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Strategic Policy Issues

Year Of The Sick Tigers

Like the collapse of Soviet-backed regimes in Eastern Europe and thebreak-up of the Soviet Union itself, the unravelling of the 'East Asian Eco-nomic Miracle' astonished the world with its suddenness. What started inearly 1996 as a worry about a property bubble in Bangkok and a relatedmalaise in the Thai banking system had, within a year, engulfed much ofSouth-east Asia, as well as South Korea, in a vicious cycle of sharpcurrency depreciation, threatened national insolvency, severe fiscalausterity and, at best, a grinding economic slowdown, or, at worst, acuterecession. Yet these were countries which had shown sustained rates ofeconomic growth unprecedented in world history. They were widelybelieved to be immune from the boom-bust cycles that have afflicted otherdeveloping countries in, for example, Latin America.

Economic self-confidence had given rise to political assertiveness aswell, and the belief that there was something special about Asian modes ofsocial and economic organisation and of intra-regional diplomacy.Economic disaster will thus also have far-reaching political, ideological andstrategic implications. They are certain to include domestic political change,increased intra-regional tension, a humiliating recognition of dependencyon the United States in the short-term, and, in the long-term, the possibilityof a nationalist backlash and a greater role for regional powers like Chinaand Japan.

What Went Wrong?In early 1997, there was still much dumbfounded admiration for the miracle,which appeared to have produced an unprecedented combination ofsustained and rapid economic growth, increased social equity, and politicalstability. By then it was clear to many - although not apparently the Thaigovernment - that Thailand was facing serious financial difficulties. Hardlyanybody, however, foresaw the extent of that country's economic disaster, letalone its contagious effect elsewhere in the region. Thailand was thebutterfly that, as chaos theory would have it, fluttered its wings and causedan earthquake.

The catalyst for the implosion was a regional downturn in exports,which particularly affected Thailand. After years of growing at close to

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20% annually, exports from the region in 1996 showed no growth at all.Three explanations are offered for this phenomenon. Firstly, there was acyclical fall in demand for electronic products. Secondly, there wasmounting global over-capacity in many other industries as well, attributablein large measure to the increased economic activity in China. There, a sharpdevaluation of the renminbi in 1994 had been followed by several years ofremarkable success in bringing down the inflation rate. These two factorsmade Chinese exports extremely competitive.

Third and most important, however, was the breakdown of aninternational currency consensus in place since the 1985 New York PlazaAccord. That had allowed the yen to strengthen against the dollar, makingJapan's exports more expensive, and encouraging its manufacturers torelocate capacity to continental Asia, where, since local currencies werelinked to the dollar, production costs were cheap. The extent of this movewas truly staggering. For example, in 1987, Thailand received moreJapanese investment than in the entire course of the previous twenty years.Put simply: Japanese investment poured into the region and cheap exportspoured out. But this happy arrangement began to unravel as the dollarappreciated - rapidly and sharply - against the yen. From its peak of about80 yen to the dollar in 1995, the yen fell to a low of 129 to the dollar at onepoint in late 1997. Correspondingly, East Asian currencies, which were alllinked in one way or another to the dollar, appreciated against the yen andmost other currencies in the world. Initially, the wave of devaluations whichthen took place in these currencies merely restored their level against theyen.

The strains this shift produced reached breaking-point first in Thailandfor a variety of reasons. Thailand was facing a structural as well as cyclicaldifficulty in its export industries. With a per capita gross domestic product(GDP) of around $2,000, it was pricing itself out of the market in labour-intensive industries. But it had yet significantly to alter its exportcomposition into the higher value-added industries like electronics.Insolvency in the banking and finance company sector loomed closer inThailand than in other countries. By early 1998, 56 out of 91 Thai financecompanies had been closed down, and four out of 15 banks had beennationalised after finding themselves unable to repay liquidity supportprovided by the central bank.

