at small farmers, such as financing and training schemes, small business, etc. provided an infant-industry type of support as is found in several, even developed, countries. The banking financial institutions consisted of about 36 commercial banks, 40 finance

218

7. 8.

9.

10.

11.

12.

13. 14.

Liberalization and growth in Asia companies, 12 merchant banks, and 30 foreign banks/representative offices up until 2001, when these institutions were merged into 10 anchor banks while the foreign banks were permitted to continue as before. The merger is expected to prevent future bailouts of weak institutions when restriction on entry of financial institutions will be lifted in 2004 under WTO rules. There was another exchange, the Bumiputra Exchange, which ceased operation in 1994. The ringgit fell in June 1998 to its lowest level in four decades to RM4.76 to the dollar, which is a 76 per cent depreciation. With unprecedented steps fixing the currency at RM3.80 to the dollar and the penalty/restrictions on withdrawals of short-term capital, the economy recovered by 2000 delivering an 8.4 per cent growth. The spread between deposit and lending rates of the Malaysian banks was 2.39 per cent in 1996. This compared favourably with Hong Kong’s 2.46 per cent against the worse cases of Taiwan (0.48 per cent) and South Korea (0.43 per cent). Even the banking sector appeared to be strong before the Asian Financial Crisis. It is interesting to note that Hong Kong, a major financial centre, also did the same in mid1998. The market rebounded for a while before declining further. Investor confidence in a neutral regulator was shaken badly in this case, though the Hong Kong government justified their intervention as being in the public interest. Krugman’s position was widely publicized in the first week of August 1998, in his web site and in the international press, including the Financial Times. Earlier, Bhagwati (1997) suggested that free trade on currencies was not consistent with free trade on goods given no satiation of demand for currency. He said that the trading in wedges was not the same as trading in dollars! Leading central bankers of the region had privately looked at controls as a quick way to end the crisis temporarily. This was evident in the authors’ conversation with them during the field trip and during subsequent meetings. However, the public stand against controls by these same people in August 1998 did not come as a surprise to us. There is no valid experience with going back to controls. Even the limited controls on hot money in Chile led to mixed results. Only time can resolve this issue. Regulations permitted banks to lend money to individuals for share purchases. At the height of the crisis, the exposure from this source accounted for about 15 per cent of the loans! The government that took over after a general election in 2004 has indicated that the fixed exchange rate has greatly assisted in reducing exchange rate uncertainty for this increasingly export-reliant economy. Hence the current regulations on fixed exchange rate and the softer version of the capital controls are there to remain for some time to come.

8. 1.

Pakistan: liberalization with internal and external shocks INTRODUCTION

The case of Pakistan serves as an example of an economy with an open trade sector but relatively controlled, one should say, suppressed, financial sector. Despite that pejorative label we have placed, the main obstacles for growth for the people of this nation with its rich resources arise not just from financial mismanagement but from political instability. These can be primarily exemplified by unstable governments as a result of multiple regime changes – more to the point, a lack of democratic process for political succession all along the 58 years since the birth of this nation. Huge sovereign debts that financed several wars had to be repaid, failure of which placed the country at red alert on the brink of default of US$40 billion. There is also massive unemployment arising from the failure of the economy to employ the huge labour force growth from a 2.2 per cent natural growth in population. When alarming and sustained depletion of reserves occurred twice, there was no choice but to enforce major reforms in 1990 and again in 1996. Major reforms taken were aimed at stimulating domestic private investment, freeing controlled prices to encourage return to market prices and, importantly, introducing badly-needed current account reforms on exchange rates. To reduce public expenditure, privatization and deregulation of barriers to entry and tax reforms were put through. Pakistan relaxed financial sector restrictions in 1990 to open the capital and current accounts to stimulate foreign currency flows on the back of the stability that these two measures normally bring to the economy. Traditionally, large amounts of money were kept by residents, especially expatriate Pakistanis, in hard currency accounts in major capital markets. Without stability in the current accounts, these deposits would remain in other countries. Politically, Pakistan was on a roller-coaster ride during all of the 1990s with each government (mostly un-elected military ones) remaining in power for at most less than three years. The tit-for-tat explosion of an atomic test device in 1998 after a similar test by India attracted economic sanctions from the world community, and soon thereafter a military takeover of a civilian-elected 219

220

Liberalization and growth in Asia

government took place in 1999. Those two events isolated Pakistan from good international relations. With the economy stalling from the economic sanctions, and ability to service the external debt suffering further, the outcome was quite predictable, a slide to the brink of default again in 1999. Following a number of developments on the back of the September 11 event,1 especially Pakistan’s readiness to support an American-led war against terrorism, new economic forces were unleashed that actually helped this country to regain some of its lost international position. The country was again embraced by the world community, which recognized its critical role in the fight against terrorism. The reverse side of all this is that the ruling elites could no longer delay much-needed reforms. Economic reforms were ushered in quickly, that led to a substantial increase to the drastically low level of foreign reserves. The country was rescued from a financial disaster, which could have devastated the future prospects for reasonable development. Passing into law, money laundering regulations in the United States were meant to freeze the accounts of terrorists but they encouraged some or most of the Pakistanis in that country and elsewhere to repatriate their savings to Pakistan. This was a boon to the financial sector, and a welcome development for a country with severe financial constraints. A detailed historical perspective of economic and social development over four decades is discussed in section 2 of this chapter. Some details about the specific reforms initiated in the early 1990s and reshaped in 2000 are also discussed in the next section. The prospect for future growth is discussed in section 4. Sustaining growth of the size needed to stabilize and absorb the bulging labour pool requires a demonstration of a permanent commitment to implement, monitor as well as evaluate, effective pro-growth policies. Crucially it also hinges on a solution to the state of preparedness for war that continues to consume precious resources. There is a lot for this country to learn from other cases in this book.

2.

ECONOMIC AND FINANCIAL STRUCTURE: AN OVERVIEW

Pakistan has experienced persistent uneven development ever since the country was established in a bloody partition from India in 1947. The first few years of this newborn country were the most difficult ones, given the violence and the refugee problems. Its economic performance was very poor in the first decade. The 1960s witnessed a sharp favourable turn for the better when growth approached 6 per cent. Since then the country has been experiencing fair economic growth, though with cyclical downturns.2 The growth trend was maintained at 5–6 per cent per annum until the mid-1990s. The major reasons

Pakistan

221

for cyclical growth were endemic political instability and huge defence expenditure for strategic reasons (essentially to try and regain a disputed land over which India and Pakistan had fought seven times). Warmongering is part of the political culture that slowly evolved to justify the huge resource mobilization for these conflicts: all political parties had to subscribe to them, and that is a major handicap for this country. Another major obstacle to development is that the population, already high at 157 million, growing at 2.2 per cent per annum, is one of the highest in developing countries. Even Bangladesh has reduced its birth rate below this level. Pakistan has traditionally been a mixed rather than a completely controlled economy not vastly different from its neighbour India, as is the case of China included in this book. Outward oriented policies in the trade sector were not pursued vigorously in India, which adopted the policy of home-grown growth through import substitution. Pakistan, on the other hand, kept the traded sector quite open, though the domestic sector had pervasive price distortions. The traded sector was relatively liberalized. The financial sector had all forms of controls to support a system of subsidies for agriculture and industries. The outcome was a lack of fiscal discipline, and the public services fostered endemic inefficiencies (thus diminishing the economy’s ability to grow) in the process of intervening in the market pricing process. Educational, social and health services were considered least important for budgetary allocation. Political institution-building based on democratic voting was thwarted – understandable given the military rule of the country till the late 1980s, and again in 1999. Pitifully, so were the efforts to build law-and-order, an impartial judiciary, efficient civil services, efficient educational institutions, etc., of the type some dictatorial countries managed to build even while destroying democratic processes: Thailand and South Korea during military rules are examples. Apart from the first decade following independence from the departing British, the country has struggled to have political stability as it continues to be mired again and again under military dictatorship fifty-six years later in 2003.3 As stated above, the trade sector was liberalized at an early stage but the capital and current accounts were closed, along with the imposition of stringent financial suppression that distorted domestic prices made perverse by subsidies. The country did not have a capital nor an industrial base at the time of its birth in 1947. Obviously, the basic focus then was on agriculture and agro-based industries. The 1960s witnessed the Green Revolution, when resources were applied to increase per capita outputs. Shortage of natural sources, especially irrigation water, required the spending of huge amounts of domestic resources as well as foreign aid loans to introduce a canal irrigation system as a backbone for the agricultural output required to feed a growing population. These efforts resulted in reduced dependence on food imports,

222

Liberalization and growth in Asia

especially wheat, and increased export earnings from cash crops such as cotton, rice, jute and sugar cane. Only after this foundation in agriculture was laid in the 1960s did the private sector become interested in manufacturing industries such as textiles, cement, fertilizers, etc. Meanwhile, investment was made in the services sector, to build infrastructure in banks and financial institutions, educational institutions and health facilities. The public sector, however, could not accelerate investment in these sectors as a large proportion of domestic resources were allocated for defence in a period of rule by generals. Despite that, some industrial sector development did occur in textiles and agro-based industries. During the next four decades, Pakistan experienced complete political instability with military regime taking over five times. All efforts at economic planning proved to be unsuccessful due to the political instability and border issues with neighbouring India, which included seven direct or indirect border clashes. The secession of the Eastern wing of the country (now Bangladesh) in December 1971 was a further slight and an Indian-assisted blow to economic prosperity. The nationalization drive in 1972–75 reversed the process of any private sector participation in economic development. Until 1980, distortions such as subsidized agriculture and industrial activities were the norm. By any stretch of the imagination, this was not pro-growth, nor did it result in the market mechanism working unhindered on the prices in the different sectors. During 1984–90, the authorities became desperate and could only do one thing, which was to reduce and eventually eliminate these subsidies.4 In these reforms, an IMF structural stabilization programme and the USAID economic aid package did what the political elites failed to do for quite a long while.5 Later, the Russian occupation of Afghanistan left Pakistan with no option but to become a direct partner to the US-led coalition war which brought a culture of drugs, ammunition, and terrorist activities in the country, diverting resources from economic planning to internal security concerns.6 Pakistan was facing severe economic and financial difficulties during the 1990s mainly due to political instability made worse by the festering preterrorism lawlessness and extremism, and further aggravated by 11 years of dictatorial regime of General Zia with his pro-US policies to avoid any international criticism and domestically leaning towards fundamentalism to win back the already entrenched extremism born out of war and disorder in the neighbouring country, Afghanistan, and in the disputed territory, Kashmir. The very high indebtedness that arose from pursuing a twin policy of subsidies to some sectors and a high defence spending brought only one result. Debt soared and inefficiency persisted. Besides political instability, many economic factors were responsible for this decline in growth in 1990s. These included

Pakistan

223

financial resource limitation, persistent fiscal imbalances, inadequate infrastructure, declining export demand, declining foreign reserves and soaring international debt. Had there been no sanctions, the severity of these problems would have been a lot less, but they made it hurt in all corners of the economy. In 1990, a major package of economic reforms had been unveiled. It had a wider focus on many development issues; exchange rate and payment reforms, privatization, trade deregulation and financial sector reforms. This was supposedly a more serious attempt at reforms than those of the 1980s. However, a lack of political consensus to implement these policies, a high level of corruption and political instability could not help the economy to grow. The result was that just meagre progress was made, that did not solve the many problems of a new young country founded on a vision that its people would get greater prosperity than they thought they would have achieved in a united India. A substantial decline in foreign reserves occurred during this period and the economy reached the point of bankruptcy several times. Timely assistance from the IMF helped the country to avoid the worst scenario. The revival of economic reforms was soon expected to take centre stage and the government focused on these reforms as its main agenda. Some drastic measures were also announced including reforms in the tax collection system, downsizing the government and incentives to attract foreign capital both from foreigners and nationals living abroad. To these were added a wide range of reforms in the financial sector, which included the development of capital markets, a relatively independent central bank and efficient commercial banks. These measures, however, failed to produce any positive result as gross domestic savings and investment continued to remain extremely low. Severe fiscal and external imbalances and a very high debt–service ratio worked jointly to create a vicious circle where lack of an efficient revenue collection mechanism leaves no choice but to borrow from domestic and external sources to meet mounting government spending. The government attempted on its own and on the behest of the IMF and the World Bank to curtail public spending and improve revenue collection. These included streamlining development plans and projects, a 19 per cent cut in the public sector development outlay, restructuring the existing tax system and imposition of an agriculture income tax. Despite the assurances and securities provided, investor confidence did not improve given the continued political instability. In the later half of the 1990s, another insidious problem emerged: nonperforming loans of the private sector worsened. The banking and financial sector suffered loan defaults of about 7 per cent of GDP in 1997 (Asian Development Outlook, 1998; p.135). On the external sector, the country was facing three basic problems: (1) remittance from nationals working abroad was declining; (2) a reduction in demand for exports; and (3) a huge allocation

224

Liberalization and growth in Asia

of funds for debt servicing. Foreign debt in 1999 stood at US$29.0 billion, which was 44.5 per cent of GDP. Although efforts were made to accelerate exports, this sector remained sluggish, and declined a further 2.7 per cent in 1997. In May 1998, the country’s decision to retaliate to the Indian atomic explosion with their own nuclear explosion brought severe economic sanctions by the world. The result: by the end of 1999, the country had an exceptionally high level of debt with foreign exchange reserves enough for a mere three months’ worth of imports. This economic mismanagement led to another military takeover in October 1999.7 This time, the regime change (or the military dictatorship) did not get a nod from the West and the United States. The country went into complete isolation. However, the post-September 11 events turned into a way out for Pakistan. Pakistan’s decision to become part of a US-led war against terrorism opened the doors for soft loans and aid from Western countries and the United States. Economic sanctions that were imposed in 1998 were gradually removed. Softening of US foreign policy towards Pakistan resulted in some debt relief and loan rescheduling. At the same time, strict United States security regulations also forced many Pakistani investors and business community to transfer their funds to a safe place, Pakistan. These two factors increased foreign reserves at an historically high level of above US$12 billion and led to a slight appreciation of the currency as well as an improvement in the country’s credit rating. By 2003, for the first time in the three decades, the country experienced a growth rate of 5.1 per cent with single-digit inflation (3.3 per cent).8 In view of the significant increase in foreign reserves, notices have been served to the World Bank and the Asian Development Bank for early repayment of US$1.078 billion worth of loans. These include 11 World Bank loans and seven ADB loans, which were originally due between 2005–2019.9 At the same time, the current peace process with historical arch-rival India is good news for economic prosperity as it has an historical chance to divert more resources to economically efficient uses. The decision, in principle, to accept Pakistan in the ASEAN Regional Forum (ARF) and also to the membership of WTO will further boost the attraction of the country for trade. The economic prospects, at the time of writing, in 2004, seem positive. Curiously Pakistan’s endearment to the secret services of the West for breaking the mighty Soviet Union and later the ongoing war on terrorism have provided perverse rewards. 2.1

Economic Performance

Table 8.1 summarizes the overall economic performance of the country during the last four decades. The average economic growth over 40 years is around 4 per cent. The figures released by the State Bank of Pakistan (SBP) report a

Pakistan

225

5.1 per cent growth in 2002–03 with the manufacturing sector being a major contributor to this growth performance: it registered an 8.7 per cent growth. This is significant. Pakistan has the potential to be an industrial powerhouse – largely based on its large size and abundance of technical workforce – for the war-torn security-scarce Western Asian countries with about 270 million people who are increasingly finding it easier to trade with Asia after the September 11 event. Would this nation rise to the occasion? Time will tell. Herein lies the opportunity to seize a moment in history to build an industrial base. Given the high birth rate and the low growth in incomes, per capita income increased by 3.4 per cent from US$104 in 1960 to only US$439 in 2002. Part of this slow growth in per capita income was due to the high depreciation of the Pakistan rupee since 1981.10 Private consumption and government consumption remained almost constant during the four decades: this meant that the capacity to save had not increased. A high private consumption of around 75 per cent (of GDP) and government consumption of around 15 per cent (of GDP) leaves no room for any private sector activities in domestic investment or even to finance international trade, even if exports were growing. It is evident from Table 8.1, that the financial sector did not grow much in the four decades. The gross domestic savings to GDP ratio of around 13 per cent during 1971–80 remained at the same level in 2002: it rose to 15.5 per cent in 2002–03. This 15 per cent saving rate is very low compared to rates in other emerging economies such as India (22 per cent), Thailand (30 per cent) and Indonesia (40 per cent). Fixed capital formation (ratio to GDP), at the same time, registered a decline from a peak of 18 per cent during 1991–95 to a mere 12 per cent in 2002. Part of the slow growth in saving is attributed to a lack of supervision of the financial institutions, which led to the sprouting of a number of bogus finance companies in the 1980s. That led to a collapse of those companies, resulting in small savers losing most of their savings. With a very low-income base, there is hardly any saving left. Further, savings are also discouraged due to a double taxation on interest income. In 2003, banks offer around 8 per cent interest (that is, the dividend yield based on Islamic profit/loss sharing accounts). With 4 per cent inflation, this leaves a real interest rate of 4 per cent. All banks deduct a 2.5 per cent zakat (an Islamic system of taxation for funding poor and destitute people) on the average balance during the year plus 10 per cent tax on interest income. This double taxation along with the depreciating value of currency (which depreciated around 10 per cent per annum until recently) leaves no incentives for saving. Fiscal balances have shown a major improvement since 1991–96 when a peak budget deficit was reached of 7.7 per cent of GDP, to 4.6 per cent of GDP in 2002. Part of this is attributed to a pressure through the IMF and the World

Table 8.1

Basic economic and social indicators of development in Pakistan

226

1961–70

1971–80

1981–90

1991–95 1996–2000

National accounts GDP growth (%) Per capita GDP (US$) Private consumption/GDP Government consumption/GDP

3.35 138.86 77.71 12.51

4.81 180.18 79.00 13.79

6.19 327.06 76.92 17.06

4.85 404.85 70.81 18.16

Financial indicators (%) Gross domestic savings/GDP Fixed capital formation/GDP Inflation (per annum) M2/GDP Fiscal balance/GDP Trade balance/GDP Current account balance/GDP Total trade/GDP Debt/exports Debt/GDP Foreign reserves/imports

– 15.37 3.51 36.14 –5.17 – – 21.20 403.90 33.91 21.27

13.81 15.38 12.42 41.76 –7.41 –8.06 –5.35 28.00 606.09 61.96 17.98

13.83 16.96 6.98 41.25 –6.74 –9.31 –2.91 33.59 509.28 64.15 11.52

14.81 18.07 11.20 43.39 –7.67 –5.15 –4.49 36.73 – – 14.24

2000

2001

2002

3.07 438.82 73.99 15.51

4.26 426.64 74.43 15.01

2.72 380.54 75.15 13.65

4.41 439.00 74.96 15.25

13.29 15.41 7.30 46.63 –6.91 –3.73 –3.17 35.16 – – 10.56

14.40 14.37 4.37 46.92 –5.47 –2.40 –0.14 34.30 550.66 90.00 14.23

14.60 14.29 3.15 48.30 –4.71 –2.30 3.41 37.37 – – 34.05

13.60 12.33 3.29 51.74 –4.62 –0.50 4.50 35.75 – – 71.86

Social indicators Literacy rate (%) Unemployment rate (%) Expenditure on education (% of GNP) Expenditure on health (% of GNP) Expenditure on defence (% of budget) Population growth (%)

– –

26.20 –

35.70 2.00

37.90 5.42

43.70 6.22

47.10 7.80

49.00 7.80

50.50 7.80

–

–

0.80

2.20

2.21

1.70

1.60

2.00

–

0.60

0.80

0.70

0.60

0.70

0.70

0.70

3.00

3.14

3.13

2.99

2.34

25.30 2.24

25.30 2.22

26.90 2.16

227

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

228

Liberalization and growth in Asia

Bank under their adjustment programmes. The regime also gets credit for recovering money from corrupt politicians and bureaucrats.11 The external account showed significant improvement with the trade deficit moving from a high of 12.6 per cent of GDP in 1984 to 0.5 per cent of GDP in 2002. Similarly, the current account balance moved from a deficit in 2000 to a surplus in 2001. The 2003 figures released show further improvement in current account balance to GDP ratio moving from 4.8 per cent in the fiscal year 2002 to 5.9 per cent in the fiscal year 2003. This was mainly due to a record increase in exports of US$11.1 billion and a further record of US$4.2 billion of inward remittances. These statistics are consistent with the twindeficit hypothesis where a decline in both the fiscal and current account deficits is averted over time by reforms (see Figure 8.1). High indebtedness remained a major bottleneck for economic growth. Total external debt has increased from US$15 billion in 1991 to US$26 billion by 2001. The debt servicing consumed around 21 per cent of export earnings in 2001. This amount could be more than enough to fund the kind of budget for educational improvements that would take the population towards creating applied skills badly needed for industrializing Pakistan. It would also take away the stranglehold the religious schools have in rural areas, so that the kind of useful education for a practical world of economic development and decent improvements in standards of living could be achieved, something that often comes from balanced education as in Thailand or in Malaysia. 6.00 4.00

BD/GDP CA/GDP

2.00

Per cent

0.00 –2.00 –4.00 –6.00 –8.00 –10.0 –12.00 1961 Figure 8.1

1966

1971

1976

1981

1986

Twin deficits, Pakistan: 1961–2002

1991

1996

2001

Pakistan

229

The total debt, that is, domestic and foreign debt, is 95.1 per cent of GDP (and about 600 per cent of total revenues) with almost 66 per cent of the total revenues used for debt servicing.12 The country registered a record high level of external debt of R1.787 trillion (around US$30 billion) in May 2003.13 In magnitude, the total amounts to about US$55 billion, of which US$30.0 billion is external debt (see Table 8.2). The debt–service ratio to exports in Pakistan reached 37 per cent of budget in 1997, the highest in Asia. In this regard, this country is facing the same dilemma that Malaysia faced in 1982 after 20 years of targeting development expenditure to the rural sector. By 1980, this had resulted in an amount of debt almost similar to Pakistan’s debt–service ratio. It was this burden of huge debt that forced her into the real sector opening initiated in the form of industrialization based on greater openness. The results were outstanding with remarkably high growth performance till the mid-1990s. Malaysia’s reforms and openness led her to sustainable growth and made her a rapidly growing country in the Southeast Asian region, although the fastest was still South Korea. The statistics in Table 8.1 show a poor performance in social indicators. With a low investment in human development, this country still has a high illiteracy rate of around 35 per cent. This is an outcome from public sector spending on education being a low priority. It is interesting to see that the country has some of the best higher level tertiary and technical learning institutions in Asia along with a culture of English-medium private schools in big cities, but poor quality of education for the masses. This new development has generated two classes of graduates: those who could afford private education are better skilled and have better job opportunities; the other category has long spans of unemployment. The public sector expenditure on health is no different: one only has to visit the major cities like Karachi to witness this. High population growth, coupled with traditional values fostered in the name of religion further aggravates the health problems. What is needed, as is true of all other cases we include in this book, is a policy mix of macroeconomic and structural adjustments, only after establishing a politically stable environment as well as a resolution of security issues, meaning weaning the population from violence and ridding the culture of hatemongering between the two neighbours (India and Pakistan). The former hinges on the latter. This is where the political tail may wag the economic dog. The economic reforms that were initiated first in 1991 and revived in 2000 should be reformulated with firm commitments of non-reversal. These commitments must be undertaken with a clear vision of what are needed in the short to medium to long-term within the policy mix. Coalition building across party lines – something which has emerged from the 2003 election empowering the current government – and even outsideinterest groups must be attempted to cement the commitment. Serious

Table 8.2

Pakistan’s external debt payable in hard currencies 1990–91 1991–92 1992–93 1993–94 1994–95 1995–96 1996–97 1997–98 1998–99 1999–2000 2000–01

Foreign exchange reserves held by SBP*

230

Debt outstanding (US$ million) Principal (US$ million) Interest (US$ million) Percentage of GDP Percentage of exports Debt servicing** (US$ million) Percentage of GDP Percentage of exports Percentage of FEE Notes: Debt: * ** FEE:

674.0

1069.0

604.0

2545.0

2937.0

2465.0

1287.0

1125.0

15471.0 17361.0 19044.0 20322.0 22117.0 22292.0 22509.0 22844.0 25423.0

1828.0

1547.0

25359.0 25555.0

782.0 534.0 34.0 252.3

921.0 592.0 35.6 251.5

999.0 649.0 36.8 279.5

1078.0 668.0 39.0 298.7

1294.0 748.0 36.3 271.8

1346.0 790.0 35.3 256.0

1250.0 745.0 36.1 270.5

1623.0 730.0 36.8 264.8

1065.0 465.0 43.3 326.8

893.0 619.0 41.4.0 295.9

1273.0 688.0 43.7 277.7

1316.0

1513.0

1648.0

1746.0

2042.0

2136.0

2265.0

2353.0

1530.0

1512.0

1961.0

2.9 21.5 13.7

3.1 21.9 13.4

3.2 24.2 15.3

3.3 25.7 16.2

3.4 25.1 16.5

3.4 24.5 16.7

3.6 27.2 17.6

3.8 27.3 17.6

2.6.0 19.7 13.6

2.5 17.6 11.9

3.3 21.3 13.8

regular debt (payable in foreign exchange only), both medium and long term debt. As at end of 30 June each year. Excluding interest on short-term borrowings and IMF charges. Foreign Exchange Earnings.

Source:

–

Government of Pakistan, Pakistan Economic Survey, 2001–2002.

Pakistan

231

situations demand serious solutions and, given the debt overhang on the economy, a very serious consensus needs to be worked by the governing elites for an agenda of economic reforms as well as security. In this respect, this country’s case for political and security concerns is unique from the rest of the cases discussed in this book. The reforms discussed in the last section prepared the economy for the main investment drive initiated in the 1990s by elected governments. There was a determination to open up the economy to boost the industrial sector. Such programmes were initiated 25 years ago in Southeast Asian economies and 15 years ago in China and Vietnam with incredible outcomes since these countries kept the commitment to reforms and did not waver with each crisis.

3.

LIBERALIZATION

Transitional economies such as China and Vietnam14 or mixed socialist economies such as India started liberalizing from a completely controlled system or a system of inward oriented policies respectively. Pakistan did not have a completely controlled system. The trade sector was more or less open following independence, though capital and current accounts were under pernicious controls. Even during the short-lived socialist rule of a reforming prime minister, who nationalized domestic resources, the trade sector continued to remain relatively open. This was the time when the economy produced huge capital investment directed to its export sector from expatriate Pakistani remittances from abroad in foreign currencies. The trade sector benefited. The liberalization and openness of the economy could be analysed in many different ways. Further liberalization of the trade sector, wide-ranging reforms in the capital and current accounts could be examined since such reforms bring benefits leading to capacity building in the traded sector during that short period. Our discussion on this is therefore to be viewed from the point of the benefits such reforms would have had on certain sectors of the economy. Since the major economic reforms were designed and implemented during the period after 1991, we restrict our discussion of liberalization process to this period only. 3.1

Economic Liberalization

Major economic reforms were initiated during 1991–93, as explained in the last section. The main focus of the reform package was privatization to address the depletion of fiscal resources. Hot pursuit of subsidized agriculture and industrial development and defence spending were the two culprits for the

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Liberalization and growth in Asia

depletion of the fiscal resources. Financial sector reforms, to be discussed in a later sub-section, were meant to accelerate savings and thus investment: that was the second set of reforms. Infrastructure development was the third policy package in this period. (See Figures 8.2 and 8.3 for historical trends of key macroeconomic variables.) Privatization became the most important argument in the reform package. The government established the Privatization Commission in 1991 with responsibility for the design and implementation of policies on industrial projects and financial institutions. Foreign investors were also to be allowed to purchase divested public assets along with local counterparts. The privatization scheme provided a legal protection under the Economic Reforms Ordinance 1992. Besides affecting a large number of medium- to large-sized industrial units, it was targeted at some large public sector institutions as well. These included the banking sector, the Telegraph and Telephone Department, and Water and Power Development Authority: these were state-owned enterprises, SOEs. The Privatization Commission, a semi-government institute to help privatize SOEs, managed to privatize about 150 SOEs during the 1990s. These included non-industrial enterprises as well: five nationalized banks, the Pakistan Telecommunication Company Limited (PTCL) and the National Press Trust. In this respect, privatization has become a way of reducing the financial overhang these SOEs had brought on to the budget problem over 35.00

Real GDP CPI M2

30.00 25.00 Growth rate

20.00 15.00 10.00 5.00 0.00 –5.00 –10.00 1961 Figure 8.2

1966

1971

1976

1981

1986

1991

1996

2001

Growth rates of real GDP, CPI and M2, Pakistan: 1961–2002

Pakistan

30.00

M2 M1 FR/IMP

25.00 Growth rate

20.00

80.00 70.00 60.00 50.00

15.00 40.00 10.00 5.00 0.00 –5.00

–10.00 1961 1966 1971 1976 1981 1986 1991 1996 2001

30.00 20.00

Foreign reserve to imports

35.00

233

10.00 0.00

Figure 8.3 Foreign reserves to imports ratio and growth rates of M1 and M2, Pakistan: 1961–2002 decades of tolerating inefficiency. That hurt the government budgets very badly. Privatization provided cash injections from the sales. These responses to the huge debt overhang are very similar to those undertaken by Malaysia a good ten years before to solve its budget problem. The only difference was that, at the time, Malaysia’s reforms took place at the most opportune time when the world economy was heavily geared towards investments in the non-Communist Southeast Asia. Another aim of the policy was to attract foreign investment from expatriate nationals living abroad as well as foreigners. Malaysia modified legislation to remove restrictions in order to provide protection to these outside investors. The incentives offered to the domestic and foreign investors attracted investments, especially in the mega projects such as motorways between big cities. The Pakistan government introduced an emergency economic package in July 1998 to deal with the deteriorating economic situation: the IMF put pressure to reform some of the major sectors of the economy. Besides some fiscal measures, the focus of this package was to counteract investors’ disenchantment specifically with the foreign exchange controls. The government, therefore, provided some incentives to the non-resident Pakistanis to bring foreign exchange into the country while keeping the exchange controls. Similarly, incentives were offered to exporters and other investors. However, a reversal of some of these policies in the aftermath of the atomic explosion

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Liberalization and growth in Asia

and economic sanctions imposed by the West led to more uncertainty and diminished hopes for any economic progress. The fiscal sector received some attention as the reform package aimed at raising money. Lack of fiscal discipline emerged as a serious management problem. A huge excess capacity in the public sector existed and the tax collection system was inefficient, both of which led to deficits. These deficits were partly financed by domestic and foreign borrowing. A quick solution based on inflationary financing through undisciplined monetary expansion led to inflation. A number of measures had therefore been taken unilaterally by the government as part of the reform process or under IMF compliance process. Compliance with the IMF conditions to revamp the tax structure and collection system took effect. The first set of reforms was implemented in the early 1990s, which included vertical and horizontal expansion of the general sales tax and the introduction of self-assessment for tax returns to get better compliance. The government also implemented supply-side policies with the objective of reducing tax rates while broadening the tax base. Policies were also devised to reduce expenses. One priority area was reduction in expenses in the services sector operated under federal or provincial governments. The authorities announced a scheme of golden handshakes for those employees who volunteer for redundancy. Another concern was the reduction in public sector enterprise reliance on budget financing. Policies designed to address these concerns were designed and implemented as per the IMF requirement to gradually curtail the worsening fiscal deficit: to get it down to 4 per cent of GDP from around 7 per cent. Due to political instability, some of these policies could not achieve the objectives envisaged earlier. The civil service was reduced substantially; however loss-making institutions such as Pakistan Railway, Pakistan International Airlines, and many more are placing a continuing burden on the national exchequer. Revenue collection also worsened due to tax evasion by a majority of those liable for tax. Some estimates show that, out of a population of 157 million, with at least 55 million employed, only about one million people pay income tax.15 During the first half of the 1990s, several attempts were made to impose tax on agriculture incomes. However, political pressure from party and provincial power bases in two of the four provinces prevented the federal government from implementing this tax reform. It is unfortunate not to have tax on agriculture income in a country where the agriculture sector absorbs about 70 per cent of the labour force and generates the bulk of the national income. In other South Asian countries with less ownership concentration in the agricultural sector,16 similar policies had been very successful. For instance, India’s revenue is a healthy 20 per cent of its GDP, and a significant part comes from this sector.

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235

The external sector was the third major focus of the economic reform package. Part of this is related to exchange rates and the payment system and will be discussed in the next section. Here, we focus on the trade sector only. Reducing import duties from a maximum of 125 per cent to 90 per cent and reducing the number of items in the restricted import list from 118 to 87 were two key reforms. These measures were successful: the trade deficits narrowed in the years 1993 and 1994 and the rate of decline was getting smaller. However, the policies could not continue after 1993 due to a change in government and a decision to roll back import restrictions. As a result the deficit started to increase again. Special Export Processing Zones were established in 1980 in big industrial cities with the objective of attracting foreign capital, technology and modern management skills for export-oriented industries. This is a well-worn tool followed by many Asian countries. It was hoped the success of that would provide new employment opportunities. Currently there are five EPZs operating in the country and two more have just been brought on stream. Since 1997, more than 270 industrial units have been approved to operate in these zones. 3.2

Financial Liberalization

The financial sector’s key role in the development process of a low income economy such as this country is well documented. Not only do efficient payment services, flexibility of foreign currency transactions, development of domestic capital and money markets provide means to lower cost of capital, a developed capital market also provides higher levels of mobilization of savings. Further it attracts both domestic and foreign funds. The financial sector reforms, it is now advised by experts, are to be dovetailed after macroeconomic adjustments in the real sector are well in place. We examine this aspect in some detail. With capital and current accounts under pernicious controls up to 1990, that sector could be described as suppressed and inefficient. It hardly developed enough to serve the trade sector which was already much more open to contribute to its efficiency. Restrictive policies of all shades ranging from interest rate controls, exchange rate fixing and unbridled growth in money supply as well as capital account closedness for most individuals and firms with no foreign sector incomes were the order of the economy. This level of financial sector closedness also went with the fiscal indiscipline. These are perhaps the reasons why the more open traded sector failed to produce the synergies observed in other economies. In other more successful cases, the financial sector was reformed alongside or in most cases, subsequent to, the reforms of the trade and fiscal sectors. Pakistan failed to obtain open trade and a balanced budget first before

236

Liberalization and growth in Asia

undertaking financial reforms. The role of the central bank was to formally implement correct policies. But in reality, it abrogated resources to the public sector by all kinds of policies designed by politicians. Although the reform packages of 1991 onwards allowed market forces to work, there are still sufficient government controls over the affairs of the central bank, which ensures that reforms could not lead to a great expectation of benefits. Table 8.3 details some important policies implemented during 1990–2002. The reforms in Pakistan were not smooth and consistent due to political instability. The first two phases of financial sector reforms in 1990–91 and 1996–97 suffered a major setback due to political uncertainty and frequent regime changes. The efforts to revamp and reform the financial sector were re-started in 2001. It is too early to evaluate these renewed efforts. However, some details are discussed in the following sub-sections. Monetary policies Monetary management moved from a state-controlled system to a marketoriented system during a transition period. Following a nationalization of the commercial banks in 1972, the state was heavily involved in frequent interventions in the operations of financial institutions. Included in these were interferences through directed lending and implicit guarantees for poor-quality Table 8.3 Major economic and financial reforms in Pakistan, 1990–2002 Liberalization policy implemented 1991

Full-fledged auctioning system of treasury bills introduced

1992

1 February: 3-day repo facility introduced to accommodate short-term liquidity requirements of the financial institutions August: Credit ceiling as an instrument of credit control abolished and replaced by credit–deposit ratio (CDR)

1994

February: State Bank of Pakistan Act, 1956 amended providing more autonomy to the SBP 1 July: Pakistan rupee made convertible on current international transactions August: Pakistan Credit Rating Agency established Central Depository Company instituted to facilitate electronic book entry system in stock market trading

1995

Restrictions on banks’ maximum lending rates except concessionary finance schemes removed 30 September: Credit–deposit ratio removed

Pakistan

237

1996

National Institutional Facilitation Technology established to move from manual to automated cheque clearing system

1996-97

Special Convertible Rupee Account established for purchase of shares in the stock market by non-residents Residents allowed to open and maintain foreign currency accounts Authorized dealers, development financial institutions and housing finance institutions allowed to extend local currency credit to non-resident nationals in real estate sector

1997

21 January: Further amendments to the SBP Act, 1956, Banking Companies Ordinance, 1962 and Banks Nationalization Act, 1974 and Pakistan Banking Council abolished providing more autonomy to the SBP for the design and implementation of credit policy and authorizing SBP as the sole entity to regulate financial institutions 26 July: Restrictions on banks’ minimum lending rates removed December: Capital adequacy ratio requirement under Basel Accord enforced Second credit rating agency, JCR-VIS Credit Rating Company Limited, instituted Capital Market Development Programme formulated to help strengthen the capital market

1998

16 June: SBP allowed banks and other financial institutions to determine their own deposit rates Security and Exchange Commission of Pakistan established

1999

19 May: Market based unified exchange rate system adopted 26 May: Changes announced in the minimum cash margin requirement on opening letters of credit for imports 3 July: issuance of Code of Conduct for Authorized Money Changers in foreign exchange October: Banks and NBFIs were allowed to provide financing facilities against shares of the listed companies subject to a minimum margin of 50 per cent for banks and 30 per cent for NBFIs of its average market value of the preceding 12 months Companies Ordinance, 1984 that restricted companies to buyback their own shares amended 14 December: SECP issued a legal framework for companies asset-backed securitization (under Companies Asset-Backed Securitization Rules, 1999) Continued overleaf

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Liberalization and growth in Asia

Table 8.3 Continued Liberalization policy implemented 2000

January: SECP authorized to regulate and supervise insurance industry Insurance Ordinance 2000 promulgated Launch of Pakistan Investment Bond (5–10 years maturity) 26 March: Limits on banks’ exposure against unsecured advances imposed 28 March: New Foreign Currency Export Finance facility announced 15 June: To facilitate e-commerce, banks operating in Pakistan were allowed to open and operate Internet Merchant Accounts in local currency or US dollars 20 June: Software houses/companies were allowed to retain 25 per cent of their export earnings in special foreign currency account 4 October: Micro-Finance Bank Ordinance, 2000 announced by the SBP stating rules and regulations related to MBF 7 October: Cash Reserve Requirement for banks increased; banks are required to maintain a minimum average balance of 7 per cent of time and demand liabilities on a weekly basis and no less than 6 per cent of total liabilities on a daily basis 14 November: Cash Margin Requirement on all import letters of credit (LCs) removed 1 December: SBP introduced spot value convention for all foreign exchange and foreign-currency money market transactions 6 December: Minimum capital requirements for banks revised; accordingly, no banking company shall be permitted to undertake full range of financial services unless and until it has a minimum paid-up capital, net of losses, of one billion rupees on or after 1 January 2003 15 December: All scheduled banks required to maintain with the State Bank special deposits equivalent of 2 per cent of their time and demand liabilities. In order to remunerate these deposits, banks were allowed to purchase Market Treasury Bills (MTBs) from SBP on one-month repo basis at the rate of 10 per cent per annum 16 December: Banks allowed to operate for extended hours (2.30–8.30 pm)

Pakistan

239

2001

13 February: Banks allowed to install ATMs without prior approval of SBP 27 March: SECP implemented the Listed Companies (Prohibition of Insider Trading) Guidelines 18 April: SBP authorized all bank branches to purchase or sell foreign currency notes, coins, travellers’ cheques and foreign demand drafts 25 July: SBP decided to undertake OMO on ‘as and when needed’ basis; a selected group of domestic and foreign banks were appointed as primary dealers 1 September: Resident Pakistanis, including firms and companies, allowed to make equity based investment/joint ventures abroad on repatriate basis, with prior permission of the SBP Financial Institutions Ordinance promulgated for the recovery of defaulted and non-performing loans Minimum paid-up capital for investment banks fixed at 500 million rupees and for housing finance companies and discount houses at 300 million rupees Corporate and Industrial Restructuring Corporation established as an Asset Management Agency with the objective of liquidation and disposition of NPLs

2002

13 February: Authorized dealers allowed to issue foreign currency travellers’ cheques to foreign and Pakistan nationals against foreign exchange in cash 2 March: All banks in Pakistan required to maintain 80 per cent of the assets as created by them against their time and demand liabilities, in Pakistan, and the remaining 20 per cent could be held abroad SBP bifurcated into two entities State Bank of Pakistan: Responsible for formulation and implementation of monetary policy, supervision and regulation of financial sector, foreign exchange management, and payment systems SBP Banking Services Corporation: Responsible for retail banking and treasury functions The SBP announced detailed criteria for establishing the Scheduled Islamic Commercial Bank; these measures were in line with the Islamization of financial system in Pakistan

Sources: (2003).

