The 10th anniversary of the turmoil that swept the East Asian economies inspired many economists to offer postscripts of those events. But at that time, most analysts were asleep at the wheel. A lack of foresight makes it likely that hindsight will also miss the mark. Alas, a lack of humility or a failure to understand basic market economics does not stop talking heads from expressing ill-formed judgements.
And so it is that many economists express as an article of faith that capital market liberalization and the opening of financial markets upended the Asian economies. As such, short-term capital was depicted as the prime villain for the upsets of 1997.
The claim that footloose capital was dangerous to economic health was based on weak, impressionistic evidence. Much attention was paid to the fact that net capital inflows to less-developed economies from developed economies rose by a factor of six in the six years prior to 1997.
From this, a simple-minded thesis suggested that reversals of these flows caused the mayhem. This thesis seemed to be confirmed by the fact that Russia’s rouble and Brazil’s real were soon to crash before being followed by the upending of Argentina’s economy. Another claim was that resisting capital market liberalization spared India and China from the torments of the late 1990s.
Politicians took up this faulty assessment with great alacrity. Pointing to fickle investors and out-of-kilter markets provided cover to the true culprits. And shifting blame to foreigners and markets allowed public officials another justification to grab resources from the private sector.
It is wrong on several counts to blame capital markets for these problems. The reality is that countries that suffered economic disasters during that time were victims of poor policy choices and failures of political governance. The same politicians who joined in finger pointing were deflecting blame from themselves.
First, pointing to the dangers of “hot capital” implies that had perfidious foreigners not taken away the punch bowl, the party might have gone on forever. But reality offers little support for this contention. Consider that over the course of a few months, Indonesia’s currency had fallen from 2,500 rupiah to the dollar to more than 17,000 rupiah by the beginning of 1998. This could not have happened without massive outflows of domestic capital.
Second, capital markets were only the messenger of bad tidings. Capital outflows were from countries with policy mixes that put investments at higher risk or there were reasons to believe yields would be lower than originally thought. Consequently, both domestic and foreign investors sought safe havens elsewhere.
I had warned in the mid-1990s that East Asian economies would likely face serious problems. These points were detailed in my book, The Rise and Decline of the Asian Century, that appeared just before the tragic events unfolded.
Refusal to accept blame for the boom-bust cycle means that governments did not abandon policies that set the rise and decline of their economies into motion. One error was the implicit or explicit adherence to a neo-mercantilist view that exports can drive sustainable economic growth. The failure of this policy was clear before the devaluation of the Thai currency sparked the regional turmoil in July 1997. Adam Smith pointed out the flaws in export-led growth in his critique of Mercantilism in 1776. As it was, Japan’s “bubble economy” of the late 1980s provided evidence that export-led growth and artificially cheap credit were a toxic recipe. It should have been no surprise that countries imitating Japan were, and are, doomed. Economic and monetary policies pump too much air into asset markets that also promote unsustainable increases in productive capacity.
Getting back to 1997, things coming unstuck in Bangkok made investors re-evaluate risks associated with their positions. All other countries following similar policy themes were destined to suffer the same self-inflicted wounds.
Unwinding massive amounts of excess productive capacity caused massive displacement of workers and hurt shareholders. But liquidation of ill-advised investments was unavoidable for these economies to return to their long-term growth potential. By creating excess liquidity and expectations that set up a false economic boom, policymakers and central bankers were the original source of the pain. China faces a similar set of internal macroeconomic imbalances thanks to excessive global liquidity. Its current economic performance is masking the likelihood of an unavoidable slump as in East Asia before 1997.
Another source of global volatility of export-led growth is that developing economies are encouraged to accumulate huge foreign currency reserves. Their central banks treat these like mercantilist treasurers treated gold or silver bullion. Accumulating reserves is an inefficient use of capital, while an artificially weak currency holds economies back from reaching their potential.
With much of India’s growth derived from within, it depends less both on exports or foreign capital. It is less vulnerable to an inevitable global correction due to a retreat of global liquidity than is China. Unfortunately, RBI and political leaders are preoccupied with a strengthening rupee and the stock of foreign reserves. Instead, their focus should be on improving the investment climate for small and medium enterprises, to encourage risk taking by domestic entrepreneurs. Domestic-driven growth is more stable and more likely to be sustainable.
Christopher Lingle is research scholar at the Centre for Civil Society, New Delhi, and professor of economics at Universidad Francisco Marroquin, Guatemala. Comment at firstname.lastname@example.org