Mr Lee examines some of the major themes for strengthening
the global financial system against the background of the financial crisis in Asia
Opening address by Mr Lee Hsien Loong, Chairman of the Board of Directors of The Monetary
Authority of Singapore and Deputy Prime Minister at the fifth meeting of Finance and Central Bank
deputies on the Manila Framework at Shangri-La Hotel on 29 August 1999.
* * *
Introduction
I am happy to address the Manila Framework Group.
Prospects for the region have brightened considerably since your inaugural gathering in November
1997, in the depths of the regional economic turmoil. The worst of the crisis is now well past. Most of
the crisis-countries are seeing growth again. Investor sentiment, while edgy, is generally upbeat.
Equity markets have surged, some beyond pre-crisis levels. Currencies have stabilised; indeed some
governments have had to temper the appreciation of their currencies.
But financial markets are notorious for their short-term memories. An upturn does not necessarily
mean that basic problems have been solved. It remains important for financial regulators and
policymakers to remain mindful of the lessons thrown up by the crisis and to tackle them before
another storm blows up.
No two Asian economies are the same. During the crisis, hardly any were spared the panic and
contagion. But how each was struck, how external problems interacted with internal weaknesses and
how each government responded, varied from country to country. These diverse experiences offer rich
materials for study and contrast. Lessons learnt at great cost of human suffering and political upheaval
may help us formulate sounder policies for the future. A thorough comparative study would occupy
several PhD theses. But a brief review of what happened in each country will be a useful basis for
examining some of the major themes for strengthening the global financial system.
Asian crisis - what happened
Thailand
The crisis began in Thailand after a long boom. The establishment of the Bangkok International
Banking Facility or BIBF and the implicit guarantee of a fixed exchange rate encouraged unhedged
borrowing in foreign currency by Thai companies. This led to a build-up of external debt and an asset
bubble.
As the Thai economy weakened, the balance of payments deteriorated and the baht came under
pressure. Attempts to defend the baht were costly and ultimately unsuccessful. When the baht was
finally allowed to weaken, its sharp fall triggered the collapse of many Thai corporations as well as the
banking system. The Thai economy contracted sharply.
The aftershocks of the Thai problem affected many other Asian economies. Confidence in the whole
region was shaken. Both domestic residents and foreign investors alike rushed to hedge or reduce their
exposure to the region.
Malaysia
Malaysia was among the next to be affected. Its economy was fundamentally sound although there
were concerns over a property boom and over investment in infrastructure. An acute loss of
confidence, partially prompted by Thailand's problems, led to a sell-off of Malaysian shares and the
ringgit. The stock market and exchange rate crashed.
Unlike other countries, Malaysia did not have excessive external borrowing. However, domestic
borrowing was very high as banks had lent large sums, often against share collateral and to large
property projects. The crash exposed these weaknesses in the private sector. On 1 September 1998,
Malaysia decided to impose capital controls.
Indonesia
Indonesia was also believed to be fundamentally sound, even well after the initial outbreak of the
regional currency turmoil. In late 1997, analysts continued to be upbeat on Indonesia's economic
prospects, expecting, on average, a strong 6-7% GDP growth in 1998. But as regional problems
stacked up, Indonesia too could not escape the progressive erosion of confidence.
The Indonesian economy had two domestic weaknesses: unsound banks and companies that had
borrowed excessively abroad in short-term loans unbeknown to the government. These companies
started hedging their exposures, sending the rupiah into a downward spiral. The companies became
insolvent, badly affecting the banking system. Policy errors by the Suharto government compounded
this. Grave social and political difficulties eventually led to a political crisis and a political transition
that is still not completed.
Korea
Korea's dynamic economy had certain weaknesses, but these were long-standing and well known:
chaebols were very highly leveraged and banks often made lending decisions on government direction
instead of commercial viability. Like Indonesia, Korea's short-term foreign debt was high. When the
crisis broke, foreign creditors refused to roll-over credit lines. Korean banks which had borrowed
heavily overseas came under severe pressure.