In addition, Thailand operated the most rigid of all the exchange ratemechanisms in the region, with the exception of Hong Kong's currencyboard system (which is fundamentally different in that the Hong Kongdollar is fully backed by holdings of dollars). This firstly had the effect ofkeeping baht interest rates much higher than those paid for dollars, toprotect the currency. Banks and companies could then borrow cheaply indollars to fund baht assets at what appeared to be negligible real interest

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Year of the Sick Tigers • 17

costs. Secondly, the rigidity of the band gave the central bank very littleleeway in defending the currency. Interest rates could be pushed sky-high,billions could be spent buying dollars, and capital controls could beimposed. At various times, all three methods were tried, sometimessimultaneously. But, after the Bank of Thailand had nearly bankrupteditself in the forward market, it was forced to give way and allow the baht tofloat. Instead it sank. Thailand became the first of four countries to turn tothe International Monetary Fund (IMF), which arranged more than $100billion in rescue funds for Thailand, Indonesia and South Korea, andsmaller emergency credits for the Philippines (which had been operatingunder an IMF programme for more than thirty years).

In retrospect, it does not seem so surprising that other currenciesshould have toppled like dominoes in the storm that followed the baht'seffective devaluation. Using the now fashionable economic measures ofindebtedness, current account deficits and non-performing loans, the othercountries in the 'ASEAN 4' (Thailand, the Philippines, Indonesia andMalaysia) also seemed vulnerable. Indonesia and South Korea sharedThailand's vulnerability to a dangerous volume of short-term foreign debt.

International currency speculators had spotted that there was money tobe made in selling the baht short. More important, local companies which,like those in Thailand, had borrowed offshore and not hedged theirexposure, began rushing to do just that, by buying dollars before their localcurrency depreciated. There was also a certain pressure for competitivedevaluation. In thin and nervous markets, such perceptions were enough tobring the other regional currencies down too.

Change At HomeThe effect was catastrophic. Currency falls of between 35% and 50% inThailand, Malaysia, the Philippines and South Korea, and, at times, of 80%in Indonesia, pushed up the cost of foreign currency debts far beyond theability of local banks and companies to service them. By February 1998,almost every company listed on the Jakarta Stock Exchange was, on paper,bankrupt. By then, what had begun as a financial crisis had become aneconomic crisis. Across the region, growth rates were falling fast. Thailandand Indonesia were in the grip of an alarming economic contraction.Factories were closing, construction projects were being abandoned, andunemployment and prices were rising.

The political consequences of this downturn were exacerbated by twofactors: many governments had based their claim to legitimacy on the abilityto deliver very rapid rates of economic growth; and in many countries aprocess of political change was, regardless of the financial turmoil, on theconstitutional calendar. In some countries, these factors combined toentrench a fragile democratic process. For example, a new constitution was

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adopted by the Thai parliament in August 1997. Many of its provisions,aimed at reducing the role of money in the electoral process, were abhorrentto politicians. The economic climate, however, made them unable to opposea set of popular reforms. In South Korea in December, Kim Dai Jung becamethe first opposition candidate to win a presidential election since the end ofmilitary rule in 1987. And in the Philippines, those manoeuvring for aconstitutional amendment to allow President Fidel Ramos to stand for asecond term in the elections due in May 1998 were forced to abandon theidea. The economic downturn militated against embarking on a divisivepolitical campaign which opponents alleged would undermine thedemocratic gains of the 1986 people power revolution.

In Malaysia, too, the economy became politicised in the rivalry betweensupporters of the Prime Minister, Mahathir Mohamad and of his deputy,Anwar Ibrahim, who is also the Minister of Finance. Anwar is Mahathir'sdesignated successor; their different approaches to handling the crisis -nationalistic and accusatory in Dr Mahathir's case, conventional andsoothing in that of his deputy - fuelled the debate about when powershould be transferred.

But it was in Indonesia that the political consequences of economiccollapse were most drastic. This was partly because that economy sufferedmore than any other. But also, its political system was the most rigid, andthe most obviously bound up with the causes of economic ruin, because ofthe commercial dominance of the family and friends of the president. After32 years in power, President Suharto appeared determined to soldier onwith a seventh five-year term, confirmed in largely ceremonial elections heldby an assembly that convened in March 1998. Food shortages, spirallingprices and a history of antagonism towards the disproportionately wealthyChinese minority contributed to widespread rioting. There were fears thatthe situation could turn even more violent, unleashing a flood of refugees,and possibly destroying Indonesia as a unitary nation. This naturallycaused near panic among officials in neighbouring Singapore andMalaysia, who also feared that a replacement regime might be ratherdifferent from the inward-looking, secular Suharto era.

