Mr. Grenville considers Asia and the financial sector Talk given by
Mr Stephen Grenville, a Deputy Governor of the Reserve Bank of Australia, to the 10th Annual
Australasian Finance and Banking Conference in Sydney, on 4/12/97.
The Managing Director of the IMF described the Mexican economic problems of
1994/95 as "the first crisis of the 21st century", with the implication that this was something new
and, more ominously, perhaps there would be more of them. Before the new century has
dawned, there has now been a series of similar problems, concentrated in the region of most
interest to us -- East Asia.
This is relevant to a conference on finance and banking, because the financial
sector in each of these countries has been the key factor in the crisis and is central to its
resolution. Those who spend time thinking about financial sectors and how they evolve over
time may find some interest in examining what went wrong, why it went wrong, and how it
might be put right. It is also of considerable importance to Australia -- not just for the effect on
our economy (which is hard to quantify at this stage), but also for the opportunity it presents for
Australia to deepen its engagement with the region.
What went wrong?
The problems in Asia, like the Mexican crisis of 1994, exhibit a variety of
symptoms, with the most prominent being large falls in exchange rates and equity markets. But
exchange rate changes of this size are not unknown in other countries which have not
experienced the trauma currently underway in Asia. In Australia in the mid-1980s the exchange
rate fell by 35 per cent, and in the early 1990s it fell by close to 25 per cent. Nor is this
uncommon internationally. Even the mighty US dollar went up and down by amounts like this in
the mid-1980s. More recently, Japan, between April 1995 and April 1997, experienced a
depreciation of similar size. These exchange rate changes may well have been a trigger which set
off a chain reaction of other events. But by themselves, the exchange rate changes would have
been an uncomfortable policy problem, not a crisis.
An uncomfortable problem became a crisis because the weakness in the exchange
rate infected the financial sector. This occurred through a variety of channels -- in some cases,
banks had borrowed heavily in foreign currency; more often, the borrowers were the non-bank
business sector. As the exchange rate fell, their burgeoning foreign exchange obligations pushed
the enterprises under water, and they defaulted on their debts to the domestic banking sector. At
the same time, foreign lenders, who had felt protected by the foreign currency denomination of
the loans, now realised that a fall in the exchange rate increased their credit risk, and so they
pulled credit lines or failed to roll over short-term debt.
This exchange rate shock impinged on financial systems which already had
fracture lines and structural tensions. There were a number of specific weaknesses -- connected
lending, government-directed loans, poor credit evaluation, lack of transparency, and inadequate
prudential supervision. The situation was sustainable if growth and capital flows were
maintained, but was not sustainable in the harsh world in which we live, where confidence is
fragile, capital flows are flighty, and the stabilising forces of the "fundamentals" are slow to
assert themselves.
Why did it happen?
The first point that should be made is that the praise which had been heaped on
these countries for several decades is entirely understandable. These countries have been high
savers, budgets have been balanced or in surplus, inflation has been reasonably well contained,
and exports had been the dynamic driving-force of growth (with the globalisation that this
implies). They ran high current account deficits because, however much they were saving, they
were investing even more. Who could, ex ante, have criticised the broad-brush developments in
the financial sector? Open capital markets were a merit-badge of economic maturity and a
requirement for entry into the industrial-nations' economics club -- the OECD.
Not only were these markets generally opened up and linked in with international
capital markets, they embraced this eagerly, including the latest sophisticated products of the
financial sector. Equity markets burgeoned and the arcane products of Wall Street were readily
available. International agencies urged further and faster deregulation, commercial financial
interests (domestic and foreign) were eager to stake out a role for themselves in the fast-growing
sector, and sophistication in financial products was seen as being as important as having the
latest in industrial technology.
While it is easy enough now to see the fracture lines and lack of resilience of
these financial sectors, it was less easy to predict the outcomes beforehand. The transition from a
regulated financial system to a deregulated financial system is intrinsically difficult. Under the
best of circumstances, it was inevitably going to be accompanied by false starts and mis-cues.
The pace of growth of credit is difficult to evaluate in a world where you would expect it to be
growing quickly because financial repression (McKinnon's phrase) is ending. The transition
leaves the financial system quite fragile during the process. There is a fair bit of evidence that
problems have arisen for almost every country during the transition, with the problem usually
taking the form of excessive lending as each institution in the deregulated financial sector
competes vigorously for its share in the new world. In the process, poor loans are made and asset
prices are bid up.