However, unlike in Indonesia, the major creditor countries, particularly the United States, got together
and agreed on an orderly roll-over of Korean banks' short-term debt. This stabilised the situation and
enabled the Korean economy to resume growth quickly.
Hong Kong
Hong Kong and Singapore were the two economies with the least structural problems or foreign
borrowings, yet neither could escape the contagion. Hong Kong's economy benefited from its linkages
with China which was relatively unaffected by the regional currency turmoil. But the Hong Kong
dollar's (HK$) peg to the US$ caused Hong Kong's real exchange rate to appreciate significantly
when all the other regional currencies fell. The full adjustment to the changed external environment
had to be borne internally, through nominal prices of assets and wages. The result was a sharp
recession from which Hong Kong is just beginning to emerge.
At the same time, the high HK$ led the markets to assess the risks of a devaluation. Interest rates rose,
further squeezing the economy. After several speculative attacks on the currency and "double-play" on
the currency and share markets, the HKMA intervened directly to buy shares in August 1998. The
speculative attacks were successfully beaten off, but the Hong Kong Government remains extremely
concerned over the dangers posed by speculators, and particularly hedge funds, to their economic
stability.
Singapore
Singapore was more directly affected by the crisis than Hong Kong because of our close economic
linkages to Thailand, Malaysia and Indonesia. Our growth slowed down drastically, turning negative
for several quarters. However, unlike Hong Kong, the S$ exchange rate could and did adjust down
relative to the US$, in line with its trading partners. This extra degree of freedom helped to soften the
impact of the sharp regional slowdown and depreciation of its neighbours' currencies.
In addition, the Government sought to make prompt and direct adjustments to the real economy,
cutting taxes and levies, reducing the CPF contributions with the support of unions and workers and
building capabilities for the longer term. These measures helped see Singapore through the storm and
are now enabling Singapore to recover, together with the rest of the region.
Lessons from the crisis
When the Asian currency crisis first broke out, many observers blamed the "Asian model". But then
other emerging markets, even the developed world, came under fire. It became clear that the problem
was not just Asia, but also weaknesses in the structure of the global financial system.
There is general agreement on what the key weaknesses were, but not yet on their solutions. Very
broadly, I identify five issues:
• Capital controls - can they help?
• Exchange rate regimes - fixed or floating?
• Hedge funds - what do they imply for global systemic stability?
• Global financial supervision - is this possible?
Strengthening domestic institutions - a prerequisite to participation in the global system.
•
Capital controls
This crisis has prompted a reconsideration of the merits of capital controls. In an ideal world, the
global capital market should be one integrated whole, with no restraints on the movement of capital.
Then savings could be channelled to their most productive uses and countries could fund their
investment needs at the lowest possible cost.
But in reality many economies still lack the institutional framework to deal with free capital flows.
Furthermore, investors are prone to herd behaviour which can result in large surges of capital into and
out of countries. These surges cause bubbles and crashes which can do great harm to economies,
especially small and vulnerable ones.
The liberalisation of capital accounts must thus be treated with caution. It must not proceed faster than
the strength of countries' domestic financial systems and institutional capability. Controls on "hot
money" are difficult to administer and subject to evasion, but they can help make countries less
vulnerable to volatile financial markets.
For instance in Indonesia, following the liberalisation of the banking sector in the late 1980s,
companies made large short-term borrowings in foreign currencies. They circumvented rules intended
to prevent this. When the crisis struck, the Indonesian government did not know how much the
companies had borrowed. Yet the total was almost US$ 50 billion1, more than double Indonesia's
gross foreign reserves.
The effects of the capital controls which Malaysia imposed in September 1998 are still being debated.
But even Malaysia, which is implacably opposed to speculators out to make a quick profit, still
welcomes foreign investors including portfolio investors buying Malaysian shares. Ultimately, all
countries still hope to enjoy the benefits of global capital markets such as more foreign investments
and transfers of technology.