State Bank of Pakistan, annual reports; Asian Development Bank reports; Hanif

240

Liberalization and growth in Asia

loans. Lending on the basis of political influence by the commercial banks resulted in huge non-performing loans, which made it impossible to secure an efficient financial management of institutions. The traditional instruments used in the pursuit of monetary policy were not very effective in the presence of these distortions. Commercial banks were subject to the statutory reserves, only 5 per cent on demand and time deposit, and a higher liquidity ratio in the form of the holding of government securities. The central bank (the State Bank of Pakistan) under orders from the government found a market for government bonds. Although the bond market developed as a result of this to levels of activities higher than in some developing countries, the main objective was to generate funds to finance fiscal deficits. Given the lack of confidence in any alternative investment portfolios especially for small-scale investors, government bonds became the de facto best option as these are issued by governments in power. However, given administered interest rates, secondary markets for financial papers did not develop alongside the large bond market. Hence for central bank open market operations, which require liquidity in the monetary sector as well as in capital markets, there were no effective markets for monetary policy actions. The percentage of required reserves has been stable since the early 1990s and hence cannot be taken as a very useful monetary policy instrument. Prudential regulations are also very weak and poorly developed as well as rarely implemented. The important policy instrument that appears to have some bite is credit ceilings where the central bank is required to provide credit directly or through specialized banks for high-priority sectors such as agriculture, housing, the export trade, small-scale industries, and small business firms. As noted in an earlier discussion, these were the very price distortions that generated fragility of the economy. Monetary policy was conducted perversely by furthering the very things that a central bank would not want to do to bring the economy to a stable growth path. No cheers for Pakistan’s central bank. Attempts were made dating back to 1989 to convert the monetary management into a market-based system. In 1991, the authorities organized regular auctions of Treasury bills and long-term federal fund bonds. The process of privatization of new commercial banks was also under way, which did give some independence to the commercial banks in establishing their own deposit and lending rates. The credit ceiling was replaced by a credit–deposit ratio (CDR) in 1992, which was later removed in 1995. By this time, the SBP also moved to open market operations as the main instrument of monetary policy. A three-day repo facility introduced in 1992 provided short-term liquidity to financial institutions. The central bank, however, still lacked full autonomy. The immediate need was to provide full regulatory authority

Pakistan

241

without interference to the central bank, which could then adopt a hands-off supervision of commercial banks. The politically introduced loans at commercial banks could not be stopped by the central bank without that. The resulting problem of non-performing loans cannot be resolved until the banking sector and the central bank are allowed to work independently. Privatization of the industrial sector has given a big relief to the banking sector, which, in the past, had been used to extend credit to loss-making state firms. Once market mechanisms are put to work through the pricing system and supported by prudential regulations, the management of the monetary system will be more effective. The other precondition that is still lacking for effective monetary management is fiscal discipline in the form of balanced budget. This has been a focus of the regime that took over in 1999. The government has been able to bring the budget deficits down to 4.6 per cent of GDP in 2002 from an average of above 7 per cent of GDP during the 1990s. Central bank reforms The State Bank of Pakistan, established in 1948, was started as a jointly owned body between the government and private sector. In 1949, the government organized a state bank, the National Bank of Pakistan (NBP). The new bank was responsible for carrying out commercial banking functions to act as the state treasurer. However, the SBP had complete monopoly in conducting monetary policies working with the Minister for Finance. Later years saw some private sector interest in the banking sector and a few more banks were granted charters as commercial banks. Due to a small industrial base, an inefficient system of tax collection, lossmaking state firms and the lack of a well-developed domestic bond market, the main responsibility of the SBP has been to extend credit to state firms and to find the wherewithal to support budgetary deficits. The domestic bond market gradually developed and a large proportion of the fiscal deficits were then financed through domestic borrowing. However, increasing public sector expenditure and stagnant or low level of revenues put pressure on the monetary authority to print money. These episodes did not allow the authorities to design an appropriate policy. The efforts and expertise of the central bank were reduced to essentially financing fiscal deficits and finding ways of meeting debt-servicing requirements, given persistent low levels of foreign reserves. The central bank had independence of the worst kind; it served the dictates of governments, which destroyed its independent pursuit of macroeconomic stabilization through effective monetary management! There was a need to develop some coordination between the monetary and fiscal policy-makers. Given the inefficiency of the central bank or rather its memory lapse or forgetting of its prudential oversight function, it has now led to the so-called zombie bank

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Liberalization and growth in Asia

syndrome, signifying a disease common with many developing countries. The other major problem faced by the SBP therefore was the design of a nationalized banking system with built-in avoidance of prudential supervision of commercial banks and other depository and non-bank institutions. This brings us to the issue of how to manage the huge amounts of non-performing loans. The 1980s and 1990s saw a large number of finance institutions collapse. But the banks were not permitted to fail. Under political pressure and influence peddling, banks were kept alive, and bound to extend credit to individuals and/or institutions with a history of non-performance. As part of the reform package during the 1991–2001 decade, some changes were brought to bear in order to bring some order on this matter. These include a series of amendments to the State Bank of Pakistan Act, 1956. The SBP began to claim autonomy with the sole objective of formulating and implementing monetary policy, setting exchange rates and supervising the activities of the financial institutions. In reality, however, SBP is still functioning under directives. The Monetary and Fiscal Policies Coordination Board established to coordinate fiscal, monetary and exchange rate policies, is the power source. The Pakistan Banking Council has been abolished and its functions merged with the SBP. The SBP has set up a comprehensive plan to modernize and strengthen the prudential regulations as well as the supervision quality of the financial system. The reforms therefore are still not sticking. More promises of reforms do not actually mean reforms are in place. The banking sector is in limbo, this time the difference being the hopes are dim that there could be reforms to unshackle the fetters placed on the central bank. Reforms in depository institutions Commercial banking experienced drastic changes over 50 years since the country started its banking sector from point zero. At the time of independence, out of 99 commercial banks only one, the Habib Bank, had its head office located in the area that was to become the new country. The other 98 banks were located in India and were under the jurisdiction of the Reserve Bank of India. Pakistan did not have its own central bank until 1948, a year after independence.17 From 1947 to 1974, the banking sector grew very well. The private sector invested in establishing commercial banks with a network of branches in the country. At the same time, the authorities granted licences to some foreign banks to operate in Pakistan. The domestic banks were nationalized in 1972. The 13 commercial banks were then merged to become five nationalized commercial banks (NCBs). The deposits in the NCBs were fully insured and their activities were supervised by the Pakistan Banking Council (PBC), also established in 1972, but abolished later.18 These NCBs enjoyed rapid expansion in terms of staff, which increased by 55 per cent, and the number of branches, by 82 per cent in just four years. High and increasing

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243

inflation resulted in deposits being reduced by about 20 per cent. Increasing economic uncertainties following the militarization of politics brought the real deposits down by about 23 per cent.19 With the martial law regime in 1980, the process of financial reform was begun with three objectives. The first was to implement policies to gradually change the financial sector from a controlled one to a market signal-based operation. The second was to introduce Islamic banking in Pakistan.20 The third reform was to create an environment for competitive banking to take root by easing entry barriers on foreign banks. To achieve these goals, the military government introduced new policies for a partial deregulation of interest rates. The expansion of NCBs was slowed down while a number of foreign banks were licensed and their branches were increased from 30 to 54. However, most of these policies were implemented by the military government without proper legal structure as is needed under the banking regulations. In 1990, the authorities were very concerned about the poor financial position, overstaffing and inefficiencies of banks in general. Privatization, which was part of the overall economic reform agenda introduced by the elected government, rare in this country, was considered to be the best of the options to deal with the problem. Since then these banks have been in the process of denationalization. Only three have been privatized.21 At the same time, the government encouraged the private sector to invest in banking. During the eleven years following 1992, many new commercial banks started operation in the private sector and have been very successful in attracting deposits. At the same time, provisions for keeping foreign currency accounts, which offered very attractive interest rates to non-residents, increased the deposits. Central bank reports show a switch from demand deposits to time deposits where the ratio of time deposits to GDP almost doubled with this incentive. During the same period, the ratio of demand deposits to GNP reduced from 15.02 per cent to about 8.8 per cent. At present, resident foreign currency deposit account for 8 per cent of GNP.22 Non-performing loans are a major problem that severely curtails banking. Loans extended to individuals and institutions under political introduction and on the basis of related party lending have not been repaid. These amount to billions of rupees according to some reports. Some of which, as at 1997, put the outstanding balance from these defaulted loans at R126.15 billion.23 Some strict measures have been formulated to deal with bank defaulters and were implemented in 1998. Recovery laws have been strengthened through the Banking Companies (Recovery of Loans, Advances, Credit and Finances) Act 1997. However, there is a need to provide the bank management and operators in the finance sector more independence and powers of prosecution against political pressures. Establishing a healthy banking sector would not be possible when banks are forced to extend loans that they know, a priori, were bad.

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Liberalization and growth in Asia

Foreign banks provide a very competitive environment to the domestic commercial banks and have become an important part of the banking industry. Due to the unstable economic environment and relatively slow reforms on foreign banks’ entry to the domestic market, there were 83 branches of foreign banks in Pakistan by March 2002, only 1.2 per cent of the total bank branches operating in Pakistan. However, foreign banks are important to develop a more competitive market as they have better managerial skills and more access to the international financial markets. As a result, though low in numbers, they receive the bulk of the foreign currency deposits. Reforms in non-bank financial institutions Lack of resources for term financing of industrial projects forced policymakers to give top priority to establishing these institutions. Long-term lending facilities for the important sectors of the economy, two examples being agriculture and housing, were almost non-existent. The first progress was made in the 1960s with the establishment of the Industrial Development Bank of Pakistan to provide loans to small and medium industrial projects. Later, other institutions, mostly in the public sector, were established to cater to the needs of some specific sectors of the economy. These included the Pakistan Industrial Credit and Investment Corporation, National Investment Trust, Investment Corporation of Pakistan, Agriculture Development Bank of Pakistan, National Development Finance Corporation, Federal Bank for Cooperatives, House Building Finance Corporation, and the Bankers Equity Limited. The traditional NBFIs in Pakistan have taken new shape with the emergence of these new types of institutions, which provided new financial instruments suited to the needs of these sectors. These institutions can be divided into sub-groups: development financial institutions (DFIs); leasing companies; modaraba funds (short-term Islamic deposit-taking bodies); investment banks; and stock market funds. These institutions were established to meet the government’s long-term objectives of reforming the overall financial system. It was thought that the financial sector would be reformed through privatizing and deregulation, developing money and capital market instruments, providing more incentives to the investors, reducing and eventually eliminating restrictions on foreign exchange flows and developing an Islamic system of risk sharing in the debt market. Alas, this was in reverse order since the fiscal budget discipline continued to falter, and all the reforms in the financial sector did not repair its weaknesses. The collapse of finance companies in the 1980s deteriorated investor confidence on some of these DFIs and has increased the risk factor. In an economy where the inflation rate has been running in double digits and real interest rates are consistently negative, the effectiveness of any reform measures to improve the efficiency of financial institutions on any grand scale

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must be taken with a pinch of salt. The market stability and some guarantees against risk are not there either. One type of DFI can be described as the industrial development financial institutions (IDFI), which are designed to meet the financing needs of industrial projects. Most of them are in the state-owned sector and the private sector has been shut out from any role they could indeed play more effectively. The second category, the financial development financial institutions (FDFI), are the mutual fund servicing companies. The National Investment Trust is an open-ended mutual fund while the Industrial Corporation of Pakistan is a closed-ended mutual fund. Leasing companies were granted approval in the mid-1980s when some laws were enacted to introduce an Islamic financial system into the country. However, lease financing accounts for only a small proportion of the total debt finances of commercial banks and DFIs. The leasing companies generate funds through equity, lines of credit from commercial banks and DFIs. In the early 1990s, the government allowed leasing companies to offer certificates of investment to the public. The main leasing activities of such companies are in financial leases, automobile leases, and leasing for industrial machinery. A modaraba is similar to mutual fund management where funds from the capital of investors are pooled. Modarabas are not allowed to borrow, having to raise their own funds through equity, and are not liable to income tax if 90 per cent of profits are distributed. They are not permitted to build up reserves. Their main uses of funds include leasing, stock trading, short-term secured lending and venture capital investment. These funds operate under a regulatory structure to monitor the performance of funds and hence have less risk as compared to other institutions. Such forms of financing play a significant role similar to mutual funds offered in other Asian countries. There are limitations placed on the fund participation in the capital market. Investment banks were allowed to operate in 1987, the objective of which was to fulfil one of the conditions contained in the World Bank extended financial sector adjustment loan agreement. These investment banks provide project financing and merchant banking facilities as well as promoting capital market activities; there are 15 of them. Two are Islamic banks with equity investments from foreign Islamic banks, six are joint ventures and seven are operated by local groups (see Table 8.4). Interest rate reforms Interest rates suppression over a very long period has been a norm till some relaxation in 1991, by decentralizing decisions on interest rate setting. However, as evident from data in Table 8.5, these measures were very slow in providing market-based structures on interest rate determination. The table shows that rates such as the money market rate and the central bank discount

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Liberalization and growth in Asia

Table 8.4 Number of domestic and foreign financial institutions, Pakistan: as of 31 March 2002 Nationalized scheduled banks Denationalized scheduled banks Specialized banks Private scheduled banks Foreign banks Development financial institutions Investment banks Discount and venture capital houses Housing finance companies Micro-finance banks Source:

4 2 4 14 19 7 15 6 4 2

Government of Pakistan, Economic Survey, 2001–2002.

rate did not change noticeably over two decades. With nominal interest rates almost constant, given the high inflation, real interest rates are negative. Banks experienced a decline in deposits during this period. Another major reason for this decline is the emergence of finance companies that offered two to three times higher returns on deposits. However, episodes of collapse of some of these finance companies affected public confidence in them and deposits are returning to the safety of commercial banks. The public diverted their business with finance companies to commercial banks. During the 1990s, demand deposits declined from 15.02 per cent of GNP to 8.86 per cent. Also, time deposits relative to GDP almost doubled, increasing from 10.06 per cent of GNP to 19.14 per cent. Reforms have not improved the situation and interest rates are still indirectly controlled by the central bank. Numbers in Table 8.5 show that the interest rates were more or less constant until 2002 when they declined significantly for the first time. This cut in interest rates is in line with the SBP’s reported claim of 3 per cent inflation. Stock market development The slow growth of the stock market relates to events in the 1970s when massive nationalization led to a negative effect on stock market performance. During the next two decades, the market was functioning without any regulatory structure and had very poor dividend records. Individuals or a group of families retained most of the equity. The investors had evidence of insider trading and market manipulations. Hence at the time of writing this book in 2003, market-watchers say that people have no incentives these days to invest in the stock market.

Table 8.5

Growth of financial and capital market indicators for Pakistan (annual averages)

247

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

Exchange rates (% change) Share price returns

0.00 –

9.57 –

8.31 9.51

7.87 –

11.26 –5.50

9.22 26.29

15.43 –24.41

–3.56 8.70

Interest rates Discount rate Call money rate T-bill rate Government bond yield

4.60 4.80 – 4.40

8.60 8.70 – 7.80

10.00 7.70 – 8.80

12.40 9.21 9.85 7.33

16.10 10.37 7.54 4.09

13.00 8.57 8.38 –

10.00 8.50 10.70 –

7.50 5.50 6.10 –

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

248

Liberalization and growth in Asia

Some regulatory measures were also put in effect in 1991 to improve the effectiveness of the stock market and to have a better monitoring system. The government established an auction market for short-term Treasury bills and long-term federal investment bonds. The secondary market for government securities was also established. The Securities Department within the SBP was set up to implement debt management reforms. The first credit rating agency was established in 1994 and a second one in 1997. The Central Depository Company (CDC) was formed in 1994 to facilitate the automated stock trading system. A Capital Market Development Programme (CMDP) was formulated in 1997 to strengthen capital market activities. Further, the Securities and Exchange Commission was established to supervise activities of this market. The stock market reacted positively to these policies, and began to attract domestic and foreign capital. The Karachi Stock Exchange index reached a peak around 1500. This positive effect on the stock market is also evident from the statistics in Table 8.6. In 1998, there were three stock exchanges, in Karachi, in Lahore, and Islamabad. The KSE is the oldest, established in 1948, and accounts for the bulk of the country’s trading. As stated earlier, the 1991–93 period saw a major increase in trading at all three stock markets. Market capitalization at KSE alone increased from R38 billion in 1987–88 to R200 billion in 1991–92. Similar trends were noticed at the other two markets in Lahore and Islamabad. This pattern continued but was broken by downturns mainly due to political instability and economic crisis. However, stock market trading has shown the highest performance during the first years of this century. One of the domestic markets, Karachi Stock Exchange, is rated as the best performing stock market in the region. Foreign exchange market During the 1991–92 reforms, the authorities announced bold measures to eliminate the black market for domestic currency and provided incentives to attract foreign direct investment. The country moved gradually to capital and current account convertibility. The SBP also issued US-dollar-denominated bearer certificates with a rate of return of a quarter of a per cent over the prevailing LIBOR. Restrictions on holding foreign currency and operating foreign currency accounts were abolished. Liberalized rules governing the private sector’s foreign borrowing came into effect. Authorities authorized dealers to operate and trade in foreign currencies. These policies worked well and resident and non-residents opened foreign currency accounts. However, the confidence was completely lost when the government decided to freeze all foreign currency accounts in May 1998, when the country reached near bankruptcy as a result of economic sanctions for test firing an atomic device. Most of the uncertainty created in the

Table 8.6

Capital market development in Pakistan: 1992–2002

249

Number of new companies listed Fund mobilized (by new companies, billion Rs) Total turnover of share Market capitalization (by ordinary shares, billion Rs) Market capitalization (percentage change) Note: Source:

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002*

178.0

110.0

112.0

155.0

90.0

36.0

6.0

2.0

5.0

12.0

9.0

25.9

15.3

13.5

59.7

52.4

19.5

13.8

6.6

20.9

6.9

26.5

– 218.4

– 214.4

2.2 404.6

3.3 293.3

7.9 365.2

11.0 469.1

21.1 259.3

38.7 289.2

67.5 391.9

38.4 339.3

34.5 428.0

219.0

–1.8

88.7

–27.5

24.5

28.4

–44.7

11.5

35.5

–13.4

26.2

* Figures for July 2001 to March 2002. Government of Pakistan, Economic Survey, 2001–2002.

250

Liberalization and growth in Asia

market was partly due to poor policies by the state bank (SBP). This is evident from the fact that the SBP issued 15 circulars concerning procedures for foreign exchange transactions and foreign currency accounts by residents and non-residents most of them contradicting each other and creating more uncertainty (see Table 8.5 for percentage changes in exchange rate since 1961). Initially, the SBP fixed the exchange rate at R46 per US dollar while the open market rate reached R70. This was probably the highest difference between the official and open market rates since 1973 when the country switched to a floating rate regime. Foreign reserves fell to their lowest level, equivalent to just two weeks of imports. This was an alarming situation in itself. During the closing two years of the twentieth century, the IMF agreed to extend partial loans and reserve the situation slightly. In 1999, the government relaxed foreign currency restriction for exporters and travellers. At the same time, in order to discourage the black market for US dollars and to reduce the gap between the official and open market rates, the SBP devalued the currency and fixed it at R50 to one dollar. The rupee suffered a second major setback when further economic sanctions were imposed as a result of the military takeover of a civilian government in October 1999. The currency touched a record low level of R62 to one dollar in 2001. As stated earlier, the global factors in the post-September 11 scenario changed this trend. In 2002, for the first time in history, the currency has gained some value in the foreign exchange market with the rupee appreciating by almost 4 per cent against the US dollar. Figure 8.4 shows the historical trend of exchange rate movements and interest rate spread from 1961 to 2002. Here we describe policies designed to promote foreign investment and trade. As part of the overall reform package discussed earlier, the authorities decided to remove restrictions. Prior approvals for new investment by foreigners as well as nationals living overseas were required: this was relaxed. Investors were permitted to own up to 100 per cent of equity ventures and this included purchase of equity in existing industrial companies on a repatriable basis. Central bank permission is no longer required for remittances of dividends and proceeds of sales of investment. Initially, these measures worked well, attracting foreign investment with legal guarantees provided by new laws passed by the government. With recent political and September-11related security developments, economic sanctions being one, confidence has been shaken. Rebuilding confidence may take a long time yet even if there is some accommodation on security issues. Financial deepening Table 8.7 contains statistics indicating the impact of limited reforms undertaken by this country. M3/GDP which was more or less stable until

Pakistan

70.00

ER IR Spread

60.00

251

10.00 9.00

50.00

7.00

40.00

6.00 5.00

30.00 20.00

4.00 3.00

Interest rate spread

Growth rate

8.00

2.00 10.00

1.00

0.00 0.00 1961 1966 1971 1976 1981 1986 1991 1996 2001 Note:

Data on interest rate spread are only available since 1984.

Figure 8.4 Exchange rate movement and interest rate spread, Pakistan: 1961–2002 2001, subsequently increased slightly to around 56 per cent. This is very low as compared to some other Asian economies covered in this chapter such as Singapore (163 per cent) or South Korea (108 per cent). Even India, with financial reforms done at about the same time, has a higher M3/GDP ratio, which increased from 25 per cent in the 1960s to 64 per cent in 2001. The financial intermediation ratio shows that the public sector is a major borrower in the credit market. The ratio of public and the private sector claims are almost the same, which is very different to those of East Asian countries, where the private sector seems to be much more active and efficient. Gross capital formation is almost stagnant until 2000 when it started declining. Foreign direct investment has improved significantly since 1993, though it is still very low compared to some relatively developed countries in the region. The huge burden of fiscal deficits forces the government to involve in substantial borrowing activities. In some periods, when foreign borrowing became difficult, the government has had no option but to borrow domestically, thus leaving the total borrowing unchanged. A proof of this historical trend of domestic and foreign borrowing is depicted in Figure 8.5. The numbers provided in Table 8.7 do not attest to any significant impact from liberalization. This may be due to the fact that the liberalization process

Table 8.7

Indicators of financial and capital market depth in Pakistan (percentage annual averages)

252

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

Money depth (M3/GDP)

40.26

46.78

49.62

50.38

49.69

50.19

50.85

55.54

Intermediation depth FIR (total)/GDP (=DC/GDP) FIR (private)/GDP

38.44 19.18

45.49 23.68

51.18 28.60

52.70 26.86

50.63 27.92

49.57 29.76

45.47 28.39

42.34 27.14

Capital accumulation GFCF/GDP FDI (net)/GDP FDI (inflow)/GDP

15.37 – –

15.38 – –

16.96 0.39 0.38

18.07 0.81 0.81

15.41 1.03 1.01

14.37 0.54 0.53

14.29 0.75 0.69

12.33 – –

1.84 3.34

3.42 3.74

5.29 1.45

5.60 2.06

4.89 2.03

4.56 0.91

2.51 2.20

3.35 1.27

Indebtedness Domestic borrowing/GDP Foreign borrowing/GDP Notes: M2 = M3 = FIR: GFCF: FDI: FDI (In): DC:

currency + quasi money. M2 + other deposits. financial intermediation ratio; claims on public + private sector (total credit), on private sector (private). gross fixed capital formation. foreign direct investment (net). foreign direct investment (inflow). domestic credit.

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

Pakistan

10.00

253

DB/GDP FB/GDP

Ratio to GDP

8.00 6.00 4.00 2.00 0.00 –2.00 –4.00 1961

1966

1971

1976

1981

1986

1991

1996

2001

Figure 8.5 Domestic and external borrowings, Pakistan: 1961–2002 that was initiated in 1991 could not be continued until 1995 due to political instability. Again the takeover of the country by the military and the changing global economic and political environment meant that the momentum that should have built up was halted.

4.

ASSESSMENT OF FUTURE PROSPECTS

The detailed analysis of the economy as well as related factors shows the complexity of development problem this country has faced over 58 years and is still facing. Decades of neglect in taking the right directions with respect to domestic price and financial liberalization are the main causes of its own misery. The country experimented with policies to boost agriculture and agribased industrial development by the usual targeted credit practices, a recipe for failure. That was well meant since the idea is based on the dictum that no economic activities at tertiary level could take place without agricultural sufficiency. But later sequence of reforms were perverse, and not purposeful. Nationalization of virtually all industrial and services sectors and financial institutions did not help when iron-clad price controls along with a heavy dependence on external capital, and limited denationalization did not produce tangible results. Eventually privatization and deregulation in the 1990s began to show some hope of a change exactly when Pakistan (and India) exploded

254

Liberalization and growth in Asia

nuclear bombs at the worst economic moment, which therefore failed to railroad recovery. The other major problem is the political instability. The country had a succession of military rules, and bureaucrat-led governments. In recent years elected governments had been dismissed by generals working behind the President. However, political instability and war-preparedness have always been two big problems. For instance, in a short period of less than a decade, the country has seen four different governments. Therefore, the main task for any government is to restore confidence of domestic and international investors that the political act will be in place now that the constitution has been changed so that the generals could not work behind the President to dismiss governments. Recommitment to bold, sustainable reforms along with long-term guarantees is needed now that the atomic-originated sanctions are resolved. One of the most pressing problems at the moment is repayment of the large external debt, which will continue to rise as long as the current account remains negative or the export sector is not expanded to generate enough foreign exchange. Though these problems cannot be resolved in a short period, policies and importantly determination to get the country out of this crisis are more in need. The financial sector liberalization will help to provide necessary efficient financial infrastructure but there is need for confidence to enable institutions to improve domestic resources as well as to attract foreign investment. The future is very grim indeed. The problems of security issues relating to atomic policy and peace with neighbours and confidence in the political process, which are political dimensions of development, are at the root of the country’s economic problems. Add to this the debt overhang at a critical juncture after half a century of a mismanaged vision to create a dynamic society based on ideals. Ideals alone are not sufficient impetus without common-sense-based correct policies, it appears with hindsight. If a new beginning is possible in the new century, then this will add another success story in time to come. Some measures are underway in late 2003. A financial reform law is in the making for submission to the parliament by June 2004 to prevent money-laundering and introduce best practices in the financial institutions.24

NOTES 1. 2.

September 11 or the 9-11-event refers to the suicide flights by 19 terrorists to crash their aircrafts into the World Trade Center towers in New York city, the Pentagon building and an attempted suicide flight towards the White House on that day. Most other countries included in this book experienced cyclical growth, but none as frequently as Pakistan. Hong Kong’s development experience has been impeccable with one recession in 1998. South Korea experienced one recession in 1980 and another in 1998. Pakistan has the record as described in this chapter.

Pakistan 3.

4. 5.

6.

7.

8. 9. 10.

11. 12.

13. 14. 15.

16.

255

These two countries adopted diametrically opposite development strategies. India, advised by the Oxford economists, among them the renowned economist Mahalanobis, opted for import substitution as did Brazil, Egypt and even China, the last on a grander scale, by shutting out the international flow of technology and with that domestic market competition, the source of productivity. The opposite policy of openness in trade to the rest of the world was pursued by Pakistan, but, given its huge resource usage for preparedness for war, the outcome was the famous Samuelson’s paradigm of choice between guns or bread-andbutter. Both strategies failed to produce prosperity. Similar experiments in India and South Korea also led to the same abysmal result, and the plans were abandoned at about the same time. During 1982–88, Pakistan was the second largest recipient of economic aid from the United States Agency for International Development (USAID). Khalid, one of the authors of this book, worked as a project officer during this time and witnessed the development process being put in place in this country. There were two phases in this war. In the first phase, Afghans were recruited by the secret services of the Western nations and glorified as freedom fighters – the mujahideens who would oust the Russians from Afghanistan. Once that was achieved, and the Soviet Union collapsed in 1991, the weapons were deliberately left in circulation in Afghanistan. That was a fatal error. The second phase was the secret support given by Pakistan to arm the Taliban – mostly the orphans of the war with Russia, but brought up in boarding schools with a strong dose of religious extremism – also funded secretly by both Pakistan and the secret services of Western nations, especially the USA. This led to the flow of arms to Pakistan, and also constituted the root cause of terrorism bases in the Northwest corner of Pakistan, bordering Afghanistan. The apparent reason cited was a comic power struggle, when the then prime minister ordered the airport tower in a major city not to give landing permission to a country’s general. The latter claimed that, with low fuel in his aircraft, refusal to permit landing constituted attempted murder. He seized power and got the prime minister jailed. However, before the Court could find the prime minister guilty, he was rushed in the darkness of night to the airport and given permission to be exiled in Saudi Arabia. The real reason was that the signs of mismanagement were there for a while, and the armed forces, used to running the country knew it. Growth rate for 2004 is estimated to be 6.4 per cent with about 4 per cent inflation (Dawn, Internet edition, 15 August 2004). Dawn Internet edition, 14 October 2003. The rupee depreciated from R9.9/US$ in 1981 to R61.9/US$ in 2001. This represents 8.9 per cent depreciation per year. It recovered slightly to R59.7/US$ in 2002. One country that matched this rate is Indonesia, also ruled by one general over 1966–98 (unlike Pakistan which has a succession of generals). Surprise! No. The National Accountability Bureau (NAB) that was restructured in early 2000, managed to recover billions of rupees from loan defaulters. Again Indonesia has similar achievements! But far-away Mexico, again a country with almost 90 years of rule by generals, had produced the same outcome! It took two US-presidential rescue plans (the Brady and Baker plans in the 1980s) for Mexico to turn the corner and the country is now reducing its debt burden. Dawn Internet edition, 21 July 2003. The reader may refer to Ariff and Khalid (2000, Chapter 10) for a detailed discussion on Vietnam. This situation is similar to the one faced by Indonesia in 1980s. There it became clear that fiscal balance would be seriously eroded if the tax base were not broadened. A similar problem faced by China led to their tax broadening efforts in the 1990s. However, in all these and other cases, only a small percentage of income earners are potentially the targets for tax collection. Therefore, the tax base needs broadening to include sales and value added tax as well as lowering corporate taxes to encourage more firms to pay taxes. The government of Indhira Gandhi reduced large land holdings in the 1970s. That disabled the power bases of opposition to reforms from rural landlords, while also freeing land to be

256

17. 18. 19. 20.

21.

22.

23. 24.

Liberalization and growth in Asia tilled by small owners or contracted labour, which led to the green revolution of the 1970s in India. No similar reforms occurred in Pakistan. Pakistan did not have any formal stock exchange, merchant or investment bank. In January 1997, PBC was merged with the SBP. See Klein (1990) for a detailed discussion on these events. The intent of this particular reform was to mobilize savings of those who would not want to participate in a secular banking system based on fixed interest rates and not a profit-sharing deposit system. These were the years of post OPEC oil boom, which was about to come to an end, and there was hope of attracting deposits from the oil-rich region to make a market in Islamic banking: Malaysia also adopted Islamic banking about the same time. The latter successfully permitted Islamic banks to exist side by side with modern banking because of far-reaching banking reforms in that country. The military takeover of Pakistan was based on a return to religious orthodoxy, which it was claimed, was not followed by the previous socialist regime, which the military disbanded. Hence the rationale for the vigour with which this was done. During 1991–92, Allied Bank Limited and the Muslim Commercial Banks were partially privatized. The Habib Credit and Exchange Bank was privatized in 1996; 10 per cent shares of one major state-owned bank, the National Bank of Pakistan were sold to the private sector in 2003. A major commercial bank, United Bank, was offered for privatization in May 2002 and another, Habib Bank, is to be sold to the private sector in 2004 (Hanif, 2003; p. 6). In June 1998 the level of foreign reserves went down drastically due to economic sanctions imposed by the USA and other industrial countries and the refusal of soft credit by the IMF. To avert the crisis, the government decided to freeze all foreign currency accounts. The holders were allowed to withdraw money in Pakistan currency at a rate fixed by the SBP, which was way below the market. This had serious long-run implications on investment by resident and non-resident Pakistanis. These restrictions were, however, removed in 1999. This is equivalent to US$ 2.66 billion; enough to meet Pakistan’s immediate needs to service and pay back some of its foreign loans. Dawn Internet edition, 8 November 2003.

9. 1.

Singapore: continual reforms to maintain financial centre status INTRODUCTION

The impetus for economic and financial reforms comes from Singapore’s position as an international financial centre, which explains why its finance sector contributes a much larger share of the GDP compared with financial sectors in other countries. Singapore’s central location along a trade route through a fast-growing region of the world and the simultaneous lack of sufficient competition from any nearby financial centre to its position provide the key to understanding its success and its adoption of pro-growth reform policies during 1973–2002.1 The city state – land mass about 650 sq. km., about two-thirds the size of Manhattan Island and with a population of about 4 million – is located at the tip of the Malay Peninsula at the heart of a major sea and air trade route through the Malacca Straits into and beyond the South China Sea towards Australia, Indo-China, China, Japan and the United States. Singapore has carefully pursued economic rationalism and increasingly nationalism – some may call it regional opportunism – and social controls within its borders to secure exceptionally high economic growth under very stable social conditions, resulting in a level of economic prosperity to her people second only to oil-rich Brunei or Kuwait or the industrial giant, Japan or the new economy of the People’s Republic of China, the last with the world’s largest reserves. A large part of the economic activities of this city state in the period following World War II were based on servicing the entrepôt trade that reached Singapore en route to other parts of the world. With its political separation in 1965 from its larger economic and land base within the Federation of Malaysia, Singapore had to find its own niche within the larger region as an international economy while constantly keeping ahead of others as a matter of survival. Its massive government revenues gathered as a country but with very little land mass to apply them to,2 it could constantly secure efficiency ahead of others burdened by larger land masses, and the need to look after the countryside interests. Many of the reforms discussed here arose from the need to make this small state a viable economy with only the location advantage as a resource. Hence, 257

258

Liberalization and growth in Asia

the political economy in 1965 dictated the drive for liberalization to open the economy fully to the rest of the world to make Singapore into an international financial centre. Some may draw a parallel with the resource-poor South Korea after the traumatic Korean War and the division of that country. It has been remarked that traumatic experiences of societies are often followed by dramatic achievements, as in the case of Sparta, Taiwan and other cases. In any case, such traumas appear to produce resolve to pursue good policies. The policy reforms to be examined in this chapter secured a level of prosperity that is far ahead of what has been achieved in other countries, many of which had the advantage – some would say the disadvantage – of larger populations and land masses to develop without the capital and technology which came to Singapore in abundance because of its easy and efficient port facility and open trade. As a free port, much of its traditional economic activities were based on open trading with other countries. That is, Singapore had more open economic relations with other countries at the beginning of reforms, a factor that made further reforms easier to make and sustain. The reforms that came later, especially after 1958, took the form of fiscal incentives – limited period tax exemption at first and other incentives later – which were offered as attractions to get targeted manufacturing and financial activities to be located in Singapore. This policy is contrary to the targeted credits practised by Indonesia or South Korea to create local expertise. These reforms attracted high-technology manufacturing-cum-servicing firms to base their international operations in Singapore instead of, for example, in Hong Kong or Australia or Japan or Sri Lanka or for that matter in Chennai.3 Financial liberalization created the right environment and the business opportunities in the region outside of this state acted as a magnet to attract international financial activities to this region. This led to the entry of a very large number of financial institutions, about 430 at one time, during the period 1973 to 1980 and again over 1987–94. The adequate business opportunities in the fastgrowing region led to the financial sector also gaining depth as the financial institutions with international linkages started providing financial products and services similar to those offered in international financial centres. Capital market and risk-management activities increased as a result, thus creating a reputation for the city state in the 1990s as one of the premier financial centres in Asia. When the financial meltdown arising from the 1997 financial crisis was played out during July 1997 to November 1998, this city state was the magnet for the deposits of huge sums of money from the neighbouring economies. The open current and capital accounts in Singapore – plus the 20-year history of appreciating currency – made it possible for both residents and businesses of the neighbouring countries to move cash to the Singapore banks in an

Singapore

259

unprecedented amount. The Singapore dollar was hardly affected while currencies in other nations dwindled in value by about half or more in some cases. Singapore served as the place of deposit to safety: these deposits helped the neighbours to preserve the value of wealth. The remainder of this chapter is organized into three more sections. The economic and financial structure is described next. The extent of the reforms and their effects on the economy are described in section 2. The reader will find there a description of specific reforms and their effects, learning more of this successful case as being relevant for any country that aspires to internationalizing its financial activities.4 The chapter ends with a summary of lessons and a few pointers about future prospects: see section 4. Overall, the reader will find that this chapter describes a case of a relentless pursuit of carefully formulated strategic reform policies to attract worldwide resources to the real and financial sectors of a small local economy, which is able to cater to the demands of the foreign capitalists as no other.

