The Road to Rtovej THE W R ' ~v'i ! EAST~~~ ASIA- : THE ROAD TO RECOVERY T EWO RL D BANK WA SH I N GTO0N D .C . Copyright (C 1998 The International Bank for Reconstruction and Development / THE WORLD BANK 1818 H Street, N.W.,Washington, D.C. 20433 All rights reserved Manufactured in the United States of America First printing September 1998 The World Bank does not guarantee the accuracy of the data included in this publication and accepts no respon- sibility whatsoever for any consequence of their use. The boundaries, colors, denominations, and other informa- tion shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any territory or the endorsement or acceptance of such boundaries. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher at the address shown in the copyright notice above. 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Contents Abbreviations and Acronyms v Acknowledgements vii Foreword ix Executive Summary xiii Chapter 1 East Asian Crisis: An Overview 1 Was the miracle real? 2 Why did East Asia falter? 3 Emergence of structural vulnerability 4 Trigger 9 Contagion 10 From currency and financial crisis to economic and social crisis 12 Conclusions and organization of this study 16 Chapter 2 Trade and Competition 19 Causes of the 1996 export slowdown 20 Cyclical or structural? 22 Competition from China and other low-cost exporters 23 Narrow specialization in the electronics industry 25 Intra-Asian trade: The domino effect 26 Asian exports in the aftermath of the crisis 28 Prospects and policies 30 Chapter 3 The Financial Sector: At the Center of the Crisis 33 Financial boom and bust 38 From bust to reconstruction: Moving forward and rebuilding 41 The short-run agenda: Restoring credit flows 45 The difficult and costly task of bank restructuring 49 Principles of bank restructuring 49 Approaches taken to date 50 iii Chapter 4 Corporations in Distress 53 The build-up of vulnerabilities in the corporate sector 54 After the crisis: Assessing the damage 61 The immediate agenda: Restructuring banks and corporate systems 62 Improving corporate governance 67 Chapter 5 From Economic Crisis to Social Crisis 73 Progress and vulnerabilities 74 Pre-crisis challenges and emerging vulnerabilities 77 The social impact of the crisis 80 What can be done? 85 Institutions, corruption, and the social fabric 92 Chapter 6 Environment in Crisis: A Step Back or a New Way Forward? 99 Environmental dimensions of the crisis 100 Chapter 7 Priorities for a Sustainable Recovery 111 Dealing with systemic banking and corporate insolvency 112 The need to restore growth in aggregate demand 116 Protecting the poor and sharing a recovery 122 Progress on structural reforms: Improving the quality of growth 124 Mobilizing additional resources to finance growth 128 The journey ahead 128 References 131 iv Abbreviations and Acronyms AMC Asset Management Company APEC Asian Pacific Economic Cooperation ASEAN Association of South East Asia Nations BIBF Bangkok International Banking Facility BIS Bank of International Settlements CAMELOT Capital, Assets, Management, Earnings, Liquidity, Operating Environment And Transparency CD Certificate of Deposit CPI Consumer Price Index DIP Debtor-In-Possession East Asia 5 Thailand, Korea, Indonesia, Malaysia, The Philippines EU European Union FDI Foreign Direct Investment FIDF Financial Institutions Development Fund FRA Financial Restructuring Authority GDP Gross Domestic Product GEP Global Economic Prospects GNP Gross National Product IBRA Indonesia Bank Restructuring Agency IMF International Monetary Fund KAMCO Korean Asset Management Company LPG Liquefied Petroleum Gas NBFI Non-bank Financial Institutions NEP New Economic Policy NGO Non-governmental Organization NIE Newly Industrialized Economies OECD Organization For Economic and Cooperation Development R&D Research and Development SET Stock Exchange of Thailand SITC Standard Industrialized Trade Classification TFP Total Factor Productivity TRIS Thai Ratings and Information Services Co., Ltd. v LA Acknowledgments This has been a team effort. The study was launched under the direction of Pieter Bottelier, Senior Advisor to the Vice President, for East Asia and com- pleted under the guidance of Masahiro Kawai, East Asia's Chief Economist. Richard Newfarmer was the task manager, and was joined by Mona Haddad and Ilker Domac as the study's principal authors. Stijn Claessens authored the chapter on the financial sector, based upon work done by Pedro Alba, Amar Bhattacharya, Swati Ghosh, Leonardo Hernandez, Peter Montiel, and Michael Pomerleano. Tamar Manuelyan-Atinc and Mike Walton authored the social sector chapter Gordon Hughes, with inputs from Magda Lovei and Herman Cesar, contributed the chapter on the environment. Several members of the team provided valuable analytical papers that were incorporated into the study: Yuzuru Ozeki (macro and deputy task manager), Dipak Dasgupta and Kumiko Imai (trade), Simeon Djankov (corporate governance), Giovanni Ferri (corporate finance), Bert Hofman (corporate sector), Michael Pomerleano (corporate finance and governance). Also, Dieter Ernst, Kenichi Ohno, Takatoshi Ito, Warwick McKibbin and Will Martin, and Nomura Research Institute, Ltd., provided helpful background studies. David Bisbee provided invaluable research support. Several people contributed short analytical pieces and boxes: Natasha Beschoner, Pieter Bottelier, Craig Burnside, Elizabeth Chien, Hilary Codippily and Elizabeth C. Brouwer, Dipak Dasgupta and the DEC prospects group, Larry Lang, Wei Ding, Mary Hallward-Driemeier and David Dollar, E.C. Hwa, Lloyd Kenward, Aart Kraay, Kathie Krumm, Victoria Kwakwa, Felipe Larrain, Rolf Luders, Behdad Nowroozi, Kyle Peters, Caroline Robb, Sergio Schmukler, Richard Scobey, and Vivek Suri. Bonita Brindley provided generous editorial assistance. We are particularly grateful to Joseph Stiglitz, the Bank's Chief Economist and peer reviewers, Amar Bhattacharya, Uri Dadush, Robert Holzmann, Danny Leipziger, Jed Shilling and John Williamson, all of whom provided thoughtful and trenchant comments at different stages of writing. Numerous other colleagues at the World Bank provided inputs and helpful critiques. vii We gratefully acknowledge financial assistance from the ADB-World Bank forthcoming study, Managing the Government of Japan through the Japanese Global Financial Integration in Asia: Emerging Lessons Consultant Trust Fund and the service of the Japan and Prospective Challenges (to which some of the par- Center for International Finance as a secretariat for ticipants here contributed) as well as the forthcoming consultants' work. Also, the study has benefited from World Bank Global Economics Prospects. viii Foreword One year after it began, the economic storm in East Asia is still gathering momentum. The crisis has spread to financial markets around the world and now poses risks to the global economic expansion. Within East Asia, recession threatens to erode the remarkable achievements of East Asia's economic devel- opment. Some 370 million people were lifted out of poverty in the two decades after 1975. This is an accomplishment that in all likelihood will withstand even the gale force of this crisis, but there is no question that for tens of millions life will be much worse in the next few years. Deep recession has exposed millions of children to hunger, deprived parents of the means to support their families, and even triggered sporadic ethnic violence in some countries. The depth of the crisis portends an enduring loss in human potential that will echo for years after this crisis has passed. Children are dropping out of school at an alarming rate. In Indonesia, for example, government officials report that enrollments are down from 78 percent to 54 percent. Economic pressures have forced countless families to split up, pushed teenage girls to enter prostitution, and put elderly poor into life-threatening privation. For the crisis countries, it will take some time to recover the level of income they previously enjoyed. But how long? Will the region suffer a Latin American-like "lost decade" or will it begin to bounce back next year? The standard of living of a whole generation hangs on the answer to these ques- tions. In some respects, East Asia's downturn is unique. It has fused a currency cri- sis, banking crisis, and a regional financial panic into a particularly virulent strand of economic malady. To be sure, its components are well known: credit booms and asset price bubbles associated with poor