In Singapore, our currency is fully convertible. We abolished exchange controls in 1978. We have no
restrictions either on the inflow or outflow of funds. Because we are a financial centre, these flows are
large relative to the size of our economy. Hence we want to be careful not to let them overwhelm or
damage our real economy.
This is why we have maintained a policy of non-internationalisation of the Singapore dollar (S$). This
is not a form of exchange or capital control. It is a monetary policy measure to deter speculation
against the S$. It prevents non-residents from borrowing the S$ for purposes unrelated to our economy
for example to fund a short position in the S$.
We believe that the S$ exchange rate should be appropriate to prevailing economic conditions and the
underlying state of the Singapore economy. Indeed in the long term, keeping the currency in line with
fundamentals is the best way to avoid offering speculators too tempting a target.
Exchange rate regimes
Massive speculative attacks on exchange rates are a common element in financial crises. Misaligned
fixed exchange rates have figured prominently in financial crises throughout the 1990s, even the 1980s
and 1970s.
In the post-crisis era, the conventional wisdom is that emerging markets should choose either a
free-floating or fixed exchange rate system.
But neither is a panacea. Fixed exchange rates are hard to sustain in a world of global capital mobility.
Furthermore, they tend to be viable only when supported by large foreign reserves and strong
institutional arrangements. Even then, the exchange rate can still become misaligned and vulnerable,
as has happened in Argentina.
In Hong Kong, strong foreign reserves and well-developed financial authorities and institutions made
its currency board workable and credible. But even the Hong Kong dollar came under fierce attack in
this crisis. In other countries a fixed exchange rate may be completely infeasible. Thus Professor Steve
Hanke's proposal to set up a currency board system to stabilise the rupiah was viewed with deep
scepticism by policymakers both in Indonesia as well as the IMF and the World Bank.
Neither does a free-floating exchange rate always work. Even developed countries do not remain
impassive when capital flows overwhelm trade flows and threaten the competitiveness of the country's
exports. A prime example is Japan. And despite a free-float, the exchange rate may spiral downwards
if there is a loss of confidence. This happened in Indonesia and Brazil after they abandoned their
exchange rate pegs.
Singapore operates a managed float. This policy has prevented the currency from getting too far out of
line and rendering our exports uncompetitive as a fixed rate might have done. A managed float has not
totally eliminated speculative pressures on the S$, but for our circumstances it is the most appropriate
approach.
The best exchange rate regime depends on the specific circumstances of each economy. While it is
important to get this right, the exchange rate does not exist in a vacuum. Ultimately, it is the strength
of the country's economy, the soundness of its fiscal and monetary policies and the confidence of both
foreign investors and its own citizens in the country that determines whether or not the currency is
stable. If these fundamentals are out of kilter, no technical fix of the exchange rate regime will avert a
crisis.
Hedge funds
Perhaps the most controversial issue to have arisen from the crisis is that of hedge funds. They
undoubtedly took positions successfully against the Thai baht. The Malaysian Government is certain
that hedge funds were behind the collapse of its stock market and currency. Hong Kong and Australia
are similarly convinced that hedge funds led attacks on their currencies.
On the other hand there is some evidence that except in Thailand the hedge funds may have been
wrong footed in the crisis. George Soros has denied being short on the ringgit, during and several
months before the crisis2. A spokesman for Soros Fund Management said in October 1997: "Recent
volatility in world financial markets is reflected in the volatility of the Quantum Group's
performance", a nice cryptic way to say that they had incurred substantial losses.
While the facts are still hotly disputed, they are ascertainable. What role hedge funds played in
different countries is an empirical question and not a matter of opinion. A Working Group on HLIs has
been set up under the Financial Stability Forum. I hope it will settle the facts unambiguously so that
the debate can move on to consider what, if anything, should be done.
