The Bubbles Economy and Overseas Borrowing and the Mis-Allocation of Resources in Asia

Learning from the Asian Currency Crisis—An Insider view from Thailand – by Surasak Nananukool…….. Page 1

Learning from the Asian Currency Crisis – An Insider View from Thailand

by Mr. Surasak Nananukool*

The Logics of the Asian Currency Crisis

If I were to explain the causes of the Asian currency crisis, I would narrow them down to three causes; namely, the bubble economy, the excessive overseas borrowing, and the rigid (fixed or non-flexible) exchange rate policy. These three mechanisms fed on to the mis-allocation of resources in Asia for over a time span of 10 years, and brought these countries to the brink of the crisis.

During this period, two other external factors also contributed to the on-set of the crisis. First, it was Japan who made available large sums of money to lend, at very low interest rate. But, should we blame Japan for providing cheap money to the world? I would not. Secondly, it was the US Dollar, which stayed undervalued during 1988 - mid1995, that gave the Asian countries, whose currencies were mostly tied to the dollars, an easy task of exporting their goods and services, which again provided a fault, but comforting feeling to these countries that they were very competitive in the world market. Since mid-1995, however, the value of the

*Mr. Surasak Nananukool is an adjunct professor at Thammasat University, Bangkok, Thailand. He is Chairman of the Master in Finance Program of Thammasat, and Director of the MBA Program of Sripratum University. He was former Deputy Finance Minister of Thailand and former Board Chairman, Communications Authority of Thailand. He graduated with a B.Sc. from the School of Industrial Management at Carnegie Mellon University in 1967, and a M.S. in Management from the Sloan School of Management at MIT in 1969.

dollar has appreciated greatly. Most Asian currencies were caught off guarded, and failed to dissociate themselves from the dollar. As a result, Asian currencies became over-valued, exports from these countries became less competitive, and these factors set up their currencies for speculative attacks. Can we blame the world currency market, and the G7’s central banks for coming up with such values for the dollar? I would think not. I would think that it was the responsibility of other currencies that decided to be tied to the dollar, to make their own judgment as to when the dollar was over- or under-valued, and it was their responsibility to make adjustment to the degree of rigidity that their currencies were tied to the dollar. This is the main duty of a currency board of a country. If a currency board can not learn from the environment of the currency market, and make appropriate adjustments, then it should abdicate such function to the market mechanism, i.e., to float the currency.

The Economics of the Bubble economy

The bubble economy is a term used to describe the process of gaining weight - as applied to the economy of a country. In management term, bubbles are inefficiencies. Bursting or reducing the bubbles is the mission of productivity.

A bubble is born when someone is able to sell something at a price well beyond the realm of making a reasonable profit. In Asia, and not exclusively, bubbles are abundance in land speculation, in the prices of housing, condominiums, office spaces, real estate, and golf courses. Bubbles are not evident in the salary and benefits of faculty members in finance and management in Asia, as so apparent in the USA, but bubbles are full blown in the pay scale of graduates who became executives in finance and securities firms. They, in turn, use their excessive purchasing power to create bubbles in the prices of automobiles and houses. As a well known fact, Asian are paying for the highest prices of these two necessities of good life.

Financial institutions in Asia have their own bubbles. They can borrow money from overseas at low interest rates, with an automatic protection from the rigid exchange rate policy of their governments, and lend at an unreasonable high rate in the domestic market.

Some types of industries with inherent high risk were able to borrow money only at a high interest rate in the domestic market, thereby were dictated by the market mechanism to limit their investments. But when the IPO markets were occasionally booming with funds from overseas, it was easy and attractive to seek equity funds at high share prices. As a result, several industries, such as telecommunications, energy sectors, and infrastructure projects were able to expand well beyond the means of the countries. Also, when the international money market were occasionally flooded with liquidity, the criteria for lending money would be slackened, and thus real estate companies were able to borrow overseas easily so as to invest in projects that were excessive.

The government also has its own bubbles. When the economy was booming due to excessive investments, the government would be collecting windfall value-added taxes and corporate and personal income taxes. Government infrastructure projects were privatized to the private sectors by collecting high concession fees for the government, which is another form of taxes. With all these excessive tax income, and even with a balanced budget scheme in place, the Thai government was spending more than its should. The concession taxes would be adding to the cost of utilities such as the gas price, the oil price, the electricity price, and the telecommunication price.