financial regulation, or financial panics driven more from the herd instincts of investors responding to an isolated and random event rather than underlying fundamentals. Even the well regulated developed countries have experienced these problems. What sets East Asia apart is the harshness and magnitude of its combination of prob- lems: a serial speculative attack on a regional group of countries, provoking ix massive capital outflows, simultaneous crises, and supervision while it also helps these governments recession for a whole region. restructure their banking and corporate sectors. This It is obviously too soon to provide a definitive review also means improving corporate and financial disclo- of a drama that is still unfolding. Our objectives in this sure, better management of debt and contingent liabili- report were more modest: to take stock of progress in ties, and implementing legal and regulatory reform. the region, highlight the factors shaping East Asia's Through its project lending, especially to infrastructure, future, and suggest broad directions of policies. the World Bank is intensifying dialogue to instill envi- The main challenge is to restore broadly shared and ronmental safeguards that address the environmental sustainable economic growth. The report focuses on a and natural resource problems exacerbated by the crisis. three-pronged strategy: These efforts contribute to the restoration of growth, and * reactivating growth based upon structural reforms growth that can be sustained. that will allow recovery to take hold sooner and To protect the poor, unemployed, and elderly from make it enduring; the social impacts of the crisis, the World Bank has sup- * protecting the poor during the crisis and ensuring ported basic health, education, targeted food subsidies, they will share in recovery when it comes; and in and labor-intensive and employment-generating public * mobilizing capital to help jump-start economic works. Social fund projects and stay-in-school pro- growth. grams have been introduced in Indonesia and Thailand, The hard work of implementation lies ahead. and improvements to social safety nets (including labor market, pension reform, delivery of social services, The World Bank's Support poverty targeting) have been developed in other coun- tries. Over the long-term, the World Bank is working In each country of the region, the World Bank is work- toward improving the social and human sustainability ing in tandem with governments to realize this three- of growth to address the social shortcomings of East part strategy. The World Bank has pledged nearly $18 Asian development-growing inequality and lack of billion to the East Asia crisis countries and disbursed formal social safety nets such as healthcare and unem- over $8 billion in loans in the year since July 1997. ployment insurance-while protecting and reinforcing Reactivating growth on the basis of structural the region's social successes-education, health, and reforms is a high priority. The World Bank is helping quality of life improvements. governments to increase their spending in efficient The Bank is redoubling its efforts to mobilize external ways, especially social spending. It has approved 45 resources for the region. Arguably the World Bank's major loans to the region in the first year after the cri- most important contribution is not in the capital it pro- sis. The World Bank has thus helped to finance a more vides but in helping the region regain the confidence of expansionary fiscal position, and the resulting demand domestic and foreign investors through sound policies. will in turn help to create jobs and income. Our focus Restoring confidence in the future is the secret to has not only been on the amount of spending but, even attracting new capital inflows. Often there is a lag more important, on the quality of spending. In prepar- between the time sound policies are adopted and the ing and supervising these loans, the World Bank has return of market confidence. The World Bank intends provided policy advice and technical assistance, a dia- to play a leadership role in mobilizing capital during logue that is supplemented with a steady stream of eco- this period. It will increase its own lending up to the nomic studies, public expenditure reviews, and limits of its own prudential regulations as long as the conferences involving partners from the private sector pace of domestic policy reforms warrants. Beyond this, and Non-govemmental organizations (NGOs). Through in conjunction with other partners-the International its multi-billion dollar structural adjustment programs Monetary Fund, the Asian Development Bank, govern- in Thailand, Indonesia, the Republic of Korea, and the ments, and the private sector-the World Bank will be Philippines, for example, the World Bank is helping looking for new ways to mobilize capital to help jump- governments to improve financial sector regulation and start growth. x The task ahead is enormous. The crisis is as important product and capital markets. Similarly, governments to East Asia as the debt crisis of the 1980s was to Latin and public governance are changing in historic ways. America. As that crisis changed irreversibly the eco- Even as they shoulder burdens from past implicit guar- nomic and political institutions of the day, so too antees to the private sector, governments are reorganiz- throughout East Asia societies are changing dramati- ing themselves to reduce these contingent liabilities and cally in ways that none would have predicted only 18 their direct role in resource allocation. They also are months ago. Virtually all of the countries in East Asia assuming new responsibilities. As traditional rural fam- are transforming the old ways of conducting their busi- ily ties breakdown under pressures of urbanization, ness and politics. Companies that borrowed freely and societies everywhere in the region are looking to gov- frequently using only the collateral of unfolding rapid ernments for help in ensuring the welfare of the poor, growth are being subjected to a new discipline. Banks the unemployed, the sick, and the elderly. In the back- that borrowed in yen or dollars and loaned in local cur- drop, a new politics of governance-from Korea in the rency using a nod from government as their only hedge, North to Indonesia in the South-seems to augur a new are being subjected to greater supervision. Enterprises openness, concern for corruption, and accountability. and banks are undergoing ownership and organiza- The journey to recovery, filled with uncertainty to be tional changes as profound as those in Latin America sure, is set on a historic course that will shape the future during the 1980s or even in the United States during the of East Asia's children. 1930s. Though it is too soon to say with certainty, com- panies and banks may well emerge with less concen- Jean-Michel Severino trated ownership, greater representation and Vice President transparency for minority shareholders, including for- East Asia and the Pacific Region eigners, and greater discipline from competition in both World Bank xi xii Executive Summary East Asia's financial crisis quickly has deteriorated into an economic and social crisis. Real wages have plummeted, and the region's major cities are filled with idled workers looking for jobs. In the countryside, the combination of drought-parched lands and dried-up rural credit has threatened the livelihood of many. Since this comes after three decades of rapid growth, a whole gener- ation of workers and farmers has never known these hardships, and societies have developed few formal mechanisms to ease their plight. This study presents an analysis of the crisis, provides a report card on progress within the region, and suggests policy directions that will affect the pace of recovery. The most urgent task ahead is to restore the conditions for robust economic growth throughout the region. This is particularly true for Thailand, the Republic of Korea, Indonesia, and Malaysia, where recession has been unrelenting and severe. The other, smaller developing countries in East Asia are feeling the ripples of the crisis, and are fighting off deep recession. The economies of Taiwan (China), Vietnam, and China have so far avoided the recession, but they too have been pushed below their trend-line growth paths. Origins of the crisis Even as growth was improving the livelihoods of the poor, it had begun creat- ing several sources of vulnerability in the mid-1990s. The