In deciding whether to restrict the activities of hedge funds, there are three considerations. First, who
are the shareholders of hedge funds? They do not represent the retail public. Typically, hedge funds
invest on behalf of wealthy individuals and institutional investors who do not need consumer
protection. From this point of view, the activities of hedge funds are private business and need not be
subject to the same strict regulations and disclosure demands as financial institutions that collect
monies from the public.
The second is a prudential concern. Are financial institutions that lend to hedge funds being
sufficiently prudent and provisioning enough capital in relation to the lending? Hedge funds are not
rated by commercial rating agencies, unlike most large banks and corporations. They often keep their
portfolios and strategies secret which hampers a proper assessment of their financial soundness. The
existing regulatory framework is not tight enough in this respect. As LTCM showed, creditors often
lent independently of one another and were not setting aside sufficient capital to cover their lending to
highly leveraged funds.
The third is a systemic consideration. Are hedge funds a source of instability in the global financial
system? While their role in the Asian crisis remains controversial, the LTCM incident shows clearly
that on occasion hedge funds can be destabilising, through their sheer size and leverage.
Banning hedge funds altogether is not the solution. Many other institutions make similar plays as the
hedge funds. Indeed hedge funds can play a positive role in international financial markets. Their
signature contrarian and arbitrage strategies can help to stabilise and even enhance the efficiency of
financial markets. However, checks are necessary to prevent them from accumulating excessive
positions, unknown to the market and to regulators.
Directly regulating hedge funds will also not work. There is the practical problem of regulatory
arbitrage - such players can easily relocate if regulation is forced on them. Besides, not all hedge
funds are large and highly leveraged. There is no need to regulate all of them in the same way.
One possible approach is indirect regulation, through their lenders and other counterparties. This
means bringing the private sector into the surveillance picture. We should create incentives in the
supervisory framework for the counterparties of hedge funds to become more vigilant and prudent.
Lenders must strengthen their own credit assessment systems, while regulators should find ways to
encourage risky borrowers to disclose more, voluntarily, to their creditors. For example, we could
introduce a higher risk weighting for borrowers who are large and highly leveraged and who do not
disclose enough to either their creditors or the credit rating agencies. This would spur hedge funds to
disclose more or to obtain a credit rating.
Global financial supervision
The crisis has set off debate as to whether the global capital market needs a global regulator. I doubt
this is workable, or even desirable. A global financial super-regulator requires countries to give up
national sovereignty. This is politically unrealistic; witness how carefully the IMF had needed to
canvas its major shareholders to support its prescriptions and how closely the US Congress scrutinises
the IMF's actions.
A more practical, albeit modest, solution is the establishment of the Financial Stability Forum. This
brings together both the G7 countries as well as non-G7 financial centres and international
organisations such as the IMF, World Bank and the BIS to discuss the vulnerabilities of the world
system. The Forum should be able to get best practices and supervisory standards implemented more
widely and effectively.
The FSF has set up three working groups to study areas of vulnerability highlighted by the crisis:
capital flows and exchange rate regimes, highly leveraged institutions and offshore financial centres
(OFC).
Singapore has been invited to participate in the FSF, together with Australia, Hong Kong and the
Netherlands. We are also in the OFC working group. OFCs have attracted considerable attention
because of the significant capital flows they generate. They are a weak link in the maintenance of
global best practices and regulatory and supervisory standards. If OFCs do not meet international
standards they will provide an opportunity for regulatory arbitrage. Financial institutions may be
tempted to migrate to such OFCs. This would make it very difficult for other jurisdictions to maintain
or raise their own standards.
There is work ahead to understand the roles and uses of OFCs and their implications for financial
stability. Singapore, together with the other members of the OFC working group, will involve OFCs in
this study. We aim to find ways to get them to meet international standards of cooperation in
cross-border information exchange and enforcement. We must create incentives for OFCs to play by
the rules or at least not disregard the rules. Bringing OFCs under the global regulatory umbrella will
help raise prudential standards and enhance the stability of the global system.