The rule of the game in a bubble economy is to pass on the bubbles, at an unreasonable higher profit, to the next person or the next buyer at the right time. The game is played both at the national and international levels. The end game is arrived when the last buyer get caught with the largest bubble imaginable – when the inefficiency is manifest, and the competitiveness is gone, then the bubble bursts. The game plan is not new, it is classic. In Thailand, there is a children game called “Morn Sorn Par”, and all over the world know the game called “Musical Chairs”.

Can We Manage the Bubble economy?

Can we prevent inefficiency? Can we prevent the bubble economy to form the next time around? Hardly. The process of gaining weight is very enjoyable, and the process of accumulating inefficiency is very rewarding to everyone involved – except the last one. Yes, the competition and the market mechanism will burst the bubbles eventually, but maybe too late to prevent a disaster.

Similarly, the process of borrowing money easily and/or gaining capital through IPO are very rewarding. And the subsequent processes of investing and buying capital goods are as enjoyable as going shopping. Can effective securities analysis for IPO purpose prevent these from recurring? I doubt it. When the capital markets are booming, all that investment bankers think about are fees and easy money.

One thing can stop the excessive borrowing from abroad though, it is the “floating exchange rate” scheme. When an industrialist borrowed dollars from abroad, he had to sell dollars for baht at a domestic commercial bank at a fixed rate of exchange, the bank would, in turn, sell dollars for baht to the central bank, again at a fixed rate. When many people were borrowing dollars from abroad, the central bank would be flooded with dollars. International reserve of a country would increase by this borrowed dollars, and they called it “borrowed reserve”. Over the last ten years, and especially over the last five years, Thailand has an exponential growth in this “borrowed reserve”. The Bank of Thailand should have questioned the rational of this “borrowed reserve”, and it should have refused to exchange baht for dollars at the fixed rate, i.e. , it should have floated the exchange rate and thereby discouraged further borrowings since five years ago.

On hind-sight, in addition to the floatation of the baht, the financial authority should have done many things, such as, slow down borrowings, restructure all borrowings to longer terms, and these have to be done for both public and private sectors. Thailand’s problem with the investment-saving gap had been known for a long time, the solution would be to slow down investment or slow down borrowing, and increase or extend the terms of savings.

A floatation of the baht would have slowed down investment and borrowing, but was not implemented by the Bank of Thailand.

On the Ministry of Finance - MOF’s side, over the past 5 years, tax revenues were abundant due to the bubble economy, therefore the Thai Government was able to reduce its own borrowings greatly. It had stopped issuing new bonds, and continued to redeem old bonds to the extent that the banking sector was short of government bonds all the time. The MOF put a cap on Government and state enterprise borrowing, and instructed all state enterprises to stop borrowing from abroad but borrow domestically instead. The MOF also set up a committee to control the foreign exchange exposure of the government sector. This Government’s self serving policy had created an ongoing tight money market, and forever high interest rate in the domestic market, which put a lot of pressure on the private sector to go and borrow from abroad. The Thai Government was giving the private sector a freehand to borrow abroad, with a guarantee of a fixed exchange rate. In fact, the Government did not know the foreign exchange exposure of the private sector. On hind sight, the Thai Government should have either required reports of all private foreign exchange exposure, or control the exposure through commercial banks, or put a cap on the total private borrowing from overseas. This it had not done; it did control the foreign exchange exposure of banks to 20% of their respective capital, but not the exposure of banks’ customers. In addition, when the MOF allowed the opening of BIBF facilities, foreign companies’ borrowings from foreign banks – which used to be booked outside Thailand, would be booked domestically, and the foreign exchange exposure of the country increased quickly.

On the saving side, Thailand’s private savings had increased on the corporate side, due to profit from real export and also from inflated profit of “bubble” businesses. Saving on the consumer side has been disappointing. Government saving was good due to tax collection from the bubble economy. On hind-sight, the issue for Thailand was not only to increase saving, but, more importantly, was to increase the stability of “borrowed saving”, i.e., to borrow long-term. If Thai did not or could not save more, we would have to use other people’s saving by borrowing. But since Thailand’s borrowings were mostly short-term, including the international reserve, there must be a system of extending the terms of the borrowings. Instead of redeeming all bonds, the Thai Government should have a program of long-term borrowings, with several objectives: first, borrow long-term an amount at least to cover its own debt, second, borrowed an amount to create long-tern stability in the financial system, and third, borrow long-term an amount to create a benchmark for long-term interest rate, so that the private sector, who has been trying to set up a long-term corporate bond market, would be able to start issuing long-term bonds or perpetual bonds. This was the area completely neglected by the Ministry of Finance.

