ECONOMIC AND SOCIAL COMMISSION FOR ASIA AND THE PACIFIC
EMERGING ISSUES AND DEVELOPMENTS AT THE REGIONAL LEVEL: REGIONAL ECONOMIC COOPERATION
(Item 6 (a) of the provisional agenda)
IMPLICATIONS OF THE ASIAN ECONOMIC CRISIS FOR SUSTAINED INDUSTRIAL AND TECHNOLOGICAL DEVELOPMENT IN THE REGION
Note by the secretariat
1. After several decades of unprecedented economic and industrial growth in selected East and South-East Asian economies, a phenomenon often called the "Asian economic miracle", the miracle came to an abrupt end in mid-1997 with the collapse of the Thai currency, the baht. The consequent contagion effects throughout the region, and in fact even in other parts of the world, have prompted academics and policy makers to review the elements and factors traditionally believed to have contributed to this "miracle". The present document briefly reviews the events and factors which caused the crisis, with focus on three countries - Indonesia, the Republic of Korea and Thailand - and evaluates the implications of the crisis for industrial and technological development in those economies and the Asia-Pacific region as a whole. In so doing it will be demonstrated that though the various countries affected by the crisis differ significantly in various respects, there are basic similarities which explain to a large extent the nature and extent of the crisis. Identification of causes is important in order to prevent the easy but not necessarily correct conclusion that the East Asian model of economic development apparently did not work. Rather than one typical model, various approaches to economic development have been adopted in selected East Asian economies that all have their merits but have failed to adjust, in line with progressive economic development, to the demands imposed by ongoing and irrefutable globalization and global deregulation and liberalization of trade, investment and capital flows. The current crisis has revealed basic structural weaknesses in all economies which need urgent addressing. In the absence of appropriate policies aimed not only at short-term crisis management, but at realizing long-term structural change in the economic and social fundamentals on a sustainable basis, the so-called crisis may have lasting effects.
2. While there are differences among individual countries in East Asia, it is generally known that a sound policy mix of export-orientation of labour-intensive manufacturing products, high savings rates, a liberal attitude to foreign investment, high investment rates including investment in infrastructure and human resources development, together with robust world economic growth and political factors, accounted for the unprecedented economic growth rates in the various economies.
3. Unprecedented growth runs the risk of becoming unsustainable and that is exactly what happened in most East Asian countries. As the causes of the crisis have been analysed and discussed at length in various reports, the present document sums up the major factors which played a role in causing the crisis and accounted for its severity.
4. Credited with the original "East Asian economic miracle", governments grew self-indulgent as economic growth boosted the nations' wealth. The close interrelationships and connections between government and business were transformed from an asset to a liability and increasingly caused distortions in the implementation of policies and programmes.
5. While globalization urged the East Asian economies to liberalize and deregulate their financial sector, such liberalization was not sustained by prudential regulation and did not go far enough in most cases, resulting in a lack of transparency of business balance sheets and loan portfolios of financial institutions. Directed credit and policy-induced loans to mega-projects of doubtful financial viability contributed to market distortions and inefficiencies, while the effectiveness of central banks was undermined by political factors.
6. When it was evident that the "bubble" economy could no longer be sustained, governments played "ostrich" politics and failed to act properly and effectively, plagued by political squabbling and finger pointing at external forces, among them currency traders and speculators.
7. While East Asian economies have faced crisis situations before, such crises were limited in scope and to some extent caused by business cycles, which are inevitable in market economies. However, as long as external capital continued to flow in, governments grew complacent and failed to implement to a sufficient extent policies in the following areas, inter alia: environmentally sound technology transfer and development, efficient utilization of natural resources, upgrading of industrial and technological skills, development of small and medium-sized enterprises (SMEs) and forging linkages with large and foreign enterprises, thereby undermining competitiveness, which had been given an artificial boost by the declining dollar.
8. While the governments share much of the blame for the crisis, the private sector certainly does not escape responsibility. The private sector is normally driven by market forces to perform business operations efficiently. However, awash with capital, it engaged increasingly in high-risk and unproductive investments, especially in the real estate market, and expansion in stagnating export products like electronics, thus creating overcapacity. However, it did not hedge those risks, protected by the supposed currency pegs. Such expansion was often highly leveraged, resulting in unsustainable levels of corporate debt.