2.

ECONOMIC AND FINANCIAL SECTORS: AN OVERVIEW

Singapore’s economy in the 1990s could have been described as a matured economy with the services sector accounting for about two-thirds of all economic activities. This is also consistent with its status as an international manufacturing-cum-service centre. The 2002 gross domestic product (GDP) of this small economy was large, S$154000 million (about US$90 billion). The per capita income in 1997 in US dollars was about $21500, second only to the levels in Brunei, Kuwait and Japan. With just over 2.1 million workers (about one in five of them foreign), its labour participation rate is very high simply because foreign labourers are not permitted to be accompanied by their families. This is also explained by a high local female participation rate and a large foreign casual labour force, which in 1996 constituted about 18 per cent of the total labour force. In 2004, the foreign workers form close to one in four in the labour force of slightly over two million. The unemployment rate has consistently been very low, for example 3.42 per cent even during the lowgrowth period decade 1981–90: it was 4.4 per cent in 2002. The economy grew at an average rate between 7.4 per cent (1981–90) and 10.1 per cent in 1994. It grew by a more subdued rate of under 5 per cent during 1997 and 2002 due partly to the Asian financial crisis in 1997–98 and the subsequent effects of terrorism-related declines in trade, tourism and economic activities in Southeast Asia: see a plot of the growth statistics in Figure 9.1. This high level of growth was achieved through an exceptionally high investment rate in excess of 33 per cent, a low consumption rate in recent

260

Liberalization and growth in Asia

35.00

Real GDP Inflation (CPI) M2

30.00

Growth rate

25.00 20.00 15.00 10.00 5.00 0.00 –5.00 –10.00 1961 Figure 9.1

1966

1971

1976

1981

1986

1991

1996

2001

Growth rates of real GDP, CPI and M2, Singapore: 1961–2002

years under 43 per cent and therefore with a high international trade component. The average investment rate in the world is 19 per cent. The total value of trade is about 280 per cent of the GDP, which makes this economy very dependent on trade as it has been over historical times. This factor explains why the 1997 Asian currency crisis affected this otherwise wellmanaged economy. The trade and current accounts were mostly healthy in that these numbers during most periods were in balance with positive foreign direct investment, FDI, and portfolio flows. After a lapse of three years when foreign direct investments declined to historical lows in 1998, FDI has reached almost four-fifths the levels it was prior to the crisis. This is admirable considering a general decline in FDI in the neighbouring economies because of China’s attraction as the preferred place of investments for manufacturing. Some of the highlights of structural changes can be seen in the financial structure of the economy. Inflation, which was high in the 1970s and also early 1980s declined to the very low level of below 3 per cent in the ensuing years: in the 1997–2002 period it declined further. This low level was achieved along with high economic growth, which, in other economies such as China, India and Indonesia, led to persistently high inflation. Another strong characteristic of this economy is its high level of savings – in excess of 33 per cent of GDP – and high gross fixed capital formation at about 35 per cent of GDP. As is consistent with the higher level of financial development of the economy, the monetary aggregates M2 and M3 grew steadily from the low figures

Singapore

261

respectively of 61.4 and 67.6 per cent during 1971–80 to 84.5 and 102.9 per cent in the 1990s. These figures are not very far from those in the OECD economies: especially by 2002, these figures had increased. Relative to the less liberalized financial sectors in other countries, these statistics underscore the effects of liberalization in this case. The financial sector grew rapidly as well during this period. The period 1971–80 saw the financial sector becoming increasingly internationalized when more and more licences were issued to new financial entities to operate off-shore banks and non-bank financial institutions. Consequently the number of foreign financial institutions that entered the financial sector increased as did also the new off-shore and non-bank financial institutions set up by local banks. The structure of the financial sector thus began to change with local banks, finance and insurance companies modernizing their operations to face the competition offered by the foreign entrants, with better customer relations practices under increased competition. The mix of products and services offered by domestic operators and the international operators also changed. The number of firms in the financial sector increased from a base of less than 100 in the mid-1970s to close to 450 in the 1990s. The financial sector deepened as specialized institutions opened for business. The financial products offered to local and regional customers also improved. Increasingly, the financial sector began to grow beyond the provision of an efficient payment system and intermediation. It undertook economic activities that added to the income generation of the economy, and thus the share of the financial sector in the GDP doubled over the years. However, following the effect of the 1997 financial crisis on the banking system, a conscious decision has been made to reduce the number of banks providing the bulk of the intermediation function. The declines in economic activities following 1997–98 led to worsening non-performing loans mainly from offshore lending activities of local banks. Thus was born the bank merger exercise. The local banks were encouraged to consolidate or ordered to consolidate into fewer banks. The POSBank, which traditionally accounted for about 40 per cent of all local deposits, was ordered to join up with the DBSBank, which had more business risk exposure. The Overseas Union Bank was taken over by the United Overseas Bank. Moves started in 2002 to further consolidate the depository institutions into fewer and larger banks, apparently to strengthen them. Instead of top four banks, the number now favoured is top two banks by the regulators. Two very large well capitalized good banks together make one greater good bank is the belief. History in other economies does not bear out this belief. Perhaps this is workable in a tight economic environment with over-banking activities as in this economy. Social development received a heavy dose of investment. Education and the development of public facilities took a major share of the budget producing a

262

Liberalization and growth in Asia

well-educated population with skill levels that are comparable or even surpassing the levels in developed economies. A public housing scheme that was originally meant to provide a roof over the head for all became in the 1990s a get-rich scheme of levering the pension savings to live in luxurious public houses: 84 per cent of the people live in well-organized public-built leased housing estates. The value of freehold private sector housing, the remaining 16 per cent, has gone up so high that it is not possible, except for the really gifted and the rich, to own a piece of land. The non-traded sector in which housing is trapped received the effect of a price spiral. But the economy became larger, providing full employment and a standard of living that was the envy of the rest of the region, at least at the end of 1996. 2.1

Economic Reforms

It is possible to state that this economy had a greater degree of economic openness during the opening years of our analysis than any others covered in this book. To start with, there were strong private ownership institutions (the laws, the courts and markets) for both the means of production as well as the contractual legal framework for workers to offer their services in a labour market with capitalist incentives. Next, because of the historical free trade status of the city state, which the other countries in the region did not have, there were no tariff walls that had to be brought down as was the case in other countries. The tariff barriers that existed in transactions relating to liquor or tobacco products and vehicles, are still preserved even at the time of writing at perhaps the world’s highest tariff levels: just order your wine at the start of a meal and you will not be that thirsty! But for almost all other economic activities, there were no tariff barriers. Thus, very few reforms were needed to open the then economy of the 1950s and 1960s to international trade as was the case with other countries such as South Korea, which failed to bring down its high tariff to preserve its domestic market for its producers till it felt ready to lower it in 1989. As a result of this (and the fact that capital flow to this financial centre was large), Singapore managed to build huge reserves. Its huge build-up of reserves from trade and from capital flows as well as a government budget (which is smaller than the revenue collected), means it has one of Asia’s greatest foreign currency reserve positions: see Figure 9.2. Singapore therefore had greater external openness from the early years, which helped it to introduce competition in the real sector without having to force it open to competition as was happening in the 1980s in the emerging economies. Where it did not have openness – land holdings and in property development, both being non-traded sectors – there was no external competition, which drove the prices of land and building and

Singapore

35.00 30.00 Growth rate

25.00

M2 M1 FR/IMP

80.00 70.00 60.00 50.00

20.00 40.00 15.00 10.00 5.00 0.00

30.00 20.00

Foreign reserves to imports

40.00

263

10.00

–5.00 0.00 1961 1966 1971 1976 1981 1986 1991 1996 2001 Figure 9.2 Foreign reserves to imports ratio and growth rates of M1 and M2, Singapore: 1961–2002 because of that, the capital markets, to unprecedented heights before these gains began to decline after 1997. Two important economic reforms occurred very early. One was in the 1950s, and came as a response to the high unemployment rate in the 1950s that persisted well into the 1960s. The economy could not absorb the post-war baby boomers who entered the labour force then. Since political events were more critical at that time, only two reforms could reasonably be put in place by the then governments. The law passed in 1958 empowered the governments to offer incentives to attract foreign investors to locate economic activities to absorb the unemployed labour. The other was the decision in 1959 to expand the then existing institutional framework of a central body – the Economic Development Board or EDB – to plan and execute reforms to attract foreign investments. These institutional reforms had far-reaching effects in making the city state the premier place to do business in the region in the next decade. They were carried out at a time when other governments did not welcome foreign capital for fear of losing control: these were the early days of the international victory of Communism, which appealed to a large section of the population. The government also invited international bodies such as the World Bank, the IBRD, etc. to help identify pro-growth policies that would help it to achieve satisfactory results.5 The first Economic Plan covered a five-year

264

Liberalization and growth in Asia

period to 1965. An important feature of these reforms was the setting up of the institutional framework, the economic planning framework, at the highest level, to research and formulate strategic policy changes to develop the economy. Readers will note that this is a special feature of the Singapore case, where institutionalizing reforms formed an integral part of economic management. These reforms may be said to have been the start of the significant economic liberalization. 2.2

Labour Relations Reforms

A second set of reforms was aimed at depoliticizing the trade union movement. Till about 1963, the trade union was a partner in putting the ruling party in power. The government in power realized that it needed pro-capitalist policies to attract the needed foreign capital to absorb spare capacity. Thus, the next set of reforms took away some of the traditional freedoms the labour movement normally enjoyed in developed countries, which were not thought – at least by the then elites – to be relevant for a developing economy. As a result, a process began to build new labour relations institutions – a sole trade union movement, an arbitration court and leadership recognition of trade unions – to incorporate the labour movement as co-partner with the ruling group. Between 1960 to 1979 a series of new laws were passed and institutions set up to make the mainly autonomous trade union movement become a partner in nationbuilding and development. This paved the way for pro-growth capitalist-oriented reforms to be undertaken with the consent and cooperation of the labour movement. Besides this the labour movement became de-linked from adversarial politicking. These reforms were highly successful in that the labour chief now sits in the cabinet as a minister without portfolio while the traditional adversarial employer–employee relation was replaced by the law requiring a cooperative relationship between labour and the employer. As a result, wages are now tied to the performance of the economy, with wages rising when the economy is in upswing; wages decline during recessions. This has worked wonders for the pay packets during good years, but not when things go bad. For example, involuntary wage cuts were implemented during the 1985–86 and the 1997–98 economic recessions, which it is argued helped the recovery of the economy. This was done with the approval of the trade union working together with the employer and the government to set the economy back towards good shape. When the excess labour pool was fully employed, by the end of the 1970s, with the entry of multinational firms attracted by freedom to manage their investments without interference from the union movement, the policy-makers decided to restructure the economy so as to attract higher value-added industries into Singapore. The controlled small wage increases that were in

Singapore

265

effect since 1973 gave way to substantial wage increases that made Singapore’s location not so advantageous for labour-intensive industries. The result was the popular campaign to usher in the second industrial revolution! The substantial restructuring that resulted as wages went up rapidly made Singapore the technological and testing centre for industries located in the region as well as the financier of industrial growth in the region, thus helping to make higher productivity possible for Singapore. However, an undesirable consequence was also the resulting high labour costs. These unsustainable wage increases coincided with a worldwide economic slowdown during 1984–86. The result was an economic recession over four quarters in 1984/85. There followed a period of belt-tightening and cost-cutting that included a general wage cut of about 5 per cent. These cost restructuring reforms made Singapore attractive again to international investors and the economy was on the mend again. The economic recovery in 1987 led to an unprecedented period of high growth which brought an asset bubble – asset prices trebled in four years – which lasted till the 1997 Asian currency crisis, which produced a potential long-drawn recession during 1997/99. Wage reductions also helped the economic restructuring to take shape quickly. 2.3

Fiscal Reforms

The government realized after the last economic recession that it needed to have budget surpluses in order to steer the economy in hard times and to pursue economic expansion into the region. So, it pursued a policy of withdrawal from unprofitable economic activities within the country and cut down on welfare schemes since there was no unemployment due to lack of jobs. The privatization policy that was pushed through the Parliament in 1984 led soon to the corporatization and sale of government entities.6 The government, which gets very high revenue on a per capita basis to develop a small island nation, decided to curtail expenditure and introduced measures that reduced government expenditure. Government consumption, which was a high of 11.2 per cent of GDP during the 1981–90 period, was slowly brought down to 8.0 per cent or thereabouts in the 1990s. At the same time, the fiscal surplus of about 3 per cent in the annual budget of the 1980s was slowly increased. The budget surplus has since reached about 10 per cent of GDP, a fourfold increase unprecedented in any economy especially sustained over such long periods. How much can the small land mass be developed with the increasing revenue share of the economy? These two measures generated resources for the government to go on an adventure to become the financier in emerging countries largely in China, Indonesia, Cambodia and India. To this end, the GICS (Government Investment Corporation of Singapore) was set up

266

Liberalization and growth in Asia

using the reserves that used to be managed by the monetary authority prior to 1982. Persuading these emerging economies to invest in tourism-related, housing, transportation and communication facilities was explained as ‘growing an external wing’. It was explained that the opportunities to grow were limited within the domestic economy. Besides, it made good sense to let the reserves earn a higher rate of return if it can be so managed. Whether the resources of the government should be so disposed in investment in other countries was never raised in any debate. However, this experiment has not had sufficient time to work, even though it started in 1982/83. In the early period till the mid1980s, most of the investment was in real estates and capital markets of the developed countries: property investments particularly declined in value when most of the OECD countries were experiencing property slumps over the 1980s. In the subsequent period, most investments went to specific projects in emerging economies, and their values after the currency crisis must have declined till recoveries lead to gains. The 1997 Asian currency crisis must have affected the values of these investments with all emerging economies except India and China experiencing currency depreciation. This series of economic reforms to grow an external wing to the economy appears to have been set back since the mid-1990s. Only time can tell how much this reform policy has measured up and contributed to the well-being of the domestic economy. Thus, economic reforms undertaken since 1958 had taken the already very open Singapore economy, the free trade area of the region under 125 years of the British rule, to greater heights. It enlarged the size of its economic activities, and helped it to overcome its size limitation. In fact, Singapore is acknowledged as a major player in the region’s development activities. Regional cooperation was based on Singapore’s participation in several progrowth forums in the region. For the majority of people, reforms secured near full employment, and social development unprecedented in Singapore and also unmatched in the region. The structures placed for economic growth are still in place to take the economy to possible greater and nimbler heights once the current crisis management yields recovery and growth in the opening years of the next millenium. Socio-economic effects of reforms The effects of economic policy reforms are examined in this section. See Table 9.1 for details. Briefly stated, the reforms had a favourable effect on economic activities. GDP increased dramatically from its base figure of under S$15 billion in 1976 to some S$128 billion in 1997. This is a high growth rate in each tested period of between 6.2 per cent (in 1992) to 10.4 per cent (1995). Inflation that was close to 10 per cent during 1976–80 moderated to under

Singapore

267

3.4 per cent after 1981. This is perhaps a significant achievement during a phase of high economic growth to also have low inflation. It declined further in the period 1997–2002. The revenues of government grew ahead of the economic growth rate: the average revenue growth was in the region of 13 per cent, which is more than twice the rate of income growth. Money growth (M1) and credit creation (M2) more or less kept a little ahead of the economy’s growth rate. Monetary expansion was about 12 per cent, perhaps sufficient to finance the expansion and also to cover the increased transaction demands of an affluent population. The foreign cash flows were very substantial, growing at many times the rate of the economy till 1995, when FDI declined by 100 per cent. The trade account generally improved throughout the period with dips only in certain years. FDI began to recover in 2000, after a dip in 2001, and rose in 2002 after the wars and security alerts that affected travel-related economic activities. The spread of the SARS virus during April–July 2002, severely curtailed economic activities again. It can be seen that the monetary ratio (M1 and M2) remained stable throughout the period. Private consumption went down from 55.4 per cent of GDP and government consumption from 10.3 per cent of GDP over the period respectively to 40.7 and 8.5 per cent. The gross fixed capital formation held at about 33 per cent of GDP except in the early years 1973–80, when it was higher during the formative period of high investment. However, the trade account was not as stable as the other aggregates. But there was no systematic decline in those accounts. Overall, the economy registered healthy growth and sustained itself to become a more international economy with domestic consumption being less than half of GDP.

3.

FINANCIAL LIBERALIZATION

Financial liberalization played a critical role, vastly different from that in any other country, in transformation. Instead of just fulfilling the needs of the economy in intermediation and efficient payment system, the financial sector became an important income generator along with other economic activities. Reforms made it possible to turn Singapore into an international financial centre. Since 1982, important risk management services started to deepen and hence provide such services to the international financial institutions and real sector firms doing business in the region. The thrust of financial liberalization is described by highlighting a number of key financial reforms. The financial sector was designed to consist of two types of financial institutions. Some are licensed to operate on full-licence basis, which entitles them to participate in both the local and international economic-financial

Table 9.1

Basic economic and social indicators of development in Singapore 1961–70

1971–80

1981–90

National accounts GDP growth (%) 9.36 Per capita GDP (US$) 605.00 Private consumption/GDP 77.67 Government consumption/GDP 10.31

9.07 2668.00 59.22 10.86

7.20 9.02 6.66 10.25 –2.37 2.25 8032.00 18032.00 22751.00 22149.00 20550.00 21538.00 46.55 44.38 40.46 40.68 42.61 43.00 11.32 9.13 9.95 10.67 12.05 12.90

268

Financial indicators (%) Gross domestic savings/GDP Fixed capital formation/GDP Inflation (per annum) M2/GDP Fiscal balance/GDP Trade balance/GDP Current account balance/GDP Total trade/GDP Debt/exports Debt/GDP Foreign reserves/imports

– 20.25 1.11 – – – – 240.30 – – 31.20

27.00 36.43 6.72 77.50 0.96 –35.25 – 267.40 43.88 48.41 39.12

42.35 39.37 2.28 127.42 2.91 –10.77 0.27 303.40 55.16 75.78 39.39

1991–95 1996–2000

51.50 34.60 2.56 140.37 12.38 –0.68 13.00 284.20 56.95 76.72 54.85

52.80 35.63 0.90 158.02 12.63 11.73 18.87 277.20 58.57 81.12 62.18

2000

48.10 29.86 1.36 160.42 11.47 14.07 17.40 298.00 56.50 85.21 59.17

2001

44.00 29.48 1.00 182.49 5.20 17.40 21.07 280.00 67.42 96.67 64.57

2002

44.70 20.60 –0.39 163.42 – 21.30 21.50 277.60 70.01 100.66 69.94

Social indicators Unemployment rate (%) Expenditure on education (% of budget) Expenditure on health (% of budget) Expenditure on defence (% of budget) Population growth (%)

–

–

2.50

2.50

3.30

3.50

2.80

4.30

–

16.50

19.10

23.00

22.00

21.00

19.40

–

–

7.90

5.50

6.90

6.80

5.10

5.50

–

– 2.42

– 1.53

– 2.34

– 3.17

– 3.20

25.60 1.70

24.10 2.80

– 0.80

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

269

270

Liberalization and growth in Asia

activities. There are also other specific financial institutions, which are issued with restricted licences to operate as offshore operators. The latter have binding limitations imposed on transactions in the domestic economy though they are free to operate fully in international activities. This is a unique arrangement introduced in 1971 for banks and in 1973 for offshore licences, by the newly-created Monetary Authority of Singapore (MAS). That attracted some institutions to Singapore purely for the purpose of operating out of its location to engage in international financial transactions. Another reason for this was the infant industry protection argument that if financial institutions of larger economies are permitted to compete on even grounds, these local institutions will lose out simply given the size constraints, so it was argued. At the start of 1998, there were 35 full-licence commercial banks (of which 22 have headquarters in foreign countries), 36 finance companies, 57 insurance companies together with 4 underwriting companies, 77 investment banks, 7 wholesale money brokers,7 1 postal bank, 1 central provident fund organization for old-age pensions, 74 mutual funds (called unit trusts) and two regulators, namely the MAS and the Board of Commissioners of Currency.8 The last-named is unusual as it is found in only a few other countries, and has the responsibility to print currency and mint coins to the extent supported by reserves as provided under a statute of the country. The postal bank named the POSBank – since 1999 merged with the DBSBank – has played a significant role since, with almost half of all savings deposits, its interest rates for time deposits largely influenced the prevailing base rate for all time deposits. These 288 financial sector organizations as of 2000 functioned in ways similar to those found in any other economies, and they carry out both domestic and foreign transactions. These were the ones that were most affected by financial liberalization whereas the remaining organizations, to be described later, were the direct result of regulations to attract special classes of financial firms to do business mostly with the international financial clients situated outside Singapore. Following the effects the 1997 Asian currency crisis had on the banks, a number are being merged. One such merger is that between the largest commercial bank, the DBSBank, and the POSBank in July 1998. Another merger was between the Tat Lee Bank and the Keppel Bank Corporation. More such mergers reduced the number of local banks to less than the 22 prior to this reform (see Khalid and Tyabji 2002). There were 14 restricted licensed banks, which cannot accept domestic time deposits below a certain amount from residents. Prior to 1990, the sum of money (in Singapore dollars) that a resident could place as deposits in a restricted bank was a minimum amount of $250000. But this sum has been reduced to a much lower figure over the years thus opening more competition in the deposit market by the entry – no doubt restricted entry – of these

Singapore

271

restricted banks in domestic intermediations market. The lowering of limits introduced more competition. Singapore is also well-known for the first-time introduction in 1968 of Asian dollar deposits (initially, the American dollar and later other currencies) which enjoyed exemption from the withholding tax normally levied on interest incomes of foreign residents.9 These offshore licensed banks have developed to engage in wholesale banking with non-residents and limited banking with resident institutions and individuals. There are about 140 offshore banks operating in a market which had grown to US$515 billion by 1997. The total value of the Asian dollar market had declined slightly to less than US$515 billion in the years after that date. Investment banks also engage in the Asian currency market. These 140 offshore operators and the 288 described earlier as full-licensed entities are the financial sector organizations in the economy. Their activities can collectively contribute to anywhere between 12 to 18 per cent of GDP. During economic boom years such as 1993, financial activities could contribute almost a fifth of the GDP. Even in abnormal times, when the economy is at a low growth, largely due to the international nature of the financial sector of this economy, the GDP share of the financial sector of this economy is about 10 per cent. In most economies, the GDP share of the financial sector activities is about 4–8 per cent of GDP. This underlines the importance of open international conditions for the operation of the financial sector of this economy. Its greater dependence on financial activities provided the impetus for the regulators to become pro-liberalization and antisuppressive to achieve open financial conditions with which Singapore’s financial sector could work for further growth. At the next stage, Singapore used its open conditions to argue in favour of openness for other countries pointing to the benefits of such liberalization to other economies that were not open. Table 9.2 provides a summary of significant financial reforms undertaken over 1971–98. Financial sector reforms may be analysed over two distinct periods. Limited suppression existed prior to 1973, and the sector is described as being moderately regulated and suppressed on two grounds. There were informal interest rate controls practised by a cartel formed by a small group of large banks with a leader who set the interest rate, and there were exchange (and limited capital) controls. The currency at that time was a common currency used in Brunei, Malaysia and Singapore with the currency being managed by an organization, the currency board, which minted coins and printed currency notes provided that a set amount of foreign currency (usually it was the British pound) was available to back the expansion in money supply, M1. The convertibility of the currency with Malaysia was terminated when Malaysia adopted the ringgit as its numeraire in June 1973.

272

Liberalization and growth in Asia

Table 9.2 Major economic and financial sector reforms in Singapore: 1967–2003 Liberalization policy implemented 1967

Introduction of Asian dollar deposits in ACUs considered

1968

Starting in 1968, withholding tax was abolished for foreign depositors

1971

Establishment of Monetary Authority of Singapore to focus on developing a sound financial structure

1971

Creation of restricted licence banks which could be licensed to concentrate on international business and limited to receive only large time deposits from residents; provided competition to domestic banks

1973

Off-shore banks licensed in 1973 to operate in the growing financing activities of the region June 1973 Limited reform in exchange rate via S$ pegging to a basket of trade-weighted currencies Most of the foreign exchange controls dismantled Currency convertibility abolished Interest cartel of the large banks abolished, and interest rate determined by market signals More financial institutions licensed in the off-shore markets 1978

Call Options market introduced in the Stock Exchange of Singapore

June 1978 Further restrictions on current and capital accounts removed; Article 8 freedom 1981–84 1983

Reforms to the financial institutions to improve efficiency, training and expertise.

1984

Privatization policy approved in Parliament and government companies sold

1987

Tax exemption on income derived from off-shore fund management

1989

Derivative market started with the launching of SIMEX

1991–99

Establishment of second board for small company listing in SESDAQ

Singapore

273

The money market and bond markets were target of reform; the discount houses abolished, and approved market makers to bid in the treasury and bond markets introduced Banks also permitted to enter into securities trades through subsidiaries set up as brokerage/securities firms Each year over this period a series of reforms introduced to further make Singapore into an international centre for financial activities Most of the reforms provided further reductions in the taxable status of income derived from activities originating from abroad. Taxes were reduced mostly to 10% instead of the previous 27% In 1996, government attracted major fund management companies to locate in Singapore. The offer of managing upwards of a billion dollars in the central provident fund and other government funds have been made Rules introduced to attract foreign company listings on the local stock market July 1997: exchange rate to free float in the face of Asian currency crisis January 1998: Deputy Prime Minister appointed to MAS: managed float again February 1998: limited internationalization of S$ and CPF fund management July–August 1998: new measures introduced to strengthen banking Tax exemptions and incentives to develop fund management expertise in Singapore. 1999: Deputy Prime Minister becomes chairman of MAS and introduces new reforms, and restructures the banking institutions December 1999: Futures market (SIMEX) merged with stock market Continued overleaf

274

Liberalization and growth in Asia

Table 9.2 Continued Liberalization policy implemented 2000–02

January–March 2000: commission rates for stockbrokers reduced from 0.95% to 0.75% for smaller than $150000 trade; negotiable for larger trade; T+3 days for security trade settlements. Insurance sector liberalized, barrier removed August 2000: Singapore–New Zealand free trade agreement has led to similar agreements with Australia, the USA and Thailand The minimum CAR lowered from 10% to 8% for tier 1 capital June: banking liberalization policy moves to second stage October 2002: Currency Board merged with central bank June 2002: A deposit insurance scheme introduced to safeguard small investors In early 2003, a neutral policy with regard to currency was put in place to let the currency follow a path against the US dollar

Sources: Hansen and Neal (1986); Ariff (1996); Ariff and Khalid (2000); and excerpts from MAS sources.

The financial sector was then regulated by a division of the Ministry of Finance till a quasi-government body was formed in 1971 to take over the functions of central banking except for the printing of money and the minting of coins, which remained with a separate board. Despite the closedness of the economy (see Edwards and Khan 1985), a major reform with longer-term effect took place three years earlier in 1968 which permitted the creation of an Asian Currency Unit to accept US dollar and other key currency deposits of non-residents. The withholding tax was removed on interest earned by foreigners from deposits in these special off-shore licensed units called ACUs. This led to the first-time introduction of a distinction between the local and foreign transactions, followed by more and more businesses receiving preferential tax-based treatment on the origin of transactions. In that sense, the 1968 innovation had a major effect in so far as it became the precursor for the segregation of the financial sector into domestic and foreign financial transactions. The entrepôt trade that dominated the free-trade nature of Singapore for several decades before the 1960s provided a backdrop

Singapore

275

against which people and businessmen from the region used Singapore to make monetary transactions. The active promotion of Singapore as an international financial centre only started in 1968. A financial centre may be defined as ‘a central location where financial transactions of an area are coordinated and cleared’ (Reed 1989: p.1). Increasingly, Singapore took the shape of a financial centre of the region, and later a centre in the international time zone. 3.1

Reform to the Structure

The formation of a quasi-government organization, MAS, to centralize the regulatory function of supervising the banking, insurance, and central banking functions was a major reform of the sector. It was a purpose-driven body created to manage the financial sector. MAS could now play a lead role to introduce further reforms. These reforms were itemized in Table 9.2. There was a centralized body to deal with all financial matters (except money creation, which was separated and done by a currency board). In larger economies, three different organizations are often formed to deal with banking supervision, securities exchange supervision and futures exchange matters. But, for a small economy, the centralized approach appears to have worked well. Exchange rate policies Like most non-major countries in the world, Singapore had a fixed exchange rate regime during the post-World War II period, till 1973. With the pound sterling and the US dollar forming the peg currencies, the Singapore dollar was a common currency of exchange in Brunei and Malaysia as well. The Ministry of Finance and the Currency Board situated in Singapore managed banking supervision and note issue functions respectively without the benefit of a central bank for Brunei, Malaysia and Singapore. All this changed in June 1973 when the Malaysian government decided to cease the currency convertibility by establishing its own currency, the ringgit. Singapore then undertook limited reforms by adopting an exchange rate based on a basket of major currencies. This simultaneous move to delink with the largely agriculture-based Malaysian economy and use a managed float exchange rate system was significant in creating focus on the local economy for the exchange rate. In that, it also got the confidence factor with the oil-rich Brunei dollar joining in the Singapore dollar as a convertible currency at par. Full current account and capital account opening was the next step in reforming the financial sector. That came five years later in June 1978. Complete openness in transactions with the outside world became possible, however within the managed exchange rate based on a trade-weighted basket

276

Liberalization and growth in Asia

of currencies. The law included a clause that empowered the authorities to reimpose controls if deemed necessary during periods of crisis. The authorities did not resort to this even during the 1997 crisis. In August 1997, the currency was free floated. The managed float was reinstated in January 1998 when a Deputy Prime Minister was appointed as the head of the monetary authority. The restrictions on the use of the Singapore dollar in international financial transactions have been relaxed since 1999. Thus, on the one hand, there is complete openness in current account and the use of the local currency, but it is still felt that a form of managed float gives confidence to local residents to hold the currency: see Tables 9.3 and 9.4. Around the same time, Singapore adopted limited capital account openness so that external transactions could be done without the oversight of the monetary authorities. The MAS consolidated all but the money-printing function. This was a boon as no other country in the region provided the extent of current account and capital account freedoms for business operations in 1973. The result was that it strengthened the off-shore Asian dollar market that began to grow after 1968: at the end of 1997, the Asian dollar market in Singapore was valued at about US$515 billion. This market was created with a reform, removing the withholding tax on interest incomes for foreign residents. Add to these two attractions, the ability of foreign enterprises to fully own and operate their own enterprises, which was a novel idea at that time. Thus, Singapore offered a fertile ground for the activities of international firms be they financial or real sector ones. The reforms in the financial sector – managed exchange rate, open capital accounts, tax incentives and whollyowned foreign management – provided the necessary impetus to make Singapore attract a lion’s share of the foreign capital. From about the middle of the 1970s right up to 1995, Singapore attracted FDI at rates anywhere from 3 to 11 per cent of its GDP. Some of the highlights of the exchange rate behaviour are noted here. The exchange rate was close to S$3.00 = US$1.00 at the start of the 1970s. Ten years after the reforms, the Singapore dollar had appreciated to S$2.20 = US1.00; by the end of another ten years, it was S$1.62 = US$1.00 in 1993. By the end of 1996, the exchange rate stood at S$1.41 = US$1.00. Following the lacklustre economic performance during the 1998–2002 period, the exchange rate has been declining – aided by the official neutral policy of the central bank on exchange appreciation – to the 2002 rate of S$1.78 = US$1.00. Thus, the exchange rate appreciated by an average of about 3 per cent per annum over a 24-year period: while it has declined by 3 per cent per year since 1996. This had both a salutary and a debilitating effect on the economy. The rising currency kept the prices of mostly imported raw materials from becoming expensive. The non-traded goods became expensive as did also the labour

Table 9.3

Growth of financial and capital market indicators for Singapore (annual averages)

Exchange rates (% change) 277

Interest rates 3-month interbank rate T-bill rate Time deposit rate Base lending rate

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

–

–3.41

–1.61

–4.78

4.10

1.71

3.93

–0.06

1.07 – – –

3.38 3.32 2.44 2.74

5.90 3.43 5.36 8.30

6.56 1.75 3.26 6.23

5.82 1.82 3.26 6.23

2.66 2.18 1.71 5.83

2.79 1.69 1.54 5.66

2.73 0.81 0.91 5.37

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

Table 9.4

Indicators of financial and capital market depth in Singapore (percentage annual averages)

278

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

Money depth (M3/GDP)

–

77.50

127.42

140.37

158.02

160.42

182.49

163.42

Intermediation depth FIR (total)/GDP (=DC/GDP) FIR (private)/GDP

– –

26.96 58.65

71.85 85.18

61.32 87.00

79.20 104.43

80.30 100.88

95.11 121.70

77.90 108.56

20.25 – –

36.43 – –

39.37 11.94 10.45

34.60 13.04 9.37

35.63 15.58 9.76

29.86 11.34 5.91

29.48 22.18 10.14

20.60 – –

Capital accumulation GFCF/GDP FDI (net)/GDP FDI (inflow)/GDP Notes: M2 = M3 = FIR: GFCF: FDI: FDI (In): DC:

currency + quasi money. M2 + other deposits. financial intermediation ratio; claims on public + private sector (total credit), on private sector (private). gross fixed capital formation. foreign direct investment (net). foreign direct investment (inflow). domestic credit.

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

Singapore

279

costs and costs of consumer items on account of the higher input costs from high rent and high wage costs. Some observers have pointed out that the high exchange rate made Singapore residents feel wealthy in terms of regional currencies, but they paid a dear price in terms of the cash flows needed to own some basic necessities in the city state. Following the 1997 currency crisis, the exchange rate declined to a lower level but still was around S$1.70 to 1.80 per US dollar. The decline of this currency by about 20 per cent is mild compared to declines of more than 70 per cent in the case of Indonesia. Interest rate policies Prior to reforms on interest rates, interest suppression was in general true under a cartel-like banking system dominated by a very large local bank and three relatively large but still smaller banks determining the interest rates for deposits. That was the state of affairs for a long time, and no one disturbed the pecking order which served the situation well in (Malaysia and) Singapore. However, the government of Singapore decided to free interest rates to respond to economic conditions then prevailing: in fact, inflation was in double digits in the 1970s and interest rates had to be competitive to bring that inflation down. Earlier in 1968, the government had formed a new bank by hiving off the investment division of the EDB. This was later corporatized as a private sector bank and it expanded to become a very large bank with a potential to disturb the status quo in the banking world. More foreign banks had also established local operations for several years by 1973. There was thus the introduction of enough competition in the banking sector so that interest rate setting could be replaced by the market. The monetary authority issued a regulation in 1972 requiring the deposit rates to be determined by market forces. Thus, interest rates began to be determined in the marketplace. Deposit rates increased and savings deposits increased quickly in response to the competitive offerings of interest on fixed deposits. Inflation of around 7 per cent was experienced during the 1971–80 decade. However, the interest rates on loans to the business sector did not jump up dramatically as there was enough credit being created and there were substantial foreign funds, given the relative openness of the capital and current accounts, for the international sector activities of foreign firms. Another important structure of the financial sector is the national savings bank, which, till its amalgamation in mid-1997 with a commercial bank, played a significant role to keep the interest rates low. The Post Office Savings Bank, POSBank, was meant to inculcate the savings habit in the population, and it started in the 1970s to cater to children and homemakers. Soon it came to have almost 60 per cent of all deposits in the economy because it provided tax-free interest income, and deposits were guaranteed by the government as well. It was because the POSBank offered such low interests to its faithful

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customers that the banking system as a whole did not feel it necessary to increase its interest rate beyond a small margin above that offered by the POSBank. In July, 1998, the POSBank was merged with the largest bank, the DBSBank. This had the eventual effect of suppressing interest rates on deposits, and therefrom on all other interest rates, in Singapore. Another institution, the Central Provident Fund Board, which collects all old-age pension contributions and self-employed persons’ contributions, decided in 1989 to offer a rate of return on pension fund balances equal to the average deposit rate of the banks. This also acted to suppress the interest rate to a very low level. What was happening was similar to the situation in Japan, where the national savings bank effectively set the bottom interest rate for the depositors, which helped to set the norms for other deposit rates. As a result of this simple interest rate suppression – even though earlier reforms helped abolish the cartel rates in the early 1970s – the deposit rates hovered around 3 per cent during most of 1987 to 1996. The average inflation was also very near the 3 per cent mark. This meant that there was almost no real interest earned by depositors. At the same time the minimum lending rate was hovering above 6 per cent during the same period. This meant that the banking system was securing a high level of profits in the intermediation market. Though this was not a deliberate policy goal, the international nature of the financial sector helped to attract too many funds into the sector, which tended to lower the rates for the depositors. For foreign investors, it was a boon as they would get currency gains in addition to the low interest rates. This was not so for the residents, who earned almost zero real interest. This changed slightly after the onset of the 1997 currency crisis. Interest rates jumped up by about 1.5 per cent, and the currency no longer appreciated, the exchange rates having fallen by about 20 per cent over the period of the crisis. With inflation remaining low, a small real interest was being earned by depositors, starting in mid-1997. With the slow growth the demand for money dried up, and the existing high liquidity since 1999 meant that the interest rate plummeted. The average deposit rate in 2003–04 is no more than 1 per cent. This situation that has persisted for five years after 1999 has been detrimental to the very large number of elderly and the retired who save the most. With the economy growing at an average rate of 2.16 per cent over 1998–2002, there is little demand for capital in this economy. Neighbouring economies, which are still not growing at anything more than 5 per cent, are not providing the demand for Singapore-sourced capital. The effect on the interest rate has been disastrous for the savers. The deposit rates have gone below 2 per cent for time deposits for several years. That places a huge burden on the retired population to earn a decent return on savings.