region's very suc- cess-rapid growth, conservative economic management and low indebtedness-made it attractive to private capital. These inflows, while spurring growth, were intermediated through poorly regulated domestic finan- cial systems and helped fuel domestic credit expansion. The pace and pattern of growth, interacting with often-undisciplined capital inflows, produced three weaknesses in the foundation of East Asia's growth: * Large current account deficits, financed with short-term flows, exposed East Asian economies to sudden reversals. xiii * Liberalization of domestic financial markets with- of non-performing loans rises, banks' cash flows are out adequate prudential regulation and supervision squeezed, forcing them to contract new lending to illiq- allowed banks and corporations to assume uid corporations and call-in even good loans to raise unhedged foreign borrowing positions that left them cash, further deepening the recession. This report there- vulnerable to sudden currency fluctuations. fore focuses on structural reforms that will reactivate * Companies, in the absence of fully developed bond demand in a sustainable fashion: speeding up the and equity markets, borrowed heavily from banks process of financial and corporate restructuring, estab- to finance their rapid expansion, and in the process lishing a better framework for financial and corporate became very highly leveraged. This left them vul- governance, enhancing public sector management, and nerable to interest rate surges. improving environmental policy. Only by progressing When markets became worried about the sustainabil- on this combined agenda can countries ensure that ity of the fixed exchange rate in Thailand, capital growth will be sustainable and of high quality. inflows became outflows. Asset values plummeted- Second, ensuring that low-income groups are pro- particularly equities and property-and suddenly tected during crisis and then share in eventual recovery. turned what had been a virtuous circle into a vicious If output were to fall by a cumulative 10 percent over one. Falling asset values reduced wealth and imposed the next three years and income distribution worsens by balance sheet losses on financial agents, demand fell, 10 percent, the number of poor people in Indonesia, and contracting markets produced greater outflows. Thailand, Malaysia and the Philippines would more Finance stampeded to safe havens, making the situation than double-from some 40 million to more than 90 worse. million. This is an unlikely but still possible scenario, and underscores the importance of renewing growth. Main challenge: Restoring growth The report lays out an agenda of pro-poor fiscal poli- cies, suggests ways to maintain incomes of the poor, and The main challenge today is restoring broadly shared focuses on enhancing social services that cushion the and sustainable growth for the region. Three elements worst effects of recession upon the poor. Reforms in form the basis of a strategy. pension systems, labor markets, and education can help Enacting structural reforms to restore high quality incorporate low-income groups into a sustained eco- economic growth. The only way to reverse the income nomic expansion. losses imposed upon the poor is for countries to reacti- Finally, the international community must do what it vate economic expansion. But the quality of growth can to restore international capital flows. The region matters. If it is not environmentally sustainable, leaves has suffered a massive swing in private capital. out the poor, or is cut short because of inadequate struc- Domestic policies that inspire investor confidence are a tural foundations, recovery will not achieve its promise. necessary condition for renewing private capital A pre-requisite is reactivating demand. Exports are inflows. With policies in place, a concerted effort to growing slowly because neighboring countries are also mobilize additional finance would mitigate the pressure in recession, investment is hobbled by systemic insol- on consumption levels in the region and spur growth. If vency in the banking and corporate sector, and declin- an additional $10 billion in external finance could be ing incomes and wealth have depressed consumption. mobilized and it were used to finance an additional fis- In Indonesia, Korea, and Thailand, 20-65 percent of cal stimulus, it would provide a strong impetus to firms are estimated to have balance sheet losses greater growth. If some of the spending were focused on low than equity. Insolvent, highly leveraged companies can- income groups, it could mitigate the worst effects of the not service their debt. Non-performing loans in those crisis. The report does not delve into specific mecha- countries are thus estimated to range from 20-40 per- nisms for mobilizing finance, a discussion that is tran- cent. The situation has created a self-re-enforcing spiring in international fora and elsewhere, but it is downward spiral: recession forces corporations to nonetheless essential that this challenge be faced delay or default on bank payments, and, as the amount squarely. xiv Looking ahead It would be easy, however, to be overly pessimistic about the region's future. Countries throughout the Recovery is likely to take longer in East Asia than in region are moving swiftly to enact new policies and Mexico and Argentina in 1994-95 because of the prob- adopt new, more transparent ways of doing business. lem of corporate and bank insolvency and because of They have shown themselves willing to work extraor- the regional scope of recession, including Japan. The dinarily hard and sacrifice today for benefits tomorrow. global economy has been so far supportive, but events Witness the region's continuing high savings rates. If in Russia and in global financial markets in recent the pace of reform accelerates and if the international months raise worrisome signs that even that bright spot community responds positively, the region will soon may be dimming. The recent floods in China also weigh find itself on the road to recovery. on the region's prospects. An expanding global econ- omy is arguably the most important element in East Asia's recovery. xv xvi East Asian Crisis: An Overview In mid-October, 21 year old Sugiyanto was still swinging a shovel at a Jakarta con- struction site. Six months earlier he had made a personal pilgrimage by overnight bus to the capital from the village of Banjarjo in centralJava. "On TV, it looked so easy to make money in Jakarta." The money, however, has since dried up. Indonesia's financial crisis has brought many construction projects to a halt. With new jobs scarce, Sugiyanto slunk home to Banjarjo in early November-only to find that his father's rice paddies had dried up too. Months of dry weather have turned the fields in to a parched brown expanse. No work, no monsoon, no escape. For Sugiyanto there's nothing to do all day but slump over a motorcycle, hoping to cadge a few faded bills in return for offering lifts. There are few takers. Villagers would rather spend their money on water.-Margot Cohen, "Unlucky Country," Far Eastern Economic Review, December 25, 1997. fter three decades of remarkable expansion, the economies of East A Asia have gone into a tailspin. The once booming economies of Thailand, the Republic of Korea, Indonesia, and Malaysia will con- tract this year. Singapore, Hong Kong (China) and Taiwan (China), with their strong financial systems and high reserves have, so far, managed to fight off the worst of the contagion, but have seen their export markets and businesses con- tract. The transition economies, partially protected with their semi-closed cap- ital accounts and low ratios of short-term debt to reserves, have emerged with the added challenges of diminished prospects for exports and capital inflows. 