9. While domestic private businesses in East Asian economies engaged in high-risk and unproductive investment, the international banks and financial institutions continued high-risk lending to those businesses, supposing that government guarantees would ensure the safety of their loans.
10. While the International Monetary Fund (IMF) and the World Bank have maintained that they had warned countries like Thailand about the unsustainability of the current account and currency peg and the instability of the financial sector as early as 1993, those and other institutions failed to predict the severity of the crisis, and their policy recommendations have had mixed results.
11. Economic and financial transactions are undertaken by humans and are therefore dependent on human behaviour, which is by nature very erratic. The onset of the crisis caused a panic followed by a "herd mentality", which may have caused the crisis to be more severe than was warranted by existing economic fundamentals.
12. Implications of the financial crisis for industrial and technological development and for economic development in general in Asia and the Pacific are many, though different countries are affected to different extents. No doubt the countries most affected by the crisis are the countries where the crisis hit directly, and it is there that both short-term and long-term impacts will be felt most. However, it is difficult to evaluate to what extent future difficulties can be blamed on the crisis alone and to what extent such difficulties can be blamed on the lack of appropriate policies to strengthen and sustain international competitiveness even if the crisis had not occurred. This said, it is also important to point out that not all implications are necessarily bad. The crisis in itself may contribute to greater awareness of the need for such policies and for ending or at least curbing "crony" capitalism and government corruption. The crisis may even lead to greater democracy and to cleaner and better government as more transparency of both government and private sector operations is called for. Recent developments in Indonesia have proved that point. The crisis may also prompt industry to restructure in order to boost efficiency and competitiveness, although the power and actions of national labour unions may well undermine those efforts. There are also signs that the long neglected agricultural sector is receiving more deserved attention, which would be to the long-term benefit of the whole economy. However, to what extent such positive impacts would be sustainable and how long it would take before governments are tempted to return to their old habits remains to be seen. After all, power corrupts and money lures. Nevertheless, it is probably safe to say that the financial crisis has provided a clear wake-up call to government and the private sector and the people at large in the crisis countries, while countries in the region not immediately affected by the crisis can draw lessons from the experiences. However, in this context it is important that the right conclusions are drawn and that the wrong message is not conveyed. For this, a thorough understanding of the roots and causes of the crisis is necessary.
13. Economically speaking, the crisis will have varying effects on different sectors. Traditional export sectors may receive a boost from the devalued currencies while advanced export sectors relying on imported parts and components will suffer. For instance, it is estimated that Thai exports contain on average 60 per cent imported components and raw materials.(1) Exports are further hampered by the general rise in the domestic price level caused by currency devaluation and skyrocketing business costs, while rising interest rates and capital shortages make it difficult to obtain credit for exports. These effects may well wipe out any benefit from the devaluation. The net impact on exports is therefore not altogether clear in the crisis economies. Exports in the non-crisis countries may also suffer as they lose competitiveness to the crisis countries. Thus, steel exports in Taiwan Province of China, an economy not hit by the crisis, have been hurt as a result of cheap exports of Korean steel. Other traditional Taiwanese export items such as electronics and refining have been hurt for the same reasons. On the other hand, this loss of competitiveness may force industry to take active measures to strengthen its competitiveness from a relative position of strength which will give it a competitive advantage over industry in the crisis countries, provided it is supported by an understanding and supportive government.
14. Industries catering to domestic demand will suffer as domestic demand will drop significantly owing to high interest rates and inflation and income loss caused by massive lay-offs and salary cuts. In Indonesia, massive price rises of essentials (and therefore relatively price-inelastic goods) such as gasoline by 71 per cent and other goods such as kerosene, electricity, and bus, train and ferry tickets, and so forth, came into effect virtually overnight in early May 1998. As a result, demand for non-essential goods and related industrial goods such as automobiles and car parts and accessories will drop significantly with dire consequences not only for large companies but also for SMEs, resulting in massive unemployment. According to a report of the Economist Intelligence Unit, auto sales in Asia were expected to fall by 37 per cent in 1998 in the face of massive overcapacity. Other industries also suffered as capital for new investment was difficult to obtain from virtually and actually bankrupt financial institutions coping with huge debts and losses, and even working capital requirements were not met. Added to this are the huge foreign currency debts of private sector industry, which are short-term in nature and are difficult to roll over. This is so not only in manufacturing but particularly in construction and real estate. In the longer run, however, the most efficient and capable industries will emerge as survivors and both the manufacturing and real estate sectors will be able to resume operations in much better shape and with a clean slate. Industries catering to domestic demand in non-crisis countries in the region are also likely to suffer in the short run as cheaper import substitutes from neighbouring crisis countries eat away at their markets. While governments can respond by imposing import restrictions (which may lead to World Trade Organization (WTO) or regional trade agreement violations), such competition may on the other hand impel domestic industry in the non-crisis countries to implement measures to strengthen its national competitiveness.