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Monetary policy Another aspect not yet discussed in this section is the monetary policy management. Prior to the 1973 reforms to adopt open current and capital accounts, monetary management was simple. Interest rate management formed the main thrust of monetary policy along with measures to keep inflation within a manageable range. With the open international conditions increasingly put into place from 1973, monetary management became closely tied to exchange rate management, since the capital inflows had to be sterilized from affecting the money supply. For this purpose of exchange rate intervention, the MAS engages in routine direct and indirect foreign exchange interventions. Most interventions are made indirectly through the network of money brokers so that these activities do not get noticed or discussed, thus preventing undesirable speculation based on public discussion on intervention activities in the open markets. The major banks and the money brokers are linked together by all means of telecommunication network operated by the Society of Worldwide Interbank Financial Telecommunication (SWIFT). The government is on record as wanting to maintain the exchange rate at high levels in order to prevent imported inflation since a significant portion of factor inputs (about 45 per cent) are purchased in the international marketplaces. Thus, monetary policy hinges heavily on exchange rate policy and on keeping reserves and capital flows to keep exchange rates high. In fact, the exchange rates against the US$ appreciated, on average by 1–3 per cent over most years followed by a similar rate of decline since 1997. Therefore economic activities are macro-managed through exchange rate management. The large inflows of funds from international sources are sterilized through conversion into foreign currency holdings so that monetary expansion through this source is prevented from affecting the domestic economy.10 There is no interest rate policy or pricing policy in the macroeconomic management. Interest rates may be indirectly affected by the exchange rate determined via policy intervention. Unlike in most economies, interest rates are not the main driver of the monetary policy in this economy. Growth in money supply has been moderate throughout the period of exchange rate intervention, which suggests that the policy aim of preventing monetary expansion did in fact work. This also had a salutary effect by keeping inflation down. Inflation in the last five years to 2002 ran at around 2 per cent. Second, prices for all traded goods were determined in the marketplace. The appreciating currency reduced if not eliminated the price increases from outside the country. However, an appreciating currency made non-traded goods (rent, labour, health services, the properties, and land) appreciate in value. This is exactly the result that

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occurred every time the economy recovered, and the currency appreciated against the major currencies. Central banking and note issue function The top four domestic banks, each with tier 1 capital in excess of US$3 billion, are now included among the top 125 banks in the world. There were two critical reforms put in place to create international confidence in the soundness of the financial sector. One relates to the separation of the money-printing function under a currency board system and the high standards of prudential supervision of all financial sector entities. The central bank was responsible for monetary matters except the printing of money, which was under a currency board. The other is the separation of the domestic financial activities from the international financial activities. The first of these reforms was the setting up of a monetary authority vested with supervision of all financial sector entities and to serve as the government’s banker. This was done in 1971 with the establishment of the MAS as pointed out earlier. Its function has been widened with the passing of laws on banking, insurance, finance companies, the stock and futures exchanges, and even informal finance organizations. The printing of money and minting of coin are managed by a currency board, which, under the laws governing it, is required to expand M1 to the extent there is available specified reserve currencies to back the amount of expansion in the money created. This acts as a Chinese Wall to prevent the central banks from indiscriminately expanding the base money. The counter argument is that most of the credit created in an economy actually comes from the money multiplier function of the commercial banks, and there is no similar discipline on the commercial banks even under a currency board system. In fact the lion’s share of money creation is by the commercial banks. Nevertheless, the separation of the money-printing function from the bank credit creation is reputed to have introduced some discipline to the banking system, and there is a general feeling that this is a good thing to keep for posterity. We leave the argument at that. However, in 2002, the currency board functions were brought under the same control of the central bank. From the start, the MAS established a reputation as a no-nonsense regulator who would assiduously prevent any financial institutions from any behaviour not consistent with the spirit of the laws and the regulations in force. To do this effectively, MAS itself relied upon good quality employees, and technical expertise obtained from central banks of developed countries. In aid of this policy, the banking laws (and corporation laws) had been amended a number of times to make it more relevant to achieve high standards of prudential supervision of the financial institutions. For example, under the related party lending rules passed in 1981 – far ahead of many other countries – MAS prosecuted a bank that flouted this rule. Similar instances of rapid-fire actions

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have been recorded in a case of a bank flouting reserve ratios, in another of international dealings in Singapore dollars, etc. At one time in 1983, the speculative attack on the Singapore dollar was prevented by actions not dissimilar to those carried out in Hong Kong in 1998 when the HK$ peg came under attack from speculators. Speculators lost money when the MAS put up a resistance to their attacks in 1983–4. Another important feature of reform was to permit international competition to the local banks to make the latter improve efficiency. Of the 35 full-licence banks in 1997 that operate in the domestic economy, 22 are subsidiaries of foreign banks from both developed and developing countries. The 13 locallyincorporated banks had responded well to the competition, and have themselves expanded. The reluctance to subject domestic banks to international competition has been a source of inefficiency in the banking systems in several developing countries. Unlike in other countries, which followed limited entry of foreign institutions, Singapore’s experience shows that there are good benefits from head-on competition rather than protection of the wealthy-and-connected crowd in the world of money. The 13 local banks have begun to merge after the 1997 financial crisis had revealed their weaknesses. The remaining local banks, whose numbers have been shrinking to less than 10, become larger with each merger, and the weaker ones have been merged with these larger ones. The DBSBank and the UOB banking groups have become the two largest banks, probably accounting for a bulk of the intermediation businesses. The adoption of the currency board system and the high standards of prudential behaviour imposed on the depository institutions contributed to the stability of intermediation during almost 30 years. An important feature of the sector is that only the very experienced and larger banks, finance companies – which are treated as deposit-taking institutions and thus come under banking supervision – or financial institutions are issued with licences. This has meant that entry barriers are erected to let only the safest enter the market, and thus contributing in large measure to the stability of the sector. A bank licence will be issued for a financial institution if it has a tier 1 capital of about US$800 million and had demonstrated experience as a well-managed bank. Similar rules apply to non-banks as well. Limiting entry to the most qualified and capitalized firms is a means of creating stable intermediation. This is an important lesson for the emerging economies. The top four banks in Singapore in 1997 are among the top-ranked banks in the region. At 176 per cent of GDP, the commercial banks’ total assets indicate a very high level of financial intermediations in the economy. Assets grew by about 13 per cent, which is ahead of the 8.5 per cent growth in the economy in the 1990s. Over the recent years, savings and demand deposits have grown at a slower rate than the growth of 13 per cent in fixed deposits. During the earlier

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decades, long-term loans with maturities of more than three years constituted about a third of all loans. High growth in fixed deposits appears to have moved ahead of the growth rate in the economy. Probably this provided stability to the liability structure of banks, which enabled financial institutions to offer longer maturity loans whereas during the earlier years with more non-fixed deposits, the banks could not have improved their maturity transformation. GDP share of finance sector As stated earlier, one of the aims of liberalization was to increase GDP by locating international financial services activities in Singapore. In 1993, when the stock market yield went up to 54 per cent because of the worldwide bull market condition then existing, the GDP share of the financial (and business services) was almost 30 per cent. GDP share of these finance and business services sectors has increased from about 18 per cent in 1976 to 28 per cent in 1993. Since that year, the GDP share has remained above 26 per cent: the share of the financial sector alone will be about half that figure. Off-shore banking A large number of new financial institutions were created to operate in international transactions in Singapore. A restricted licence means that a restricted bank (not off-shore banks) cannot accept time deposits below $250000 per deposit from non-bank customers; they cannot operate savings accounts and they may not open branches (Ariff et al. 1996). These are generally called offshore banks. These are Asian dollar units, which deal with foreign currency transactions, limited-licence banks, which acts as banks in transactions outside the country; and other special institutions. There are about 450 such institutions which operate in the international side of the economy, and generate a level of income far in excess of their operations. Thus, the regulation has been designed to separate the domestic from the international transactions, licensing them separately so as to have a greater degree of control. Hong Kong does not separate the financial activities in this manner, thus, it is reputed that their domestic operations have had greater exposure to risk. There is an element of truth in that. Hong Kong has had frequent failed institutions, and Singapore has had none over four decades. Non-bank financial institutions There are several classes of non-bank financial institutions. Finance companies are normally grouped under credit unions as non-bank entities. In an earlier section we noted that finance companies are treated as deposittaking institutions, and they come under the banking supervision norms. There are several in this category: the merchant banks which act as investment bankers in Singapore; the money brokers; the insurance companies; the

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POSBank till mid-1998; the Central Provident Fund Board. These institutions have all been modernized over the years with the impetus for it coming from the entry of international counterparts to do business in Singapore. In this respect, competition policy has been instrumental for this. Even the pension fund has now been asked to lend its balances to international firms to obtain higher returns from managing the assets internationally. The CPF is not merely a pension fund. It has over the years become a social welfare mechanism funded by the contributor. It funds education, health expenses and serves as a financier for public and private housing purchases. Beyond that, it also finances the government as much of the money is on loan to the government for such purposes as housing and investments. In this regard, a self-funded scheme has become an anchor for providing the usual assistance from public funds. Capital markets Singapore has been a traditional location for capital market activities in the Malay Peninsula. However, since the cessation of currency convertibility in 1973 and especially after Malaysia’s cessation of double-listing since 1989, the capital market activities in Singapore are very much connected with the domestic economy. Prior to these dates, a significant quantity of the transactions in Singapore were on Malaysian-origin companies. With the development of a large capital market of its own, Malaysia required its corporations to seek listings only in the national exchange. As a consequence, the size of the capital market in Singapore declined in 1990. However, with more firms including government-linked ones seeking listing on the stock market, the size of the market had increased substantially by the end of 1997. At the end of 1997, there were 259 listed firms on the share market capitalized at around US$170 billion. The share market had intense activity: turnover per firm per year was US$565, which figure compares favourably with most developed capital markets. As at 2002, the market has grown to about 400 listings, and capitalization has increased to over US$200 billion. The debt market is less developed than the share market. The government issues Treasury securities periodically to determine the going interest rates through regular Thursday auctions of the issues. Since the government has perennial surpluses, it is not able to issue large debt issues. Corporations have found that they could borrow money from banks at reasonable interest rates given the interest suppression noted earlier. Thus, businesses do not have incentives to issue public debt in large amounts. As a result, the public debt market has been very small and is at best inactive over the study period. The current face value of the debt market is under 15 per cent of the GDP, one of the smallest international centres for debt issues. But official statistics include a huge listing of the Ginnae Mae on the board, which masks the fact that the

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debt market is at best non-existent in this otherwise large international money centre. This remark also does not take into account the syndicated loans that originate as private placements of debt from the region’s governments and the private sector in the banking system: there is a large position in this market. The Singapore International Monetary Exchange was set up in 1982 to specialize in financial futures contracts. This market has now established itself as a very successful risk management centre for investors in the region. Twothirds of the value of the contract are some forms of interest rate instruments, e.g. Eurodollar futures and the euro–yen futures. There are 17 instruments traded. These and other developments had made Singapore into a successful international financial centre linked to the major centres in Tokyo, New York and London. On exchange and interest rates It was noted earlier in this section that the exchange rate appreciated at an annual rate of about 3 per cent per annum. In actual terms, the exchange rate was US$1.00 = S$2.242 during 1976–80; it improved to US$1.00 = S$1.412 in 1996; it had depreciated to S$1.75 at end-2002. The overall impact of this was to make the real sector enjoy a level of protection from imported inflation in the earlier period of appreciating currency. However, its effect on the domestic non-traded sector was dramatic and damaging. The prices of land, labour and housing appreciated so much that these items are now beginning to weigh down economic activities. One redeeming feature of the management of this economy is that policy-makers are willing to permit a cut in the prices of these non-traded goods every time the country faces a recession. In that sense, a balance is managed over a period, but then it creates instability from the managed exchange rate regime. The effect on interest rates has been less salutary. With the financial sector becoming internationalized, there are large fund flows into the economy, which in itself provides for cheaper costs of business finance. A look at the SIBOR (Singapore Interbank Offer Rate) suggests that the 1990s had too many funds in the economy so that the market clearing rate was somewhat less than half of the rates during the 1976–90 period. The mild interest rate suppression that originated from the low interest rates offered to the pension fund balances and the depositors in the POSBank had led to very low returns to depositors. In fact real interest rates had become negative in the 1990s right up to 1996. On balance, it must be stated that the high spread between the deposit and minimum lending rate suggests a very high profit rate for intermediation. In fact the return on equity of the banking system during recent years has been about 13.5 per cent per annum after the 1987 economic recovery. However, this high return has declined ever since the financial crisis in 1997. Banks earned very low profits in this latter period.11 Depending on

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which sector one belonged to, the effect of interest rate and exchange rate reforms has been a mixed blessing. Three specific financial services that have become very large through the reform process are in foreign exchange transactions and Asian-dollar and bond markets. These have developed at phenomenal growth rates helped by the set of reforms aimed at attracting international business. About 10 per cent of the world’s US$1750 billion trade in currencies is transacted in this financial sector. Financial sector reforms coupled with the growing regional focus of the financial sector led to competitive pricing in the currency markets. The demand for currencies came from both central banks and businesses doing international activities in the region. The total foreign exchange trade has grown very fast as a result of the popularity of money market deposits in major financial centres and bankers’ speculative positions on the currencies markets. The total transactions in currencies is growing at 11 per cent per year, much faster than growth in merchandise trade of about 5 per cent! Singapore traded US$370 million in currency in 1973 before the reforms prior to the expansion in the currency deposits. At the end of 2002, it traded about US$150–160 billion per day, and it has gained the fourth position in the international trade of currencies. This position is gained by trading mostly in other-than regional currencies since the regional currency share of the transactions is less than 20 per cent. A large forward market in US dollar and yen has developed in the 1990s. It is estimated that this market has become large, valued at about US$52 billion. There is also a huge forward market that has grown along with the growth in spot currencies. The forward market consists of currency swaps and outrights (i.e. the forward rate agreements). According to MAS, the value of forward rate agreements averaged US$52 billion monthly in 1994, and is growing in importance in the face of rapid changes in interest rates since 1994 as has also the hedge fund activities. These deals are in US dollar and yen contracts representing 50 and 36 per cent respectively. Currency futures contracts and currency options valued at US$39 billion were registered in 1994. As risk management is becoming important after the Asian currency crisis in 1997, these contracts are expected to grow significantly. There are also large Asian-dollar deposits adding to about US$515 billion in year 2002. The 1970 value of Asian-dollar deposits was US$400 million compared with the 1995 figure of US$478 billion. That is a growth of 31 per cent per year: during 1995–2000, the Asian-dollar deposit growth has slowed to a mature 4 per cent per year as investment demands had slowed in the region since 1994. An Asian-dollar bond market is also growing out of the latter: the current size of the outstanding issue is small, US$1260 million. Given the growing demand for infrastructure financing in energy and transportation in Asia, there is expected to be growth potential for this market

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when the regional governments issue bonds, perhaps after a period of adjustment to the 1997 crisis. The spread over LIBOR in this market is estimated to be around 100 basis points, which puts it in good competition with other international centres for syndicated or line of credit debt financing by large corporations and governments in the region. With the world interest rates in major centres being very low – coupled with high liquidity in the market here – the spread has narrowed well below 100 basis points in the year 2003. 3.2

Domestic Effects from Liberalization

Other reforms carried out had more to do with deepening the market by offering licences to new players, originating new securities and improving liquidity as well as regulating to improve the soundness of the financial institutions. Of particular interest are the detailed regulations that govern the operations of financial institutions in Singapore. These regulations are many and far-reaching (not shown in Table 9.2) and were aimed at creating a prudential supervision framework based on shared values of how to create sound financial institutions. This has taken many forms. First is the quality of the joint-stock company that indicates the financial capacity of the controlling management of a financial institution. To safeguard investor protection, the capital base for licensing a bank has been set very high at US$800 million for a bank to be licensed. Institutions with proven track records are the only ones likely to be licensed. The regulators consider that the small size of the economy dictates that about 22 foreign-origin banks from many countries are the useful number for providing sufficient competition so that no new major addition to this number is needed in the near future. A number commonly cited is that on a 100000 population, Singapore has more bank branches than many economies: in that sense, it is claimed to be ‘over-banked’. However, Hong Kong and other money centres have a lot more banks under a more benign licensing environment, which, the proponents of protection would point out, leads to periodic failures of the weaker institutions as has happened in London, Hong Kong and Luxembourg. Second, the entry of more financial institutions during the 1973–97 period in the special forms of ACUs (Asian currency units), restricted-licence banks, off-shore licences, financial institutions providing specialized services in investment banking, money broking, risk management, insurance, etc. has helped to improve competition in the industry. The results are seen in (1) improved customer services; (2) competitive prices for financial services; (3) stable difference in the deposit and lending rates; and (4) greater choice in the forms of securities available. Of particular interest is the low interest rates that prevailed between 1984 and 1997. Interest rate reforms, competition from new

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entrants and improved mechanization of operations took place during the period when the MAS improved its supervision and worked together with the industry to improve the soundness of all financial institutions. 3.3

Indicators of Financial Liberalization

Table 9.4 gave the numbers on four measures of financial liberalization. There are a number of favourable effects from the liberalization documented here. First and foremost is the depth of the financial sector. Money depth defined as the M3-to-GDP ratio suggests that this indicator improved from a base of 78 per cent in the 1971–80 period to 163 per cent by year 2002. This improvement suggests that the credit and deposit balances increased significantly during the last three decades. The next noticeable improvement is in the total financial interrelations ratio (FIR/GDP). This ratio represents the claims of all parties on the financial sector. This number was about 27 per cent during 1971–80, improved to 72 per cent during 1981–90, dropped to 61 per cent from 1991–95 and again improved to 78 per cent by 2002. This suggests that the reforms of the 1970s created an expanded financial sector. However, with the asset bubbles in the 1990s, the FIR declined significantly. The private sector that owns these assets appears to have not been so badly affected as the ratio improved from 58 per cent in 1971–80 to 109 per cent by 2002 without experiencing a decline during the first half of the 1990s. Gross fixed capital formation also held steady over 1988 to 1997. This was affected by the Asian crisis and has not yet reached the peak level of 39 per cent it achieved in 1981–90. The high ratio in the earlier years suggests that there were intensive capital investments in building the infrastructure to attract international investments. These were in educational facilities, roads, airports, ports and telecommunications, all of which received priority in the 1970s. The subsequent investment rate of about 32 per cent is also very high by international standards. Some would even argue that this level of investment rate is excessive for a growth rate of under 10 per cent. The investments were both for the productive sector and for building a level of social amenities compatible with the political norm of comfort in a crowded island state. The investment rate in Hong Kong was lower yet it had higher growth. But the level of social comfort in the physical environment requires massive capital in the early period as well as the later periods. That accounts for the high investment rate. What is not shown in Table 9.4 is the important fact that this level of growth was achieved without any public domestic or foreign debt. Housing for the population was built with their own savings in the pension funds, which they withdrew to buy their houses. The government did not borrow internationally to develop these facilities. It is perhaps because of the small size of the land to

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be developed that no borrowing was needed and yet there was enough to sustain all economic activities. Perhaps the other reason is that funds to the tune of about 4 to 10 per cent of GDP were coming in regularly as FDI to finance the business expansion. This meant that there was no pressure from the business sector to compete for funds from domestic savings. The issue is complex in this case, and cannot be dismissed with simple generalizations. In 1995, Singapore was rated as an AAA creditworthy nation among a few in the world (Piggot 1995). Overall the amount of cash flow from international sources has been favourable to this economy. It is evident that the FDI and portfolio funds complemented the domestic direct investment in the real sector. There was a tenfold increase in direct investment over the 1976–97 period: US$578 million to US$6912 billion. Portfolio investment did not play a significant role till the 1990s, when the share markets started to build a bubble when these funds grew more than 100 per cent over 1990 to 1996 only to be pulled down by half by the end of 1998. An interesting statistic is that after the current accounts were opened in 1978 there was faster growth in portfolio flows into the economy. The per-year average portfolio flow was about $410 million during the 1976–85 period but this number increased dramatically after this period to an annual average of $5000 million – 12 times larger – during the next eight years before declining in 1994–95 by an annual average of $2700 million per year. Asian currencies suffered exchange rate declines of 30 to 40 per cent over May–October 1997.12 The financial liberalization had largely a beneficial effect in improving the investment rate of the economy, and in creating financial depth in general. The reforms had a perverse effect on the non-traded sector, which was the source of instability. But this is due to the managed exchange rate which tended to create the perverse effect in order to benefit the business sector in the forms of cheaper loans, ready credits, and low input costs. The asset bubbles appear to break each time there is a recession, but, with the managed exchange rate momentum sustained from the surplus of reserves, the same structural weakness reappears at each turning point of the business cycle. Would a full free float have been beneficial? An answer to this question requires further analysis. 3.4

Influence on Trade and Capital Flows

Trade and capital flows are examined here informally in that their relative growth paths against the GDP growth are examined: see Table 9.5. These numbers show the growth rate in GDP alongside the similar numbers for growth in trade, growth in FDI inflows, and changes in exchange rates. It is assumed that, with openness shown to have existed from a financially

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Table 9.5 Cumulative average growth rates in trade and capital flows in Singapore Year (five-year moving average)

Real GDP growth rate (%)

Trade growth rate (%)

Net FDI growth rate (%)

5-years to: 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

8.59 9.31 9.69 9.61 9.86 8.19 8.31 –1.62 2.30 7.44 11.63 9.62 9.66 6.43 6.54 12.69 11.42 8.01 7.65 8.54 –0.09 6.93 10.25 –2.37 2.25

15.40 31.70 33.90 10.50 2.10 0.90 6.50 –4.00 –3.20 23.10 30.00 10.00 11.40 5.34 2.20 16.40 18.20 13.20 5.10 5.70 –6.20 6.60 22.90 –9.40 1.50

9.70 142.80 32.90 23.40 15.90 –37.90 17.80 –7.90 42.30 60.80 24.00 –0.10 101.90 –28.90 –34.90 94.20 92.00 –6.90 26.20 30.90 –64.70 123.80 –35.50 81.50 –

– – – – – – 2.114 2.133 2.200 2.177 2.106 2.012 1.950 1.812 1.727 1.629 1.617 1.442 1.417 1.413 1.673 1.690 1.720 1.790 1.785

– – – – – – – –0.89 –3.14 1.05 3.26 4.46 3.08 7.08 4.69 5.67 0.74 10.82 1.73 0.28 –18.40 –1.02 –1.78 –4.07 0.01

8.34

14.26

29.37

Appreciation of 3.02 per annumb 1.59 per annumc

–

Average over 1976–96 (%)

Exchange Exchange rate rate US$1 appreciation (% per annum)

Notes: a FDI is declining from 1992 except for a big increase in 1993, which makes the moving average for 1993 onwards look good. Part of the reason for the net negative FDI growth is due to active promotion to invest outside Singapore to take a foothold in the growth of the region. b Currency revalued by 3.01% per annum to year 1996. c Currency revaluation cut by half by the huge devaluation from the effect of the 1997 Asian currency crisis. Sources: SEACEN Financial Statistics, July 1996 and IFS various years.

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liberalized economy, trade growth and net capital flows must grow at faster rates. If this is observed, then it can be argued, using evidence of slow growth in capital flow and trade patterns of not-open financial sectors, that the faster growth in capital flow and trade is due to liberalization in the financial sector. This is not direct demonstration of the effect; in a sense, it is weaker evidence than the one produced in the earlier discussion. The average real growth rate of the economy in this set of figures was about 8.3 per cent per annum over the 19 years of data shown in the table: data shown against each year are an average of growth rates in the previous three years. Thus, given low inflation of under 3 per cent in the test period, growth has been phenomenal when considered against the world average growth rate in the same period of about half that rate. This growth has been possible due to real and financial sector liberalization as well as reforms in the management of economic activities. Growth in trade was 14.26 per cent per year over the same period. The pattern of merchandise trade over 1978–97 showed a persistent deficit which is always made up by non-merchandise inflows thus not weakening the trade link with the exchange rate. Further, the fiscal budget surpluses over many years also provided foreign exchange reserves to support the exchange rate. Hence, it can be seen that the trade growth has been ahead of real sector growth by a margin of 6 per cent. This level of growth would not have been possible if the current and capital accounts were not fully liberalized in June 1978. It can be argued that the substantial portion of the trade growth is due to the region’s growth coinciding with the efforts of the planners to further internationalize the economy. Third, capital flows grew at rates twice that of the output growth at least till 1994, when Singapore’s planners began to undertake massive FDI in emerging economies. This led to capital outflows to emerging economies. With more data available in the future on this external wing to the Singapore economy, perhaps one could learn if this reform policy was as successful as the others before. Figure 9.3 provides information on the effects of liberalization in the financial markets.

4.

ASSESSMENT OF FUTURE PROSPECTS

Among the economies studied in this book, Singapore may be singled out as a unique case of financial liberalization that made it possible for the city state to become a financial centre linking the major securities markets in Tokyo, New York and London. Active pursuit of policies was designed to achieve this status in competition with Hong Kong and Sydney as potential competitors till about the late 1980s. In the early 1990s, Bangkok, Kuala Lumpur provided some competition, but have done so no longer since the currency collapses in

Singapore

3.5

ER IR Spread

3

293

4.5 4

Exchange rate

2 1.5 1

3 2.5 2 1.5

Interest rate spread

3.5 2.5

1 0.5

0.5

0 0 1961 1966 1971 1976 1981 1986 1991 1996 2001 Note: No data were available for interest rate spread for the period 1961–79.

Figure 9.3 Exchange rate movement and interest rate spread, Singapore: 1961–2002 1997–98. Sydney provided some competition in 1997–2000; however, Singapore continued to provide an efficient low-cost location for financial transactions. The fact that Singapore has emerged ahead of several potential competitors is due to the location and organizational advantages of Singapore. The lessons learned from this case are relevant to other aspirants with the aim of becoming international or regional financial centres. The financial crisis of 1997–98 has perhaps enhanced the role of Singapore in this regard as several of the regional economies are experiencing currency instability and the attraction to investors as a haven for deposits in Singapore still exists. Once growth returns to this region, Singapore will again emerge to play a significant role as the financier of the region and provider of specialized financial services to the region. Meanwhile, this city state is also building a capacity for manufacturing in high-tech and bio-tech and in services industries to keep its relevance to the Asian region. It is cleverly building free-trade linkages with major economies cherry-picked to suit its long-term policies and outreach: Australia, New Zealand and the United States have so far signed on with more on the cards. This would make Singapore an attractive place to do business for several economies wishing to establish linkages for seeking entry to the major markets.

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NOTES 1.

2. 3.

4. 5.

6.

7.

8. 9. 10.

11. 12.

The jockeying for international financial centre position is so intense that more and more neighbouring financial sectors are hoping to become yet another international financial centre in the vast region. Taipei, Bangkok, and Kuala Lumpur – and since 1998 Sydney, Australia – have similar ambitions, and have incorporated plans to move their financial sectors to become regional centres. Malaysia has since 1991 taken serious steps to make herself into a major centre especially in the stock and bond markets as well as Islamic financial instruments. These ambitions were clipped when its stock market plummeted by 70 per cent, and the currency by 42 per cent in 1997. The liberalization plan documents of all these countries contain an item on this idea. Hong Kong, which is less than twice the size of Singapore with a larger population of about 5.5 million has done a lot more with attractive direct and indirect tax schemes. Sri Lanka was at an advanced state of development during the 1950s to have been the natural location for many of the things that Singapore did successfully. But, the region that was growing was Southeast Asia and not South Asia. If South Asia had developed ahead, Sri Lanka would have been the natural choice of a centre as it had several stronger attractions such as larger resource base, more educated workforce, etc. Madras is now Chennai. An example that comes to mind is Thailand as the international capital market of the IndoChina peninsula and Iran as the financial centre of the central Asian countries around the Caspian Sea. Another example is Egypt’s Cairo and Alexandria Stock Exchange. One estimate puts the number of man-years of expert help that Singapore received as very large (see Ariff 1998c). Through a system of local counterpart training, the persons selected to work with these experts learnt modern management techniques and expert knowledge in their fields. This was taken as a serious business and the government of Singapore is on record acknowledging how this helped in the development process. There were 505 government-linked firms of which about 50 were targeted for corporatization and subsequent sale to the public as listed companies. The sales pitch was that the population were to become share owners but these privatized entities were such firms as the telecommunications, the airline, printing firms that printed government publications, power companies, etc. Only a small number of firms had been privatized during 1984–98. Singapore is also noted for a very liberal attitude in licensing retail money trade in foreign currencies. About a thousand licensees ply the trade of changing money so that the spread in transaction in Singapore is a fraction of the spread in major money centres. These ubiquitous money changers help to make the money market very efficient driving transaction costs in handling money to very low levels. Similar benefits could be obtained if these licensees could also trade in other money market instruments now protected in the halls of the banks, etc.: with these people entering inter-country transmission of small cash transactions, Singapore can make money transmission more efficient than has been possible with the modern banking structures. This excludes the few traditional financial organizations in Singapore which have little impact on the sector. The Asian dollar market started as a result of changes to the US laws to limit further outflow of capital in 1967, through changes to the US Tax Code. This is a significant refocus of monetary management. It is through the sterilization of funds flow that the effect of large inflows are prevented from translating as high inflation. If one may recall, it was the failure of sterilization of foreign capital flows into China that resulted in the hyperinflation in that country over 1980 to 1994. The return on equity of foreign banks was slightly above this rate. The source is an ongoing study of the performance of local and foreign financial institutions. The worst hit were the Thai, Indonesian, Philippine and Malaysian currencies. Other currencies such as the Australian dollar and Hong Kong dollar (reportedly defended heavily with spending of US$11 000 million over a month in October 1997) suffered much smaller shocks given their dependence on the region for their trade.

10. 1.

Thailand: open external sector, exposed financial sector

INTRODUCTION

Thailand is a moderate-sized country with a population of 60 million occupying a land area of 513000 sq. km. The Thai economy experienced a remarkable growth trend during the last three decades. South Korea and Thailand suffered the worst effects of the 1997–98 currency crisis, after which the two countries are still making brave reforms to recover the lost momentum. Hit by the two oil shocks, first in 1972 and the second time in 1978–79, Thailand managed to recover sooner than many other developing countries thanks to its more open trade sector. One key feature of the quick recovery was the policy pursued towards macroeconomic stabilization. As a result, the main sectors of the country’s economy, such as investment, economic activities and prices stabilized very quickly. It was not so lucky in the aftermath of the financial crisis. This country had the most open external sector in the region with almost no tariff on goods and services. But its financial and monetary sectors were relatively closed and poorly managed. Commentators have squarely put the blame as the source of the Asian financial crisis on its bad management of the financial sector. However, the country has learned good lessons from the crisis. Surprisingly, and against early predictions, the country showed a remarkable recovery from the crisis until the terrorism-related fears started to retard further investment and growth. It is believed that the IMF bail-out and restructuring plan, the country’s own commitment to restructure the economy and regional factors, contributed to managing a modest growth about half of its previous record. This chapter is one of the important ones in the book as it covers details of financial liberalization for a country, which has had a very steady liberalization process. In section 2 we will discuss its economic and financial structure. Section 3 will provide the details of liberalization measures adopted by Thailand during the last 34 years. Finally, we assess future prospects in section 4.

295

296

2.

Liberalization and growth in Asia

ECONOMIC AND FINANCIAL STRUCTURE: AN OVERVIEW

Thailand came under the control of Great Britain in 1855 though Thailand’s king still nominally ruled the country. Like other places under Britain in the region, Thailand adopted no control over trade and capital movements under the tutelage of the British. This reflects the historical reality that this country did not vacillate, like others in this book, between episodes of extreme controls to relative opening to the rest of the world. Bangkok provided the easy passage to all sorts of traders in that tradition of openness which is still preserved. In the old order, its currency was linked to the pound sterling, later to be switched to the US dollar, while exports of rice were free of all duties and imports were subject to a mere 3 per cent duty. Some fiscal autonomy and increase in import duties was allowed in 1926 but full fiscal independence was only achieved in 1947. From the late 1930s and until 1957, the country pursued a policy of increased protective tariffs and import-substitution, but it never came near to the kind of closure found in India. This attitude changed rapidly after the Korean War, when Thailand again opened up its economy. During the years 1957 and 1973, Thailand pursued internal and external sector open policies to attract increased foreign and domestic investment. Many concessions were made such as abolishing import duties, tax concessions, free movement of capital-cum-remittances and 100 per cent foreign ownership of business, which is one of the earliest instances of this kind, although it was later withdrawn in the mid-1960s. These policies helped this country to emerge as one of the rapidly growing economies in the region. Several other countries emulated the policy choices of Thailand especially in the 1970s. The second oil crisis resulted in recession for many countries including all in the Southeast Asian region for some periods over the time of stagflation in the first half of the 1980s. Thailand was no exception and was badly hit by this recession. During the first couple of years, inflation turned out to be the major concern as it jumped to double-digits while the trade deficit breached the point of 10 per cent of GDP. To overcome the recessionary pressures, Thailand accelerated its reform process and concentrated on export promotion, which helped the economy to recover as early as 1986. Since then, Thailand has enjoyed a remarkable growth only surpassed in the region by South Korea. But banking fragility in this country went on unnoticed until the country was hit very hard in July 1997 by the worst crisis in its history: this crisis will go into the history books as the ‘1997 baht crisis’. In the 1960s, the per capita GDP of Thailand was slightly higher than many other countries in South Asia and Latin America. Over 30 years later, per capita income relative to most developing countries is about 10 times larger.

Thailand

297

That should be welcome as a big achievement, a significant fact of development, despite the fact that income inequality was more widespread in general, as well as between regions of the country.1 One important aspect of policies implemented was diversification of the economic structure through a comprehensive programme. The 1980s saw a transformation from an agricultural economy towards an industrial economy in much the same way as Malaysia was transforming from a rural to an industrial focus. That changed the then economic structure. This led to sustained high growth after the restructuring. This diversification reduced the contribution of agriculture from 25 per cent to 15 per cent by the 1980s. At the same time, manufacturing increased from 25 per cent of GDP to 35 per cent, similar to Malaysia. The restructuring was aimed at creating capacity for exports. This then led to a boost in exports which contributed about one-third of the country’s GDP. The rapid growth in exports is also due to the dynamism of the less hamstrung Thai private sector, a fact that agrees with the story we told at the beginning about the traditional approach of this country’s relations with the rest of the world. This industrial transformation leading to export growth forced the authorities to restructure the financial sector to augment financial efficiency. They developed new money and capital markets as well as removing capital and some currency controls, though the currency’s basket peg – at one point in 1996 with 80 per cent of it made of the US dollar – was to become the Achilles heel a decade later, ushering in the baht crisis. These measures were needed at the early stage of industrial policy implementation to mobilize domestic funds as well as to attract foreign capital flows. However, financial reforms had been taken gradually, and some aspects of that reform were inadequate and in fact the omission of prudential regulation of the bankingcum-finance companies led to a loss of the growth momentum since 1997. 2.1

Economic and Financial Structure

The economy of Thailand emerged as one of the strongest Southeast Asian economies in the region, and in the 1990s was tipped to become the fifth Asian tiger. In the first six years, the average growth rate was the highest. Table 10.1 highlights basic economic, financial and social indicators of the economy. The average annual growth in GDP was 8 per cent in the 1960s, 7 per cent in the 1970s, about 8 per cent in the 1980s and, on average, above 8 per cent in the 1990s until the baht crisis of 1997 led to massive currency overshooting and thence to a decline in growth. The industrial sector was certainly the leading sector in this growth process, growing on average by more than 15 per cent during the period of the early 1960s to the late 1980s. Private consumption to GDP ratio showed a decline from a high of 70 per cent in the 1960s and 1970s to around 60 per cent during the 1980s and further reduced to around 55 per

Table 10.1

Basic economic and social indicators of development in Thailand, 1960–2002 1961–70

National accounts GDP growth (%) 8.32 Per capita GDP (US$) 142.00 Private consumption/GDP 70.17 Government consumption/GDP 10.13 298

Financial indicators (%) Gross domestic savings/GDP Fixed capital formation/GDP Inflation (per annum) M2/GDP Fiscal balance/GDP Trade balance/GDP Current account balance/GDP Total trade/GDP Debt/exports Debt service/GDP Foreign reserves/imports

– 20.04 2.30 25.69 –1.30 – – 38.10 86.33 15.26 71.72

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

6.79 404.00 67.34 10.89

7.89 961.00 61.01 11.85

8.62 2225.00 54.31 9.75

0.62 2262.00 54.90 10.84

4.64 1967.00 55.94 11.39

1.80 1833.00 56.87 11.57

5.43 1993.00 56.46 11.22

21.50 24.21 9.98 35.14 –2.95 – – 43.63 99.76 19.58 47.20

24.90 29.83 4.44 55.91 –1.02 –3.82 –4.11 56.81 107.35 27.52 24.03

34.70 40.30 4.80 76.83 2.86 –4.12 –6.42 81.92 22.81 8.57 44.02

34.10 28.00 4.27 97.86 –1.54 6.26 4.08 102.07 23.58 13.71 49.12

33.10 21.97 1.55 105.56 –2.20 9.55 7.60 125.08 33.60 22.47 44.75

32.00 23.00 1.66 103.70 –2.40 7.44 5.40 125.65 37.32 24.67 47.10

30.50 23.04 0.60 99.19 –1.41 7.73 6.05 122.22 48.09 31.13 52.32

Social indicators Unemployment rate (%) Expenditure on education (% of budget) Expenditure on health (% of budget) Population growth (%)

–

–

2.00

1.60

2.20

2.40

3.30

2.40

–

2.20

17.99

21.30

24.49

25.83

24.44

23.40

– 3.26

4.02 2.54

5.70 1.80

7.83 1.24

7.98 0.96

7.58 1.23

9.58 0.95

7.35 0.83

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

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Liberalization and growth in Asia

cent in the 1990s. Public consumption has remained steady at 11 per cent, on average, since 1960. Inflation has been moderate during most of this time, falling within single digits since 1981 while broad money (M2) showed a growth rate of less than 20 per cent per annum. This level of rapid economic growth and structural changes was accompanied by an increasing trend in the gross national investment and national savings (as a ratio to GDP), which rose to levels between 37 per cent and 41 per cent, respectively during the first six years of the 1990s. These indicators also show that the economy had been successfully converted into a relatively more open economy in the tradition of the Thais. The growth in the export sector was remarkable, growing by an average of 19 per cent while imports grew by about 17 per cent during 1991–95. On internal balance, the country experienced the same upward trend when the fiscal balance began to recover in the 1990s to positive levels from earlier deficits. The current account balance however deteriorated during the same period: the deficit was 7 per cent of the GDP. Thailand did not have a major debt problem until the country accepted the IMF bail-out plan. Since then, the debt/GDP ratio has increased from 13 per cent to 31 per cent. However, the country enjoys reasonable foreign exchange reserves with a foreign reserves to imports ratio of around 50 per cent since the 1970s. Figure 10.1 shows the historical trend of the growth of GDP, CPI and M2 in Thailand. On social indicators, Thailand’s record is very impressive. The 30.00 25.00

Real GDP CPI M2

Growth rate

20.00 15.00 10.00 5.00 0.00 –5.00 –10.00 –15.00 1961 Figure 10.1

1966

1971

1976

1981

1986

1991

1996

2001

Growth rates of real GDP, CPI and M2, Thailand: 1961–2002

Thailand

301

unemployment rate remained under 2 per cent during the period under analysis with a slight increase during the Asian financial crisis. The country has been successful in controlling population growth which has been brought down to around 1 per cent. A reasonable proportion of about 24 per cent of the total expenditure found its way into education while 8 per cent was spent on health: these are high by the levels of the region except in comparison with Malaysia. This impressive performance reversed in just a few weeks after the 1997 baht crisis when Thailand experienced the first recession in two decades. The GDP growth shrank first to –0.40 per cent in 1997 and then to –7.8 per cent in 1998. The fiscal balance turned negative and the unemployment rate rose to 7.6 per cent in the same year. However, IMF assistance and timely policies helped the economy to recover from this crisis, sooner than expected. All economic, financial and social indicators were back to their normal trends by 2002 with the GDP growth registering a remarkable figure of 5.43 per cent in that year. The fiscal deficit has been reduced to 1.41 per cent of GDP while the current account surplus has increased to 6 per cent of GDP. Unemployment has also declined to 2.4 per cent. Interestingly, expenditure on education and health was spared major reduction, a policy which was completely different from other regional emerging economies such as India and Pakistan where these two sectors faced major cuts in a crisis. This is an indication of policies of sustainable growth targets.