1 The smaller economies, from Mongolia to Fiji, are buf- class, coming as it did after the most rapid sustained feted by the storm around them. The Solomon Islands expansion in human history, will undoubtedly be as may contract by 10 percent or more in 1998. profound. The end of the 20th century for East Asia is The currency and financial crisis has quickly deterio- changing the way business is conducted, the way rated into a social crisis. In the past, steady economic resources are allocated, and the very economic and, in expansion provided the underpinnings to the livelihood some cases, political governance of countries. of the poor, and substituted for a formal social safety This study looks at these changes and focuses on poli- net. Today that is gone. Unemployment is rising. Real cies for a sustainable recovery. It is designed to be a wages of low-income urban workers have plummeted, snapshot of where the region stands, a progress report and the region's major cities are filled with idled work- on the enormous changes that have been made in the ers looking for ways to make a living. Inflation has last year, and an analysis of the remaining obstacles to risen, with the possible effects of worsening income dis- establishing a firm economic recovery. But, the region tribution and further reducing the real wages of low- cannot be satisfied with a short-lived growth spurt. It income groups. To make matters worse, drought has must aspire to nothing less than recapturing the lost parched much of the region's otherwise fertile land, growth momentum of the last three decades. making it difficult for farmers to take advantage of Subsequent chapters look at those policies. This chap- higher food prices. The effects of falling incomes are ter reviews the gains of the past and the causes of the cri- felt most severely by poor women and children. Also, sis. in some countries economic pressures have ignited latent social prejudices against minorities and immi- Was the miracle real? grants. The effects go beyond the poor. The currency fall and East Asia's achievement of spectacular welfare gains in crash of the equity markets has wiped out savings of the the last two decades is beyond dispute. Poverty has middle class and newly rich. The decline in equity val- declined, not only in breadth (the number of poor) but ues in the region has surpassed US$400 billion since also in depth (severity of poverty). Life expectancy at July 2, 1997. Meanwhile, efforts to improve the qual- birth, infant mortality rates, and literacy indicators ity of life of all East Asian citizens through greater social have all improved in tandem, generating real improve- and environmental investments have stalled. ments in peoples' lives. The region succeeded in convert- Signs of a new, if fragile, financial stability are appear- ing persistently high growth rates into improvements in ing in four of the five crisis-affected Asian countries welfare because growth, supported with widespread (Korea, Philippines, Malaysia, and Thailand). The social services, created jobs for the poor and enormous Philippine economy has thus far come through with opportunities to expand productivity. The miracle was surprising vitality. Thailand and Korea, after suffering real and tangible. collapse in their financial systems, have established The region reduced the number of people living in firmer values for their currencies and are rebuilding poverty by half in the last 20 years. As figure 1.1 shows, reserves. Indonesia is still fighting to regain a modicum the number of poor living below the international of stability. However, the economic recovery that all poverty line of US$1-a-dayl was reduced from 720 mil- had hoped would come soon is not yet in sight. While lion to 350 million. Moreover, the rate of decline accel- the prospects are uncertain, it is clear that the changes erated over the past decade: the total number of people wrought by the events of 1997 will be as profound as in poverty fell by 27 percent during the period 1975-85, those brought on by the debt crisis in Latin America and fell an additional 34 percent during the period during the 1980s. Although unemployment in East 1985-95. This pace of poverty reduction was faster Asia will probably not reach the levels of some coun- than in any other region of the developing world, and, tries in Latin America, a far greater share of the popu- as a result, the share of the world's poor living in East lation in East Asia is living just above the poverty line, Asia has declined. While six out of ten East Asians lived so any substantial slowdown puts their livelihood at in absolute poverty in 1975, roughly two in ten did in risk. Furthermore, the shock of recession to the middle 1995. 2 East Asia: The Road to Recovery Within East Asia neither poverty levels nor rates of * Encouraged high rates of savings by keeping inter- decline were identical across countries. In 1975, China est rates positive in real terms and by effectively pro- and Indonesia alone accounted for 92 percent of the tecting deposits in financial institutions2 region's poor, largely because they were the two most * Limited price distortions populous countries. Since 1975, however, both coun- * Encouraged absorption of foreign technology tries have recorded substantial declines in poverty, 82 * Avoided implicit taxation and other biases against percent in Indonesia and 63 percent in China. In agriculture. absolute terms, the number of poor decreased by more Several studies have confirmed that high rates of sav- than one-half in China and fell by almost three-fourths ings, investment in human capital, and stable macro- in Indonesia (the head count declined from 64.3 percent economic policies are key determinants of growth.3 in 1975 to 11.4 percent in 1995). By 1995, the two countries accounted for 84 percent of the region's poor. Why did East Asia falter? Although Indonesia's record was remarkable, Malaysia had the largest proportional reduction between 1975 Such remarkable economic and social performance and 1995 (95 percent decline, from 17.4 to less than 1 made the sudden downward spiral of the East Asian 5 percent) and Thailand was a close second (90 percent all the more startling. Several structural problems were decline from 8.1 percent to less than 1 percent). well known and analyzed prior to the collapse of the Propelling these achievements was a high perfor- ThaibahtinJulyl997. Didthesestructuralproblems mance engine of economic growth. Several factors lay finally produce the exhaustion of the East Asian model, behind this growth performance. Governments gener- much as import substitution in Latin America became ally: fully exhausted during the crisis decade of the 1980s? - Kept inflation low and exchange rates competitive Or, was the crisis in East Asia the result of short-term through conservative macroeconomic policies macroeconomic mistakes and financial panic, a type of - Invested in human capital through public expendi- macro-financial accident? tures on education Rapid growth, urbanization, and industrialization were spawning new and difficult development prob- lems prior to the crisis. These were building in three fl G1JRE=Ai-.1ffiffig = dimensions. First, rapid growth, in the absence of Poverty in East Asia fett dramaticaity sophisticated financial and capital markets and with a large government presence, left the corporate and finan- Total population in billions cial sectors unusually reliant on financing long-term 1.8 investment with short-term debt capital (this will be dis- 1.6 cussed below). Second, economic growth was under- 1.4 mining the traditional protection mechanisms for the unemployed, the sick, and the elderly. East Asia relied 1.2 on high personal savings and family ties to provide 1.0 Non-poor security for its elderly. It came to rely on growth itself 0.8 to provide an ever more buoyant labor market. The 0.6 \ 7imESi>B 2B|g forces of growth, with their demands for an increas- ingly mobile labor force, migration, and wider scope for 0.4 l _ Poor \_;_ personal consumption, were putting strains on tradi- 0.2 tional ways of solving social problems. In the transition 0.0 countries of China and Vietnam, the old commune and state enterprise system of welfare was under analogous Source: World Bank 1997, Everyone's M4iracle? strains with the spread of markets. In the wealthiest countries, lifetime employment guarantees in the cor- porate sector were proving increasingly out of tune with East Asian Crisis: An Overview 3 the modern economy's needs for rapid change and flex- financial markets that were growing rapidly. The sce- ibility. Third, a weakness of a different kind resulted nario played out as follows: The push from global cap- from the exploitation of national resources, particularly ital markets, often without due diligence and beyond forests. Southeast Asian growth was fueled, in part, by prudent limits, interacted with poorly regulated domes- over-logging, intensive exploitation of fisheries, and tic financial systems to fuel a domestic credit expansion. wasteful agricultural practices. Although national This manifested itself as an asset price bubble, particu- income accounts