15. The impacts on trade and tourism in the crisis economies are also expected to be significant as a substantial portion of trade is intraregional and a large portion of tourism is from other countries in the region. Such negative effects are only partially offset by increased exports of traditional items to extraregional countries and tourism from such countries seeking bargains in the crisis economies. The same can be said for investment. While domestic investment will suffer because of large debts and scarcity of capital, FDI will not particularly increase. The boost in FDI is possible only if urgent bottlenecks in economic development are addressed, which are problems not directly related to the crisis. In fact, surveys have indicated that existing foreign investors are not too much put off by the crisis, while export-oriented FDI could actually benefit, depending on the extent of its import requirements. As a whole, FDI declined only modestly in the five crisis countries.(2) Driven by market share and the need for a global presence to be internationally competitive, many transnational corporations (TNCs) have actually started to acquire domestic companies in selected Asian economies available at bargain prices owing to the currency devaluations. Together with the stringent conditions imposed by IMF, this could lead to nationalism and a general backlash towards foreigners. In other countries, like Indonesia for instance, political instability following the crisis will most certainly lead to a significant drop in FDI and tourism to those countries, while the increasing trend in xenophobia may also undermine the interest of foreign investors, who will divert investment away to non-crisis countries in the region, such as China and Viet Nam.
16. Another way of looking at the potential impacts on economic growth of the crisis is to assess what impacts the crisis has on the two most important production factors in industry: labour and capital. As massive lay-offs are expected, the supply of labour is expected to increase substantially. Countries with flexible labour regimes may therefore experience a drop in the wage level, restoring competitiveness. However, social legislation, including minimum wage provisions, may prevent such adaptations. The increase in supply of labour, even if it is cheaper, may not lead to substantial increases in demand either, since domestic industry is not in a position to afford labour expansion right now (though in the future it may) and foreign companies require higher skills which the laid-off work force may not possess. Thus, while the supply of labour increases in quantitative terms, it does not do so in qualitative terms, at least not in the short run. Hence, the great importance of human resources development policies to boost international competitiveness, which the crisis has now revealed and emphasized. In the meantime, countries are resorting to ousting expatriate labour to free jobs for local labour, often in a not too humane way. In the longer run, however, in the absence of effective human resources development policies, countries like Thailand may resume importing skilled labour from overseas in order to sustain, or rather restore, national competitiveness.
17. The impacts on demand for and supply of capital are probably the most severe. As the domestic private sectors are beset by huge debts, domestic financial institutions are closing doors because of the large quantity of non-performing loans, and interest rates are increased to stem the capital outflows, the supply of capital is severely constrained while the demand for capital to service debts is enormous. However, as IMF, export banks in Japan and the United States of America and multilateral financial institutions like the World Bank and the Asian Development Bank have been forthcoming with huge loans to boost domestic external reserves and capital for exports, the immediate pains are somewhat relieved. Nevertheless, it is clear that such assistance is dressing the wound but not curing it. And it may not prevent the wounds from reopening. Keeping interest rates at high levels is an IMF-imposed condition for assistance and is meant to attract external private capital and dampen domestic demand for capital in the absence of adequate supply. However, as foreign investors are wary of East Asia for the time being, they may not be tempted to come back in a big way while a continuation of the high interest situation will further depress the economy and force otherwise healthy companies into bankruptcy, leading to higher levels of unemployment, and so forth.