3.

LIBERALIZATION

Although reforms dated back to the 1970s, major economic and financial sector liberalization measures were initiated only in 1989. Interest rate reforms, which had been delayed for the longest time among the ASEAN countries, were introduced and the financial sector was reorganized during this period. A key factor in the initiation of reforms was the need to mobilize resources for use by the industrial sector to capture continued economic growth. There were also high levels of commitments to reforms, although the authorities chose not to remove exchange controls under a basket peg with a heavy reliance on the US dollar. Their commitments to GATT and later to WTO to open up the trade sector by reducing trade barriers were faithfully followed. 3.1

Economic Liberalization

Economic reforms were initiated as early as the 1960s. However, as the result of the first oil shock, major reforms were made only after 1973 to expand the public and private sector investment. These policies helped to accelerate

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Liberalization and growth in Asia

growth and investment but also led to public sector deficits. At the same time, the current account deficits rose to 7 per cent of GDP in the early 1980s while external indebtedness increased from 15 per cent of GDP in the 1970s to 35 per cent during the same period: this was not as bad as the indebtedness of her neighbour, Malaysia, nor that of Pakistan. The situation further deteriorated after the second oil shocks in 1978–79 and with the onset of world recession. After the first oil shock, Thailand embarked on extensive reforms conducive to greater industrialization and export expansion. This required major changes and restructuring in various sectors of the economy. Besides the financial sector reforms, which are the focus of this study, the government undertook some bold measures to restructure its fiscal sector and the trade sector implementing policies to reform the pricing structure in the industrial sector. An important basis for fiscal management was laid in the 1959 budgetary law, which restricted the planned deficits to not exceeding 20 per cent of planned expenditure. The law was later amended in 1973 to include 8 per cent of the principal repayment of the public debt while still maintaining the 20 per cent restriction. This law forced the governments to restrict spending. In 1960, the government imposed a restriction on foreign borrowing by imposing a ceiling on debt-service ratio at 5 per cent: this restriction was not in place in the fast-track period of the 1990s that led to the crisis in 1997. At the same time, the authorities stipulated that the foreign debt service cannot be more than 13 per cent of planned revenues. There has been a gradual revision to the debt-service ratio. In general, fiscal policy was expansionary over the period 1975–80 while the reverse, a contractionary policy, was adopted during 1980–90. In the 1990s, the focus was again on fiscal expansion. But at the same time, the authorities attempted to reduce fiscal deficits arising by curtailing public spending. The reform policies in the 1990s focused on social sector development including education which resulted in an increase in the average share of the social service sector of 35.5 per cent. Domestic borrowing was used as the main source of financing the deficits during this period especially through commercial banks in order to control the inflationary effect of central bank borrowing. This worked well and since 1981 (and until the Asian crisis) inflation remained in single digits. Later on, in the 1990s, the authorities realized that the surplus was sustainable and hence retired some of the public and foreign debt and implemented measures of tax reduction. However, the currency crisis in 1997 forced the government to go for extensive foreign borrowing as part of the IMF restructuring plan. The second major focus of economic reforms was the industrial sector. Besides a heavy emphasis on outward oriented and export promotion policies, the Board of Investment (BOI), which was established in 1960, provided certain incentives to accelerate investment including tax holidays and import duty exemptions to particular firms or industries. In 1962, the government

Thailand

303

implemented the Promotion of Industrial Investment Act, which gave more independence and power to the BOI. During the 1980s, a focus towards export promotion linked the external sector policies to the foreign exchange policies, which made the role of the BOI even more important in policy planning. These measures coincided with policies to liberalize and unify the exchange rate and relax foreign exchange controls. In 1991, controls were further relaxed by allowing residents to open foreign currency accounts and foreigners to open Thai baht accounts. In 1994, the authorities had laid the foundation for developing the market as the regional financial centre for Indochina. However, a fast pace of financial market development in Singapore and Hong Kong restricted Thailand’s bid to serve as a regional financial centre. The government has traditionally adopted a liberal attitude towards foreign direct investment (FDI). Initiatives to attract FDI date back to the 1960s when new laws were passed and old ones amended to eliminate any distinction between the domestic and foreign investment except in land ownership and the volume of skilled manpower permitted to work in Thailand. The firms were allowed to have 100 per cent ownership during much of the 1960s and 1970s, a figure which was reduced to a maximum of 50 per cent in 1983. These policies led to a surge of FDI into Thailand and by 1997 the magnitude of FDI reached to around US$3.8 billion per year. Net portfolio investment, during most of the period in the 1990s, remained very strong reaching a peak of US$5.5 billion. Short-term capital flows into the banking sector and from thereon to the finance companies were the primary cause of the weakness in the economy during 1994–97. Short-term capital flows swamped the country with most of the money going into non-profitable or slow-profit-making ventures. Elsewhere, this has been pointed out as the reason for the baht coming under attack in June 1997. 3.2

Financial Sector Reforms

The financial sector reforms in Thailand were very gradual, initiated in the early 1970s and continued until the 1990s. However, the rapid growth of the economy in the 1980s necessitated upgrading its existing financial infrastructure. In Table 10.2 the reader will find a summary of major financial sector reforms in Thailand in chronological order. This sub-section discusses these reforms. Monetary policies Since the beginning of the reform process, the BOT had a cautious approach towards pursuit of its monetary policy. The monetary base and money stock were kept under control in view of substantial increases in net foreign assets resulting through a balance of payments surplus over most of the first half of

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Liberalization and growth in Asia

Table 10.2 Major financial sector reforms in Thailand: 1979–2002 Liberalization policy implemented 1979

Amendment of the first Commercial Banking Act 1962 to break the family-controlled shareholding structure in most Thai banks and to have more private participation; under this amendment, no single shareholder can own more than 0.5% of shares; Repurchase market established as a first step to develop money market

1980

The 15% limit relaxed; under new rules, interest rate charged by financial institutions would be set by the Minister of Finance upon the advice of the Bank of Thailand

1984

Amendment to the Securities Exchange of Thailand Act 1974. Thai baht is pegged to basket of currencies; BOT imposed minimum margin loan requirement 25% for finance companies

1985

BOT introduced Bangkok Interbank Offered Rate as a reference for the pricing of floating rate loans. Financial Institution Development Fund established within BOT to help the financial institution in times of tight liquidity

1987

Deregulation of commercial banks and finance companies’ businesses

1989

Ceiling of interest rate on time deposit with more than one-year maturity lifted; relaxation of foreign exchange controls allowing the transfer of capital for dividend, interest and principal payment for foreign loans

1990

Interest rate ceiling on time deposit with one-year maturity or less abolished; all current account transactions were liberalized and restrictions on capital movement reduced

1991

Liberalization of foreign exchange controls including more liberal outward transfer of funds and provision for Thai individuals and residents to open foreign currency accounts The stock market introduced Automated System for the Stock Exchange of Thailand, a fully computerized trading system Minimum asset requirement for foreign banks increased from 5 million to 125 million baht

1992

Ceiling on interest rate on savings deposit removed; requirement for commercial banks to hold government bonds as a proportion of total deposit relaxed from 8% to 7%

Thailand

305

Commercial banks and finance companies liberalization allowing them to operate as selling agent for debt instrument of government and state enterprises, information, sponsoring financial advisory and custodial services Foreign exchange controls further liberalized for exporters, financial institutions, and resident and non-resident individuals Interest rate ceiling removed on commercial bank loans and finance and credit foncier companies’ loans Minimum paid-up capital for finance companies increased from 60 million baht to 100 million baht by July 1993 and 150 million baht by July 1994 Minimum paid-up capital for credit foncier companies increased from 30 million baht to 50 million baht by July 1993, 75 million baht by July 1994, and 100 million baht by July 1995 CBs and FCs were allowed to issue NCD with minimum of three months and a maximum of three-year maturity with a face value of not less than 0.5 million baht 1993

BIS standard for CBs adopted; CBs were allowed to maintain 7% of capital to risk asset ratio; foreign bank branches were required to maintain 6% of tier 1 capital to risk asset ratio 46 CBs were allowed to operate international banking business known as BIBF or IBF The first credit rating agency, the Thai Rating and Information Service (TRIS) established Export-Import Bank of Thailand (EXIM) Act promulgated to be effective from 7 September 1993 and established in 1994 CBs capital to risk asset ratio increased to no less than 7.5%, with the first-tier capital fund to risk asset rate to no less than 5%, by 1 April 1994 (8% and 5.5%, respectively, by 1 January 1995); foreign bank branch’s capital fund to risk asset ratio increased to no less than 6.5% by 1 April 1994 and 6.75% by 1 January 1995 Adoption of BIS standard for FCs whereby FCs were required to maintain 7% of capital-risk asset ratio (5% first tier capital–risk asset ratio), effective 1 July 1995 Setting up of Bond Dealer’s Club to function as a secondary market for debt instruments

1995

BOT issued short-term bond worth 10 billion baht on weekly basis with one month, three months’ and six months’ maturity Continued overleaf

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Liberalization and growth in Asia

Table 10.2 Continued Liberalization policy implemented 1996

1997

1998

BOT issued long-term bonds with one and two years’ maturity Government Savings Bank and Financial Institutions Development Fund to participate in the auction FCs and FRCSs required to maintain liquidity reserves at the BOT at 7% of non-resident baht borrowing or deposit with maturity of less than one year, including the issuance of P/N, B/E, or NCDs. CBs, FCs, FRCSs and BIBFs required to have cash reserves of 7% of total short-term borrowing and deposit from abroad; Electronic Clearing System starts operation; Financial Institutions Development Fund Bonds issued; capital to risk asset ratio increased to 8.5% for CBs and 8% to FCs Foreign bank branches allowed to hold debenture, bond or debt instrument issued by FIDF as liquid asset 27 June: Thai Finance Minister orders 16 finance companies to be closed; the order is reversed by the Prime Minister with a bailout plan of US$28.6 billion August: Suspension of 58 insolvent finance companies 11 August: IMF approves a total support package of US$17 billion for Thailand 20 August: IMF Executive Board approved a three-year Stand-ByArrangement of US$4 billion; World Bank and Asian Development Bank pledged US$2.7 billion while Japan and other countries contributed US$10 billion September: BOT tightened loan classification and bank licensing rules 8 December: First Quarterly Review of the IMF programme. In view of deteriorating economic activity, additional fiscal measures introduced; the government also announced indicative range interest rates and time-frame for financial sector restructuring announced 7 January: Measures announced to enhance foreign currency flows 30 January: BOT abolished two-tier foreign exchange market; accordingly, the financial institutions are allowed to engage freely in spot foreign exchange transactions involving Thai baht with non-residents 4 March: Broad changes proposed in the second quarterly review of the IMF programme (with a shift to accommodating fiscal policy)

Thailand

307

31 March: BOT modified the financial institutions’ supervision standards 10 June: Third quarterly review of the IMF programme recommended an increase in the allowance for fiscal deficit target from 2% of GDP to 3% of GDP 14 July: BOT announced interest rate ceiling on deposits; accordingly, maximum deposit rate of commercial banks was set at 2% above the savings deposit rate announced by the BOT; the maximum rate on promissory notes issued by finance companies was set at 3% above the reference savings deposit rate announced by the BOT 31 July: Rules governing the composition of liquidity requirement on short-term foreign borrowing modified July: BOT announced regulations for debt restructuring and collateral appraisal 14 August: BOT announced financial sector restructuring plan 21 August: Interest rate ceiling for negotiable certificate of deposits set at the reference rate plus a margin of 3% 25 August: Capital Adequacy Ratio of commercial banks maintained at 8.5% but its composition of tier 1 capital reduced from a minimum of 6% to 4.25% CAR of finance companies and finance and security companies maintained at 8.0% but its composition of tier 1 capital reduced from a minimum of 5.5% to 4.0% October: Revision of Bank of Thailand laws; completion of amendments to foreclosure laws December: Completion of disposal of assets of 56 (of 58 suspended) finance companies; new prudential regulations; stronger rules governing disclosure, auditing and accounting practices; new deposit insurance scheme 1999

14 January: SEC expanded category of securities by including derivative warrants as a type of security 1 February: BOT reduced bank rate to 7% per annum 23 April: Composition of liquidity reserve assets of commercial banks and BIBFs modified; accordingly, the deposit at the BOT reduced from not less than 2% to 1% of deposit and short-term foreign borrowing 19 May: SEC imposed a ratio for securities investment on mutual fund (no more than 25% of the amount of its unit trust) Continued overleaf

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Liberalization and growth in Asia

Table 10.2 Continued Liberalization policy implemented 26 May: SEC amended the regulation on securities borrowing and lending 15 June: BOT announced criteria, procedure and conditions for financial institutions participating in the tier 1 and tier 2 capital support schemes of the Ministry of Finance 25 June: BOT reduced bank rate to 5.5% per annum 1 July: BOT announced measures to improvement cheque and payment clearing system 9 July: Bank rate is reduced to 4% per annum 5 August: Some modifications to the capital adequacy requirements announced June–December: Government announced measures to promote bond market 2000

January: Stock Exchange Market of Thailand approved the securities transaction through the Internet 7 January: BOT announced the criteria for non-performing assets and regulations with which the asset management companies must comply. 10 February: The BOT announced criteria for the use of the Internet for the services of commercial banks, finance companies, and credit foncier companies 3 March: BOT issued regulations on bond repurchase agreement to facilitate intraday liquidity 23 May: Monetary Policy Board of the BOT announced for the first time the use of the 14-day repurchase rate as the key policy rate within the inflation target framework; the rate was set at 1.5% per annum 29 May: BOT allowed commercial banks to resell foreign exchange securities to domestic investors 12 September: BOT decided to abolish the credit targets for various economic sectors

2001

26 February: Regulations for finance companies and credit foncier companies on lending, deposit taking, and funding from the public 1 April: SEC set criteria for establishing Retirement Mutual Fund 12 July: The 14-day repurchase rate increased to 2.5% per annum 1 October: BOT abolished the bank rate to increase the effectiveness of its policy interest rate (the 14-day repurchase rate) as a signal

Thailand

309

16 October: Revision on criteria, conditions and procedures for establishment and operation of Foreign Investment Fund 25 December: The 14-day repurchase rate reduced to 2.25% per annum 2002

21 January: The 14-day Repurchase rate reduced to 2% per annum 29 March: Bangkok Metropolitan Bank PCL and Siam City Bank PCL merged 11 September: BOT allowed financial institutions to include debt instruments issued by government agencies or state enterprises established under specific laws in the maintenance of liquid assets 19 November: 14-day Repurchase rate reduced to 1.75%

Sources: Bank of Thailand, annual reports; Asian Development Bank reports; the Internet; Khalid (1999c).

the 1990s. At the same time, the BOT also imposed limits on maximum credit deposit ratio and credit growth on commercial banks to control the volume of short-term lending by them funded by foreign borrowing. These measures, however, did not work when the financial fragility of the system was exposed after the collapse of the baht. The government bond repurchase market was established in 1979 to provide liquidity to the financial institutions. However, as a result of financial market liberalization and availability of credit to commercial banks from internal and external sources, the scope of open market operations began to decline in importance. The selling volume of BOT bonds in the market significantly declined after 1987 while commercial bank borrowing from abroad substantially increased.2 In June 1991, BOT replaced the reserve requirement ratio by the liquidity requirement ratio which allowed commercial banks more flexibility to invest the minimum required percentage of deposits in other selected debt instruments issued by state institutions. In order to finance government budget deficits, commercial banks were also subject to a rule to maintain 16 per cent of the total deposits in government bonds. This requirement was removed in 1993 when the budget balance changed into surpluses. Central bank reforms The Bank of Thailand (BOT) was established in 1942 under the BOT Act. With an initial capital of 20 million baht and another 13.5 million baht transferred from the Thai National Banking Bureau, BOT started as the Central Bank of Thailand. It consisted of 10 members, with the Governor and Deputy Governor as ex-officio Chairman and the Deputy Chairman, respectively, appointed by the King, with no fixed term of office. The

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Liberalization and growth in Asia

BOT’s operations are supervised by the Minister of Finance, who must approve a major policy decision. As such, the BOT is not an independent central bank (which is the case for all the other countries analysed in this book). The main functions of the BOT are to act as the banker to the government and financial institutions and as the agent of the government in dealing with international organizations such as the IMF. Besides designing and implementing monetary policy to achieve its goal, the BOT is also authorized to manage public debt and international reserves and exchange rates. In 1962, it was empowered to supervise commercial banking under the Commercial Banking Act. In 1979, the BOT’s supervision also included other institutions such as finance companies, finance and securities companies, and credit foncier companies. This did not prevent ineffective control of the finance companies, 58 of which had to be closed down during the first stage of the 1997 crisis. Price stability is given as the main objective of the BOT. Its monetary policy is based on three main objectives, namely, liquidity management, prudential regulations, and moral suasion, which are achieved using two policy instruments, the repurchase market and the loan window. The repurchase market for government and enterprise bonds is one of the important components of the money market and has been crucial for liquidity management. The loan window serves the purpose of lender of last resort, which is similar in all other banks. Originally, it was open only to commercial banks but was extended to finance companies in 1994. The bank rate charged on such loans is adjusted from time to time and thus serves as an important signal for the future direction of the interest rates in the market. Until 1997, Thailand had a pegged exchange rate regime (pegged to the US dollar) and used the Exchange Equalization Fund as a mechanism to maintain this. On 2 July 1997, after the collapse of the Thai baht, this system was abolished and the exchange rate regime was changed to a floating exchange rate based on a trade-weighted basket. Under the IMF restructuring plan effective from mid-1997, the currency was free floated. At the time of writing the free-float is still holding, and it has brought some degree of stability to the currency since then. Currency devaluation benefited the country’s exports. Thailand is increasingly a favoured location for manufacturing in the region although China’s attraction further north in this regard is still retarding the full potential of Thailand’s attraction. During the same time as Thailand moved to a floating exchange rate regime, the BOT also adopted monetary targeting. It would set a daily and quarterly target for the monetary base and ensure stability in the interest rate and liquidity of the financial system. Later, in May 2002, the BOT switched to inflation targeting which is still in place at the time of writing.

Thailand

311

Reforms in the banking sector Since the 1970s, the banking industry has gone through many changes with the establishment of both foreign and domestic branches. Commercial banks are regulated by the BOT under the Commercial Banking Act of 1962. The regulations and later amendments helped the domestic banking industry to expand their businesses away from traditional banking to more sophisticated service industries. By June 1995, Thailand had 15 domestic commercial banks with 3289 branches, 49 overseas branches, and 14 foreign bank branches and 44 foreign bank representative offices. The largest nine among the 15 commercial banks represented 82 per cent of total commercial bank assets and about 94 per cent of net profits. Offshore banking is an important component of the commercial banking industry. In 1993, the government established the Bangkok International Banking Facilities (BIBF) to further promote the offshore banking facilities. Accordingly, 46 licences were issued to 15 Thai banks, 11 foreign banks operating in Thailand, and 20 new foreign banks. To further expand the offshore banking activities, the authorities granted 37 licences for provincial banking facilities (PBF) to operate in areas outside Bangkok. The BIBF is involved in taking deposits or borrowing in foreign currencies from abroad, lending in foreign currencies in Thailand (note the similarity with Indonesia) and abroad, foreign exchange transactions, trade-related financial transactions, and loan arrangements through foreign sources and fund managers. To encourage and facilitate financial institutions operating under the BIBF, the authorities provide them some tax concessions such as reduction in corporate income tax, exemption from special business tax, withholding tax on interest income and stamp duties. Both banking and non-banking institutions have been open to ownership by foreigners since 1997. Reforms in non-banking financial institutions Thailand’s financial market offers a variety of non-bank financial institutions (NBFIs) and the financial sector reforms initiated in the 1970s helped to develop this sub-sector. Some of the important NBFIs are: finance companies and finance and securities companies (FCFSCs), securities companies, credit foncier companies (CFCs), mutual fund management companies (MFMCs), the Government Savings Bank (GSB), the Government Housing Board (GHB), the Bank of Agriculture and Agricultural Cooperatives (BAAC), the Industrial Finance Corporation of Thailand (IFCT), the Small Industry Finance Corporation, the Export–Import Bank of Thailand, the Small Industry Credit Guarantee Corporation, agricultural cooperatives, savings cooperatives, and life insurance companies. In terms of assets, FCFSCs hold the largest share of financial sector assets after commercial banks; about 19 per cent of the total assets at the end of 1994

312

Liberalization and growth in Asia

in 91 such firms. The finance companies are regulated under the Finance Business, Securities Business and Credit Foncier Business Act implemented first in 1979 and amended in 1992. Securities companies are the second major non-bank financial institution in Thailand, supervised by the Securities and Exchange Commission (SEC). Issuance of promissory notes and borrowings from commercial banks are the main sources of funds along with bills of exchange and certificates of deposits, while the funds are used for short-term lending to commerce as well as medium- and long-term lending to industries, agriculture, commerce, housing and consumers. The main source of income of securities companies is brokerage fees, fixed by the Stock Exchange of Thailand (SET) at 0.5 per cent of the value of transactions for common stock and 0.3 per cent for mutual funds and from margin loans. Foreigners could hold up to 49 per cent of equity in each security company. This relaxation or similar rules in the capital market are found in South Korea, Indonesia and Malaysia, all of which thus attracted large short-term funds. In 1995, the government designed the Financial System Master Plan to improve the efficiency of these institutions allowing them to expand their business to include foreign exchange business. CFCs are primarily involved in extending loans for the housing and real estate sector using the mortgage method. At the end of 1994, the value of their assets was estimated at only 1 per cent of the total assets of the financial sector with 13 CFCs operating. CFCs are governed and supervised by the BOT under the provisions of the Finance Business, Securities Business and Credit Foncier Business Act initially implemented in 1979 and amended in 1992. CFCs generate funds through the issuance of promissory notes of no less than one year with a minimum amount of 1000 baht. The reform process led to an expansion of their activities, which now include arranging, underwriting, and dealing in debt securities, loan servicing agency, insurance advisory services for real estate and property services. MFMCs are supervised by the SEC under the Security and Exchange Act of 1992 and constituted about 2.8 per cent of the total assets as of 1994. The MFMCs issue unit trusts to generate funds and use the proceeds to buy securities approved by the SEC. Until 1993, there was only one mutual fund company, a figure which increased to eight companies in 1996. The number of funds has also increased from 27 in 1992 to 91 in 1994 with 84 equity funds, 4 fixed income funds, and 3 balanced funds. The GSB was established in 1947 under the GSB Act of 1946. In 1994, this was the third major player in terms of total assets (3 per cent of total assets of financial institutions) and had 538 branches throughout the country. Its main function is to mobilize funds and to finance government’s fiscal deficits, hence its importance as a major intermediation agency. The GSB provides services similar to commercial banks and mobilizes funds through savings and fixed

Thailand

313

deposits as well as the sale of premium savings bonds. With the improvement in the government’s fiscal position since 1988, GSB are authorized to extend more credits to state enterprises and the private sector, though the proportion is still under 20 per cent. The Government Housing Board (GHB) was established in 1953 under the GHB Act. It is completely owned by the government and supervised by the Ministry of Finance. The main function of the GHB was to extend housing finance to middle and low income groups as well as housing and land purchases under long-term instalments. The GHB Act of 1953 was amended in 1973 transferring some of the GHB’s assets and liabilities to the National Housing Authority. Moreover, under the amendment, the GHB was allowed to accept deposits of any type and maturity from the public. The Bank of Agriculture and Agricultural Cooperatives (BAAC) was established in 1966 under the BAAC Act with the sole purpose of providing credit to farmers and farming groups at low interest rates. Most of the loans are short- and medium-term loans. As part of the reforms, in 1977, the functions of BAACs were expanded to provide technology and technical assistance and advice to farmers under various agricultural development projects. Further liberalization permitted them to extend credit to undertakings related to agriculture, particularly, the cottage industry. The Industrial Finance Corporation of Thailand (IFCT) was established in 1959 under the IFCT Act. The government owns about 13 per cent of the shares while the remaining shares are held by the private sector, mainly the domestic commercial banks. These shares are listed and traded on the exchange. The main function of the IFCT is financing fixed assets through extending medium- and long-term loans mainly to private industries. The IFCT, through an amendment in 1972, is allowed to undertake certain operations related to the development of capital markets in Thailand. The Small Industry Finance Corporation (SIFC) was established in May 1992 with the objective of developing domestic industries. The SIFC extends financial support to small industries for the establishment and improvement of production capacity and efficiency. The Exim-Bank was established under the Export–Import Bank of Thailand Act in 1993 to: promote exports and investment overseas by extending direct loans, loan guarantee, export insurance and other financial services. It started its operations in February 1994 under the supervision of the MOF, while the governor of the BOT is the Chairman of the Board of Directors. Since its establishment, the operations of export refinancing have been transferred to the Exim-Bank from the BOT. The Small Industry Credit Guarantee Corporation (SICGC) was established in February 1992. Since its establishment, the credit extension from financial institutions to small industries has been transferred from the Industrial Finance

314

Liberalization and growth in Asia

Corporation of Thailand to SICGC. The SICGC operates under the MOF and extends a credit guarantee to small industries that may lack sufficient collateral to obtain credits on their own. The agricultural cooperatives (ACs) and savings cooperatives (SCs) operate under the Cooperatives Act of 1968 but are regulated by the Department of Cooperatives Promotion and the Department of Cooperative Auditing, both under the Ministry of Agriculture and Cooperatives. ACs are the largest in number and by the end of 1994 there were 2474 agricultural cooperatives. ACs are organized by farmers to cooperate in farming activities and extend credits to members at low interest rates. The funds are generated through borrowings from the Bank of Agriculture and Agricultural Cooperatives and capital accounts. SCs are the second largest cooperatives basically organized by public sector employees. The funds are generated through paid-up share capital (members’ own contribution) and are used to extend loans to members for a variety of unexpected needs. Long-term credit may also be provided for purposes such as house purchase or financing secondary occupational activities. Life insurance companies operate under the Life Insurance Act of 1967, amended in 1993 and supervised by the Ministry of Commerce. At the end of 1994, there were 12 life insurance companies operating in Thailand while one was registered abroad. According to the above Act, life insurance companies are required to be public companies and should make a security deposit of 2 million baht as well as maintain minimum capital funds of 50 million baht and deposit a minimum portion of its insurance reserves with the official insurance registrar. The amendment introduced in 1993 allowed life insurance companies to invest in promissory notes, leasing of assets, of land and real estate, managing provident funds and investing in foreign stocks and debentures. The authorities also established a new company in 1993, ‘the Saha Life Insurance Company’ to provide insurance services to members of agricultural cooperatives. The money market reforms The instruments of the money market include the repurchase market, loan windows (both operated by the BOT), interbank loans, overdrafts, NCDs, and commercial bills such as promissory notes, bills of exchange (B/E), and postdated cheques. Commercial banks and finance companies are the major players while commercial bills have a maturity of less than one year, mostly between three and six months. The development of the money market has been very gradual. The interbank market is the oldest of the markets and was established in the 1930s. It is a market for short-term loans, mostly ranging between overnight to two weeks in duration and are traded between commercial banks, finance and security companies and other institutions. Due to the high volatility of interest rates in

Thailand

315

the market, the Bangkok Interbank Offer Rate (BIBOR) was introduced in May 1985. However, only selected banks and finance companies were allowed to use BIBOR. The Singapore Interbank Offer Rate (SIBOR) is the most commonly used rate for the pricing of foreign exchange denominated transactions. One major problem with the market is the lack of money brokers, which makes the market less competitive relative to the markets in Malaysia and Singapore. The Treasury bill (TB) market was established in 1944 and became operative in 1945. Besides the BOT, commercial banks are the main purchaser of TBs as they are allowed to use these Treasury bills as part of their cash reserve requirement. In 1979, the BOT established the government bond repurchase (repo) market as part of the money market development process. Until 1986, the interest on bonds was tax exempted. Banks could borrow from the BOT using their government bonds as collateral. Financing of budget deficits being the main purpose of issuing government bonds, the activities in this market gradually diminished as Thailand moved into budget surplus in the early 1990s before the Asian crisis reversed this. As a result, the amount of outstanding bonds also declined, except the small amounts held by the CBs and FCs as part of the liquid asset requirement (legal reserves) imposed by the BOT. Besides the above, the other instruments of the money market include the commercial bills market, commercial paper market, and transferable bills of exchange market. As a result of financial liberalization and internationalization of the financial markets, the money market is closely linked to the foreign exchange market. The BOT also made certain amendments in the rules governing the operations of financial institutions in 1992 allowing the CBs and FCs to issue NCDs. With renewed independence from too much intervention that was the norm before, BOT has emerged as a more independent central banker after the 1997–98 financial crisis. The capital market reforms This market has a short history. After Thailand’s transformation from an agriculture-based economy to an industrial economy during the 1950s, the first capital market with private incentives was established in 1962. In July of the same year, an organized stock exchange was formed. In 1963, this changed into a limited company, named the Bangkok Stock Exchange, and started trading in equities and debentures. The market was inactive and eventually ceased operations in 1970 due to a lack of investors and lack of government support. In 1974, the government enacted the Stock Exchange of Thailand Act and a formal securities market was established in April 1975 when the SET had 16 securities quoted from nine companies. The activities in the market were slow to pick up until 1984, when the Act was amended to control insider trading and to enable the listed companies to offer new shares. In 1992, the

316

Liberalization and growth in Asia

Securities Exchange Act was implemented which provided more transparency, efficient and effective enforcement and better supervision of the securities industry by strengthened investor protection. The supervision was then unified under the Securities Exchange Commission. With IMF restructuring, the capital market has many of its restrictions removed, thus it is a more liberalized marketplace these days than it ever was. Capital markets experienced rapid development during the 1990s to 2002 mainly as a result of the liberalization process. The establishment of a legal structure, which included establishment of the SEC and a credit rating agency, the Thailand Rating and Information Services (TRIS) in 1993, a Bond Dealers’ Club (BDC) in 1994, and an over-the-counter (OTC) market in 1995, all helped. The TRIS is responsible for information to investors on the quality of the bonds and the issuers. The BDC was established to promote trade in secondary debt, while the OTC facilitates trade in unlisted companies. The BOT also introduced a new electronic clearing system for the transfer of cheques and funds. The primary market for equity comprises common stocks, preferred stocks and unit trusts. Since 1998 both common stock and unit trusts have enjoyed very high growth rates. The authorities have taken strong measures to develop the secondary market for equity. These include setting up an ‘alien’ board for foreign investors in 1987, installing the ASSET computer system for trading securities, relaxing entry requirements for provincial companies for listing on the SET in 1993, establishing a maintenance margin system for margin loans in 1993, and extending trading hours in 1994. As a result, by the end of 1994, the capitalization of the equity market was 3.3 trillion baht with the SET index reaching 1360.9. During the same period, there were 389 listed companies and 91 mutual funds with a net asset value of baht 179.6 billion. The market took a big correction by 75 per cent following the Asian crisis and has since fast recovered. The non-equity market comprises government and state enterprise bonds, debentures, floating rate notes, and leasing. The market for government bonds has declined due to consistent fiscal surpluses, which increased the importance of state enterprise bonds. As a result, the quantity of them increased from baht 6.7 million in 1990 to baht 57.1 million by the mid-1990s. Most debentures are traded in the unorganized OTC market with mutual funds and insurance companies forming the major players. Since 1991, the amount of debentures issued in the domestic and overseas market has increased from baht 6.3 million to the 1994 figure of baht 133.2 million. Floating rate notes (FRN) have also increased over time and many institutions have issued FRNs abroad, mostly in US dollars. Leasing emerged in Thailand in 1987 but did not develop much until 1991. Since then the leasing business has grown rapidly, and is now a competitive alternative to hire-purchase financing.

Thailand

317

The Asian financial crisis led to a decline in the capitalization by 77 percent by the end of 1998. In 1992, Thailand established the Bangkok International Banking Facilities (BIBF) with the objective of developing Thailand as the regional financial centre for Indochina. It was expected to provide services for trade, investment and financing. The other objective of BIBF was to improve the efficiency of the domestic financial sector by increasing its exposure to other more advanced financial markets in the region. The government provided certain privileges such as reduced corporate income tax of 10 per cent compared to the usual 30 per cent, exemption from withholding tax, business tax, and stamp duties. These policies enhanced the importance and share of BIBF in net capital inflows. Interest rate reforms Interest rate reforms were gradual with all ceilings on interest rates abolished only in the mid-1990s. The first step towards interest rate liberalization was taken in 1989 when the government abolished the ceiling on time deposits with maturity of over one year. Malaysia adopted this reform about ten years earlier. This policy was aimed at helping accelerate domestic saving and longterm capital investment. The remaining ceilings on time deposits, saving deposits and loans were abolished in 1992 for both commercial banks and finance companies. In an effort to improve transparency, certain restrictions on commercial banks were imposed to advertise the minimum lending and retail rates charged to their prime customers and retail customers, respectively. Historical trends of different interest rates are provided in Table 10.3. Despite the fact that interest rate reforms were delayed, this country always enjoyed positive real interest rates due to a history of low inflation even at times when interest rates were subject to ceilings. The magnitude of real positive interest rates further increased when reforms were introduced in the 1990s to deregulate interest rates and to further control inflation. The reforms also changed the spread between borrowing and lending rates which moved into positive numbers providing more incentives to commercial banks for loan growth. This spread is depicted in Figure 10.2. Foreign exchange market reforms The design and implementation of exchange rate policy in Thailand rests with the BOT. However, major decisions such as devaluation have to be approved by the Minister of Finance. With currency stability as the main objective of the exchange rate policy, Thailand adopted the fixed exchange rate regime by pegging the baht to the US dollar between 1960–80. However, as the US dollar appreciated against the yen, the mark as well as the pound sterling in the early 1990s, this system overvalued the baht in terms of these currencies, thereby

Table 10.3

Growth of financial and capital market indicators for Thailand (annual averages)

Exchange rate (% change)

318

Interest rates Discount rate Money market rate Government bond yield Time deposit rate Base lending rate

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

–0.18

–0.16

2.38

–0.53

10.97

6.08

10.77

–3.31

– – – – –

5.52 4.66 5.29 3.63 5.29

10.70 11.75 10.53 11.50 10.53

10.20 8.57 10.75 10.24 10.75

8.70 8.11 9.08 7.90 9.08

4.00 1.95 6.95 3.29 6.95

3.75 2.00 5.82 2.54 5.82

3.25 1.76 5.07 1.98 5.07

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

Thailand

Exchange rate

45

ER IR Spread

6 5

40

4

35

3

30

2

25

1

20

0

15

–1

10

–2

5

–3

Interest rate spread

50

319

0 –4 1961 1966 1971 1976 1981 1986 1991 1996 2001 Note:

Data of interest rate spread were not available for the period 1961–76.