are difficult to adjust for environmen- larly in Thailand, and added to the excessive debt of tal damage, some estimates are that Malaysia's growth already over-leveraged firms, which exposed the region in gross domestic product (GDP) would have been to the shocks of changing investor expectations. approximately 20 percent less if adequate allowance bad been made for resource depletion. Ready availability of capital Nonetheless, there is not much evidence that these long-term development problems alone were enough to Globalization of financial markets has been occurring drag down growth, much less precipitate a sudden at a dizzying pace. From 1990 to 1997, the volume of reversal of fortune. Productivity growth was generally private capital flows to developing countries rose more within the normal range for developing countries.3 In than fivefold-from US$42 billion in 1990 to US$256 that sense the "miracle" was no miracle at all. Rapid billion in 1997. While world trade grew by about 5 per- growth relative to other countries was achieved by dint cent annually, private capital flows grew by nearly 30 of sacrifice reflected in East Asia's famously high sav- percent annually. The most mobile forms of flows, ings rates, hard work as reflected in the dramatic commercial bank debt and portfolio investments, set increases in labor force participation rates, and invest- the pace. ments in education as reflected in the skill level of the Propelling this expansion was an aggressive search work force. Productivity, per se, is less important than for ever higher returns to capital. "Emerging markets" increases in per capita income, whatever the source, and were booming, and offered greater profitability than East Asia simply out-performed other regions of the investments in developed countries. Banks and finan- world by this more meaningful measure. cial institutions, often trapped in slow-growing but Even if declining returns to investment eventually were to set in, the question is when and whether they FIGURE 1.2 would be sufficient to precipitate sharp slowdown or crisis. Comparisons with a conventional Solow model skyrocketed suggest East Asian performance exceeded predictions in most countries (see box 1.1). Moreover, any growth 350 slowdown associated with diminishing returns is likely 300 to be well into the 21st century, not the mid-1990s. The main sources of the crisis will have to be found else- 250 PortfoLio equity fLows where. 200 Debt flows Emergence of structural vulnerability 150 Three forces interacted to leave some countries in the 100 region-notably Thailand, Korea, and Indonesia- 50 vulnerable to external shocks: a burgeoning availability 50 dL n a of private capital, especially short-term capital, that 0 Officia[ development finance was in search of higher returns; macroeconomic poli- 1990 1991 1992 1993 1994 1995 1996 1997a cies that permitted capital inflows to fuel a credit boom; and newly liberalize,butinsuficientlyega. PreLiminary. and newly liberalized, but insufficiently regulated Source: World Bank Debt Reporting System. 4 East Asia: The Road to Recovery Of paper tigers and productivity growth In an influential 1994 articLe, Paul Krugman drew attertion to the then-novel findings of a number of economists that growth What would Sotow say? in East Asia had been due more to increases in inputs rather than increases in the efficiency with which those inputs were used. (Log of GOP pet wlorker) This finding prompted him to refer to the economies of East Asia as a collection of "paper tigers" whose growth rates were bound 10 Predicted to decline vith the onset of diminishing returns. Have events Actual vindicated this view? Rapid factor accumuLslion unaccompanied by rapid productiv- ity growth logically impLies that growth rates must eventually decLine as diminishing returns set in. The key question, of course, is when this witl occur, and by how much. To provide a back-of- 8 the-envetope answer to this question, the figure betow plots the Indonesia log-level of per capita income, and the tog-level of income pre- dicted by the Solow growth model, assuming a measured total factor productivity (TFP) growth rate of 1 percent per year, for Indonesia and Korea. In addition, the model is used to project forward income tevels, assuming unchanged TFP growth and sav- ings rates and tabor force growth rates that are equal to their 6 ,˘ ° . avere.:es over the penod 1991-95. The ficure suggests thit, con- N e ". N X N K f ' ° '^ sistent with the converitionaL wisdom, a simpte model of giowth driven pnmarily by factor accumulation and with only modest productivity growth provides a reasonably good description of these ountris' hisoricalgrowthexperinces.What do these calculations imply for recent events in East thesecounties' istoHal grwth eperieces.Asia? The financial crisis has undoubtedLy dampened growth The figure plots the log of actual GDP per worker and that pre- AsaThfnnclcrisasudbtydmpedgoh iThed bygthe Sotos model,gof assumigaGDPper cona T d grthat prte prospects for these countries for the next several years. However, of 1 percent per year. The figure also shows that consistent with the decline in growth rates is much larger and more dramatic than of pc p a h g L h twhat would be expected as a r.'sult of the simple petering out of the theory, growth rates can be expected to decline over time as diminishing returns set in. However, the decLine in growth rates thirapid growth due to the onset of diminishing returns. Atthough is fairly gradual. As shown in the table for these and for the other th ish sreLyvtoe a ortant f rovth longer t it three cnsis economies, the onset of diminishing returns can be has nlttle reLevance for the recent growth collapse a point Mr. expected to account for only rather moderate dectines in growth Krugman himself has made. raLes over the next few years relative to historical averages. Diminishing returns and other culprits (Average annual growth in GDP per worker, percent) 1960-96 1997-2000 Difference Predicted by GEP Predicted by Actual Solow Model projections Solow M' del GEP Solon Indonesia 3.5 4.1 -0.1 4.1 -3.6 0 0 Korea, Rep. of 5.9 5.5 0.4 4.3 -5.5 -1.2 Malaysia 3.7 4.4 1.5 4.2 -2.2 -0.2 Philippines 0 7 2.9 1 2 2.1 0 5 -0.8 Thailanid 4 0 4.1 -1.8 3.9 -5 8 -0.2 GEP proiŽctions taken frcm the rebrrr 1998 GLobal Economic P'ospe.ts Updaie Source- WNor' Sank staff East Asian Crisis: An Overview 5 highly competitive home markets, scanned the globe for gains were high. Thus, the link to the U.S. dollar in investment opportunities. Hong Kong (China) or the strong currency policy in The very success of East Asia made it an ideal location Singapore did not result in a real exchange rate mis- and the combination of rapid growth, low debt ratios, alignment. To further complicate matters, the yen and a history of sound macroeconomic management depreciated against the U.S. dollar throughout much of attracted capital like a magnet. 1996, so the pegged currencies lost competitiveness against the important yen market. But, the most impor- From inflows to credit boom: Macroeconomic tant effect was the incentives the policy gave to borrow and exchange rate policy abroad. Exchange rate policies played a particularly large role in motivating capital flows. By reducing the Macroeconomic policy in East Asia inadvertently cre- perceptions of exchange rate risks, incentives to hedge ated incentives for private agents to take advantage of external borrowing were suppressed and, moreover, the the easy access to international capital, and these flows relatively narrow exchange rate movements created a financed a domestic credit boom. Indonesia, Korea, bias toward short-term borrowing. Malaysia, and Thailand experienced a sharp accelera- Between 1994 and 1997, the net private capital tion of domestic demand. The macroeconomic policy inflows as a share of the rapidly expanding GDP mix used to deal with the overheating pressures and increased throughout the East Asia 5. The exception capital inflows in the 1990s added an impetus for fur- was Thailand where, by 1994, the net private capital ther inflows, particularly for the accumulation of short- inflows had already reached 14.5 percent of GDP (see term, unhedged external liabilities. However, tightening figure 1.3). monetary policy in an effort to sterilize inflows and cur- East Asia generally absorbed nearly 60 percent of all tail credit expansion increased domestic interest rates, short-term capital flows to developing countries. In the as well as the