18. The future scenario in developing Asia and the Pacific for sustained economic development in general and industrial and technological development in particular is difficult to outline exactly as much depends on future trends in the region and in the world economy, which in turn depend on the answer to questions such as:
(a) Will governments in the region have learnt their lesson, clean up shop and implement the necessary policies?
(b) Will countries look inward as a response to the crisis to protect themselves from similar external shocks in the future, or will they continue to liberalize their economies in a sustainable manner?
(c) Will the crisis continue to worsen in Asia and will it bring about social upheaval and unrest?
(d) Will the Japanese economy collapse or will the government be able to clean up the banking sector (and the rest of the economy)?
(e) Will Hong Kong, China be forced to abandon the peg of its currency with the United States dollar and will the Government of China finally be forced to devalue the yuan renminbi?
(f) Will the boom in the United States continue and for how long?
(g) Will the introduction of the euro in Europe continue to be smooth or will rigid labour policies wreak havoc?
19. While it is very difficult to predict the answers to these questions, the outcomes have far-reaching consequences. In particular, a further decline of the Japanese economy may start another round of currency devaluations and mounting debt, while drying up Japanese official development assistance (ODA) and investment capital. Despite recent pledges of $30 billion in aid to South-East Asia and a domestic economic stimulus plan of 23.9 trillion yen, the most pressing problem is internal banking reform, as nothing would help the crisis economies better than recovery in Japan. According to official estimates, Japanese banks hold at least 87.5 trillion yen ($650 billion) in bad loans, although the figure may be as high as $840 billion. The recent bankruptcy of a major Chinese investment trust has shown that not all is right in the Chinese economy either and that more financial trouble is ahead. Even in a robust economy such as that of the United States, some signs that the economic boom there may end in 1999 have already appeared. The recent crisis in Brazil will certainly affect the United States, which would in turn affect export growth in East Asia. Generally speaking, in the short term the region can expect a major slowdown in economic growth and even contraction of the economy in the wake of a severe capital shortage. Full recovery is not expected before three to five years have passed. It should not be forgotten that between 1996 and the second half of 1997, capital movements to Asia swung from annual inflows of almost $100 billion to outflows of the same size, while international bank loans to non-banks in Asia (excluding Japan) fell by more than $9 billion in the final quarter of 1997, the largest drop ever.(3) It will certainly take time before confidence among international investors and financial institutions will have returned and the capital outflow will have reversed to pre-crisis levels.
20. For the most affected countries in East Asia the following brief observations can be made.
21. The situation in Indonesia is not expected to improve soon. Reforms undertaken so far include further bank restructuring, privatization, amendments to outdated bankruptcy laws and increased monitoring of reforms on a daily basis. Some large capital- and import-intensive infrastructure projects have been postponed and need to be re-evaluated in the light of the changing political situation.
22. Inflation is expected to decline from 78 per cent in 1998 to around 20 per cent in 1999, still high as printing money is the only way to provide liquidity. Non-performing loans amount to around 62 per cent of total bank loans, while total corporate debt is still at $80 billion. The Indonesian economy was expected to contract by around 18 per cent in 1998, according to leading international investment banks. Falling industrial output, in particular in the textile and garment industries, has cut demand for imported capital and intermediate goods, and the contraction will be intensified by shortages of working capital and trade credit, and the low level of reserves. The automobile and publishing industries have also been particularly hit, facing soaring prices for imported inputs and lagging domestic demand. Also the shipping industry, facing stiff international safety regulations, cannot afford to import the necessary spare parts. But as the basic endowment of Indonesia remains unchanged, domestic demand will ultimately recover early in the next century along with external demand for the country's export products other than oil and gas.
23. The situation in the Republic of Korea is marginally better than in the other crisis countries, owing to its rather higher development level and therefore relatively stronger economy and better wherewithal to weather the storm. Much of the debt is owed by banks, which makes rescheduling relatively easier. Along with substantive banking reforms a recent agreement to reschedule short-term debt in the banking sector has also helped to shore up the financial system. Non-performing loans of the banking sector amount to one third of total loans. In May 1998, industrial production had dropped by 10 per cent from a year earlier, while capacity utilization in the manufacturing sector fell to just over 65 per cent from 81 per cent a year earlier. Foreign investment has now been eased. The economy is forecasted to contract by 6 per cent, but growth will be restored in the year 2000.
