Commentary | 18 March 2014

1997 all over again? Not quite

1997 all over again? Not quite

Dr Stephen Grenville AO


18 March 2014

1997 all over again? Not quite

Dr Stephen Grenville AO


18 March 2014

Executive Summary

The decision by the U.S. Federal Reserve to taper its quantitative easing program late last year sent shivers through financial markets in emerging economies, with the so-called fragile five economies of Brazil, Turkey, South Africa, India and Indonesia identified as especially vulnerable. Few commentators could avoid drawing comparisons to the disastrous 1997-98 Asian financial crisis, with just a hint that it might happen again. But while history might rhyme, it rarely repeats: Despite some similarities between then and now, a recurrence is very unlikely.

It could be instructive, however, to consider today's circumstances in light of those turbulent years. In the heat of the Asian crisis, the key causes were identified as crony capitalism, macro-policy mistakes and failure to float exchange rates. With time, we now see that this was a faulty assessment. The 2008 global financial crisis demonstrated that imperfections in financial markets are ubiquitous. Inadequate financial-sector regulation, a key characteristic of the crisis, was hardly a failing unique to neophyte Asian bank regulators unable to discipline fast-growing financial sectors.

Striking similarities

The central factor in the 1997 crisis was excessive foreign capital inflows in the half-decade leading up to the crisis. Thailand, for example, received capital flows equal to 13% of its gross domestic product in 1996. These excessive flows could not be absorbed smoothly. They pushed up exchange rates to uncompetitive levels and fueled domestic asset-price booms in equities and property. Current account deficits opened up quickly, reflecting credit-stimulated economic activity and overvalued exchange rates. This was a house of cards waiting to collapse.

When foreign investors recognized this, capital flows made a sudden exit, flowing out faster than they had come in. Once the baht fell, foreign investors re-examined Indonesia and then South Korea, repeating the sudden reversal.

If volatile foreign capital was the key cause of financial turmoil in 1997, what about today? Capital flows to emerging economies are actually larger now, as a percentage of GDP of the recipients, than in the early 1990s. The "taper tantrum" last May, when Fed Chairman Ben Bernanke spooked markets by hinting at a QE taper, suggests that financial markets are just as volatile and just as ready to startle, even at events that are both minor and predictable. Markets still exhibit lemming-like behavior: Once some investors head for the exits, the rest follow in a rush, fearing to be caught by the currency collapse that they themselves are causing.

Even if the capital-flow environment is just as volatile, most emerging countries have learned their lesson. Scarred but battle-hardened, they are now better prepared. Their prudential supervisors have a better handle on what is going on in the financial sector, as well as better bank regulations and crisis management protocols to contain potential problems. They have more flexible exchange rates, with less chance of being caught out with an exchange rate well above equilibrium. They know, too, that they cannot let their budget deficits or external deficits get too big, even if this means sacrificing some growth.

There has also been a sea change in global thinking about capital flows. In 1997, the International Monetary Fund tried to have its Articles of Agreement changed to elevate free capital flows to the same status as free trade, an unambiguously desirable policy to be followed by all countries. It failed in this attempt, but there was still a powerful presumption at the IMF, as well as in academia and financial markets, that any form of constraint on capital flows was to be strongly condemned. This was taken to absurd extremes. When Indonesia tried to collect data on capital inflows during the 1990s, this was roundly condemned in markets as a form of capital control.

Thus it is not just emerging markets that are older and wiser. So too is the IMF. Without ever admitting to earlier error, the fund now recognizes the challenge to emerging economies from volatile capital flows. It accepts the case for capital flow management, although only as a last resort. Chile and Brazil now have a track record of capital flow management -- restricting inflows rather than crisis-control of outflows -- which should be judged a success.

Another aspect of the fund's involvement is the dramatic revision in the scale of its rescue operations. The amounts made available in 1997, even supplemented by bilateral assistance from neighboring countries, were simply too small to offset the sudden outflows. This time around, the IMF's assistance to European peripheral countries has been orders of magnitude larger.