Regional WeaknessOne of the reasons for the founding of the Association of South-east AsianNations (ASEAN) in 1967 was to engage Indonesia in a peaceful regionalclub, and so bury for ever the memory of the period of confrontation betweenit and the Federation of Malaysia in the early 1960s. These origins helpexplain the importance ASEAN members attach to the principle of non-interference in each others' internal affairs. This mutual tolerance hadserved the organisation well in avoiding conflict, but by 1997 had provedinadequate to deal with a series of challenges from a coup in Cambodia to

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Year of the Sick Tigers • 19

the appalling smog that smothered much of South-east Asia later in theyear.

Most disappointing for ASEAN members, the organisation was unableto provide any effective form of mutual self-help in the face of the economiccrisis. Dr Mahathir, in particular, pushed the idea of an Asian or ASEANfund to provide balance-of-payments support for countries whose cur-rencies were under attack. Japan's withdrawal of backing for the scheme,however, left it an empty shell, and it was replaced by a 'Manila frame-work' agreed in October 1997. This, in essence, left regional economichealth-care in the hands of the IMF. The only substantive ASEAN initiativewas a proposed regional surveillance mechanism that would help co-ordinate macro-economic policy and promote peer pressure. Such amechanism would be useful. But it came too late. ASEAN had failed topersuade Thailand to tackle the economic troubles which sparked thecrisis. It was unable to dissuade Mahathir in August and September frommaking speeches blaming foreign speculators and threatening retaliation,and hence aggravating the markets' antipathy to the region. And byFebruary 1998, regional leaders were watching helplessly as PresidentSuharto accepted the advice of an American economist, introduced bySuharto's children, who was prepared to peg the Indonesian rupiah bymeans of a currency board system, like that in Hong Kong. Other ASEANmembers thought this could be disastrous for Indonesia, and hence, byextension, for themselves.

Mahathir was meanwhile promoting a more modest form of regionalcooperation: the use of the local currencies in intra-regional trade. But manyof his ASEAN colleagues believed in private this would be impracticableand, if not, would have only a marginal impact on exchange rates.

More Squabbles To ComeAlthough there was a frenzy of high-level meetings among ASEAN leadersand they maintained their unity, the limitations within that unity becameclearer. Ironically, ASEAN has achieved a greater degree of economiccohesion in distress than in prosperity - the markets, at least, have treatedthe region as a whole, so economic policy in one has a direct effect on theothers. As the region sets about recovery, this is likely to lead to furthertension.

Another reason for believing there may be more rather than less frictionover economic policy is the likelihood of increased competition for exportmarkets. The best quick fix to the region's troubles relies on tapping the stillhealthy growth of American demand. This goes against the trend that hasdeveloped in recent years towards a rapid growth of intra-regional trade.With Japan and South-east Asia both in a period of slower growth, thepressure to increase market share in the US will mount.

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The pressure will become particularly acute if the contagion spreadsmuch further in North-east Asia. By early 1998, Taiwan as well as SouthKorea had seen its currency depreciate. The fear was that China, despitefrequent denials, could be forced by a slowing domestic economy, mountingunemployment and, perhaps, social unrest to cheapen its currency, leadingto another round of devaluation.

Migrant labour may well create a further aggravation. Malaysia hassome 1.8 million foreign workers, mainly from Indonesia. Thailand has upto a million, mostly from Myanmar. Both host countries responded to theeconomic slowdown by threatening to deport large numbers of illegalimmigrants. In late March, Malaysia began to force some recent illegalimmigrants back to Indonesia. The threats to export large numbers,however, were probably designed more to placate domestic opinion than forimminent realisation. Yet a prolonged downturn will inevitably createshortages of jobs and potential trouble as foreigners are asked to return tohomelands also in serious economic difficulty.