24. Much depends on the extent to which the Government succeeds in reining in the chaebols. Just 10 big chaebols account for 19 per cent of all bank loans, up from 17 per cent in 1996. The smallest will be most likely to reform, while the giant export-oriented ones will resist reform much longer. Continued resistance to reform may lead to their ultimate decline. The Government and IMF demand that they slash their debt levels to 200 per cent of equity by the end of 1999 from the current 400 per cent (compared with 70 per cent in the United States) and reveal their cross-subsidiary loan guarantee schemes the following year. In the meantime, the SME sector, in particular high-tech firms, will be able to attract large amounts of venture capital and is expected to weaken the economy's dependence on chaebol performance only.
25. While Malaysia has so far been spared the same fate as Indonesia, Thailand and the Republic of Korea, its short- to medium-term prospects are not too good either. The country's economy has received a severe battering. As the currency has depreciated by more than 60 per cent since 1996, exports have received a boost but import costs have also soared. As Malaysia's industry relies on imported raw materials and parts and components to a large extent, the sector is expected to go into a protracted slump, in particular the electronics sector, which also faces a slump in world demand and increased competition from neighbouring countries. However, a recovery in the world semi-conductor market has offset some of the pain. The national car industry, the Proton, is also expected to face a slump in demand despite its relative price advantage. Malaysian Airlines has been forced to postpone its latest aircraft orders. The Government has adopted an austerity programme, cutting spending by at least 18 per cent while deferring some large-scale infrastructure projects. Bankruptcies have skyrocketed since mid-1997 and the end is not yet in sight, in particular as the Government is reluctant to let firms and banks fail. Interest rates have been only moderately raised while money is printed to keep the economy afloat, boosting inflation, which will in turn tighten fiscal and monetary policy.
26. Like the other crisis economies, the financial sector is inherently unstable with a concentration of loans in non-productive assets. The loan/gross domestic product (GDP) ratio in Malaysia is about 170 per cent, the highest in the region. Over 30 per cent of these loans have gone to the broad property sector consisting of housing, real estate and construction, causing a similar bubble which is expected to burst any time. However, as yet the relatively low non-performing loan ratio (less than 5 per cent), better provisioning, lower levels of external financing and better banking supervision make the Malaysian financial sector better able to withstand shocks while the Government is encouraging a consolidation in the banking sector through mergers. Although FDI to Malaysia has markedly declined, it was expected to pick up by the end of 1998 as the fundamentals of the Malaysian economy were basically sound. However, the recently implemented capital controls may well further undermine FDI inflows while creating an illusion of stability. The economy was forecasted to decline by 6 per cent in 1998 but may recover in 1999.
27. The Philippines also witnessed a sharp decline in its currency and has faced the impact of the financial crisis. In particular industry has been hit. As in the other countries, the most important export industries derive a large part of their value from imports. Thus, computer chips and microprocessors account for nearly 50 per cent of exports, but nearly 70 per cent of their value is derived from imported components. Another important export industry, garments, consists of 70 per cent imported textiles. Companies severely hit by the crisis include the National Power Corporation, Petron (oil refinery), Philippine Airlines and the beer industry because of declining demand. Philippine Airlines was forced to close in September 1998 as no compromise with unions could be reached. Generally, the Philippines has been able to weather the storm well with timely government action. Though the country also witnessed large inflows of short-term capital, those inflows came later and at lower levels and could be better absorbed. The real estate does not suffer from speculation and oversupply and the government budget has been balanced over the past five years, though surpluses have been falling and the public sector as a whole was in deficit in 1998. The economy was forecasted to decline by a little over 1 per cent in 1998.
28. The situation in Thailand is expected to improve slowly. However, more companies are expected to go bankrupt and more lay-offs can therefore be expected. The situation has worsened as most debt is owed by individual corporations, which makes rescheduling difficult. While there are signs that the economy is recovering, this may lead to complacency and stall much-needed reforms. Already, the implementation of bankruptcy and foreclosure laws and alien business laws has been hampered. It is unlikely that the much-needed recapitalization of the banking sector will be completed by the middle of 1999, as is the intention of the Government, while a loan auction in December 1997, reputedly the world's largest one-day sale, was considered a failure. Non-performing loans currently amount to 48 per cent of total loans.