Figure 10.2 Exchange rate movement and interest rate spread, Thailand: 1961–2002 adversely affecting the trade balance, bringing about sharp declines in the Thai exports market. Further, the level of international reserves in 1984 declined from the previous ten years’ level of seven months of imports to just US$2.3 billion or an equivalent of three months of imports. To keep the country’s competitiveness intact and to correct the balance of payments deficits, the baht was devalued, first in April 1981 by 1.7 per cent, then in July 1981 by 8.7 per cent and finally in 1984 by 14.8 per cent.3 In 1984, the system of pegging the baht to the dollar was replaced with a basket of currencies including the US dollar, the yen, the mark, the pound sterling, the Hong Kong dollar, the Singapore dollar, and the Malaysian ringgit with the US dollar having the maximum weight of 85 per cent (65 per cent in 1985).4 These measures helped to restore the stability of the Thai baht and the country enjoyed balance of payments surpluses after 1985. Moreover, the level of international reserves increased to US$39.4 billion in 1995, the debt–service ratio was reduced to 11.7 per cent as compared to 27.5 per cent in 1985. Since 1985, the baht appreciated against the US dollar at a rate of 0.8 per cent per annum while it depreciated at the rate of 3.7 per cent during 1978–85.5 However, in an effort to maintain the stability of the exchange rate, the BOT

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Liberalization and growth in Asia

lost control over the money supply, where it would react to the balance of payment conditions. The continuous interventions of the BOT in the foreign exchange market to keep the currency stable increased the gap between foreign interest rates and domestic interest over time, which led to an increase in short-term capital flows. To prevent any adverse effect of these flows on inflation and current account deficit, in 1995 the BOT imposed certain restrictions on capital. These measures included: (1) imposing reserve requirement for BIBF’s out–in business; (2) the minimum amount of loans made through BIBF was raised from 500000 baht to 2 million baht, and subsequently 5 million baht; (3) cash reserve requirements for non-residence baht accounts was raised from 2 per cent to 7 per cent; and (4) imposing a 7 per cent reserve requirement for foreign borrowing of financial institutions. In 1996, the BOT also intervened in the swap market for some Asian currencies (the Singapore dollar and Hong Kong dollar) to prevent speculative attacks on the baht based on the rumours of an expected devaluation of it. These bold steps helped to restore the stability of the baht but at huge costs until the currency crisis on 2 July 1997 when the currency was free-floated.6 The historical trend of the changes in exchange rates is provided in Table 10.3 while movements of exchange rate are shown in Figure 10.2. Another aspect of the foreign exchange market reforms was initiated in 1990 when commercial banks were allowed to conduct foreign exchange transactions for customers without BOT approval. The second phase of liberalization measures was implemented in 1991 when residents were allowed to open foreign currency accounts while non-residents were allowed to open local currency accounts. Exporters were also allowed to make payments from and receive into these accounts for trade purposes. The third phase of reforms came in 1994 facilitating trade and investment in the region. Financial liberalization effects Thailand has pursued quite an open external sector policy. The reforms started as early as 1970 and were implemented very gradually. Some of the important reforms were implemented only in the 1990s. This is consistent with policies adopted by some other Asian early reformers such as South Korea and Singapore and the advice given after the Asian crisis. The reforms had a positive effect on the overall economy. These reforms provided enough incentives to the private sector and helped to accelerate domestic saving and investment as well as attracting foreign investment to contribute to economic growth. Policies of domestic financial and external sector reforms significantly increased the inflow of capital and the foreign direct investment increased by more than 50 per cent during 1996. The country later on paid the price for this huge short-term capital inflow without an adequate monitoring

Thailand

321

system. Nevertheless, GDP growth showed remarkable improvement in the late 1980s and mid-1990s until the baht crisis hit the economy in 1997 when Thailand experienced its worst recession in decades. However, with the help of the IMF and some internal policies, the economy recovered sooner than expected from this crisis. Indicators of financial liberalization Table 10.4 provides a summary of financial liberalization ratios. The positive effect is visible from the depth of M3/GDP, from about 35 per cent in the mid1980s to about 90 per cent in 2000 (reduced to 83 per cent in 2002). The reforms increased private sector participation in the market as the claims to the private sector (as a ratio to GDP) increased from 25 per cent in the 1980s to 121 per cent in 1997 before experiencing a drop due to the Asian crisis but then recovered slightly and were then 81 per cent in 2002. Gross domestic capital formation remained low until 1990 and picked up later. It remained stable at around 42 per cent of the GDP until 1997 but then dropped back to 21 per cent after the crisis. The significant impact of capital flows to Thailand is evident from Table 10.4. The FDI (net) accounted for 3.9 per cent of the GDP during the first half of the 1990s, declined during the crisis but recovered to a level of 3.5 per cent by the year 2001. Thailand does not face a major indebtedness problem as some other countries discussed in this book, such as Pakistan. The fiscal sector gradually moving to surpluses reduced the need for any domestic or foreign financing for budgetary purposes. Table 10.4 shows that foreign borrowing is a very small percentage of GDP (in fact negative in 2002) while domestic borrowing accounted for 2.7 per cent of the GDP in 2002. The positive impact of these reforms is also evident in Figure 10.3 which shows growth in M2 as stable and the foreign reserves to imports ratio having improved over time.

4.

ASSESSMENT OF FUTURE PROSPECTS

The consistently recurring theme in the development history of this country is that Thailand remains a more open country with conditions favourable for development to occur rapidly. Growth has been secured by the dynamism of the private sector, which largely dominates all economic activities. Though the real sector was very much open to competition both in the country and from the entry of foreign firms – increasingly with little barriers to entry – there has been greater reluctance compared to others such as Malaysia to relax controls on the financial and monetary variables. This reluctance has grown thin in the aftermath of reforms since 1997. Periodic interruptions to sustaining the growth have also come from external shocks – an example is the oil price

Table 10.4

Indicators of financial and capital market depth in Thailand (percentage annual averages)

322

1961–70

1971–80

1981–90

1991–95

1996–2000

2000

2001

2002

Money depth (M3/GDP)

30.85

35.97

55.58

75.48

85.76

89.77

88.15

83.43

Intermediation depth FIR (total)/GDP (=DC/GDP) FIR (private)/GDP

16.95 14.43

37.57 25.24

62.19 45.66

82.72 81.76

120.90 106.22

111.17 85.66

100.40 73.67

102.04 81.07

Capital accumulation GFCF/GDP FDI (net)/GDP FDI (inflow)/GDP

20.04 – –

24.21 – –

29.83 1.27 1.20

40.30 1.78 1.51

28.00 3.88 3.63

21.97 2.73 2.75

23.00 3.45 3.31

23.04 0.85 0.77

– –

– –

– –

– –

0.13 0.23

1.00 0.33

2.20 0.02

2.68 –0.59

Indebtedness Domestic borrowing/GDP Foreign borrowing/GDP Notes: M2 = M3 = FIR: FIR (total) = FIR (private) = GFCF: FDI: DC:

currency + quasi money. M2 + other deposits. financial intermediation ratio. claims on public and private sector (total credit). claims on private sector. gross fixed capital formation. foreign direct investment. domestic credit.

Sources: IMF International Financial Statistics (CD-ROM); World Bank, World Development Report (various issues); ADB, Asian Development Outlook (various issues); Ariff and Khalid (2000).

Thailand

Growth rate

60.00

M2 M1 FR/IMP

90.00 80.00

50.00

70.00

40.00

60.00

30.00

50.00

20.00

40.00

10.00

30.00

0.00

20.00

–10.00

10.00

Foreign reserves to imports

70.00

323

–20.00 0.00 1961 1966 1971 1976 1981 1986 1991 1996 2001 Figure 10.3 Foreign reserves to import ratio and growth rates of M1 and M2, Thailand: 1961–2002 shocks – and domestic instability created by weak coalition governments and/or military interventions. Despite these recurrent problems, a growth rate of about 8 per cent per annum during 1980–96 is a strong record of the possibility for future growth. Besides other factors, failure to take steps to reform the political process, lack of an efficient monitoring system and delayed regulatory reforms for the financial sector led to the collapse of the economy in 1997. Growth of about 7–8 per cent per year has been reduced to an average of 2.05 per cent per annum since 1997! Timely assistance by the IMF and focus on the above areas helped this country to recover from the worst crisis of its history. The central bank has been strengthened to pursue pro-growth policies with the urgently needed increased independence. The financial sector is being restructured and some steps have already been taken to put forward regulatory measures for the functioning of the financial system. Future prospects for Thailand are good with some dependence on the regional economic environment.

NOTES 1.

An aspect that keeps popping up in our analysis is the great degree of income inequality in all the countries. Thailand’s bottom 20 per cent of households had but 5.6 per cent of GDP (the top 20 per cent had 52.7 per cent), a situation worse than Indonesia. This is recognized as a

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Liberalization and growth in Asia

source of instability today following the work of the Nobel Laureate A.K. Sen. Uneven distribution encourages income capture by capital owners, who, after a period of growth as in Thailand (and Indonesia), engage in speculative spending in the non-productive sector. Could this be the real cause of financial instability in developing countries? This aspect deserves to be studied as it goes to aggregate level inefficiencies to trace the fault lines that destabilized many economies in the 1990s. 2. The bank borrowing from abroad as a percentage of total borrowing has increased from 56 per cent in 1985 to 90 per cent in 1995 (Nidhiprabha and Warr 1996, p. 15). 3. It may be interesting to note here that the Governor of BOT lost his office as Governor by opposing the Minister of Finance over devaluation of the baht. This simply shows the limited independence the central bank enjoys in implementing major policy decisions. 4. The weight of each currency in the basket is undisclosed and so is dependence on the relative importance of that currency in the Thai trade flows. 5. Most of this appreciation of the Thai baht was considered as artificial and analysis indicated that the Thai baht was overvalued by about 30–40 per cent. These views suggest that part of the depreciation of the value of the Thai baht during the currency crisis was, therefore, a correction. 6. The causes and effects of the Asian currency crisis are discussed separately in Chapter 2 of this book.

11. Lessons for development through liberalization 1.

WHAT YOU CHOOSE IS WHAT YOU GET

Even a casual visitor to Asia will get one overriding impression of progress in some countries and an abject lack of it in others. Herein lie the lessons to be learned that arose from liberalization-led development. Some countries such as South Korea, Malaysia, Taiwan, etc., appear to have created more visible and real creature comforts for their people than some other countries in the region.1 The key to the achievement or non-achievement of creature comforts appears to us at least to have come from one constant factor. That factor is the extent of liberal policies adopted or not adopted by the Asian nations. This finding is true even after considering the damage from economic and social shocks from the Asian financial crisis during 1997–98 and in the aftershocks in some countries in the closing years of the twentieth century (even, in Indonesia, as late as 2002). In this book,2 the reader is in a sense taken through a grand tour of the process of policy-making by governments and economic agents across several decades as steps – an aspect this book covers extensively – were taken to put through series of connected ideas which became key factors for changing the circumstances. It is a careful analysis of the much-talked-about Asian experience, which in some cases secured and in others failed to secure social development. Financial and social statistics over three or more business cycles over a 30-year period have been presented to support the findings on which we now look for lessons to be learned by others from the Asian experience. What are the other lessons, apart from the choice of models for development? A careful analysis in an earlier book and eight countries in this book on the long-term development trend in Asian countries suggest one key lesson for others. Undertaking a liberal mix of reforms secures high sustainable growth and prosperity, provided the financial sector had safeguards to deal with the onset of serious shocks from external sources. The elements of this lesson are examined in some detail in this chapter. The analysis of the financial crisis in 1997–98, which wiped off some years of economic gains, suggests another, second, lesson. Failure to stem financial fragility in the real and financial sectors made the high-growth open economies – in hindsight with less 325

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capacity to handle sudden reversal of capital flows – more vulnerable to speculative attacks on currencies at the wrong time when the currencies were in need of devaluations in response to falling export growth. The policy mix adopted as a continual course of liberalization is quite often based on a common-sense approach to managing an economy with the sole aim of creating better conditions in severely war-ravaged countries. The choices made by the bigger players such as China and India were based on a clear vision – so it seemed at that time the vision was formed – of their founding fathers of newly freed nations. But for smaller countries, the choices to be made had to produce quick results because these nations were in dire straits. Taiwan was reduced to a burdened island nation in 1949 after the Communists drove out an opposing government along with a lot of skilled people who settled in the island.3 The South Koreans were devastated by a 1954 war brought to their shore from superpower hegemony. The Malaysians were rudely awakened by a savage civil war, the root cause of which was inequity among different peoples making up that polyglot country. Indonesia almost broke up in a 1965 civil war that needed a quick fix to alleviate untold human suffering. Singapore, an island of about 2.4 million people then – grown to about 4 million by 2003 – living in a space no larger than Manhattan Island, had been cut off from the more resource-rich Malaysia on political policy differences and historical wounds suffered from racial politics. These latter nations, all much smaller than China or India, were more pragmatic and less doctrinaire, less vision-bound, nevertheless more apt at seeing what would work quickly. These nations chose the export-led industrial growth path through vigorous liberalization. Thus, the economic policy choices made by a given nation were to some extent preconditioned by the individual experiences of the countries, all having in common smallness forcing upon them the need to become nimble at making rapid changes while the two giants, China and India, slumbered. The major shift towards liberal policies swept China in the 1980s, and India in the 1990s, which were decades after the smaller nations adopting market-friendly policies. Of course, the liberal policies these countries adopted, which later produced the most beneficial outcomes as seen by any observers in Asia, have their roots elsewhere. The modern ideas of how to formulate and execute growthpromoting policies to harness growth that could improve the well-being of people in nation states with different resource endowments were there from the experiences of other countries and from the knowledge banks of economic schools, despite differences in the way to pursue such policies. But there was no consensus back in the 1960s and 1970s about liberalization being the correct path, when in fact competing ideas of central planning or import substitution held sway much more strongly: Japan and South Korea were

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perhaps the two places that bravely chose export-led growth ahead of others. That liberalization is possibly the route to sustainable development was not well understood. It took time to sweep across the world from a germ of an idea born in an Austrian economic school, which today is linked to the classical ideas of Ricardo, Marshall, the later ideas of Friedman, Bagwati, Sen and others bolstered (in later years by ideas of Mundell on currency and McKinnon, Fry and Cole on sequencing of liberalization) to form the neoclassical development paradigm so much in vogue today. That liberalization to return economic activities to market-based signals underlies the theme for the success. The first lesson of development is therefore a paradoxical one. The choice was among alternative paths to development. It holds the key to the success or failure of development made since those choices were made at the start of the process and influenced the policies to be followed in the ensuing period. In this regard Asia can be said to have made choices from among conflicting ideas then prevailing some three to five decades ago: the central planning of the Soviet model (former command economies); import substitution for a closed model of development (Brazil and India); and liberalization (Japan and South Korea) to ensure export-led industrial growth. It appears that the choices were made more on political considerations – to some extent the Cold War politics of the second half of the last century – to suit the conditions prevailing in the post-war years than on any rational examination of what would be the most appropriate path to development. In any event, import substitution appeared then to be a rational path based on the Keynesian idea that a government deficit is needed to bring unemployed resources – and Asia had plenty of them – to full use, as was being done soon after World War II in the more developed countries in the West. The natural attraction of this policy was not surprising. Even Taiwan followed it for about a decade in the 1960s, which led to the building up of a huge foreign ownership of the means of production. Soon that course of action was abandoned in Taiwan. In contrast, India relentlessly created a rule-based bureaucracy from about 1954 when most significant economic activities were delegated to the public sector, which, over time created the ‘licence Raj syndrome’ from which the country is still reluctantly extricating itself. Then there was the attraction of the Marxist-Leninist model of central planning. That choice led to disastrous economic outcomes from which Asia’s Communist adherents are still trying to extricate themselves by returning to a market economy model, a euphemism for adopting capitalism (with or without an incomes policy) in place of a failed policy of the Communists. Finally, there is the open economy model pursued quite happily by much smaller nations as Hong Kong, South Korea, Singapore and Taiwan on a path to development, which made them the first Asian tiger economies later to

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become the newly industrializing economies (NIEs). These nations created per capita income growth twice as fast as other nations on average. The result is that all of them have today become middle and upper income countries. After a period of failures to secure the development needed to make the people better off, wrong policies were reversed by China in 1979 and in India in 1991 with the right policies slowly beginning to be put in place since then. Hence, this gave the early reformers, all of whom managed to create higher levels of creature comforts be it in Taipei or Seoul or Kuala Lumpur while the transitional economies in Beijing or socialist in Delhi made short-term gains from their later adoption of liberalization as the route to growth. The early adopters of economic and social reforms managed to secure a far greater degree of improvements in the social well-being while even the late-reformers are beginning to obtain some degree of initial successes. That is what will impress an observer about Asia. In the next section, we identify two sets of lessons: one relates to the preconditions for liberal economic policies to work; and the other relates to the elements of the liberal policies themselves. In Section 3,we look at the results of the liberalization policies. In the following section, we examine the lessons from the Asian financial crisis. Financial fragility appears to be the source of the troubles while exchange rate pegs are somewhat responsible for the overshoot of the currencies in 1997–98. In the fifth section the reader can find a discussion on the important question of sequencing of the reform steps. Though no consensus among experts existed prior to the crisis, it is now widely accepted that some degree of current account controls is needed to fend off sudden systemic shocks to an economy. In the final section of this chapter, the reader is given a glimpse of the future prospects for the kind of reforms this book advocates to all those peoples who yield more to actual experience rather than succumb to creature comforts. Growth is attainable is our optimistic message, provided the political process is in the hands of the peoples in Asia. We hope Asians will stop listening to demagogues promising quick fixes for their conditions and the right things are then done by their elites and rulers to secure growth through neoclassical growth policies. Another plank in this framework is the role played by financial liberalization to support real sector openness. It appears that there is less consensus in this regard. Not till the later 1980s was the idea born that financial sector openness had to be sequenced carefully – some (Cole and Slade 1998) would even suggest that it should be delayed till real sector openness is completed. Is it possible that the bare openness of the financial sector in the Southeast Asian countries was too early and led to them catching the financial crisis in 1997? In particular, when these countries did not have the legal safeguard to reverse openness at the time of external shocks (the Chilean plan). There is evidence in this regard from the experience of Chile,

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where there is a mere provision in law to control capital flows, to lend credence to this idea. The five economies that suffered severe growth collapse could well be held up as an example of too-early openness in capital and current accounts. South Korea, which eschewed strict controls for a long time on capital flows, collapsed within about 18 months when it removed these controls in 1996 to join the rich-country club, the OECD. We are of the view that this issue requires further scrutiny, and the jury is still out on this issue.

2.

THE TEN COMMANDMENTS OF A FREE MARKET ECONOMY

Preconditions While the grand design of what one chooses appears to be preconditioned by history, it is much easier to document the elements that make up the liberal policy mix. In our opinion, this task is less controversial. ‘Good neighbourliness’ is a precondition for sustaining growth over time.4 Failures of nations to create good neighbourliness have caused many countries with potentially fairly good prospects of growth to slide slowly into a malaise. India and Pakistan are apt examples. Why is it not easy for India and Pakistan to realize that this is the critical building block for going forward?5 If a third party is willing to underwrite the costs of conducting war (North Korea vs South Korea), then of course, one can throw all the resources at making an economy grow. In fact a nation at war could order people to work harder and make sacrifices as did South Korea. Not many nations are so lucky as South Korea, perhaps! Thus, the first element in a growth-promoting policy mix appears to be an absence of resource allocation to war efforts so that the famous Samuelson’s choice can be made by a nation for more bread and butter instead of more guns and tanks.6 The second element is building a coalition of peoples for liberal policies. Lack of consensus, as is happening in India will retard the growth process substantially. The consequence in India has been a marked slowing down in the speed with which growth promoting policies can bring in favourable outcomes. We saw that India’s weak coalition governments since 1994 were unable to go all the way to adopting the reforms that Rao’s government was putting on the agenda. Similarly, the coalition of Congress and Communist parties formed in 2004 are appearing to show similar strain in the early days of the new government. Deng Xiaoping of China and Dr. Mahathir of Malaysia of course are two famous cases of building coalitions for adopting liberal policies.7 This second element is a political lesson on economic development.

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Leaders must be aware of the need to put a coalition of support among the people to want to make the reforms, and get the mandate to do so from them, preferably in democratic elections, which provides legitimacy to the process. Of course, there are also rare examples of some men forcing liberal economic policies without necessarily actively building coalitions, least by democratic means. It happened in South Korea when Park Chung Hee unilaterally dismissed the elected government and initiated market friendly policies, thus laying the groundwork in the period 1963–73 for the country to embark on the road to prosperity. Let us not forget that there were several attempts on his life and eventually one was fatal. These last two elements of development are more in the domains of political economy than the other elements to be discussed shortly. McIntyre (1998) shows clearly the dominant influence of political factors that precipitated, for example, the Asian Crisis. So, we do not belittle the political factors. A third set of elements in the form of institution building for development has been pointed out as essential for making the transition to the open economy model, in fact for sustaining the process. These require the development of sound laws that enshrine private ownership as the backbone of a developing process. Let us not forget that only when private initiatives were in place did the Communist economies respond to reforms. This also requires that an independent judiciary is developed to protect the rights of individuals to pursue private gain activities consistent with ideas of fairness. Along with this are institutions that foster such things as good disclosures of information from economic agents (government, corporations and banks) and developed accounting standards, and not an undue tax burden, all of which are needed to give assurance that there is sufficient institution building to back development. Elements of Liberal Policy Mix We refer to the three elements so far discussed as ‘preconditioning factors’, and proceed now to identifying the economic-cum-financial policy elements, the proper concerns of this book. Our discussion about these remaining elements is based on the experiences of the cases included in the book. First among them is the need for ‘competition policy’. Whatever a country did to put in place or manage existing producing units, an important precondition for success appears to be active promotion of competition among firms. Here the economic dictum, ‘many buyers and many sellers’, any one of whom is not likely to influence the equilibrium prices, has to have real meaning in policy implementation to the extent necessary to ward off the kind of feather-bedding by chaebols in South Korea or government monopolies in India. Shoddy cars were produced for several years after Communist China started one company that had the sole licence to produce cars locally; India licensed one company

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to produce its cars; Indonesia created cartels to manage its very profitable spice production with disastrous results. The reader will find so many cases of restricting competition in the production process practised in Asia. Years after these decisions were put in place by well meaning bureaucrats or politicians, the results were poor quality goods being produced and often the sole company producing the goods goes about shutting out any new entrants from making better quality products. On the other hand, when the Japanese decided to enter any goods production, they started at least three companies. Not as bad as the rest of Asia eh! When Japan decided to make cars, it had the Nissan, the Toyota and Honda corporations all competing among themselves to produce better quality cars. In electronics, there were the NEC, Hitachi, and National corporations that competed fiercely to produce world-class electronic products. At the appropriate stage of development, opening the domestic markets to international competition is also observed – Taiwan and South Korea are two examples – after the infant industry protection is removed by scaling down the tariff rates more or less to a single-digit level.8 The financial corporations should also be subjected to competition. One should not have to wait till the year 2006 to have this: this should have happened much earlier! Thus, domestic real and financial sectors must have broad-based competition through reduced barriers to entry within the country in the early phases of development when infant industry protection is needed. But there should not be the kind of Indian or Chinese practices of licensing one company or cartels to produce goods. Of course in these two countries, these firms were owned and controlled by civil servants, and not the private sector. Systematic feather-bedding practices in the state-owned enterprises led to these firms making shoddy products and yet the profits were not there to justify the high prices the public was forced to pay out of necessity, for these shoddy goods. The next element is to progressively expose the real sector to international competition by first reducing tariff rates steadily to single digits as did many successful economies. This is often done in two stages. In the first stage, while reducing tariffs, domestic firms are encouraged to seek joint ventures to bring in expertise that are efficiency improving: India and China did this extensively, and are still doing this as a major strategy. At the later stage, foreign firms are given full entry with 100 per cent ownership rights to produce and sell their goods. India has moved to this stage in the 1990s while China is still keeping the foreign firms in the economic zones. Needless to emphasize, those countries that had very little resources and were themselves small economies – Singapore, Malaysia, etc. – adopted the two stages of opening to competition almost at the same time by freeing restrictions on foreign entry at a very early stage of opening the economy. As a result, such economies have multinational firms and financial institutions present

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abundantly in the domestic sector while the tariff levels have been very low for a considerable period of time. Real sector openness is then an important reform the readers would have noticed in all the eight countries. While real sector openness is taking place, decisions on two further elements are likely to be made. There is widespread debate, particularly after the 1997–98 Asian financial crisis, as to the appropriate time for these steps to be taken. We are referring to current account and capital account openness: these are the next elements. Restrictions maintained in the current and capital accounts in China and India, appear to have prevented speculative attacks on the currencies of these countries in 1997–98 while the same restrictions could have prevented domestic firms and individuals from joining in the speculation on their own currencies as happened in Indonesia and Malaysia. This appears to be a sound enough reason why full current and capital account openness may not be advisable during the early stages of development. Consensus among experts (McKinnon, Cole and Frenkel, among others) is that current and capital account openness must not be undertaken until the real sector opening is advanced enough and even then only after government budgets are in balance. This was discussed in each chapter of this book. This was a critical factor in the way that laxness in this aspect led to severe problems in the aftermath of the 1997-98 crisis in South Korea and Indonesia, for instance. Capital account openness is needed to enable the producing units, the domestic and foreign firms, to seek capital resources outside the country and then be able to pay for such services as dividends, royalties, management fees, etc. To a lesser extent, individuals may not need that full freedom, provided the ceiling on individuals to move capital is set at reasonable levels – as is being done now in India and Malaysia – not at levels injurious to the demands for foreign capital. There are good reasons therefore for a moderately high level of openness to be put in place early enough for there to be market-based exchange rates and to permit efficient flow of capital resources into an economy for all the real sector participants under development. In a later section, our discussion will move to this issue of where to sequence these steps in an overall design of the policy mix. The next element is fiscal reforms. The current idea on development within a non-inflationary economic environment requires that the government budget is balanced except when exceptional circumstances such as an economic recession require temporary overspending as deficits. Our analysis of the eight cases shows three dominant patterns in this regard. The budget surplus country is Singapore. Budget balanced countries are Malaysia, Thailand, South Korea, Indonesia (ostensibly prior to the crisis). Deficit countries are China, India and Pakistan, all of which had budget deficits over most periods. Singapore (a budget surplus country) created huge external resources, in this regard also

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being able to obtain foreign currency reserves from trade and/or capital flows. This led to its currency appreciating consistently. So did the non-traded goods: if you live in Singapore, you know what it means to own non-traded assets such as a house. Budget-balanced Thailand and Indonesia gained some degree of control on inflation during the period when the budget was in balance. South Korean firms, given their huge demands for capital raised in a largely closed financial sector, bid up interest rates, and through this lost control of inflation. Indonesia had high demands for capital often raised the capital in Hong Kong and Singapore at high interest costs. It also had off-budget expenses under the control of the President, the impact of which is still not fully understood. The third group, the majority of countries, appears to have muddled through long periods of inflationary experiences with the loss of control on the monetary policy away from the need to balance the budget by printing more money or from over-borrowing or from raising too much domestic debt. The ill effects were rampant inflation rates in these countries. A balanced budget appears therefore to be a critical factor in managing an economy well and seems to be the norm in achieving price stability in the economy. Appreciating currencies often require constant upgrading of the skill contents of the producing sector, which means that large doses of capital have to be made available periodically to make the adjustments to higher technology. This perhaps explains the high capital use of the Singapore economy, relative to others in similar stage of growth. An appreciating currency makes the non-traded sector become too expensive for domestic purchasers. In the cases of the balanced budgets, noticeable improvements in price stability and exchange rates were achieved. This was the case for most East Asian economies in the 1990s, which gave the impression of good fundamentals. (The rot from bad investments sanctioned by very imprudent banks was revealed when the financial crisis hit in July 1997. This will be discussed in the next section.) Much has been said of the mismanaged fiscal budgets. This took two forms. In those cases with significant state firms in the producing sector (China, India, and Malaysia till 1984), budget support for the loss-making firms was squarely to be blamed for the loss of fiscal controls. Prior to the new reform in 1998, Indonesia spent large amounts to support state firms. Even today, when the state sector is more reformed to make profits as their targets, China is still supporting loss-making firms in order not to create unemployment, which would create discontent with the government. China employed the spectacular strategy of letting the private sector growth over 1979–2003 smother the inefficiency of the state sector but the rot is still there to be removed under the brave reforms of the new Chinese administration in the new century. India has sold off part of the loss-making firms, having decided

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to nurture about 150 of the central government-owned firms to become efficient through restructuring and corporatizing. Indonesia is still undecided as to how to proceed on this front, again placing further burden on the budget. Thus, a significant problem of fiscal budget balance is tied to the next element of reforms, namely privatization of state-owned firms belonging to central, state, provincial and city governments. The need for returning state firms to private sector competition has been a theme of popular capitalism all around the world. But in Asia, not every country is enthusiastic about this. China has, rightly or wrongly, decided to nurture 1000 of its state firms to satisfy East Asia’s liking for big-is-better despite the failings of the big-firms zaibatsus and chaebols. Worldwide preference is to see the reduction of state firms to account for less than 10 per cent of GDP in areas that are considered to be in the domain of public goods production. This is a critical factor in many large countries even outside Asia. Unless this element of the reform mix is achieved, a weakness may linger in the management of the economy even if all other elements are correctly managed. In this regard, some countries such as Thailand, Malaysia and Taiwan had progressed much faster than others since the financial crisis. Three final elements of the reform package are related to the financial sector. These are (1) need for sufficient competition among the financial sector firms; (2) prudential supervision of the financial institutions; and (3) central bank independence in conducting prudential supervision. We remarked very early, in Chapter 1, that weakness in the financial sector, which was closely aligned with capital flows as well, precipitated the Asian financial crisis. Throughout Asia, the worst managed corporations are the firms in the financial sector. Exceptions are in the completely open economies of Hong Kong and Singapore. Why these two are efficient is easy to see. They are international financial centres where the presence of international players has improved competition among the financial institutions and the governments cannot mess them up, and if they did try to do so would not be able to control these firms without losing their status as financial centres. There is an even balance created by the self-interests of the government and that of the international banks. The central banks in these countries, whether they have independence or not, are aware of this fine balance that creates efficiency. As for the rest, the common problems seen are many. The critical ones may be identified as severe lack of competition. In the transition economy of China, only now is private ownership of banks beginning. At the speed they are letting this happen, it will take decades before the impacts of the private sector banks can make a difference to the state of affairs. There is a fear of the foreign banks: to face the efficiency of these banks some nations are strengthening the capital base of domestic firms as is the case in Malaysia and

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Singapore. Domestic banks in some other cases are state-owned. In the case of Pakistan, the banks were nationalized and efficiency declined significantly. But the denationalization and increased presence of significant private sector financial institutions in Pakistan is beginning to introduce competition to the public sector banks, thus producing efficiency gains much faster than is the case with transition economies like China or Vietnam. In each country chapter, we have given the impacts of financial structures on the performance of this sector. Competition policy requires privatization of the state-owned financial sector firms too and then removing barriers to entry for domestic and foreign firms: something a number of the countries covered in this book have undertaken to do in the year 2006. This has to be done speedily in order to improve financial efficiency so essential for the real sector firms to reduce their financing costs. Imagine the high costs of about 7 per cent for just raising capital in Jakarta compared with just about 1.5 per cent in Kuala Lumpur or Singapore. Firms work so hard to earn a rate of return of about 10–15 per cent on capital whereas the investment banks in less competitive situations can cream off 7–10 per cent of the capital raised as fees alone for fund-raising activities. Mutual fund managers give back to fund contributors a rate of return less than half that of average market rate in these places: this is from inefficiency in the management of superannuation funds. These are some stark results from lack of sufficient competition as well as lack of prudential rules such as self-listing rules or zero-front end fee rule for funds to improve competition. Next, prudential regulations must be carefully devised and implemented. Some commentators (Cole and Slade 1998) have gone to the extent of suggesting separating savings functions from the transaction functions of banks so that the damage to savings can be limited if inefficiency from payment systems is the main reason banks get damaged. New approaches are being suggested in the light of the Asian financial crisis. Among them is a suggestion that the Basle standards on capital adequacy (an 8 per cent cap on equity capital and risk-weighted capital) are sorely inadequate to meet the needs of developing countries. The Basle II has proposed higher risk-weighted capital requirements, which will be adopted in the years after 2008 by most developing countries, it is hoped. This would strengthen the financial sectors. Finally, a word about central banking independence. This is not taken kindly by all the governments of the countries included in this study. For a brief period following the financial crisis, the central banks had gained some degree of independence when the help of the World Bank and the IMF was sought to help restore the economies to health. In some cases such as Indonesia and South Korea, laws have been passed to mandate the

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independence of central banks. Only time can tell if the new minders, the governments, will allow independent central banks to exist when the temptation to order quick remedies through interventions is the order of the day, also an old habit over decades, in Asian countries, at least going by past patterns.9 In some countries, Indonesia included, far-reaching changes to the management of the central bank and banking supervision are being put in place. Central banking independence is being enshrined in new legal and administrative structures put in place by 2002. After a phasing-out period, the prudential supervision of financial institutions will be centralized in a new independent body in the fashion of Australia and the United Kingdom: this will be implemented in year 2005 or so. The central bank retains the responsibility of managing the monetary policy and fiscal agency functions. Of course, the law-makers have provided that central banking independence is attained. Again only time can tell if these experiments will lead to signal success in Indonesia and South Korea for others to want to put such reforms in place. The Lessons Table 11.1 is a schematic representation of the discussion on the lessons about the liberal policy mix needed for ensuring sustained economic growth to occur. The reform steps are sequenced in an order that is often claimed by experts to be the desirable one. In actual practice, some countries may take a slightly different approach as did, for example, Indonesia in 1970, when flushed with cash from petroleum sales, it opened the current account fully before lifting the high tariff rates in the real sector. This could well be the case of a financial centre such as Singapore, which must open its current and capital accounts fully to achieve growth from the financial sector. This economy produces some three times more GDP from its financial sector compared to an economy with no financial centre status. In summarizing the lessons from this study, it appears that for a modernizing economy to secure growth towards a sustainable path, it needs to pay attention to the ten elements included in Table 11.1. Three of them are in the domain of political decision-making and institution building to serve the development process. These are very long-term in nature, and are today considered as necessary conditions to put an economy on a growth-seeking path. The seven economic elements about which much evidence has been given in this book are essentially to do with real and financial sector reforms within the context of competition, prudential management and opening to the rest of the world. The specifics may be different in each country, the broad thrust seems to be gradual openness and prudential discipline of matters financial.

Lessons for development through liberalization

Table 11.1

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Elements of liberal policy mix needed for development

Preconditions 1. Development strategy choice among competing models 2. Good neighbourliness or absence of war 3. Institution building to strengthen private sector initaitives via property rights, independent judiciary and effective bankruptcy laws and low taxation, software for development Elements of liberal policy mixture 4. Competition policy ● Domestic real sector competition to improve efficiency ● Gradual tariff reduction under infant industry protection ● Foreign firm entry relaxation after real sector efficiency 5. Capital account opening ● Capital account for domestic firms opened; individuals restricted ● Later capital account for foreign firms opened 6. Current account opening for real sector firms ● Limited current account openness for individuals ● Fuller opening of current accounts to individuals later 7. Fiscal prudence through balanced budgets ● Taxation reform and tax administration reforms ● Privatization programme to limit damage to fiscal sector ● Build civil service’s administrative capacity for reforms 8. Competition policy for financial institutions* ● Remove or relax entry barriers; modernization; training 9. Prudential supervision of financial institutions ● Build capacity for transparent prudential capacity ● Emerging economies need higher capital adequacy norms 10. Central banking independence ● Slowly restrict central banks to reform monetary functions Note: *Opening the financial sector firms to competition takes place at the same time as nonfinancial firms as denoted in element number 4 in this table. The numbering does not indicate any particular ‘must follow’ sequencing of reform steps.

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Liberalization and growth in Asia

THE RESULTS SPEAK VOLUMES

This book provided analysis of data over several decades as to how reforms in some cases or failure to take reforms in other cases led to the outcomes described. The reader is not going to be belaboured on this point. Wherever reforms were in the direction of improving competition and greater openness and prudential discipline, etc., etc., the result was a stunning income growth, which led to great social improvements in several countries. When prudential discipline became a scarce commodity in the 1990s, the same countries such as South Korea, Indonesia and Thailand experienced sudden loss of controls that led to the loss of several years’ gains. Table 11.2 records some of the striking results just before the Asian financial crisis hit some of the economies. While the early reformers achieved an average economic growth rate of 8.1 per cent per annum in the 1991–96 period, the hesitant reformers achieved about half that. The hesitant reformers with closed financial systems (as well as low exposure to the international economy) did not suffer from the 1997–98 financial crisis, so maintained reasonable growth. But the more financially open economies had growth collapsed for two years, but reforms placed the nations on recovery in all cases, except Indonesia, now undergoing a gigantic democratization process away from authoritarian rule. The transition economies, which had only recently adopted liberal reforms, grew at an astonishing rate of 10.1 per cent ahead of the early reformers simply because of the sudden release of pent-up energy leading to huge investment splurges that are taking place in these economies. Look at their price management outcomes. The Communists had failed to control inflation in that period with an average inflation rate of 23 per cent, which is six times the rate experienced by the early reformers with more appropriate management of the economy: since adopting modest reforms in this regard, the inflation has been brought down to single digits in the 1995–2004 period. The hesitant reformers had an average inflation of 9.4 per cent per annum: they too, with modest reforms, brought inflation to single digits in 1994–2004. Thus, using the criterion of growth under price stability, only the early reformers had achieved notable successes, while the slightly less rigid economies of the hesitant groups did moderately well. Of course, one needs to compare these outcomes with almost zero growth in so many Asian countries not included in this study. Looking at the ability to increase savings or being able to attract foreign capital, the early reformers had almost twice the amount of investment as the others. The Communist market economies attracted large capital inflows, and yet their capital formation is still at 28.6 per cent of the GDP compared with the 34.7 per cent for the early reformers. One might also point out that the over-dependence on foreign capital in all these countries except Taiwan

Lessons for development through liberalization

Table 11.2

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Growth friendly policy outcomes in Asia, 1991–96

Economies

Growth Inflation Capital/GDP Trade/GDP* Income (%) (%) (%) (%) class

Early reformers Indonesia South Korea Malaysia Singapore Taiwan Thailand

8.1 7.3 7.4 8.7 8.5 8.8 8.1

4.9 7.4 7.2 4.2 2.1 3.2 5.0

34.7 34.8 36.9 37.8 34.8 22.7 41.2

64.2 27.0 38.0 96.0 135.0 47.0 42.0

– Low Middle Middle Upper Upper Middle

Hesitant reformers Bangladesh India Pakistan Philippines Sri Lanka

4.5 4.4 5.2 5.0 2.8 5.0

9.4 3.9 10.5 11.4 11.2 9.9

21.1 15.4 23.9 19.1 22.5 24.5

13.5 4.3 8.5 9.5 38.0 7.4

– Low Low Low Low Low

Transitional economies China Vietnam

10.1 11.3 8.9

23.1 13.4 32.8

28.6 37.6 19.5

11.8 17.5 5.0

– Low Low

Notes: * Trade value divided by twice the GDP. The information in this table is drawn from Ariff and Khalid (2000). However, only countries (in bold) in the first column are included in this book. Sources: See the individual chapters for the sources.

created the conditions ripe for the financial crisis. Yes, that is part of the story. The real reason why too much borrowing led to that crisis is in the first place due to the long gestation of investments using short-term capital to offset the economic slowdown from declining export earnings during 1994–97 that went unnoticed by planners. As soon as the entry of more cost-effective economies such as China led to the loss of competitiveness and with China devaluing its currency twice in the 1980s and 1990s to attract more investments to itself, troubles started to arise for the early reformers. Finally, trade dependence, which is a measure of the openness of the economy to the rest of the world, is very high (five times higher) for the early reformers. These countries chose the

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pragmatic path of export-led growth through industrialization, and in that process also made themselves more subject to world demands for their goods dictating their policy choices. That is not a surprising result for a quick and favourable route to prosperity. The others are still not such open economies, and are unlikely to be so for some years to come. The transition economies have in fact moved up by taking the export-led growth path: note that they have built a high level of external exposure in a short period. The hesitant reformers (excepting the Philippines) who followed a closed policy naturally have the lowest trade dependence: their ratio is one-fifth of the early reformers. Finally, and more important, the social impact of the growth is very telling. The early reformers, all of whom were a notch lower in the income classification, moved up the income ladder. The exception is Indonesia with its huge population absorbing all the benefits of its high growth without an effect on the class of income group to which that country still belongs. One of the boasts of the latter was that in 30 years after development started under Suharto, the number of people in poverty had been reduced from some 60 per cent of the population to just 8 per cent by the mid-1990s: this was reversed to 38 per cent after five years of political disorder in that country by 2001. Of course, the political and economic crisis in Indonesia, given the huge share of the GDP going to a small group of people, has made about a third of the population again go under the poverty line within just three years of the crisis. If the incomes from all these years of good growth were more evenly distributed (perhaps this is predicted by Sen’s hypothesis), the impact of the crisis would have been very different indeed. The Nobel laureate, Sen’s, argument appears to hold very well here. The trickle-down effect of growth has to be countered by good policy of income equality, so it appears to us, to forestall the kind of collapse Indonesia experienced by following a policy of very low wages. Low wages kept a large segment of the population just above the poverty line even though the economic growth which was taking place was of the same order as in the other early reforming countries. Thus, the proof of the pudding presented in the table as the saying goes, can be used to justify the statement that ‘the liberal policy mix followed by the eight countries had produced predictable results’. The outcomes are welfare improving for the peoples of these countries. Data from the earlier period can be used to show that the decent growth rates the hesitant reformers and the transitional economies had achieved in the 1990s are in fact because of the liberal reforms they undertook: also because liberal reforms were placed speedily after the financial crisis to bring the countries back to growth by the year 2001. Otherwise, their 1990s growth would have been more pitiable had they continued their command economy or import substitution approaches to growth. The reader can see these blatantly clear outcomes coming out of

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liberalization. Now we turn to the effects of the 1997–98 Asian financial crisis to learn additional lessons on what not to do to reverse the favourable results coming from liberalization.