These two things come together in mutual reinforcement when the problems come
to a head. Lenders who had used collateral as their main loan-evaluation technique find their
security to be illiquid and inadequate. At the same time, it is almost inevitable that the process of
financial deregulation will run ahead of the capacity of the prudential supervisors to devise a
suitable regulatory framework. To start with, the climate of deregulation is often inimical to the
regulators. This was certainly our experience in Australia during the 1980s: as we tried to put in
place the basis of some "rules of the game" for the new deregulated financial sector, many
people who should have known better were calling this "re-regulation by the back-door", and
criticising us for being out of sympathy with the brave new world of deregulation.
This experience seems to have been repeated elsewhere. Managers at all levels
have been dealing with products and systems with which they are unfamiliar (but to admit this
would disqualify them from participating in this exciting new world), and commercial
imperatives encouraged them "to boldly go where no man has gone before". As we look at the
problems of foreign currency borrowings in some of our Asian neighbours, one might recall the
similar experience with Swiss franc loans in Australia during the 1980s, with the (fortunate)
difference that these were, in a macro sense, quite small for Australia.
There is another difficult issue here for the authorities. Even when problems were
identified, there was the classic dilemma well known to prudential supervisors -- do you "blow
the whistle" on the problem and precipitate a crisis (for which you will surely be blamed), or do
you quietly work behind the scenes to try to avert the perceived problem, in the hope that you
will succeed or the problem will go away of its own accord, but knowing that if it doesn't, it will
be a bigger problem than if you had precipitated it early on. No credit is given for precipitating a
crisis early, but there is plenty of blame for being present at the scene of the crime. So it is not
surprising that there was, beforehand, a certain amount of hand-wringing about financial sector
weaknesses, but this was muted background noise in the general enthusiasm to embrace the new
world.
What might be done?
The first point that should be made here is that the main burden for getting things
sorted out again clearly rests with these countries themselves. The related point here is that, for
some, (to borrow the catch-cry from positive-thinking management texts) "this isn't a problem,
it's an opportunity". For some of these countries, the process of institutional reform may be like
punctuated development in evolutionary theory, where progress takes place in jerky stages, with
a crisis such as this causing people to focus on the issues and to reform weaknesses. In this view,
countries can come out of this trauma stronger than before. It seems quite likely that some
countries will be better than others at turning these problems into opportunities.
While part of the reaction to these problems must be institutional strengthening of
the financial system, there remains a question whether the broad thrust of macro policy -- and,
by implication, the spanking rates of growth which these countries have achieved over the past
couple of decades -- is sustainable. To put this more specifically, is it possible to achieve the
sorts of integration with international markets, the large inflows of capital which went with this
and the rapid transformation of economies, without leaving these economies vulnerable to the
sorts of changes of sentiment that we have seen in recent months? The constraint on growth is
not the conventional one of resources and technology. The constraining factor here is just how
resilient can the financial sector be made: the more robust it can be made, the faster these
countries will be able to travel.
We know the historical experience of Singapore, which ran current account
deficits averaging 10 per cent of GDP for more than two decades. We know, too, that this was
an important element in the extraordinary progress that Singapore has made. We know,
however, that large current account deficits were one of the elements which made the other
ASEAN countries vulnerable in recent years (and this vulnerability has always been a concern in
Australia, too, despite the academic case that current account deficits resulting from private
sector decisions were matters between "consenting adults" and therefore not something with
which policy should concern itself).
Analysts have pointed to the problems caused by the US-dollar-fixed exchange
rates that prevailed in these countries until recently. They argue that, if exchange rates had been
allowed to appreciate, credit growth would have been better contained and the economy held on
a tighter rein. Greater exchange rate flexibility is surely an element in the new policy regimes.
But the lesson of recent months is that, once a fixed exchange rate is freed, it can move by large
amounts. Over-shooting is par for the course. All the more reason why a resilient and robust
financial sector must be in place if flexible exchange rate regimes are now the norm.
Much of this involves careful, slogging, time-consuming institutional
improvement -- making accounting systems better, tightening up legal and bankruptcy systems,
improving disclosure, and strengthening and deepening experience in prudential supervision.