differential between domestic and foreign mid-1990s, much of the short-term private capital came rates. This had the perverse effect of creating further from Japanese banks as they followed their corporate incentives for investors to borrow abroad to make local foreign investors into Korea and Southeast Asia. The investments. On the fiscal side, governments through- Europeans soon followed in an aggressive search for out the region had generally run fiscal surpluses from the late 1980s, and were unaccustomed to using fiscal FIGURE 1.3 policy as a macroeconomic instrument. While fiscal policy in most East Asian countries remained conserva- to East Asia tive in a medium-term structural sense, the fiscal impulse (the change in the fiscal stance) turned positive Net private capitalflows to East Asia, 1994-96 at the time when these economies were experiencing demand pressures.5 ThaiLand Most of the Association of Southeast Asian Nations (ASEAN) countries adopted a nominal anchor policy PhiLippines by pegging loosely to the U.S. dollar in the run-up to the crisis, switching from real exchange rate targeting in the MaLaysia m 1994 earlier period. Informal pegs to the U.S. dollar encour- - 1995 aged capital inflows due to large interest rate differen- Korea, 1996 tials. Predictable nominal rates encouraged unhedged Rep. of external borrowing. A wedge was driven between the actual and equilibrium real exchange rates due to a loss Indonesia of competitiveness and declining corporate profitability 0 5 10 15 20 on the one hand, and a real appreciation on the other, Source: WorLd Bank GLobal ievelopment Finance, 1Bi8. Exceptions were Singapore and Hong Kong (China) where labor markets were flexible and productivity 6 East Asia: The Road to Recovery profits. By 1996, the Bank for International term debt relative to overall external liabilities began Settlements (BIS) reported that European Union (EU) rising sharply. banks' outstanding bank loans amounting to US$318 Capital inflows and the credit boom increased vul- billion; the Japanese banks had US$261 billion; and the nerability in two dimensions. On the one hand, the U.S. banks had US$46 billion (WEO, 7). ratio of short-term debt to foreign reserves, a rough These inflows fueled the domestic credit boom measure of a country's ability to meet its current oblig- throughout most of the region. In the East Asia 5, ations from its own liquid resources, rose sharply from broad money (M2) expanded at a near 20 percent 1994 to 1997, except for Indonesia, where it remained annual rate in 1996 and 1997. This was nearly twice at high levels. In the three most-affected countries- the rate of China, Taiwan (China), Hong Kong (China), Korea, Indonesia, Thailand-short-term debt-to- and Singapore-countries that would later fare better in the storm of speculative attacks. The credit boom, f 4 : - XL -- - -- in turn, led to an increase in assets prices, creating the Korea and Thailand require ever greater appearance of high returns. Property values in investment to achieve the same level of output Bangkok, Seoul, and Jakarta rose at double digit rates growth through 1996. Rising asset prices provided greater col- Incremental capital-output ratios lateral to banks, and led to greater lending. At the same (five-year moving averages) time, middle- and upper-class owners of these assets, 6 feeling more well-heeled, consumed more freely. Rising aggregate demand encouraged yet more foreign bor- rowing. 4 Weak financiaL systems Led to poor 3 investments and excessive risks 2 As capital inflows increased, the quality of intermedia- tion became increasingly important. Invested in high- 1 return activities to creditworthy borrowers, these capital inflows had the potential to spur East Asian 0 1988 1990 1992 1994 1996 growth. However, incremental additions to invest- Korea, Rep. of ments appear to have yielded a lower return. As indi- Incremental capital-output ratios cated in figure 1.4, the incremental capital-output ratio (five-year moving averages) in Thailand and Korea, after some fluctuations in pre- 6 vious decades, rose every year after 1988. East Asian countries receiving foreign capital primar- 5 ily through the domestic banking system or through direct corporate borrowing became more vulnerable 4 than countries relying predominantly on foreign direct 3 investment.6 This was especially true in Thailand. Private decisions that resulted in an excessive buildup of 2 risky forms of leverage on the balance sheets of finan- cial institutions and non-financial corporations, in par- 1 ticular of short-term foreign currency debt in excess of foreign currency resources available on short notice. In 0 8 9 9 1 1 several East Asian countries in the late 1980s, short- 1988 Th9 d 1996 Source: WorLd Bank GLobaL DeveLopment Finance 1998. East Asian Crisis: An Overview 7 reserves ratios had risen to well over 150 percent by Three microeconomic factors accentuated the incen- June 1997. Malaysia and the Philippines were not as tives to borrow abroad. First, the implicit insurance- badly exposed, with ratios at less than 100 percent. for example, the fixed exchange rate-provided to Credit growth was evident in the high ratio of broad financial institutions motivated excessive risk-taking, money to reserves, and the two were correlated, as seen including large foreign exchange risks, that were in figure 1.5. A broader measure of vulnerability, the passed on to the rest of the domestic economy. Second, ratio of M2 money to reserves, indicates the potential high domestic funding costs and market segmentation for a "run" on the foreign exchange reserves of a coun- added to the incentives to borrow abroad. In Thailand try with a fixed exchange rate by its own residents when during the period 1991-96, domestic financial interme- there is a loss of confidence in the local currency. diation costs accounted for 28 percent of the nominal Countries with exchange controls and less open capital baht interest cost.7 The domestic cost of funds was sig- accounts are less vulnerable than this measure would nificantly higher than the costs of borrowing "off- otherwise indicate because of the difficulty in shifting shore," even after taking into account exchange rate funds out of the country. risks, which only added further incentive to borrow for- Patterns of indebtedness varied across countries. In eign funds. Since this access to foreign markets was only Thailand, finance companies and banks, availing them- available to the largest and best credit corporations, selves of extremely low-interest, yen-denominated these firms and banks enjoyed a market advantage, and loans, borrowed through government sanctioned chan- undoubtedly used their access to political leaders to nels to invest in rcal estate. Financial institutions' net protect their position, making it more difficult for regu- foreign liabilities rose from 6 percent of domestic lators to limit "off-shore" borrowing to prudent levels. deposit liabilities in 1990 to one-third by 1996 (Global Third, the creation of "off-shore" financial markets in Economic Prospects (GEP), 1998). Korean banks also which local corporations could, because of regulatory increased their exposure to foreign borrowing. In and tax advantages, obtain lower-cost finance than in Indonesia, however, corporations became the primary domestic markets. This situation was the most severe in borrowers from foreign sources, with much of it com- Thailand. ing from "off-shore." The inflows also fed into a system of corporate finance that heightened risks from abrupt changes in FIGURE 1.5 interest or foreign exchange rates. The corporate sector VulnerabiLity indicators had grown rapidly during the previous decades in a (Selected countries, June 1997) context of under-developed bond markets and over- reliance on bank financing. The debt-equity ratio of 800 Korean corporates, for example, was over 317 percent * India by the end of 1996, twice the U.S. ratio, and four times 700 Indonesia the Taiwanese ratio. The top 30 Korean chaebols had 600 Korea, Rep. even higher leverage, on average more than 400 percent PhiLippines Thailand in 1996. Correspondingly, interest burdens are very 500 MLs high in East Asian countries. In Korea, for example, the 400 e * Mexico * Russia interest-expenses-to-sales ratio of all manufacturing 300 * Turkey corporations in 1995 was about 6 percent, compared to ChiLe 2 percent for Taiwan (China) and 1 percent for Japan. 