4.

LIBERALIZATION AND THE ASIAN FINANCIAL CRISIS

It has taken a long period of trial and error to learn from mistakes in the making of development policies in all the countries. But the biggest of the mistakes made so far appears to have been (1) the benign neglect of banking reforms and (2) over-exposure to short-term foreign capital flows at exactly the wrong time when the declining export sectors were weakening the currencies of South Korea, Thailand, the Philippines and Indonesia starting from October 1994. In three years the crisis occurred. Understanding correctly the major reason for the financial crisis will enable other countries to learn proper lessons from this one episode which sapped so much energy of the world community as never before. The sequence of events from July 1997 and December 1998 and again from 1999 to 2003 were listed in Chapter 2 (Table 2.2) to provide a background reference to the Asian financial crisis. In this section, we will describe the sequences of events to provide lessons about the crisis for others to learn. The Asian financial crisis had its origin in two unfolding events that started to happen several years before its onset. The first is related to export growth. With the memory of the 1989 Tiananmen Square incident beginning to fade, China resumed its attractiveness as a cheap place to produce many things the world wanted to consume. The rise of China as an attractive place for costreducing production (there were more to join in as Vietnam, India and others removed restrictions on foreign investments in the closing years of the 1980s) meant that some day the early reformers would lose their competitive edge. This started to happen from 1994. Thailand was the first country where export growth started to decline. Export growth rates that hovered in excess of 20 per cent on a year-on-year basis were starting to come down from 1991 till in 1994 they became negative in the fourth quarter of that year. It took a mere six quarters to reveal the bad shape these economies were in. Meanwhile, China, which had regained its momentum after the June 1989 fallout from Tiananmen Square, had twice by 1994 lowered its exchange rates by half, which gave it a tremendous advantage over other countries. One by one exports declined in all the hitherto fast-growing countries. And pressures built in these countries to maintain a high level of investments. Paul Krugman wrote an article in 1994 questioning the myth of the East Asian Miracle, claiming that without positive total factory productivity, the high growth is

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merely input driven and not the result of efficiency. This led to a re-evaluation in the political closets in the Asian countries. There were secret meetings behind closed doors in the capital cities since Krugman’s preaching went directly against the claims of all the politicians that they were good at economic policy-making – the claim was that Asian leaders had found the formula for growth. Led by some cash-rich countries, a call was made and a few conferences later, a scheme was mooted to improve the infrastructures of the economies in Asia with massive investment in such long-term projects as power plants, roads, airports, bridges, etc. This is exactly the opposite of what these countries had been doing for 25 years. Caution against using demandcreating policies was the order of the previous 25 years. That caution seems to have been relaxed now. Soon the politicians’ major benefactors, the World Bank and the Asian Development Bank, produced documents to suggest that US$500 billion was needed to upgrade the infrastructures in Asia to gain efficiency and momentum for growth: this lent credibility to the politicians who said there was an unmet need for infrastructure improvement to get at factor productivity. Alas, this led to over-spending on what is called landbased investments, with long periods for payback, just at the wrong time when the exports were declining to support normal economic activities. Short-term foreign money coming from lax banking rules was going to long-term investments. It was the politicians’ answer to gain factor productivity! With permission granted to banks in 1994 to borrow and lend in foreign currencies (in some countries), a lot of short-term cash found its way into these countries, got channelled through new financial institutions (the failed Bangkok Bank of Commerce for example) to unproductive investments. The managed float of the currencies was made possible and was thought to be a permanent fixture as these countries had huge foreign reserves to throw at the speculators to defend their currencies. This is exactly what had been happening since 1995 as the currencies were weakening and the ever-vigilant central banks were defending their pegs to the dollar or to a basket of currencies as wished by their political masters. Meanwhile, more and more investments were being committed or planned that would provide decent returns in the long run, but not in the short run. The crisis led to the abandonment of the peg, and introduction of restrictions on foreign loans as well as restrictions on banks speculating in foreign currencies. These are laws in many countries, reversing the wrong responses by polititians about two to three years before the crisis. That relaxation went on for almost a year and a half till the weak coalition government of businessman Banharn in Thailand committed serious errors in managing the impending disasters arising from the connected lending problems in the Thai financial system. The rot set in after 1994 and the disease became full blown by mid-1997. Weaknesses started to develop after the 1994

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reforms in several countries to attract short-term capital. At one time, 91 Thai finance companies had as much as 25 per cent of the total credits, most of them from loans to the overpriced properties markets in Bangkok.10 Property bubbles built in all the countries except Indonesia. For example, in two years in the first half of the 1990s, the property index went up 120 per cent in Singapore. Once the free-wheeling economy of Thailand buckled, it was a matter of time before investors started to do some new arithmetic and pulled their cash out. When looking closer lenders found that the money sent to these star emerging markets was probably being squandered on grandiose projects, though much of them were sound ones, and they began to pull their cash out of the region in a general rout as had never been experienced before in Asia. As the currency tumbled, so did the stock markets (in foreign currency terms, the stock markets of the crisis-hit countries lost 75 per cent of their pre-crisis values). The currency crisis (see Chapter 2) started on 2 July, and is often said to have ended only in November 1998. There were three distinct phases in the event. The first phase was from 2 July 1997 to September 1997. By September, the IMF was already in charge of some economies and there was much optimism that the crisis would soon pass. The compelling explanation was that the fundamentals were right and that the speculative attack was to be blamed solely for the crisis in all countries, not only in Malaysia. No one at that time made any connection to the hollowing out of the free-market economies by the attraction of China (and other new entrants) as a major competitor nor to the clever devaluations of the renminbi that gave a severe jolt to the hitherto good quality economies of East and Southeast Asia. It still had not dawned on the analysts that a fundamental shift was taking place. The currency realignment from this major crisis is simply a large-scale revaluation of these small economies in a more competitive world with the entry of the third-generation developing countries with abundant and cheaper resources. One observer said that if the world opened the door for the skilled workers of China and India alone, there would be a total of some 300 million who would qualify for the jobs in the more successful economies. Continued competitiveness based on a fixed exchange rate could not be sustained as it causes severe damage to other nations’ balances. With the likely relaxation of currency controls on the Chinese currency, it would soon be evident that the high growth could not be sustained in much the same way as was experienced by Japan and South Korea in the 1990s. Attempts to bring in reform to this aspect have been rebuffed by China in October 2003. From November to May 1998, the second phase of the currency crisis revealed itself as actual new policies were being put into force. Thailand’s government had fallen and a new one was narrowly elected to office. The election in March of Suharto in Indonesia for a seventh term unleashed

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political fallout, which led to riots and then his resignation on 20 May 1998. Things started to get worse as the Asian crisis appeared to have spread worldwide between June 1998 and January 1999. Two episodes, one in Russia in the form of a currency collapse of 12 per cent in November 1998 and the other in the USA when the First Capital Fund was threatened with a loss of some US$3000 billion, occurred, which observers linked to the Asian crisis. Fortuitously, the timely intervention of the US Federal Reserve halted worldwide panic. By June 1999, the crisis seemed to have dissipated and several of the currencies except the fixed ringgit and the rupiah had recovered part of the losses on the back of healthy growth in foreign currency reserves from improved export growth coming from regaining competitiveness (Phillips curve effect) and from aid disbursements. A significant statistic to remember in order to understand the crisis is the capital flow to these countries. In 1996 a total of US$96000 million found its way to this part of the world: in 1998, the net outflow was US$120000 million, a net negative foreign direct investment of about US$24000 million. These statistics speak volumes about what had happened to these economies. Next, all the countries lost more than half the long-term growth rates that had been in place in 1996, while 1997 saw a net economic decline of some 3 per cent. By all predictions, a modest growth came in 1999 for all but Indonesia. Indonesia elected a new parliament on 6 June 1999. The parliament elected a new president in an election in November when the choices were made between the bad and the worse than ever before in its history. Normalcy returned to Indonesia, the largest economy in Southeast Asia in the year 2000. But the minority government had its ups and downs, and with the international terrorism issues spreading to that country (the Bali Bombing in 2002), the growth was lacklustre. Mass media reports the return of serious corruption in all public activities, which was sapping the energy of a freed economy even in 2004. A new election in July produced no clear winner, and a second round planned for November, 2004, led to a decisive choice. What lessons are there for others from this crisis? We agree with the assessment made by McKinnon: For many years, diverse financial institutions in each of the five (crisis) countries had struggled with festering bad-loan problems from over-investment in real estate: lending to profitless real industry; government-sponsored mega projects; subsidized rural lending; and so on … undermined the capital position of banks. (McKinnon 1998, p. 86).

The final straw appears to have come from the way the banking business has been conducted with no prudential concerns in almost all these countries. Even when the finance ministers or the central bankers pointed to the right decisions to make (recall what happened to the brave Thanong Bidaya, the Finance

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Minister of Thailand in June 1997) the system favoured quick fixes and moved on to doing the same thing again. In our opinion, banking fragility came from corporations taking too much debt as evidenced in Chapter 2, undertaking profitless investments, etc. These activities give rise to a general financial fragility. (Thailand and South Korea are the biggest culprits here with a dollar of equity supporting four or more dollars of debt in the corporate sectors.) This appears to have been tolerated by the regulators as a necessity to address the urgent problem of lack of infrastructure, which, if not removed, it was thought, might continue to make growth unsustainable. The origin of tolerance for financial fragility came from political decision making, in particular to continue the high growth even as their countries were losing competitiveness to China and India resulting in declining exports. Cole and Slade (1998) actually advocate setting lower growth targets under these changed circumstances. No country could afford this strategy of fine-tuning by adding more infrastructure at the wrong time. Had exports been held up to a level of 20 per cent or more as a percentage of GDP, the act of high growth coupled with some improvements in infrastructure would have gone for some more years. Thus, in our opinion, financial-fragility-promoting policies – of course, we are saying the lack of prudential regulation as stemming from financial fragility – were the sources of the problem. The banking sector mirrored this condition described by McKinnon as a festering bad-loan problem. The father of financial liberalization theory appears to have got it right. Several other observers have attributed the origin of this crisis to political reasons (MacIntaire 1998); to excessive private debt amid asset bubbles (Ichimura et al. 1998, p. 3); to the wrong exchange rate policy based on some sort of pegging. Yes, political reasons are often the more powerful explanations of single events, but they fail to explain systematically across all the countries. Exchange rates are perhaps a better explanation at least for the way the rupiah behaved during July to December 1997, and in the years since then. Had the Indonesians moved to some form of free floating long ago, the market may not have so deeply devalued the rupiah by some 27 per cent by December 1997, since all indicators for this country then suggested strong fundamentals (there was no public knowledge of the off-budget expenses of the President) and the government was always ready to act decisively unlike the Thai government of Barnharn. Had the more open economies had some residual controls of the type Taiwan had on the current and capital accounts, at least the domestic firms and individuals would not have lined up behind the foreigners taking the short-term money out of the country. But an exchange rate explanation as a source of the crisis can only explain overshooting. A free float tested and well in place may still lead to depreciation but certainly not to the extent of the overshooting experienced.

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The reader will note therefore that the primary origin of the crisis was the gradual loss of competitiveness by the free-market economies when Communist China started to hollow the free market economies by aggressive pursuit of capital flows currency. The currency peg in place was especially protected by the huge foreign reserves in place. This permitted politicians not to have to mandate or even punish central banks who permitted lending by banks to sustain inappropriate investments in what Nasution (1998b) called land-based investments. Prudential oversights normally expected to come in force were relaxed when unprofitable investments in whatever form were being encouraged by banks working in concert with big business and the government, using savings entrusted to the banks. The decisions of the network of powerful people undermined the safety of the savings in banks of the ordinary firms and individuals in many countries. The speculators exploited this weakness to make fortunes for themselves. That could happen again unless the reforms of the kind that South Korea and Indonesia are taking take real hold. As long as these reforms are implemented with the prudence required of the central banks in the new century, we may not see another crisis of this kind. Thus the lesson from the financial crisis appears to be consistent with what we charted in an earlier section. That is, prudential oversight on the financial sector has to be done by independent central banks and regulators. Needless to say, the connected lending where some form of implicit encouragement is given by governments must be avoided at all costs.11 This practice, if ever tolerated in the new century, will again lead to the sanctioning of unprofitable investments if politicians use this loophole to railroad bad investments to pay off political support of interest groups (Thailand), or to be kind to the children of first families (Indonesia; and others), related party lending (the chaebols of South Korea), and so on.

5.

HOW ABOUT SEQUENCING THE REFORMS CORRECTLY?

Economists have long debated the benefits of free markets and economic liberalization. However, the speed and sequence of financial sector reforms have been found to be crucial to the success of liberalization policies. The literature on this issue is mixed and sadly suggests that there is no universal rule to be adopted by all the countries. Before we discuss the optimal sequencing of the liberalization process, it seems important to look into the specific objectives for which an economy may be undertaking liberalization. In general, the financial sector reforms are intended to relax interest rate controls, develop money and interbank markets, tighten prudential regulation

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and the supervisory system, strengthen competition among banks while also liberalizing credit regulations, develop capital markets and the payment system, and restructure foreign exchange markets. These reforms have been put in place over 1998–2002 in all the countries, both IMF-restructured and Malaysia. It is the structural linkage between these goals that provides a basis for debate on which policy action should be taken first. Research on sequencing simply suggests the order of policy sequence that may be used while liberalization is initiated. The handful of serious researchers on this subject appear to have two main concerns (Gibson and Tsakalotos 1994). The first research question is ‘Is there an optimal order for liberalizing the domestic real sector, the domestic financial sector, the external real sector and the external financial sector?’ That is, find out the best case order of things to be liberalized as would be suggested by a given model of what outcomes may be expected. The second approach is based on McKinnon’s work, where he seeks to identify if certain prerequisites exist prior to financial liberalization to enhance economic outcomes. Despite the simplicity of the issues involved, no consensus exists among the experts about an optimal sequencing path. Most disagreement appears to be on the issue of whether the domestic financial sector should be liberalized before the trade sector. If a country liberalizes its domestic financial sector before the trade sector, credit could flow to the tradable sector, which may be kept profitable by the protection provided by the high tariff wall. In theory, this has to be an inefficient allocation of credit because one sector, namely the traded sector, gets more ready credit lines than the non-traded sector. On the other hand, if the domestic financial sector is liberalized after the traded sector, that would hamper the ability of domestic industry to compete in the world markets, at least in the initial stage of the reforms. Similarly, opening the capital account too early increases opportunities for currency substitution. That would lead to capital flight in search of higher returns. This will lead to an appreciation of real exchange rate and incorrect allocation of resources between tradables and non-tradables. Liberalization of the capital account will also restrict the ability of the domestic banking industry to compete with foreign banks given the strict regulatory system under which they often have to operate in the current world with more stringent domestic regulations for domestic firms. At the same time, capital account liberalization and real appreciation of the exchange rate will increase the resource availability to an economy. On the prerequisites, McKinnon therefore suggests that two conditions must exist before financial liberalization. These are fiscal discipline and prudential control over domestic banks. The debate on sequencing was initiated by Shaw (1973) and McKinnon (1973) who advocated reforming the whole economy at one go. Initial

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financial liberalization based on the original recommendations led to severe adverse effects in some Latin American countries during the 1970s, when financial liberalization policies were first implemented. Having had such a bad experience, Edwards (1986) and McKinnon (1982; 1989; 1991) contributed a series of papers making some original contributions on sequencing. Many other economists joined in this search and these included Edwards (1994), Levine (1996), Cole and Slade (1998), Fry (1997b), Villaueva and Mirakhor (1990) and Eichengreen and Mussa (1998), among others. One point, they all agree, is that the external sector should be liberalized after the domestic sector. In this chapter, we referred to these as element number 4 in Table 11.1. The reader will note therein that the tariff reduction and entry relaxation for foreign firms are listed after the domestic firms are subjected to more competition. Earlier literature on sequencing dealt with this issue in a political economy framework and recommended a gradual liberalization. It was only in 1973 that McKinnon restated this question as an important economic policy issue, and the subject was treated as a legitimate economic issue. As stated earlier, McKinnon changed his view in his later articles, that complete liberalization should be not done at one go and that it is a gradual process. The main message from McKinnon’s research to date is that the capital account should be the last one to open. He argued that Chile performed better than Mexico due to it first opening the trade sector and keeping the capital account closed: to that we can add South Korea from this study since that country only opened its capital account in June 1995.12 Argentina suffered severe currency depreciation and later high inflation because the capital account was opened before the trade sector had been subjected to tariffreduction-induced competition. He argues that relaxing the capital account earlier would lead to capital inflow and hence make the real exchange rate appreciate. This is an unwelcome economic effect when the trade sector is liberalized because that would work against export competitiveness. This is also counterproductive as such capital inflows can become unsustainable, exactly the results that happened during the Asian financial crisis, no doubt after a long period of capital flows. McKinnon also suggests that trade liberalization should take place after any fiscal deficit has been eliminated. Edwards and Edwards (1987), Frenkel (1983) and Krueger (1984, 1985) supported this view in their own theoretical and empirical work and suggested that the current account be liberalized before the capital account. Cole and Slade (1998) argue that the capital account should be the last major policy area to be liberalized. Coming as it does after the crisis, this advice is well-heeded. Liberalization of capital accounts before financial and trade sector reforms, they argue, would lead to less efficient capital allocation to investments and could lead to potential economic disruptions. The authors

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also note, however, that opening of the capital account in the early phase of liberalization may help maintain fiscal discipline because the fear of unbalanced government expenditures if sustained for too long would bring in severe devaluations. Fry (1997a), based on the findings of comprehensive empirical research, suggests that reforms in small economies compared with the large economies should be faster. He argues in favour of a capital account liberalization soon after government budgets are balanced – so this is an argument for sequencing. Sell (1988) argued that the capital account should be opened before the current account, which are two too many important dissenting views on the order of sequencing. They believe that a free-floating exchange rate is crucial to a liberalized economy. If one were to examine the behaviour of the more open Asian economies especially at the levels of high growth secured in Indonesia, Malaysia, Singapore and Thailand soon after current account liberalization was introduced, these views appear to make good sense. But, it is no longer the case, since the very same condition made these economies ready for the huge output losses via the Asian financial crisis (without the Chilean safeguards). Only the speculators laughed all the way to the banks. Villaueva and Mirakhor (1990) took a different point of view and looked at appropriate sequencing of liberalization along with effective bank regulation.13 They argue that eliminating credit controls abruptly without adequate prudential supervision of bank lending may increase the moral hazard problem. Once again McKinnon’s earlier quote comes to mind. It is the absence of prudential oversights that led to financial fragility and then the collapse of economic growth in 1997–99. Villaueva and Mirakhor suggest that macroeconomic stabilization and stringent prudential regulations must exist before complete relaxation of interest rate controls. (They describe the experiences of three Latin American countries, namely, Chile, Argentina and Uruguay). Some of the East Asian countries adopted this gradual approach in interest rate liberalization in their years of greater prudent behaviour. Alas, the same countries later relaxed bank supervision. Indonesia permitted foreign loans to be freely available to domestic firms in foreign currencies. Government banks and one private bank actually were given permission to lend to domestic firms in foreign currencies! These laws have been reversed after the crisis. Indonesia is also an example of reverse sequencing where the capital account was thrown completely open as early as 1970, but then they had huge capital inflows from their crude oil exports. That led to wastage of resources, since the currency declined: 450 rupiah to a dollar in the 1960s to 2500 in 1996 to 8000 in 2003. One may argue that Indonesia paid the price for such a policy in 1997. Thailand permitted credit creation at 68 per cent in some years in the 1990s, and most of that went to related-party lending and to land-based investments. At end-June 1997, just before the crisis erupted, lending to the

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property sector constituted 28 per cent of all bank lending not counting the loans from the finance companies. Most listed firms in Malaysia got into the property development business in the 1990s when the trade sector was declining, and the banks joined in to provide easy credits. The same thing happened in Singapore. The non-traded sector had asset inflation of 120 per cent! This was one of the main causes of the currency crisis in Thailand, South Korea and Indonesia where the post-1991 financial reforms were in total disregard of all prudential norms. Some observers in the financial press were aghast at the level of stupidity in such actions, when these countries have been the paragon of proper economic behaviour in pre-1991 years. Wealth created in good years perhaps makes people less vigilant. Theoretically, it is possible to identify an optimal sequence of reforms but in practice it is a daunting task. Most developing countries have a variety of distortions present in the economic systems and any reform process would be meaningless without removing some such serious distortions at the same time as taking reform steps. The experience of the 1997–98 Asian financial crisis suggests that there is a need for proper sequencing and adequate – perhaps the reader would say more than adequate – prudential regulations if there is an optimal path to uniform strategy. The exact sequencing for a particular country may also depend on the political will to take hard decisions against interest groups running the financial systems as well as the stage of economic development; the teeth the legal system has to act impartially and fairly; the presence of institutional traditions, etc. Cole and Slade were rightly cautious on this when they wrote: these recent crises compel us to consider whether it is possible to create in a few years the essential preconditions for a safe and sound, privately-owned financial system, operating in a free-wheeling globalized world, especially in developing countries that are still in the early stages of establishing effective, democratic political and legal systems. (Cole and Slade 1998, p. 339)

Thus, it appears that there is less likelihood of not having distortions for one to rely upon a simultaneous holds-barred liberalization to be successful in an imperfect world. Perhaps, only in the sterilized world of model building would such a world exist, and such type of big-bang approaches have not produced a single success case so far. Just think of the pains in Poland, Hungary, or even Russia – alas, for the perfect world. There is, however, a consensus, a growing one, that economic liberalization should not be delayed because some of the prerequisites do not exist or a bigbang is difficult to implement completely. This is the lesson that international agencies have taken on board, and over 1998–2002 they put in place a greater degree of liberalization in the financial sector than before, while ensuring that prudential norms are introduced in capital adequacy, corporate capital ratios,

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related party lending and hosts of other issues. The literature reviewed in this section draws some policy conclusions. A capitalist system creates its own distortions and hence freeing markets to do the watching through invisible hands is the first priority when reforms are initiated. Capital controls should not be relaxed before the complete liberalization of the domestic economy. The order of sequencing suggested and supported by most writers amounts to five simple lessons. ●

●

●

●

●

The liberalization process should start with curtailing the budget deficits of governments followed by reforming the labour market (see the coverage on labour reforms in the Singapore chapter). The liberalization of the goods market should then take effect next followed by liberalization of the domestic financial markets, which must include greater competition within the banking sector. The capital account should be liberalized only after the above steps are completed successfully. As in Chile, some legal teeth should be retained even as controls are relaxed. A good dose of prudential regulations is needed to be designed and implemented under transparent regulatory controls by well-trained efficient regulators with independence to act prudentially, under the watchful eyes of a stable government. Only then should the financial sector reforms be implemented. The banking sector must be carefully placed under greater prudential oversight, while also improving the capital adequacy and credit expansion functions.

What this section advocates therefore is not at all contrary to what we have stated in earlier sections in this chapter. There is thus a desirable sequencing in a world with distortions. Given that, any simultaneous big-bang opening of the Russian type of experiment is at best risky. Experimental economic reforms of the Chinese type are less risky. Hesitancy to take the right steps towards reform is potentially wrong.

6.

THE BRAVE NEW CENTURY FOR OPPORTUNITIES?

New beginnings are possible so goes the old adage, to make up for missed opportunities. Will this be the case for Asia? We think so. It was not till the 1990s that the fruits of liberal policies began to be noticed more clearly as having made a big difference to all parties. Now that the crisis has come and gone with some blips on major statistics in 1997–99, the subsequent reforms have made the economies sounder. Even after the ill-effects of the financial

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crisis had done their predictable damage to five economies, the attraction for liberalization has not waned at all though some aspects of liberal policies (privatization for example) may not receive enthusiastic support after the lessons learned from the crisis years. In this concluding section of this book, we make an educated guess about where Asia may head soon under some possible conditions unfolding. First and foremost, liberalization has gained sufficient reputation as a correct choice for putting ailing economies back to work. This is especially true after the spectacular results from experiments and from the economic and financial recovery after the crisis in 1997–99 with market economy reforms where once the command economy model led to spectacular failures around the world. So, it appears that liberalization will be a favourite fixture in the new century offering greater attractions to many Asian economies which have yet to make the transition to the new way of managing their economic affairs. Here, we are anticipating the adoption of this policy by a majority of Central and West Asian economies long used to central guidance (and a good dose of authoritarianism) and little of the market signals. The first thing we are confident of is that the platform for liberal reforms may reach broad-based consensus in Asia very fast as the new century unfolds, especially after the lessons of the crisis. Next, globalization going as fast as it is progressing is likely to speed up the demands for visible economic growth in more countries than the eight described in this book. Political developments in Asia have moved away from colonial rule to self-rule, in some countries self-rule is being replaced by authoritarian regimes only to find growth collapses as happened under the military regimes in Myanmar (Burma), Thailand in the 1970s and Pakistan in the 1980s and so on. More and more countries are experimenting, not certainly with the pukka British democracy, but are slowly evolving more democratic traditions as the yesteryears of despotic rules of Mao, Zia, Marcos or Saddam give way to more people-focused rule. That is good for preparing the groundswell for liberal policies to find more attraction. But there are also rare exceptions when authoritarian rule was growthconsistent: two examples are the periods under Park Chung Hee in South Korea and Chiang Kai-shek in Taiwan. Some Asian countries for a while squandered opportunities when they were trapped within the Soviet model, or under despots, who set the clock back in almost all cases. Faith in great helmsmen is waning as people become more educated and are able to take responsibility for their own decisions collectively. The second theme we predict therefore is more democratization of the political system, which is good for liberalization and coalition building for sustained development. Even in the worst case of Communism, China in this regard, villagers are beginning to make democratic choices to flush out corrupt Communist cadres from

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mismanaging village affairs. Suharto’s error was not lack of development, but the mistakes of not yielding to demands for more democratic institutions and not curtailing those nearer to him from taking too much private licence for business gains. This slow consensus that is building everywhere in Asia, that some degree of free choices and ownership rights are needed for growth to occur augurs well, especially under more democratic decision processes. If we assume that the entry of larger economies with cheaper resources is going to constantly rearrange the ranks of countries in a competition table, then change in the fortunes of countries is ever more linked to their ability to undertake meaningful reforms. Necessarily few of the countries, especially Hong Kong and Singapore, may emerge as the leading financiers of Asian countries. This is not any different from the role New York plays in the United States or the City of London plays for the world. Asians would increasingly resort to finance from Asia as more resources are found in Asia for Asia’s development needs. By year 2004, reforms put in place to invigorate the assetbacked securities markets are beginning to pay off, as for example in South Korea. That augurs well for more self-sourced funds in each economy away from foreign borrowing. The group of nations now forming the NIEs will continue to become smallscale Japans in the way Japan helped to spread industrialization in South Korea and Taiwan, so too will these ‘clones’. In this, the new century may find Malaysia and Thailand becoming members of the NIEs not too far in the future. With the right policies being pursued, the Vietnams of Asia may find themselves coming out of poverty by adopting liberal policies the same way others, for example Indonesia, before them had done. The transitional economies with resources, Myanmar (Burma), Kazakhstan, Uzbekistan, etc., may make fast gains as their resources are increasingly exploited by multinational capital and know-how brought in by reforms. If liberal policies take them in the same route as for example Thailand, then there is much hope for Asia to progress. That of course needs clear political choices in these countries for liberal policies. A big unknown in all this prediction is the way the Communist countries will bring their love of their doctrine to play in the economic games with free market economies. If the hollowing out of the free market economies is possible, then why not do by stealth what guerrilla wars of the 1960s and 1970s failed to do through doctrinaire uprising. If Communist countries use the economic clout from the cheap input-cost advantages they have, then the free market economies have to move up the ladder of skill just as Taiwan has done. This will create some degree of beggar-thy-neighbour policies, which may create tensions in the years to come. Some economists are predicting more instability arising not just from this gamesmanship but also from other

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larger economies constantly rearranging the game of competition through trading blocs, the new style game in place of currency devaluations, the old style. Happily, the remedy for such calls lies in a more focused and dedicated pursuit of development policy to reach a higher economic stage of development. That again is a happy outcome as has been demonstrated by South Korea and Taiwan as they moved to become NIEs or attain developed country status. Thanks to the rich menu of experiences of the eight countries over the last 30 to 40 years, the rest of Asia could and may learn some tried lessons for their formulation of long-term policy to secure prosperity for their peoples. These tried lessons did not come from the rarefied rooms of a few famous prognosticators. In the predictions based on tried policies, we are more confident.

NOTES 1. 2. 3. 4.

5. 6.

7.

8. 9.

Such as Vietnam or Bangladesh or Sri Lanka. The reader is referred to Ariff and Khalid (2000) for a detailed discussion on the liberalization and developmental process in these countries. This chapter is based on a broader analysis to be found in our earlier book (Liberalization, Growth and the Asian Financial Crisis, published in 2000 by Edward Elgar Publishing) as well as in this book. Exclusive discussion on Taiwan is not included in this book. The reader is referred to Ariff and Khalid (2000, Chapter 7) for details on financial liberalization and economic development in Taiwan. Ariff is deeply indebted to John Dunning for his elucidation of this concept. John used it in his speech at the Melbourne Club in 1999. Of course, in his paradigm for development, good neighbourliness features prominently, and we have extended that to cover the neoclassical reform structures. Looking at the most recent developments of a peace process between India and Pakistan, one can infer that these two countries have realized this and hope that more focus will be put in place to resolve economic issues. In his widely popular economics textbook in the 1960s and 1970s, Samuelson, the famous Nobel-prize-winning economist, made the proposition that a country has a choice between allocating more scarce resources to producing guns and tanks for making war or making bread and butter to secure prosperity. That adage is still apt, and we feel that those countries that chose to make more of the means of war making in Asia did not make as much progress as did the others. Dr Mahathir stepped down as prime minister after serving 22 years. His deputy took over as the new prime minister. Whether Malaysia continues to pursue a dogmatic approach towards economic development policies is anyone’s guess. The handover seems to have been smooth but political and economic decisions taken in the short- to medium-term will determine the future path of development for Malaysia. It is observed that these two countries put in place invisible barriers to trade in the forms of onerous health certification for food products, for example. We disregard this aspect in our analysis. Imagine the Hong Kong government being told not to attempt a stock market rescue in August 1998. Or imagine the People’s Bank of China cutting off budget support to the 1000 firms that are being nurtured as firms of excellence to provide competition to the foreign and private sector companies. In the week prior to the floating of the currency, the Thai Prime Minister Banharn ordered the US$2.86 billion bailout of 16 finance companies by the central

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10.

11.

12.

13.

355

bank and the finance minister ordered them to be closed in July 1997. To expect the unthinkable, that the right things will happen, is to fool ourselves. Only time can tell. One of the crude indexes of property bubbles is the number of cranes you watch as you drive from the airport to a city. This index must have fallen by 95 percentage points between early June 1997 and May 1998. The authors were in Thailand during those dates on research trips, and were not surprised to find this even as the Thai economy was brought to its lowest point by end-1998. The US government gives implicit guarantees to borrowing by agencies and even some foreign governments. But such decisions are subject to the vote of the House and the Senate. The point is that this is an institutionalized way of borrowing with full disclosures compared with the behind-the-scene deals promoted in the 1990s in the East Asian economies. There has been a re-examination of this conclusion by none other than the IMF. The consensus in 1999 was that there were other explanations as to why Chile did better. However, currency speculators have noted that capital controls that Chile had in law, could be reimposed very easily if speculative attacks were to occur. The residual capital controls have not been removed from the law books yet. Cole and Slade (1998) and Caprio (1997) also supported measures to have adequate bank and non-bank supervision before steps for financial sector liberalization are taken.