One point that might be noted is that some capital flows seem to create more vulnerability than
others, so there is a case for discouraging short-term flows and encouraging direct
investment/equity and longer-term bond flows.
The best talent in these countries should go into the core financial
institutions -- principally banks -- even if this means that the latest whiz-bang innovation of the
financial rocket scientists remains unexploited. This is not to argue for stepping back from
financial development -- on the contrary, these countries must move forward to deepen markets.
But the resources should go into design and implementation of a robust financial architecture
and -- to continue the analogy -- useful design parameters are simplicity, a strong basic structure,
and attention to detail.
One useful objective is to put the banking system in a central position as the
guardians on the gateway of investment. If a project has to pass the scrutiny of a bank which will
hold the loan on its balance sheet, there is still no guarantee of success, but maybe the chances
are improved. What is clear is that private businesses have mis-assessed the risk they faced,
tempted by attractively-lower foreign currency interest rates but not sufficiently aware of the
need to worry about the variance of the prospective cash flows. An experienced banker might
have helped. Of course, this will only work if the banking system is allowed to do its job,
untrammelled by connected or directed lending. Banks cannot provide "due diligence" scrutiny
on loans which they were required to make.
The first priority, always, is to get the banks -- the core of the financial
system -- sorted out quickly. The need is to keep the process of financial intermediation flowing:
it is the life-blood of the real business sector. The problems are not, in fact, examples of some
new "crisis of the 21st century": they are, at heart, the old problems of bank collapses and the
remedy is, in principle, well established. Restoring confidence is the critical factor and for this
(as Bagehot observed) central banks should "lend freely, but at a penalty rate". Insolvent
institutions must be separated from the solvent, dealt with, and the remaining institutions
supported.
None of this is easy. Intractable problems of moral hazard exist, but this should
not be allowed to paralyse action. Serious money will be required to fix the problems.
Experience over the past couple of decades shows just how expensive these financial sector
rescues can be. The 1994 Mexican problems have cost about 12-15 per cent of GDP; the Nordic
countries spent 4-8 per cent of their GDP fixing their problems a few years ago; even the S&L
problems in the United States (merely a small sub-group of the financial sector) cost around
3 per cent of GDP to sort out. But the cost of failing to address these problems decisively can be
more painful still -- a long drawn-out period of financial introspection and inertia which severely
retards real activity. A positive point is the strong fiscal positions (and therefore low government
debt outstanding) of these countries, so the capacity to fund the restructuring exists.
All this is, clearly, largely a matter of domestic policy, with the costs to be borne
mainly by taxpayers in these countries. In a more speculative vein, let me return to the idea that
what we are witnessing is a problem of the 21st century, and acknowledge that, while what we
see has many of the characteristics of an old-fashioned financial sector crisis, it has one
important new element -- the major role played by international capital flows. Domestic
financial intermediation takes place within a broad set of "rules of the game", laid down by
prudential regulators. There is no international analogue of this. Over time, it can develop, as
countries implement consistent rules of prudential supervision, perhaps along the lines of the
BIS Core Principles. This might -- together with better information on private capital flows and
cross-country position-taking -- provide a response to this new element of the current
problems -- the role of large-scale capital flows.
What relevance is it to Australia, and to this audience (Australian and overseas)?
We acknowledge our stake in the outcome, with two-thirds of our exports going to East Asia
(including Japan). Australia is taking part in the IMF-co-ordinated facilities for Thailand,
Indonesia and Korea. These funds help restore confidence and help the process of adjustment.
We will use our relationships -- via our regional central bankers group EMEAP and, in due
course, the newly-formed Asian Surveillance Group -- to provide examples of how prudential
systems work elsewhere, analysis of how the specifics might be done in particular countries,
technical assistance where it can be useful, and -- the most difficult and subtle task of
all -- understated and understanding support for the reform elements who have the task of
fashioning a stronger financial sector.
A last word directed specifically at this audience. Some of you come from the
countries involved: I wish you well in the vital task ahead. For the rest of us, is this, too, not a
problem but rather an opportunity? The countries to our near north are going to be devoting
considerable resources to strengthening their financial sectors. I hope some of you will find a
role for yourselves in this process, and by doing so will look back on this as an opportunity to
strengthen our links with our northern neighbours.