29. The manufacturing production index showed output contracting year on year by almost 11 per cent in December 1997. Overall, industrial output fell by 0.7 per cent in 1997 and was expected to fall an additional 1.5 per cent in 1998. It may take at least three years before existing capacity is fully reabsorbed. Selected industries, in particular such subsectors as cement, steel and automobiles, witnessed substantial declines in sales in 1998. Sales dropped by over 38 per cent in the automobile industry in 1997 with a further expected decline of 30 to 40 per cent in 1998. Import-intensive industries such as canned seafood and the electronics industry, which accounts for 30 per cent of total manufactured export earnings with an import content ranging from 80 to 100 per cent, have also contracted sharply. Production costs in both sectors have risen by about 35 per cent as a result of the baht's depreciation. Computers and parts have registered a 25 to 30 per cent rise in input costs, jewellery 20 to 25 per cent, textiles 15 to 17 per cent, and footwear 15 per cent. Some export-oriented industries such as textiles, food, petroleum products and integrated circuits have gained competitiveness as a result of the baht's depreciation, but this gain is artificial and may prevent much-needed upgrading in technology and skills.
30. While the Government has earmarked $1.2 billion for the restructuring of industry, financed by international organizations led by the World Bank, only 1.3 per cent of that amount is set aside for skills development. The economy as a whole is expected to contract by 7 per cent. However, exports have rebounded, the baht has stabilized and current account surpluses have returned, paving the way for a full-fledged recovery in the year 2000 provided the Government continues the needed reforms.
31. The crisis has revealed many weaknesses and flaws in the economy, in industry, in the financial sector, in governance and the political system as a whole, in fact, in the whole way a country and its economy has been managed. As a result, policy measures are easy to formulate and in fact a host of policy measures have already been recommended by international institutions and implemented by national governments, in particular with regard to crisis management. However, for long-term sustainable industrial and technological development the imperative need has arisen to formulate and implement policies that would restore and strengthen individual countries' national competitive advantages based on increased industrial productivities, which would be private sector led with proper government guidance and a strong domestic financial sector. That need was evidenced by two recent independent reports issued, respectively, by the International Labour Office (ILO) and the Brooker Group, revealing that the failure of Thai industry to increase productivity had made Thai exports less competitive than those of its regional neighbours rather than other factors such as a rise in the minimum wage.(4)
32. In particular, the Commission may wish to discuss the following policy guidelines:
(a) Continuance of sustained privatization, deregulation and liberalization of private sector operations and establishments, trade and investment and the financial sector while adopting prudential regulation and supervision of financial institutions and markets, including strengthening of central banks and improving their autonomy, elimination of insolvent financial institutions, debt restructuring of potentially viable financial institutions and private enterprises, adoption of or strengthening of bankruptcy laws and expanded foreign participation in the various economies;
(b) Upgrading of factor conditions, in particular physical and social infrastructure, technology and research and development, and skills development on a priority basis in cooperation with the private sector; ensuring linkages among research institutions, universities and vocational training institutions and private sector industry;
(c) Development of support institutions and environment with focus on strengthening the legal framework and financial system and eliminating moral hazards and adverse selection; reliance on market forces as much as possible;
(d) Support of industrial restructuring towards higher value-added and technology-intensive industries; development of supporting and related industries, in particular SMEs, and forging backward and forward linkages among SMEs and between SMEs and large companies, both domestic and foreign;
(e) Encouragement of best business practices and a culture of hard work, outward business orientation, risk reduction through appropriate hedging techniques and fair competition, including a level playing field for both domestic and foreign companies.
33. The Commission may also wish to deliberate on some of the regional actions, especially in promoting economic cooperation among countries, so that such crises are avoided in the coming century.
1. See "Asia commercial overview - 17 April 1998", United States Department of Commerce, STAT-USA/Internet Service.
2. United Nations Conference on Trade and Development, World Investment Report 1998: Trends and Determinants, United Nations, New York and Geneva, 1998.
3. Bank for International Settlements, 68th Annual Report, 1 April 1997-31 March 1998, Basel, 8 June 1998.
4. International Labour Office, "Wage Policy and Labour Competitiveness in Thailand", December 1998.