Strengthening domestic institutions
The most important and reliable safeguard for economies which open themselves up to the global
market is a strong domestic institutional framework. Governments must strengthen domestic financial
institutions and companies by adopting best practices of financial supervision and corporate
governance. Banks need a strong credit culture while other companies too need a rigorous business
culture.
In the helter-skelter growth before the crisis, Asian governments had neglected these institutional
underpinnings. While this was not the sole cause of the crisis, in many countries weak domestic
institutions undoubtedly made things much worse. What Indonesians have termed KKN - corruption,
collusion and nepotism - is now generally recognised to be a serious problem to be combated and not
just accepted as the way business is done.
Strengthening domestic institutions will enable Asian countries to sustain long-term recovery and
growth. Governments must restructure the financial and corporate sectors. Insolvent financial
institutions need to be closed down or merged with stronger ones. In the corporate sector, unviable
companies must go while weak, but viable companies must restructure their balance sheets and
rationalise their operations. This calls for deft handling and sensitive political judgement as to how fast
and far to go and how to trade off between social and political objectives on the one hand and
economic efficiency on the other.
A sound banking system is fundamental. This starts with the adoption of high standards of financial
supervision and regulation supported by a sound legal system. More importantly, regulators and
governments should not neglect the establishment of a strong credit culture. This is the "software" of
good banking governance. Banks must lend in a disciplined way, based on commercial viability rather
than "relationships". A relationships-based system undermines competition and disclosure. It results at
best in misallocation of resources and at worst in a collapse of the whole financial system.
Banking governance must be complemented by strong corporate governance. Poor corporate
governance practices have allowed massive unreported losses and hidden liabilities to develop.
Upgrading corporate governance means raising the quality and influence of boards of directors,
protecting shareholder rights and raising and enforcing accounting and audit standards. All these
preconditions are necessary before market discipline can work properly.
It is encouraging that most of the crisis Asia countries have declared their intention to work towards
international best practices in corporate governance. But business environments cannot be changed
overnight. It involves changing entrenched social relationships and norms that vary from country to
country. This will take time. The best hope for individual countries to restore long-term growth in the
global village lies in their succeeding in this transformation.
Conclusion
There is no escaping the process of globalisation. In theory, countries can opt out, but in practice the
price is prohibitive.
While the globalisation of trade flows undoubtedly benefits all countries, the globalisation of capital
flows carries much greater risks. Ideally, capital markets should be self-stabilising and should promote
economic efficiency by directing capital to its best uses on a global basis. But whether this always
happens in reality is an open question. The frequent crises, of which this is just the most recent, give
us reason for doubt.
The Asian crisis has wrought grievous harm on many countries. But one positive consequence is that it
has provided a fresh impetus for reconsidering and strengthening the global financial system.
Countries will not want to dismantle the existing structure and start from scratch, as happened in
Bretton Woods after World War II. More likely and prudently, they will pursue incremental
improvements to strengthen the structure and remedy the flaws which have been uncovered. We must
find ways to make bubbles and crashes less likely and make countries less vulnerable to such mishaps
when they occur.
While we can strengthen the global financial system, we can never eliminate bubbles and crashes
completely. Manias, panics and crashes are inherent to capitalism dating back to the tulip mania and
South Sea Bubble of the 17th century and probably before. In theory, investors make independent
decisions which collectively result in a stable and efficient market outcome. In reality, uncertainty due
to incomplete information and a basic human instinct to herd can prove destabilising and disastrous.
For small open economies, the best defence against an uncertain and sometimes dangerous
environment is to pursue prudent macroeconomic policies, strengthen their financial systems and
improve their governance framework. Sound domestic policies and institutions cannot eliminate panic
and contagion. But they can cushion the adverse effects and make the economies more resilient to the
financial shocks when they occur.
Thank you.