How Some Asian Countries Handle the Crises

Each Asian country has its own set of problems. Most do have some forms of bubbles in their economies, except a few who don’t. A few do borrow a lot of money from abroad, but an equal number are very rich – they are net lenders. Many still peg their currencies to the dollar, but some have adjusted and devalued against the dollar, and some have floated freely. To understand and predict how Asian currencies behave, it is necessary to do factors analysis of each country. (See the attached table.)

Japan has a lot of bubbles in real estate and in banking. It chose to burst the bubbles slowly though. When a country chose to solve problems slowly, it gave the private sectors more time to adjust, hoping that, in the process, the private sectors can soften the impact. But Japan has the luxury to do this because it is a rich country with a lot of money to lend and a lot of international reserve, it has no overseas debt, it maintains a low interest rate policy for over a decade, its currency is already floating, and the Yen has devalued against the dollar. Most of all, Japan is still very competitive in most industries.

Singapore and Taiwan are two other countries that have survived the storm very well. Both do not have much of the bubbles as in other places. Singapore has very high current account surplus. Both have low overseas debt, have high international reserve, and both remain very competitive in most industries. Most of all, both have devalued their currencies slightly.

Hong Kong has a fixed exchange rate system and it has a big bubble in the real estate sector. But this may be misleading; although Hong Kong fixes its exchange rate, it occasionally floats its real estate prices – meaning it allows occasional crashes in real estate prices to burst the bubbles. Hong Kong has some, but low overseas debt, it has high international reserve, and it is very competitive.

China has a fixed exchange rate system but it has occasionally devalued it currency. It has big bubbles in the state enterprises, but it is in the process of restructuring these state enterprises. It also has a bubble in the real estate sector, but China is quick to point out that most empty office buildings belong to foreigners via foreign direct investment. China has moderate overseas debt. It has high international reserve, very high foreign direct investment, and high current account surplus. It is very competitive in many industries.

Combining Hong Kong and China, it is a strong country, and it will survive any speculative attack.

How the Bubbles Burst in Thailand and Korea

The crises in Korea and Thailand were unexpected. Korea is a NIC country. It was on the verge of promoting itself into a more-developed country status when the crisis struck. Thailand was a five-star emerging economy, the one that the IMF used to take on road-show as a good example of how to manage an emerging country. (see “Thailand: Adjusting to Success - Current Policy Issues”, IMF Occasional Paper No. 85, August 1991).

In fact, both countries were inefficient in many industries, and in state enterprises—they met the “bubbles criteria”.

Both have excessive overseas debt. Both have international reserve that were mostly “borrowed”. Both have low foreign direct investment. Korea fixed its exchange rate to the dollar; Thailand fixed its exchange rate to a basket of dollar-yen-mark. Both countries met the “high debt-fixed exchange rate” criteria.

When the situations were ripen, currency speculators attacked both currencies. Both countries were able to stand the attacks for a while, then they have to succumb to the attacks because of their inherent weaknesses.

The aftermath of the currency crisis started with the devaluation of the currency against the dollar. Corporations and banks that borrowed in dollars would take immediate substantial losses, because the loan obligations would be increased in proportion to the devaluation. Debt servicing also increased immediately. Therefore bubbles would start to burst in banks and financial institutions and in industries due to the devaluation factor alone.

In addition to that, the cost of importing raw materials, energy and machinery would increase greatly; import businesses would collapse. Out-bound tourism would be greatly reduced. The side effect of business contraction and failures would turn out to be a much lower tax collection by the government. Budget cuts would have to be made, thereby contributing to more economic contraction. Foreign lenders would panic and call back their money, thereby creating an avalanche of capital outflows. Banks would be calling back their loans. The liquidity of the whole country would dry up, forcing even the best of businesses to slow down their activities.

On the social side, massive unemployment will happen in many businesses and industries. Inflation will increase due to more expensive import content, including oil prices, energy cost and transport cost. Students studying abroad will be greatly hurt.