200 * Columbia This would present a painful dilemma to macroeco- U Peru 100 a nomic policy makers when the crisis hit: they could use VenezueLa interest rate adjustments to maintain exchange rate sta- 0 0 50 100 150 200 250 bility but only at the cost of imperiling their highly Short-term debt-to-reserves ratios, in percent leveraged corporate sectors and creating a domestic liq- Source: BIS, IMF, and GEP, 1998. uidity crunch. 8 East Asia: The Road to Recovery In retrospect, it is also clear that the regulations nec- This created a potentially explosive situation that only essary to manage the integration of global external required detonation. finance had not kept pace with capital inflows. Inconsistent reforms and inappropriate sequencing of Trigger liberalization added to the buildups of vulnerabilities. For example, licensing and supervision regulation of Macroeconomic imbalances and financial sector weak- merchant banks in Korea permitted groups of compa- nesses were most pronounced in the case of Thailand: nies to own both banks and the same groups of firms the current account deficit, which reached very high lev- to whom they were lending. In Indonesia, the number els of 8 percent of GDP, was financed by short-term of banks expanded very rapidly and the supervisory inflows. The heavy inflows and credit boom channeled authorities spent too little time screening the integrity of substantial investment into real property, creating an owners and managers to keep out applicants with poor asset price bubble. The private sector had borrowed prospects or fraudulent ventures. In Thailand, the huge amounts from abroad and, taking advantage of scope of finance companies' activities greatly increased the promise of a pegged exchange rate, did not hedge in the 1990s without a commensurate improvement in against foreign currency risks. Thai borrowers, many of their supervision. In several East Asian countries, the which were under-regulated finance companies, capital account was liberalized for inward and outward invested in the booming property market. In the mid- flows for foreign investors; domestic investors, how- 1990s, an investor could borrow in yen at near zero ever, did not always have the opportunity to invest interest rates and invest in Bangkok skyscrapers, whose abroad and thus, could not diversify their risks. Finally, expected annual return was 20 percent. throughout the region, regulations requiring prudential In 1996, export growth hit a wall. After growing 20 management of currency risks, credit evaluation, and percent in 1995, exports actually contracted by 1 per- public financial reporting were wholly inadequate. cent in 1996. Although all East Asian exports had The time bomb was loaded. Rising global liquidity slowed in conjunction with diminished world demand, fed huge amounts of capital into a poorly regulated Thailand was the worst hit. The impact was the result institutional setting with limited transparency, and of three elements: the loss of wage competitiveness related party lending, often with negligible due dili- associated with appreciation; the demand for its prod- gence from foreign lenders. Implicit and explicit gov- ucts, particularly electronics, slumped badly in world ernment guarantees on the exchange rate and selected markets; and because growth in its markets, notably investments fed into a domestic credit boom that Japan, slowed sharply. At the same time, prices of real macroeconomic policy failed to manage. East Asian assets stopped growing. Vacancy rates increased in countries had taken risks that left them exposed to 1996 as the supply of office space began to outpace shocks in several ways: demand. The finance companies began to experience * Widening current account deficits, financed with serious difficulties in early 1997. The government short-term debt, exposed the economies to sudden response to furnish them with liquidity, only added to reversals in capital inflows. the supply of funds in the market ready to attack the * Weaknesses in the under-regulated financial sector peg. had allowed expansion of lending into risky invest- Equity investors were the first to withdraw. The stock ments of inflated values, often with currency and market peaked for the year in February, and fell by maturity mismatches, which exposed entities to more than 30 percent by year's end. As the yield curve exchange rate risks. tilted against Thai borrowers, short-term borrowing * Corporations, often with insider relationships with became increasingly common. Perceptions began to banks and having little incentive to use capital effi- take hold in the market that asset prices were getting ciently, became even more highly leveraged when too high and the exchange rate was misaligned. In early presented with additional funding options from 1997, total private capital flows started to taper off. In abroad, which exposed them to relatively small the first half of 1997, bond issues and syndicated loans interest rate shocks. fell by 30 percent relative to the same period in the pre- East Asian Crisis: An Overview 9 FIGURE 1.6 large volume of liquidity to support them. Even more The East Asia flu became contagious baht were chasing fewer dollars. Soon capital began to seek safe haven, and reserves fell. Finally, on July 2, Index of values of East Asian currencies (July 2, 1997=100) 1997, the government yielded to the market forces and East Asian 5 abandoned the peg. The crisis that was to rock East 100 Asia and reverberate throughout world financial mar- kets had begun. 84 Contagion 68 The Thai devaluation triggered a withdrawal of capital - Philippine Peso from the region as a financial panic progressively set in. 52 Malaysian Ringgit Developments in Thailand caused investors to look - Indonesian Rupiah more critically at weaknesses they had previously 36 Korean Won ignored. In the process, they discovered new informa- Thai Baht 'i ~ ' ;> tion that amplified their concerns, especially about the 20 _______________ health of the financial system and the magnitude of A A A A cA b ° b , short-term debt. Market doubts were compounded by P #9 e.'U' 9 v the lack of transparency about the financial and corpo- rate sectors, and thus, about the magnitude of contin- Index of values of East Asian currencies (July 2, 1997=100) gent liabilities. Once investors lost confidence that East Asian 5 100t Asian 5 reserves would cover short-term debt, both foreign and 100 domestic investors scrambled to get out.8 Markets became much less forgiving. The lack of a mechanism 84 for orderly workouts of corporate and bank debt undoubtedly contributed to the full-scale financial 68 - Singapore Dottar panic that swept Thailand, Korea, and Indonesia, and Taiwan DolLar to a lesser extent Malaysia. 52 Japanese Yen Contagion produced simultaneous declines in asset prices and spurred capital outflows.9 Within the space of six months, capital outflows from the region erased 36 the inflows of the first semester, and turned the net flow to a negative US$12 billion. As shown in table 1.1, in 20 , the space of a year net capital flows reversed by more M5\'9 59ce8 <>=zee:Xp ivv =ha 4eiiwce aim r than in any previous downturn in East Asia, and iirimicjes and ;~titva =alo4i~s~ a=par: = zm and the first half of 1998 show that private flows came ..,~~~~~...in. ~~~~~~ to a virtual standstill for all East Asian countries. Trade links between countries meant that declines in demand of imports in one country led to decline in .*reatc - = = g ~ exports m other countries. However, these trade link- ~exi~kwgwr~ttacktatsiirn is~sages explain only a small portion of the co-move- 8tpve1. g4&r different niuw;iitirn¶s ments.10 Intra-regional exports among East Asian countries accounted for almost 40 percent of total 2 ~~~~~~~~~~ ~~~exports in 1996, up from 32 percent in 1990. If Japan is included, the figure rises to 50 percent. These high levels of intra-regional trade reflect a process of special- ization and outsourcing of activities from the more advanced, to the lower income countries in the region. About three-fourths of the intra-regional trade is in raw tiMaLaSt 40~ tfy. Financial i'nkages in the region, including through SmAttn mr ste i ... C foreign direct investment, bank lending, and capital market activities, may have meant that events in one ~~nAtLAsn ~~~~~~~Investors from outside the region may have been forced onewrt es sa .