Thus the fund's role in any new crisis can be expected to be much better matched to the task and, supplemented by countries' greater readiness to use capital controls, much more likely to succeed. These efforts would be backed up by post-1997 swap arrangements, including the Chiang Mai Initiative Multilateralization, or CMIM, and swap arrangements between central banks. None of these has yet been fully tested under crisis conditions, but the U.S. Fed swap proved particularly effective for South Korea in 2008.

The IMF has also learned that exchange rates do not always behave helpfully, moving smoothly in small adjustments from one equilibrium to the next. Thus, the fund now finds a place for foreign exchange intervention. In readiness, Asian economies have built up considerable war chests to counter overshooting in exchange markets.

Investor behavior key

That said, the main bulwark against a repeat will be competent policies on the part of the emerging economies. They understand, better than they did in 1997, that foreign financiers often have shallow knowledge of the countries they invest in. They rely on a few key indicators: external debt, current account, budget deficit, and, perhaps, inflation. If investors were consistent in their evaluation of these key indicators, avoiding capital reversals would be a simpler task. They are not. When they are feeling confident, or "risk on," they ignore warning indexes. When some trivial incident puts them uniformly in "risk-off" mode, they all bolt, each striving to stay ahead of the fleeing crowd.

Thus the task of policymakers in emerging economies is to maintain competent policies, within the judgmental indexes. In particular, they must publicize their performance so that the market can distinguish between their individual behavior and that of the aggregated mass of emerging economies. They need to establish a reputation for competence. To handle the risk-on/risk-off changes in perception, they need intervention capacity.

Over the past year, Indonesia has demonstrated this capacity. After being singled out as a member of the fragile five, Indonesia trimmed its budget deficit by reducing fuel subsidies, tweaked its interest rates higher, allowed the currency to depreciate significantly, allowed the slowing economy to improve the external deficit and backtracked on some of the economically dubious policies that have accompanied pre-election populism. External debt is quite low and currency mismatch, a major factor in 1997, is much more constrained. Asset prices are not in bubble territory. The reward of competent policy has been an exchange rate that has adjusted quite smoothly to a new and better equilibrium. Indonesia no longer merits inclusion in the fragile five. Similarly, India and Brazil have tweaked policies to reduce vulnerabilities.

If some emerging economies are establishing a reputation for competence, others seem not to care, or are constrained by political pressures from adopting the proper policies. Argentina seems to have learned nothing from its turbulent economic experience in recent decades. Turkey's politics is not helping its reputation. Thailand's political crisis would probably have already triggered capital outflows, were it not for the fact that it is running an external surplus, needing no new capital inflows to fund a deficit.

China is a special case. It seems invulnerable to an Asian-style crisis because its still-substantial surplus and gargantuan foreign reserves make capital flows irrelevant. Other forms of crisis are still possible -- everyone is keeping a close eye on credit growth and the shadow banking sector -- but unlimited policymaking powers and effective capital controls mean that China is immune from the sort of externally driven crisis that happened in 1997.

There could still be a crisis in countries lacking the discipline to stay within the performance criteria set by financial markets. But the inexorable contagion of 1997 would be prevented by the market's better ability to differentiate between countries.

This may be an improvement over 1997, but it is still not a perfect world. The market's criteria are crude and probably impose unnecessary constraints on recipient countries, which could act more boldly to grow more quickly. To move toward a better world, emerging economies have to attract more "patient" capital in the form of foreign direct investment and long-term bond holding. For this, their financial markets have to develop a range of assets that foreign financiers trust. With this done, emerging markets would be in a position to take the next step of consciously discouraging the volatile inflows that proved so damaging in 1997.

Stephen Grenville, a former deputy governor and board member of the Reserve Bank of Australia, is a visiting fellow at the Lowy Institute for International Policy in Sydney. He works as a consultant to the IMF, Asian Development Bank and World Bank on financial issues in East Asia.