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Index Act Bank Negara Malaysia 198 Banking 198 Glass-Steagal 129 ADB 132, 306, 342 agencies, collection and distribution 6 agriculture cooperatives 311, 314 American Banking structure 57 credit union 40 -led war against terrorism 220 American model with deposit insurance 53 Approach, big-bang 90 Argentina 348 ASEAN countries 16, 176, 300 economies 94, 98, 107, 176 Regional Forum 224 Asia Pacific Rim 60 region 26 Asian bankers 59 banks 54 countries 1, 47, 325 currencies 320 currency crisis 175, 260 currency units 274, 288 drama 25 dollar bond market 287 dollar deposit 271–2, 287 dollar market 271 dollar units 284 economies 176 liberalization 17 experience 325 financial crisis 1, 13, 16, 24–5, 32, 43–4, 58, 61, 71, 113, 115, 137, 184, 300, 317 liberalization 126 miracle 2, 4, 22, 24

nations 325 region 61 Asia’s development 353 Asia’s Growth experience 25 authoritarian regime 352 authoritarianism 132, 352 average life expectancy see life expectancy asset inflation 350 assets, non-performing 111 Australia 38 Australian dollar 38, 294 Australian experience 139 Austrian economic school 327 bad management 295 Badla 123 baht contagion 32 baht crisis 32, 139, 145, 203, 297 baht devaluation 38 balanced budget 9 Bali Bombing 344 Bangkok Bank of Commerce 342 Bangkok inter-bank offered rate 304, 315 Bangkok International Banking Facilities 311, 317 Bangkok Metropolitan bank 309 Bangkok Stock Exchange 315 Bangladesh 221, 354 Bank of Agriculture and Agricultural Cooperatives 311, 313 Asian Development 46, 186 of China 62, 80 China Everbright 79 of Communications 79 Guangdong Development 80 Indian Overseas 119 Indonesia 52–3, 133, 148, 156 of Korea 166, 178 Negara Malaysia 39, 48, 60, 194, 201 376

Index Shenzhen Development 79 Shenzhen Merchant 79 of Thailand 45–6 US 55 bank(s) assets 311 agricultural 12 borrowing 324 central 53–4, 57, 59, 61, 84, 103, 141, 146, 178 commercial 51, 70, 72, 102, 120, 240, 302, 307, 311 full-licence 270 government-owned 14, 166 private sector owned 104 customers 55 DBS 57 deposits 115 development 12, 210 failures 55 foreign 12, 70, 196, 283 deposit-taking 80 liabilities 37 -origin 102, 288 government 349 government-owned 13–14 of Guangdong 13 Indian 102 investment 12, 194, 335 Islamic 210 Japanese 57 Joint stock commercial 80 lending 350 licensing 306 limited-licence 284 locally incorporated 283 merchant 12, 210, 284 nationalized 102 non-state 147 off-shore 261, 271 POS 57 private 103, 119–20, 152, 349 Privately owned 79 public-sector 120, 147, 335 restricted licence 288 savings 210 small to medium enterprise 12 specialized 70, 77, 79, 81, 119 commercial 61

state 12 commercial 80 owned 111 universal 70, 77, 80 zombie 241 banking central 77 commercial 70, 79, 132, 151 domestic 311 failure 54, 59 fragility 38, 40, 54–5, 296, 345 government owned 121 industry 311 infrastructure 196 investment 288 Islamic 198 model 55 mono 55 monopolistic 57 off shore 284, 311 oligopolistic 13, 57 organizations 54 private sector 14 reforms see reforms, banking sector, state-dominated 103 services 120 supervision 284, 336 system 283 traditional 311 zombie 152 bankruptcy(ies) 123 barrier to entry 9, 219, 331 base money 282 basket peg 144, 147 pegging 212 Basle II 335 Basle standards 335 Bill Clinton 54 bills commercial 121 of exchange 314 Treasury 111, 117 bloc, communist 5 board financial reform 37 Bombay Stock Exchange 103 bond (s) financial 83 foreign currency 70 government 177, 240, 309, 315–16

377

378

Liberalization and growth in Asia

government and enterprise 310 federal-fund 240 Treasury 83 Special Treasury 72 State enterprise 316 borrowing(s) central bank 302 commercial 85 bank 309 domestic 89, 124, 252, 302 and foreign 234 external 53 foreign 124, 252, 302, 309, 320 currency 44 public-sector 139, 148 short-term 43, 306 short-term foreign 307 Brady and Baker plan 255 Brazil 5 Bretton Woods Agreement 25 Bretton Woods period 144 British colonial rule 189 British democracy 352 British pound 271 British rule 266 Broad-based consensus 352 broad money (M2) 300 Brunei 198, 275 budget balance 309, 332 deficit(s) 66, 315, 332 surplus 315 budgetary allocation 221 law 302 Bumiputra 190, 196, 200–202 CAMEL 147, 152 Canada 38 capacities industrial and infrastructure 2 capacity indigenous 2 industrial 2, 94, 105, 139 industrial output 100 infrastructure and industrial 22 institutional 1 manufacturing 143 to mobilize savings non-oil exporting 146

real sector 177 for risk management 10 supervisory 112 capital account(s) 152 freedom 16 liberalization of 347 opening 142, 337 openness 142, 170, 332 accumulation 91, 124, 183, 215, 252, 278, 322 adequacy 111, 115, 118, 121, 335, 350–51 controls 184 , 351 flight 173 flows foreign, short-term 138 foreign 120, 142 formation 125, 136, 214, 338 gross domestic 125 inflows 138 movement 60, 296 outflows 138, 184 repatriation of 142 rule 220 shortage 170 capitalism, crony 13 capitalist 1 capitalist system 351 capitalization of equity markets 316 market 84 stock market 49 cash reserve requirement 320 Central bank banking independence 335–6 independence of 336 planning 30 and West Asian economies 352 Central American countries 171 centre international financial 12 Chaebols 64, 170, 173, 179–80, 185, 187, 330 Chiang Kai-shek in Taiwan 352 Chile 348, 351 Chilean safeguards 349 China Agriculture Bank of 80

Index Agriculture Development Bank of 79 Economic growth in 68 Export–Import Bank of 79 Insurance Regulatory Commission 82, 84 Interbank Offer Rate (CHIBOR) 84 International Trust and Investment Corporation 81 Investment Bank 80 People’s Bank of 70, 77, 85, 101, 354 People’s Construction Bank of 80 People’s Republic of 257 Securities Regulatory Commission 74 State Development Bank of 79 China’s accounting system 67 China’s attraction 260, 310 China’s declining growth 68 China’s experiment 95 China’s farm products 88 China’s open to the world policy 74 China’s private sector 20 China’s reserves 41 China’s unemployment rate 67 Chinese Communist Party 62 currency 92, 343 economy 62, 67 foreign joint ventures 83 free-market reforms 89 small businesses 32 State Council 88 type 351 Wall 282 City of London 353 civil disorder 137, 140 unrest 142 civilian-elected government 219 classical ideas 327 coalition-building 352 coalition of willing 58 Cold War 4 Cold War conflict 171 Cold War policies 161 Cold War rivalry 8 Cole and Slade 350 colonial domination 4 period 197 colonial rule 352

379

commodity boom 190, 197 commodity-based ear 191 common stocks 316 Communism 68 Communist China 63 control 68 preaching 2 propaganda 195 subversion 190 Communist China 330, 346 Communist coup 141 Communist era 55 companies bank-holding 194 Credit foncier 308–9, 311 finance see finance companies finance and securities 310–11 foreign 114 foreign-funded insurance 82 fund-management 84 Indian 114 insurance 82, 284 joint stock insurance 82 private 102 life insurance 311 mutual fund management 311 non-banking financial 119 public 314 securities 311 consumption government/public 66, 98, 161, 191, 225, 265, 267, 299 private 161, 191, 225, 265, 267 contagion 32–3, 36, 137, 143, 194 bath 153 theory 50 control(s) capital 50, 112 and exchange 189 outflow 103 on capital and currency 92 currency 50 currency-cum-capital 196 current account 328 exchange 101, 113, 146 foreign exchange 112, 303–4

380

Liberalization and growth in Asia

government 102 interest rate 346 regulatory 351 cooperatives rural credit 77, 80 urban credit 77, 80 corporate sector 177 corporations foreign trade 85 public 64 corporatization 265 corrupt bureaucracy 106 communist cadres 352 politicians and bureaucrats 225 corruption 103, 127, 129, 223 countries Central and Eastern European 63 Commonwealth 119 Communist 353 crisis-hit 58, 189, 343 developed 105 developing 54, 283 dictatorial 221 fast-developing 156 fast-growing developing 27 fast-track 28 Latin American 348 low-income 96 South Asian 48, 96 underdeveloped 5 war-ravaged 326 country low-income 171 resource-rich 189 CPF 273, 280 credit allocation 84 ceilings 240 controls 208 creation 117, 178, 267 domestic 46, 89 expansion(s) 178, 213 growth 309 rating 125, 224 agency 304, 316 regulations 347 short-term 77 targeting 6 union 15, 210

crisis Asian financial see Asian financial crisis banking 26 exchange-rate led 26 financial see financial crisis genesis of 32, 58 impact 41 multi factor-led 54 political 44, 107, 140, 149 cultural evolution 68–9 currency(ies) basket of 304, 319, 342 basket-peg 37, 44 black market for 142 board 51 in circulation 60 collapse 292 contagion 51 control 297 convertibility 30, 108, 272 crisis 60, 174, 295 baht 33 depreciation 35, 47, 266, 348 devaluation 354 exposures 123 free-floating 57 futures contracts 287 instability 293 options 287 overshooting 140, 297 overvalued 51 peg 346 regional 287 speculation 26, 189 speculative 44 speculators 48, 205, 355 stability of 115, 317 swap 287 trade 189 trade-in 287 trading 136 volatility 25 weakening 59 Currency Board 274 current account 290 balance(s) 300 deficit(s) 142, 320 opening 16, 337 surplus 67, 141, 300

Index transactions 304 current and capital account 332 cyclical downturns 220 Danaharta 201 Danamodal 201 Danareksa 146 debentures 316 debt bad 143 burden 140 domestic 333 to equity ratio see ratio, debt-to-equity financing 153 foreign 44, 48 short-term 128 instrument 304, 309 international 113 issues 285 private 47 problem 300 public 47, 143, 190 public and foreign 302 public-sector 139 restructuring 307 securities 312 servicing 11, 122, 228–9 short-term 156 sovereign 137, 190, 219 decentralization 79 declining export demand 223 foreign reserves 223 defence expenditure 11 deficit(s) balance of payments 319 budget(s) 241 current account 46, 107, 172, 302 financing 46 fiscal see fiscal deficits planed 302 public sector 302 trade 109, 166, 228, 296 trade and current account 98 demand, internal 63 democratic decision process 353 elections 330 institutions 353

processes 221 democratization 352 Deng Xiaoping 68, 329 deposit demand 40, 117, 283 fixed 283 insurance 52, 55, 307 management 55 non-fixed 283 short-term 6 deregulation(s) 219 devaluation(s) 107, 137 built-in 151 development bureaucracy 8 capital market 84, 179, 211 economic 20, 44 and social 26, 220 experiment 180 export-led 161 failures 3 fast-track 15 financial sector 195 free market based 2 industrial 149, 222 infrastructure 231 land-based 153 literature 159 long-term 325 model of 327 models for 325 money market 82 neoclassical 327 model of 7 outlay 223 plan 223 planning 4 property 194 social 325 and economic 4 socio-economic 132, 188 software for 337 strategy 337 sustainable 327 sustained 352 through liberalization 325 developmental process 354 directed credits 141, 147 disclosure(s) 115 discount houses 197

381

382

Liberalization and growth in Asia

dollar Australian 38, 59 US 51 domestic financial firms 12 funds 297 saving 317 double taxation 225 downsizing the government 223 Dr Mahathir of Malaysia 329 dual-listing 211 Dutch colonialist 152 Dutch firms 152 early reformers 7 East and South Asia Economies of 343 economic activities 265, 295, 327 activity 47, 58 affairs 352 agents 1, 330 aid 178 clout 353 conditions 47 disruptions 348 expansion 176, 196 factors 222 and financial policies 1 and financial recovery 352 forces 220 gains 325 games 353 growth 257 double-digit 7 management 176 mismanagement 224 performance 220 planning board 178 policy-making 342 prospects 224 prosperity 1, 222, 257 recession(s) 162, 196, 265 recovery 265 rent 58 restructuring 3, 173, 265 sanctions 219 schools 326 slowdown 265, 339 stability 189

stabilization 146 structure 297 transformation 139, 163 economies ailing 352 Asia Pacific 186 Asian 8 command 13, 20, 57, 327 to market 18 and mixed 14 communist 330 market 338 crisis-hit 25, 47, 51 developed 105 developing 55 East Asian 94–5, 178, 355 East and South Asia 210 emerging 51, 53, 283 export-based 132 fast-growing 56 fast growth 16, 58 fast-track 14, 17 free-market 9 tiger 14 free enterprise based 6 free-market 11–12, 14, 16–17, 20, 346, 353 industrializing 95 market 21 mixed 18, and command 14 newly industrializing 160 OECD Open 125 reforming 95 regional 50, 293 regional emerging 301 service-dominated 2 slow-growing 128 slow-growth 9, socialist 210 South Asian 95 Southeast Asian 98 tiger 7 transition 340 transitional 30, 328, 339, 353 economy agricultural 297 agriculture-based 315 Chinese 89

Index command 1, 61 completely controlled 221 developed 160 domestic 107 external 94 fast growing 173, 184 free market 12, 329 Indian 99 Indonesian 51, 132 Industrial 297, 315 industrialized 160 industrializing 195 industry-based 217 market-based 74 modern 99 newly industrializing 18 official 2 planned mixed 115 rapidly growing 296 tiger 7 totalitarian 7 transformation of the 190 transition market 61 transitional 1 efficiency allocation 13 in production 9 real sector investment 13 and resource allocation 8 efficient payment systems 261 electronic clearing system 316 Employees Provident Fund 49, 194 endemic inefficiencies 221 English model of banking 53 enterprise(s) central government owned 63 domestic 73, 85, 162 finance 166 government in India 7 loss-making state owned 73 money-lending 120 non-state 64 private 31–2, private sector owned 5 public 63, 106–7 risk management 102 shareholding 70

383

small to medium 166 and medium-sized 6, 64 state 66, 305 state-level 106 state-owned 31, 69, 73, 126, 331 taxation 73 entry of foreign firms 16 equity, negotiable 84 exchange of goods and services 6 over-the-counter 112 Exchange Equalization Fund 310 exchange rate clearing-house 152 devaluation 145 fixed 218, 343 instability 54, 143, 145, 154 intervention band 148 management 138, 145, 175–6 market 85 market-average 175 market-based 332 pegs 328 regime 143 stability 141 uncertainties 176 unified 86 vulnerable 25 expatriate Pakistanis 219 expenditure(s) on defence 135, 165, 225, 269 on education 135, 165, 193, 225, 269, 299 on health 99, 135, 193, 225, 269, 299 planned 302 export(s) competitiveness 348 expansion 302 Indian 100 non-oil 51 promotion 296 sector 104 exposure, foreign exchange 51 external indebtedness 302 resources 332 sector 295

384

Liberalization and growth in Asia

factor productivity 145, 341 falling export growth 326 fast-growth, Asian economies 1 Federal Reserve 35 Fight against terrorism 220 Fiji 216 finance companies 39, 46, 80, 194, 303, 310–11 non-performing 45 organization 282 financial activities 258 advisory 304 capacity 288 companies 39, 384 conditions 191 constraints 220 cooperation 119 corporation 331 crisis 39,43, 54, 109 deepening 13, 55, 123, 214, 250 depth 56 intermediation 124 difficulties 222 disaster 220 distress 47 efficiency 297, 335 fragility 1, 15, 36, 44, 51, 54, 57, 153, 309, 328, 345 indicators 134, 191, 226, 268 institution(s) 39, 51, 309, 311, 315 in China 81 failures 44 private-sector-based 197 intermediaries 58, 173 intermediation 283 intermediation ratio see ratio, financial liberalization 20, 55, 58, 60, 75, 132, 253, 258, 295 and internationalization 315 theory 345 management 15 markets 55 direct 55 liberalization 309 mismanagement 219 openness 57, 216 press 350 products 261

reforms see reforms, financial reforms, sequence of 163 resource limitation 223 sector restrictions 219 strength 40–41 suppression 221 system 46, 55 transformation 197 transactions 55, 75, 166, 216, 293 weakness 41 financially deep Indonesia 55 financing bond 83 capital 84 direct 84 inflationary 83 firms non-exporting domestic 109 foreign and domestic 109 state loss-making 31 and inefficient 3 owned 64 fiscal adjustment 46 agency 336 balance 132, 161, 191, 300 budget(s) 333 balance 334 deficit(s) 73, 83, 307, 312 discipline 53, 73, 221, 234, 241, 349 expansion 302 health 138, 213 imbalances 223 incentives 15 independence 296 management 302 measures 306 spending 46 surplus(es) 47, 52, 316 fixed capital formation 184, 260 float managed 174, 276 pegging-cum-managed 54 quasi-free 174 floating-rate notes 316 flow(s) capital 114, 291 financial globalization of 54

Index foreign capital 98, 297 foreign currency 219, 306 funds external 137 portfolio 290 short-term 27, 54 capital 303, 320 cash 53 of short-term money 59 trade and capital 6, 17, foreign assets 303 bank branches 311 bank representatives 311 capital flows 341 currencies 342 currency 143 accounts 303–4 reserves 333 trade 16 debt exposure 37 debt service 302 direct investment see investment, foreign exchange bourse 140, 142, 146 controls 10 interventions 281 market 306 openness 143 securities 308 sterilization 151 swap operation 122 trade-in 146 traders 150 trading 86 transaction 146, 152, 306, 311 investment 341 ownership 118, 296 reserves 28, 46 trade 287 Foreign Investment Fund 309 free trade 33 agreement 274 function, currency board 282 fundamentals 197 Gang of four 3 GATT 25, 301 GATT rules 166 Ghana 216 globalization 26, 352

385

government agencies 309 bail-out 140 Bond yield 247 bonds see bonds, government borrowing 213 budget 98, 160, 177, 262, 332, 349 bureaucrat-led 254 consumption 132 deficit 327 entities 265 expenditure 66, 349 finance 109 monopolies 330 non-communist 22 owned inefficient state enterprises 28 revenues 154, 213 securities 115, 117 spending 223 Government-directed development programme 161 government and economic agents 325 Government Housing Board 311, 313 Government Saving Bank 311 Great Britain 296 Great depression 59 Great leap forward 67–8 Green revolution 221 gross capital formation and domes saving 161 growth collapse 159 credit 43 engine of 9 export 44, 51 export-led 190, 196, 326, 340 export-led industrial 327 fast-track 186 modest 195 momentum 297 momentum for 342 money 115 money supply 66 population 67, 300 primary-produce-led 189 private sector-led 18, prospects 94 potential 287 sustainable 325 growth-seeking path 336

386

Liberalization and growth in Asia

guerrilla wars 353 Gulf War 39 Hong Kong banking system 40 Hong Kong dollar 319 Hong Kong government 354 Hong Kong share market 33 Hong Kong stock exchange 12 Hungary 350 IBRD 263 illiteracy 194 IMF 1, 24, 26, 32–5, 40, 43–7, 49–53, 58–60, 132, 136, 139 activities 148 advice 52, 152 aid 24 Article 8 115 assistance of 182, 301 bail-out 24, 51, 295 bail-out package 47, 49 bail-out plan 24, 46, 300 compliance process 234 conditions 234 directives 179 Executive Board 306 grants 33 instructions 174 intervention 166 , 205 moves 155 package 46 path 205 policies 50 prescriptions 47 program 32, 306–7 reconstruction schemes 24, 26, 35 requirement 234 rescue plan 144, 147 restructuring 316 restructuring plan 302, 310 restructuring schemes 167 sources 40 structural stabilization programme 222 suggestion 52 support 42 team of experts 163 type 141 IMF’s annual review 50 import duties 235, 296

substitution 94, 99–100, 104, 161, 221, 296, 326–7, 340 tariffs 10 income inequality 323 indebtedness 91, 124, 155, 183, 215, 222, 252, 322 independence, central bank 38, 337 independent body 336 central bank 223, 336, 346 central banker 315 judiciary 330, 337 India ICICI 118 Imperial Bank of 102, 110, 118 Industrial Credit and Investment Corporation 119 Industrial Development Bank of 118 Industrial Finance Corporation of 118 Insurance Corporation of 102 Life Insurance Corporation of 118 Reserve Bank of 102, 105, 109–10, 118, 120, 122 State Bank of 102, 110, 118 Stock exchanges in 103 Unit Trust of 102, 110, 120 India Overseas Bank 119 India, post-reform 104 India’s adoption of liberal policies 95 India’s bond market 114 India’s capital market 113 India’s financial system 118 India’s half century 94 India’s interest rate regime 118 India’s neighbours 128 India’s political elites 95 Indian atomic explosion 224 companies 114 economy 99 financial sector 103 firms 125 rupee 121 Indian Ocean 157 Indian-assisted 222 indicators financial and social 297, 300 openness 155 social 98–9, 135, 193, 227, 229, 269, 299

Index Indonesia Bank Restructuring Agency 52 Communist Party of 131 Debt Restructuring Agency 53 Indonesia’s President Suharto 34 Indonesia’s rupiah 33 Indonesian currency 140 economic transformation 139 economy 50–51, 143, 157 interest rates 42 liberalization 141 rupiah 38, 51 society 140 industrial era 191 focus 297 giant 257 output 190 policy 185 policy implementation 297 policy resolution 110 restructuring 159 transformation 297 industrialization 197, 302, 353 industry(ies) agro-based 221 cottage and heavy 14 electronic 44 export-oriented 235 heavy and chemical 162 manufacturing 222 primary processing 142 securities 84 small-scale 240 inefficient management 13 infant industry protection 330 mortality 99, 160, 163 inflation 19 double-digit 20 oil-price led 20 rate see rate, inflation single-digit 137, 224 target framework 308 targeting 148, 310 inflationary effect 203 experience 333 financing 46, 234

387

tendency 178 inflow(s) capital 20, 98, 136, 281 external 154 short-term 28 foreign capital 20, 153 non-merchandise 292 infrastructure(s) financing 196 improvement 342 inadequate 223 institution-building 330, 337 institutional barriers 174 framework 160 impediment 180 institutionalized 355 institutions asset-based 210 bank and financial 222 deposit-taking 166, 202, 210, 284 depository 79 educational 221–2 financial non-bank 140, 210 and non-financial 77 state-owned 11 foreign financial 12 non-bank financial 61, 71, 81, 261 instruments call money 121 financial 121 futures 123 money market 20, 121 risky money 121 short-term money-market 111 insurance advisory services 312 interest income 311 interest rate(s) ceiling 307 instability 196 liberalization of 317 management 177, 281 spread 209, 251, 319 suppression 280, 286 volatility of 314 intermediation agency 312 intermediation depth 155, 183, 215, 252, 278, 322

388

Liberalization and growth in Asia

internal balance 300 capital formation 186 international agencies 350 banks 334 business 287 competition 283, 330 data 39 financial activities 258 financial centers 257 financial transactions 270 Fisher Effect 151 linkages 258 manufacturing-cum-service center 259 meltdown 258 money center 286 organizations 310 players 334 positions 220 press 63 relations 220 reserves 310, 319 transactions 284 International Bank for settlement 152 intervention(s) deficit-financed 22 government 5 reduced 2 state 22 investment(s) capital 289 direct 290 domestic 89 domestic direct 290 domestic private 219 foreign direct 2, 15, 17, 48, 67, 85, 109, 143, 161, 303 foreign portfolio 27 infra structure 98 land-based 143, 342, 349 long-term capital 317 portfolio 59, 126, 184, 290 property-based 53 public and private sector 301 real 2 real sector 14 unproductive 342 unprofitable 346 investors

international portfolio 27 Islamic banks 245 financial system 245 profit 225 Jakarta stock exchange 146 Japan 353 Japan’s financial markets 27 Japan’s Sanyo securities 34 Kashmir, disputed territory 222 Karachi Stock Exchange 248 Kazhakstan 353 Keynesian deficit budgeting 122 Keynesian idea 327 Korea Development Institute 178 Export–Import Bank of 168 Housing Bank 168 Industrial Bank of 167 Stock Exchange 171 Korea’s economic development 159 Korea’s large trade dependence 176 Korean development experience 159 economy 162, 167, 185-6 experience 186 exports 170 government 162 people 160 share market 27 stock exchange 170, 173 War 161, 258, 296 Won 182 Kuala Lumpur Stock Exchange 48, 195, 197 Kuwait 257 labour force 145, 259 intensive 171 outputs 145 land ownership 303 law(s) bankruptcy 74, 337 company 74 enterprise 74 National security 84

Index Leading financiers 353 leasing 316 leasing business 316 legal framework 51, 69 structure 316 lenders foreign, short-term 38 lending connected 44, 57, 59 connected bank 36 multilateral 113 policy 80 prudential 55 related party 351 restrictions 117 rules related-party 282 short-term 309, 312 Letters of Intent 47 liberal policy mix 336 liberalization current account 109 domestic 176 early stage of 79 economic 90, 350 economic and financial 27, 89 exchange 147 exchange rate 140 experimental 4 external-oriented 160 financial see financial liberalization of financial sector 51, 147 gradual 348 economic 69 interest rate 154 and openness 8 policies 50, 137, 195, 328, 346 price 74 process 51, 295, 316, 346 sequencing of 327 trade 31 liberalization-led development 325 liberalized marketplace 316 LIBOR 248, 288 license Raj syndrome 327 life expectancy 99, 160, 163 liquid asset requirement 315 liquidity management 310

389

requirement 115 shortage 47, 52 squeeze 52 literacy rate(s) see rates, literacy loan(s) bad 39, 185 classification 306 defaults 223 foreign 36, 40, 113, 304 currency 36–7, 40, 138 exchange 81 interbank 314 long-term 6 margin 312 non-performing 14, 30, 36, 39–41, 44, 48–9, 59, 148, 241, 261 outstanding 14 policy 166, 177 quanzi 54 servicing agency 312 short-term 44–5 window 310 London inter-bank markets 197 macroeconomic imbalances 53 instability 68 management 69 stability 141 stabilization 241, 295 and structural adjustment 229 macro-finance 149 Malacca Straits 257 Malay Peninsula 257, 285 Malaysia Credit Guarantee Corporation of 198 Federation of 257 Industrial Bank of 198 Malaysia’s economy 47–8, 189 Malaysia’s reform 229 Malaysian currency 207 economy 275 government 275 Malaysian-origin companies 285 Malaysian ringgit 33, 319 Managed float 342 management bad bank 15 companies 308

390

Liberalization and growth in Asia

macroeconomic 60 prudential financial 2 Manhattan Island 326 Mao Zedong 18, 352 Marcos 352 market(s) Asian dollar and bond 287 based, incentives 216 black 63 bond 114, 179, 211, 308 and debentures 123 call options 272 call-money 101, 122 capital 114, 152 capitalization 248 commercial bills 315 commercial paper 315 corporate bond 180 debt 180, 285 deep money 122 emerging 114 exchange 123 forces 177 foreign exchange 67, 85, 101, 123 swap 71 forward 123, 287 futures 101, 123 government bond 101 government bond repurchase 309 Indian 114 interbank 79, 83, 211, 314 bond 72, 83 international capital 112 mechanism 202, 222 tax collection 14 money 121, 123, 314 money, capital and derivative 12 money and capital 12–13 overseas 316 participants 51 prices 219 pricing of capital assets 6 pricing process 221 primary for securities 82 protected 94 public debt 180 real estate collapse of 44

rediscounting 101 regional 50 repurchase 310 secondary for securities 83 securities 292 share 59, 180, 211, 290 signals 352 spot and forward 45 stock 113 swap 71, 320 transferable bills of exchange 315 treasury bill 315 market-based signals 327 Marxian economic experiment 4 Marxist-Leninist command economy model 4 Marxist-Leninist model 327 McKinnon 344, 348 McKinon’s work 347 mechanism supply control 77 Melbourne club 354 Mexican crisis see tequila crisis government 43 Mexico 26, 348 migrants, Chinese 3 Military dictatorship 224 Miracle see Asian Miracle Mixed economies of South Asia 14 modaraba 245 modaraba funds 244 model à la Soviet 67 American 54 capitalist 5 centralization 62 command-economy Marxist–Leninist 4 free-market 18 market-economy 1, 5, 61 interventionist 5 mixed and command 1 neoclassical development 5 liberal 1 open-economy 327, 330 socialist mixed economy 6

Index Soviet 5, 78, 352 State-planning Marxist–Leninist 5 monetary board 178 control(s) 43 depth 18, 20 effects of the crisis 40 expansion 178, 180, 234, 265 growth 213 intervention(s) 147, 151 management 89, 143, 177, 194, 241, 281 matters 282 policy 151, 281, 303 instrument(s) 147 ratio 267 target 148 money Broad 137 broking 288 brokerage firms 121 brokers 284, 315 and capital depth of 20 depth 19, 91, 124, 156, 183, 252, 278, 322 growth 137, 267 laundering 220 market depth 56, 125 instruments see instruments, market operations 200 transactions 10 multiplier 117 printing of 282 supply 281 monopolistic 57 monopolistic practices 186 moral hazard 55, 349 moral suasion 310 Multinational capital 353 multiple regime changes 219 multiplier function 282 Myanmar (Burma) 352 national accounts 134 investment fund 172 National Saving Bank 194

391

nationalization 222 negotiable certificate of deposits 151, 307 neoclassical economic principles of 9 New York 353 New Zealand 38 newly industrializing economies 18, 327 Nobel laureate 324 Non-bank(s) customers 284 entities 284 financial institutions (NBFIs) 284 non-chaebols 180 non-equity market 316 non-performing assets 308 North Korea 5, 61, 159 nuclear explosion 224 OECD club 128 OECD countries 26, 266 OECD economies 179 OECD group 160 OECD grouping 2 OECD, the rich-country club 329 official development assistance 178 Oil Crisis, second 296 dependence 138 exports 349 price(s) hike 207 shocks 295 oil-rich Brunei 275 OPEC 256 open market operations 77–8, 240, 309 openness capital account 9 external 16, 63 gradual 336 and liberalization 7 one sided 159 real-sector 11, 328, 332 tradition of 296 optimal path 350 optimal sequence 60 options over-the-counter 123 ownership rights 353 Oxford economists 162

392

Liberalization and growth in Asia

Pakistan Agricultural Development Bank of 244 Banking Council 237, 242 Credit Rating agency 236 government 232 Industrial Credit 244 Industrial Development Bank of 244 International Airlines 234 Investment Bond 238 Investment Corporation of 244 Islamic banking in 243 National Bank of 241 Railway 234 Security and Exchange Commission of 237 State Bank of 224 Telecommunications Company Limited 232 Pakistan’s central bank 240 Pakistan’s decision 224 Pakistan’s economic problems 11 Pakistan’s readiness 220 Pakistani investors 224 Paris Club 139 Park Chung Hee in South Korea 352 Paul Krugman 34, 341 payment clearing system 308 pejorative label 219 Philippine peso 33 Philippines economy 204 Pilgrim Fund Board 194 Pioneer industry status 11 planning central 326–7 central bank 101 communist central 61 policy 303 Plaza Accord 172, 176 Poland 350 policies bad 107 beggar-thy-neighbour 353 expansionary 139 external sector 303 foreign exchange 303 government 55 growth-promoting 326 illiberal 1

import-substitution see import substitution interventionist 3, 178, 202 inward-oriented 231 liberal 1, 8, 28, 95, 138, 196, 325–6, 329, 351–2 economic 328 of liberalization 57 macroeconomic 78 market-friendly 330 monetary 236 neoclassical 44 outward oriented 221 pro-capitalist 264 pro-growth 61, 220 pro-growth liberal 196 pro-growth reform 257 restrictive 235 sequencing of 51 supply-side 234 tariff reduction 15 taxation 138 policy central bank lending and rediscount 77 competition 330, 335, 337 contractionary 302 decisions 324 economic 326 economic-cum-financial 330 exchange rate 154, 242, 317 expansionary 208 fiscal 47 tight 52, 60 growth-promoting 329 industrial 185 Industrial Revolution 106 instrument 310 interest rate 154, 281, 308 monetary 333, 336 in China 75, 78 liberal 47 tight 46-7, 52, 66, 191 of nationalization 101 one-child 67 open external sector 320 pricing 281 responses 44 political changes 163 consensus 223

Index considerations 327 crisis see crisis, political culture 221 decision-making 336, 345 developments 352 dimensions 254 disorder 340 drama 38 and economic crisis 340 economy 330 elites 60, 222 factors 330 fallout 344 instability 32, 47, 50, 131, 219, 221 institution-building 221 oligarchy 153 parties 221 pro-US 222 process 153 risk 132 stability 221 strains 163 support 346 transformation 163 uncertainties 38 uncertainty 131, 139, 236 unrest 137, 153 population growth 161, 165, 193, 299 population growth rate see rate, population POSBank 279 post-Bretton Woods 189 post-independent period 189 post-September scenario 250 pound sterling 296, 317, 319 pre-reform growth rates 28 price(s) asset 105 competitive 288 distortions 221 equilibrium 330 limits 147 multitiered 61 oil 141 rigidities 75 risk 123 stability 310, 333 pricing

393

competitive 287 efficiency 103 printing money 83 private consumption 161 creditors 53 ownership 6, 330 incentives 10 sector incentives 141 private sector-led expansion 214 privatization 79, 219, 232 privatization commission 232 privatization programme 337 process China’s reform 90 democratic 219 liberalization 18 production efficiency 12 industry-based 160 Prognosticators 354 programs capacity building 14 promissory notes 307, 312 property bubbles 343 rights 337 protective tariffs 296 prudent behaviour 349 prudential banking rules 37 capacity 337 discipline 336, 338 financial management 2 management 336 norms 32, 350 oversight(s) 346 reform 15 regulation(s) 57, 78, 152, 156, 240, 297, 307, 309, 335, 345–6, 350–51 rule(s) 10 supervision 288, 334, 337 public finance 213 goods 213 ownership 61 saving 152 spending 69, 302 privatization 219

394

Liberalization and growth in Asia

Rajiv Gandhi 107 rate(s) bank 87, 116, 310 base 175 base lending 87, 181, 206, 277, 318 borrowing and lending 317 call money 116, 149–50, 181, 206, 247 central bank discount commercial lending 116 currency overshooting of 43 deposit 87, 117, 122, 307 depressed 57 and lending 288 to depository institutions 69 of depreciation 98, 154 discount 150, 163, 181, 206, 247, 318 enrolment 98 exchange 29–31, 42–52, 59, 87, 206, 277, 318 black market 85 dual 85 fixed 112 management 281 official 85 parallel market 85 unified 86 female participation 259 fixed exchange 34, 38, 41 growth long-term 98 inflation 136 inter-bank 175, 277 interest 29–31, 41 labour participation 259 lending 117, 149, 280, 286 literacy 137, 193, 227 market-clearing 286 money-market 318 official and open market 250 population growth 95, 137 profit 286 real interest 31 in Japan 27 repurchase 308 risk-free 117 tariff 88, 330 T-bill 150, 181, 206, 247 Time-deposit 181, 206, 277, 318

unemployment 67, 135, 165, 193, 227, 259, 269, 299–300 youth dependency 95 ratio(s) asset-liability 70 bank flouting reserve 283 capital adequacy 52, 60, 78, 307 capital fund to risk asset 3–5 capitalization 56–7 corporate capital 350 credit–deposit 236, 309 debt-service 48, 223, 229, 302 debt-servicing 190 debt-to-equity 37 financial intermediation 18, 20, 56, 214 financial interrelations 289 financial liberalization 182 foreign reserves to import 108, 145, 185, 204, 323 import liberalization 172 intermediation 19, 125 liquidity 78 loan-to-GDP 48 M3-to-GDP 289 price-earning 114 private consumption to GDP 297 reserve 121, 151 risk-asset 304 statutory liquidity 111 statutory reserve 200 real estate and property services 312 real sector opening 16 recession(s) 159 recessionary pressures 296 reform(s) badly-need current account 219 banking 31, 79, 142–3, 147, 153, 168, 341 capital market 31, 143, 200 comprehensive 143, 145, 154 currency 62 economic 69, 142 and financial sector 69 and social sector 328 exchange rate 98, 153, 174, 176 experimental 3 external sector 69 financial 109, 197, 297 sector 61, 69

Index fiscal 14–15, 64, 129, 332 foreign exchange market 320 free-market 89 IMF-led 141, 170 interest rate 82, 117, 182, 288, 300 317 large scale banking 26 liberal 21 market-economy 352 monetary 57, 153 much needed 220 price reducing 105 pricing 69, 104 prudential 15, 141 real and financial sector 16 real sector 10–12, 98 regulatory 322 sequencing of 328 social-sector 69 state-sector 73 structural 61–2, 174 tax 22, 98, 129, 147, 153, 168, 199 taxation 9, 337 reformers early 18–19, 29, 328, 339 hesitant 17, 29, 338–9 late 18–19 refugee problems 220 regime authoritarian 352 basket-peg 151 currency peg 44 exchange rate 310 fixed exchange rate 25, 41, 121, 317 floating-rate 250 free-float 38 managed exchange rate 286 managed-float exchange rate 46 military 222, 352 pegged exchange rate 310 region Asia Pacific 26 fast-growing 257 South Asian 95 regional opportunism 257 regulation(s) money laundering 220 prudential see prudential regulations regulatory

measures 322 structure 61 remittances 108, 223 repo 151 auctions 101 representative offices 79 repurchase agreements 173, 315 requirement capital adequacy 308 cash margin 238 cash reserve 238 liquidity 307 reserve(s) depletion of 219 foreign 46, 51 exchange 51, 61, 89 requirements 77, 117 statutory 43 resource allocation 6, 329 endowments 326 mobilization 221 poor 258 restricted licence 270 restrictions capital and currency 24 quantitative 88 restructuring corporate sector 52 debt 53, 307 financial sector 52, 306–7 plan 295 scheme 173 Retirement Mutual Fund 308 returns share price 116, 150, 181, 247 revenue collection 234 mechanism 223 oil-based 138 Richard Nixon 25 risk, operational 54 risk-management activities 258 rule (s) authoritarian 35, 352 by generals 222 lending 40 Maoist 82 military 221 one-party 63

395

396

Liberalization and growth in Asia

people-focused 352 prudent 44 prudential banking 37 socialist 231 ruling elites 220 ruling party 264 rural population 100 Russia 350 Russian occupation of Afghanistan 222 Russian type 351 Saddam 352 Samuelson 354 Samuelson’s paradigm 255 SARS virus 36, 267 saving(s) cooperatives 311 domestic 136 scheme(s) unemployment insurance 74 sector banking 52 and corporate 47 financial 29–31 and monetary 295 loss-making, state 63 non-financial 117 non-open financial 291 non-producer 10 non-productive 324 non-traded 132, 143, 262, 286 open trade 295 productive 289 property 40, 349 real 29–30 real and financial 2, 14 tertiary 100 securities commission 194, 197 companies 79 government 83 markets 79 private debt 37 shot-dated 197 transactions 308 Securities Exchange Commission 312, 316 securitization 191 semi-produced manufacturing 145

September 11 event(s) 220 sequence of financial liberalization 16 financial-sector reforms 346 optimal 350 sequencing appropriate 349 of financial sector process 346 optimal 347 order of 349, 351 proper 350 service civil 66 shocks economic and social 325 external 39 oil-price 105 SIMEX 273, 286 Singapore dollar 259, 275, 283, 319 economy 259, 292 Government Investment Corporation of 265 Inter Bank Offer Rate 286, 315 Monetary Authority of 270, 272 Small Industry Credit Guarantee Corporation 311, 313 Small Industry Finance Corporation 311, 313 soaring international debt 223 Social control 257 impact 340 indicators 135, 165 statistics 166 society poor and fragmented 132 socioeconomic improvement 166 South Asian countries 234 South China Sea 155, 257 South Korea 6, 348 Financial Reform Board of 37 South Korea’s development experience 178 South Korea’s external sector 17 South Korea’s liberalization 176, 184 South Korea’s output 159 South Korea’s rating 41

Index South Korean Economy 171 experience 154 firms 37 internet sources 39 stock market 34 won 34 Southeast Asia 196, 259 Southeast Asian countries 328 region 296 Soviet model 327, 352 speculative attack(s) 46, 48, 50 Sri Lanka 354 stable intermediation 283 stagflation 196, 212 stamp duties 311 stand-by agreement 306 State council 78, 80, 84 State-owned financial sector 28 statistic(s) financial and social 325 statutory reserve 205, 240 strategies interventionists 21 strategy Asia’s liberalization and growth 2 development 161 economic development history 4 export-led growth 6 free-market based 2 import substitution 5, 22 interventionist 2 liberal development 4 merger 46 missed economy 2 neoclassical 21 uniform 350 structure American banking 57 economic and financial 99, 295 pricing 69 subsidies export 88 government 63 Suharto in Indonesia 343 superpower hegemony 326 supervision of bank lending 349 sustainable path 336

397

system banking 81 currency board 283 dual exchange rate 85 legal and judicial 11 mono-banking 61–2, 75 two-tiered pricing 63 Taliban 255 targeted credits 141, 143, 151 tariff barriers 262 reduction(s) 147, 200, 337, 348 tax administration 337 business 73, 311 collection 73 mechanism 14 system 223 concession 296, 311 consumption 73 corporate 213 income 311 corporation 73 exemptions 272 holidays 15, 302 incentives 123 income 73, 129 personal 213 reductions 110 returns 234 structure 234 system 223 value-added 46, 73 tequila crisis 43, 47 Thai baht 32, 44, 304, 306, 310, 319, 324 Thai banks 311 Thai currency 42 Thai currency, basket pegged 25 Thai Danu Bank 45 Thai economy 295, 355 Thai export market 319 Thai finance companies 343 Thai government 345 Thai individuals 304 Thai interest rates 43 Thai National Banking Bureau 309 Thai Rating and Information service 305 Thai trade flows 324

398

Liberalization and growth in Asia

Thailand Bank of 304, 307 Central Bank of 309 Export–Import Bank of 305, 311, 313 Industrial Finance Corporation of 311, 313–14 Rating and Information Services 316 Stock Exchange of 312 Stock Exchange Market of 308 Thailand episode 24 Thailand’s attraction 310 Thailand’s financial markets 311 Thailand’s government 343 Thailand’s record 300 Thailand’s transformation 315 Thank financial system 342 theoretical predictions Tiananmen reformists 204 Tiananmen square 92, 341 incident 341 tiger economies 190 trade balance 180, 319 dependence 340 deregulation 223 external 94 legalized private 146 sector 221 surplus 67 union movement 264 transactions foreign exchange 86 trade-related 86 transfers inter-bank 77 transparency 163 treasury bill(s) 240 twin-deficits 228 two-tier regulatory system 201 unemployed labour force 142 unemployment, massive 219 unemployment rate see rate, unemployment unit trusts 316 United Engineers Malaysia 49 United Kingdom 197 urbanization 194 Uruguay 349 USAID economic aid package 222

US dollar 174, 287, 296, 301, 317, 319 US financial market 194 US-led coalition 222 Uzbekistan 353 value-added manufacturing 171 Venezuela 26 ventures Chinese-foreign joint 82 Vietnam 353–4 Vigorous liberalization 326 violence and civil disorder 94 wage reduction 265 Wall Street Journal 201 Wall Street lobby 27 war civil 326 Cold 94 warmongering 221 weighted average 175 Western economic thinging 5 withholding tax 271–2, 311 word community 220 recession 202 World Bank 1, 128, 176, 223, 245, 263, 306, 342 Trade center 254 War II 59, 96, 257, 275, 327 WTO 75, 301 China’s accession to 92 China’s membership to 67, 88–9 India’s membership to 128 membership 17 Yield, government bond 318 yuan 86 Zaibatsus and chaebols 334 Zakat 225 Zao Ziyang 64 Zia 352 zones economic 331 economic and technological development 75 export processing 11, 110–11, 235

Index free trade 61 free trading 16 open economic 74

399 special economic 69, 75, 111 special export 31 time 115