Friends In NeedThe failure of the region to help itself, threw the role of saviour onto theIMF, and, in particular, its largest shareholder, the US. Both, inevitably,found themselves unpopular in some regional circles. The IMF was criti-cised for imposing a 'one size fits all' package of austerity measures,structural reforms and monetary policies regardless of the huge differencesbetween the Asian economies and earlier beneficiaries of IMF help such asLatin America. The IMF was accused of ignoring the fact that these weregovernments with a record of fiscal prudence, and that the externalpayments crises were largely caused by private sector borrowing. Hence, theargument went, the budget surpluses and high interest rates prescribed bythe IMF were unnecessary and likely to deepen the recession. Whenmassive IMF intervention failed to halt the slide in late 1997, criticism of theorganisation gathered ferocity. IMF officials argued that its critics weremissing the point - the key element in its packages was not the fiscal targets(which in February 1998 were eased for Thailand), but the structural reformit was suggesting. It also pointed out that high interest rates were likely tobe essential until currencies had stabilised. They were dictated by themarket.

Meanwhile, the IMF was under fire in the US from liberals (appalled atits rescue of dictators like Suharto), from free marketeers arguing it wasbailing out the Western banks which had financed the bubble economies,and from a domestic trade lobby afraid the Fund was going to costAmerican jobs by supporting export-led growth in its client countries, someof which were now super-competitive because of devaluation.

The US likewise found itself facing contradictory charges in Asia: thatthe crisis was a result of a conspiracy it had thought up to cut Asia down to

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Year of the Sick Tigers • 21

size and that it was not doing enough to help. Mahathir articulated theconspiracy theory most angrily, repeatedly denouncing the hedge fundoperator George Soros, who was seen as having close White House links.To most in the West, the idea of a concerted conspiracy seems preposterous,but it would be wrong to under-estimate the regional constituency for sucharguments.

The feeling of being let down by the US was most acute in Thailand. Anumber of politicians pointed to Thai-US cooperation during the wars inVietnam and the Gulf, and felt slighted now that their country was nolonger of such strategic importance. The US insisted this was not so, andthat it had played an active role in formulating the Thai package, andindeed had contributed directly to the Indonesian and South Koreanrescues (seen in Thailand as confirmation that the militarisation of theKorean peninsula, the importance of Indonesian sea-lanes, and the greatersize of, in particular, the South Korean economy, gave those countriesgreater geo-political importance). Europe was also criticised in Asia for notdoing enough to help out. But there was a recognition that the crisisrequired American political and financial leadership. This was galling tomany of the region's leaders who had made much of their self-reliance andhad railed against what were perceived as US attempts to impose itspolitical values and economic rules on the world as a whole.

The IMF's managing director Michel Camdessus, as part of hisargument for funding from the US, claimed that the fund's disbursements inAsia were in America's interests. That was precisely the accusation levelledby nationalists in Asia: that structural reforms in their markets (inparticular in banking) meant prising them open to the benefit of UScompanies. Few were as explicit as Mahathir in denouncing this 'new formof colonialism', but the resentment was shared by many ostensiblyacquiescent Asian politicians.

This has to be seen in the context of the frequent skirmishes between theUS and Asia over a range of issues. The countries of South-east Asia share,in varying degrees, worries about China's rising political and militarymight. Most, partly for that reason, welcome American involvement in theregion's security. Yet, whenever ASEAN meetings bring all these countriestogether, the ASEAN countries routinely squabble with the Americans, andfind China on their side.

Once economic recovery is underway, a backlash against US influenceis quite possible. Indeed, by early 1998 it had, to a certain extent, alreadybegun. It could be seen in Suharto's attempts to find a quick fix outside thescope of his IMF programme; in Mahathir's futile efforts to rewrite the rulesof intra-regional trade; and, in a more benign form, in the nationalist (andeconomically insignificant) campaigns introduced in Malaysia, Thailand,Indonesia and, especially, South Korea, to mobilise donations from thepublic to mitigate the effects of the slump.

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