~~~~~~ to sell assets in one country in response to losses in other countries. The market structure of foreign exchange East Asian Crisis: An Overview 11 BOX 1.3 What triggers market jitters? In the chaotic financiaL environment of East Asia Last year, Now news about locat and foreign events affect daily changes-usually falls-in stock prices of as much as 10 stock markets percent became commonplace. A recent paper by Kaminsky and Schmukler analyzes the twenty Largest one-day swings in stock (Percent average daily movement up or down) prices (in U.S. doUars) in Hong Kong (China), Indonesia, Japan News about Local events affecting local stock market Korea, Malaysia, the Philippines, Singapore, Taiwan (China), and Ecno m*E,icLatewsl Agreements Thailand since January 1997 to see what type of news moves the r / .5, fta , ating Agency changes debt ratings markets in days of extreme market jitters. Of particular interest i- -> Politicat events was whether news in one country wouLd affect markets in artother, External sector and if so, what type of news. Also, did news have a persistent, Governmeent fiscal and monetary policy trend-changing effect or was it merety transitory? The L- ifnassociated researchers classified news into seven different categories: news Foreign country news affecting locaL stock market related to agreements with international organizations, the Credit RatingAgency-changes debtratings financiaL sector in each country, monetary and fiscal policies, MultiLateral/BiLateral Agreements credit-rating agencies, the real sector, and political announce- Political events _:Capital controls ments. L ,-..-' Economic news The results? Some of the Largest one-day downturns cannot be . Externat sector explained by any apparent substantial news, either economric or vernme Fisca and MonetaryPolcy political, but seem to be driven by herd instincts of the market 0 2 4 6 8 10 12 itself. Second, most movements are triggered by locaL news, not news of a country's neighbor or the major Organization for Lighter bars indicateinsigniflcant means. Economic Co-operation and Development (OECD) trading part- ners. The most weighty events in the market's eyes are news about agreements with international organizatiorns, capital con- While the anaLysis focuses on the Largest daily movements, the trols, credit rating agencies, financial sector, and politircal events results do not necessarily reflect shocks that are immediately or rumors. Still, some types of news from abroad have significant reversed. In fact, the study found that, on average, the one-day effects on the stock market. For example, agreements with irnter- market raUlies are sustained and trend-changing. This is not the national organizations-IMF, the World Bank, and others-have case of market downturns. Within a few days, the largest one-day a substantiaL effect on both home countries and neighbors. In losses are recovered, suggesting that, on baLance, investors over- fact, positive news about an agreement in a given courtry in the react to bad news. region produced, on average, a 9 percent increase in another Source: Graciela Karninsky and Sergio SchmukLer, 1998, 'What Triggers: Market country's stock market. Jitters? A Chronicle of the Asian Crisis,' Wortd Bank mimeo. trading may have also played a role. Also events in one From currency and financiaL crisis to country may have led market participants to revise their economic and sociaL crisis model of development in East Asia more broadly, which may have negatively affected asset prices in a larger As the Thai crisis spread throughout Southeast Asia, group of countries. and then to Korea, the currency crisis became a finan- Announcements of delays or revisions in multilateral cial crisis, which became, in turn, an economic and agreements in one country were associated with nega- social crisis. These have had sweeping domestic politi- tive price effects in other countries, particularly in the cal ramifications in Korea and Thailand, where transi- stock markets. Analysis of movements in exchange tions were managed relatively free of disruption. rates and stock prices across countries in response to Indonesia experienced an even more profound political announcements and events in other countries in East crisis. Asia reveal that there were important spill overs. These The outflow of capital in 1997 required huge swings effects were not limited to East Asia only, but also in current account balances. New surpluses were affected some countries outside the region (see box 1.3). achieved primarily through import compression and reductions in income, rather than through exports (see 12 East Asia: The Road to Recovery ~~~~~ ~~~~~~~~ -~~ thcr erorane hs otben uficinttomae h pogamedt be as5 percent inLgt fisca yea 1979 n undergone adusmet anddefate ~demcatnd.1 maeraiz, h e xgpostw fisca stne wa otatoay .! ~ ~ ~ I A Ii~reL a B h _g_!g_X4i)_ig!m P~~ r4ap t0 iil induced a run on their currencies. Rising interest rates towhich we art oin chapter 7a 1 Hig raes~ copuddtepolmso h etldnthearcesin nJaanHn Kon (China alosem copoae eto.Inees css oe texclyte O r9etim etndt tgaini J198ThPilpnead ther pofis erefalin wit the adancingreession, Sigaoe av ardoewa aetr butes ˘gclg)- g- A - fingur 1.6).o Whie exorsl xprincedset oh somes increased, beensrealized Fror thexampes growt intnoes ial was thecirgtc perormaceasl inlotn ben astufficen to makeai bsr the proram edaose 5n per oyent in fica helarb1979r mand Ficuren alccn wadjustentswt viwithout rsteep seo inomi 3Beren min1998/9, inumbetrs notea inctonsistentvith unergone Dj ustment, and adefltedt demad marsiie, lte exD of sace. wa contratie onsta MionenTharyland,fsa policyu wast19 tihenedmas crounries indoeed,ioas thmdptyo thae roteessont became evide nt strugled to coperwith theGD finacal pat-igtnic g,thatha polic beufcamtuccessivdetaly mores expnsixonary (tadpoin inded aim oroun n t currenie urpls. Riigiterestas towc wee rtu in catei 7. as w M a fire intendedr t inclea 1th periced o omestincgaseset teh ailad, ories a Indonesia,kand Malays have fle tanmeak thedmonre havet been sutronoler ntf foaeign of toeiragred fowh pt into adee rucseson,o andort facm currenjcyeund aBsut,thins aiseout deifficu reoffs. proespnt onf shap reo nomic ontraction ine 198. With Hightratscompo undaed ivthenproblemsavo thlnes debt-lad e priaecessionmin Japan Hong Kong (Chna alsouse see codrporae secutor.enters cost roeflate dexactydh. tm desteinlied toeeotfsa stagntoni c99.Te Philippracionesand. thirpofitsawren fisalpling with tihe ee ad ancn rcesoun,re SIngapore havte faedt somtewhatsio bettme u tesient anugld man coulpo ervice thei debts.ia Non-perform-a ecoomicbesam willcprobablymexprine "grnsowthreceapoi- ingue lansu on thei bala ncihets.oh basnks inereasedtin"tai,got rates so lwc the willr nothptr ) forc ingthemde to caincloanseh pine a f strggestoc mainetais bsr theil inc,Krease Indnemployment Mlyin theabor mar-e Ficalrpolic wans. set, wthi ravisew towardul ofdeffsetin Byspc mid-1998,ecindmicatr coftrealtsector activity tihe costes cmofudbt destrutuin andocurbin ofuture inftla-e shoed littesso eidnceaan Hofg reovery TChailnd, theo first tion.raeec InTaln,therAugustts1997aeoomctlprograme dsinedto reesiogn,ayini hav.Te botmdotiPheiloorne ond thimploied awerento D falig isca bhelt-tghtncing, weesith, thS aufcuingaoehv faned realsalesha inextr hold stheady teaim ofn producingt aservcen suerplubs. INdon-esiaos Kore seenmis tol prbeabotoiny uta wxerell. Malaysia andes firstiprgrahm incaludedlani a 1.2rpercentotighteaig. Theseb the Phlpinesare ino yetmpickieng up. Exotse haver not- tarecots woul nobt hae benstrcuin ngl curbngfturactionfary accwedleratled foridngcte adjustmvent. ohilnto impor cirm- had projected assumptions about economic growth pression and output reductions (see figure 1.6). This is East Asian Crisis: An Overview 13 FIGURE 1.7 Trade and production Thailand Thailand industrial production index U.S. dollars in billions June 1997 =100 6.5 120 6.0 110 5.5 5.0 Exports 100 4.5 \4/ 4'. \90 4.0 Imports 80 3.5 3.0 70 A, / 9\9 2\ 9 o 9oO A,O 9A) ,S8\ C/\ 9\ 9\9\9O 9o Korea, Rep. of Korea industrial production index U.S. dollars in billions June 1997 =100 14.0 110 Exports 12.0 100 10.0 90 Imports 8.0 80 6.0 7 Indonesia Indonesia manufacturing index U.S. dollars in billions June 1997 =100 5.0 120 Exports 115 4.5 110 4.0 105 3.5 Imports 100 95 3.0 90 85 2.5 80 2.0 75 ,99\~~~~~~~ ,98 ,, 9\ 9\ ,9\ 9 ,° 9< ,\ 9\ 9\ ,99 ,9o O 14 East Asia: The Road to Recovery 2- 1 - - = --- Trade and production (continued) Philippines Philippines industrial production index U.S. dollars in billions June 1997 = 100 3.5 120 3.0 s~ 110 3.0 %~~~~s It Imports /~~~~ 80 % 100 2.5 S ~~~90 2.0 80 1.5~~~~~~~~~~~~~~~~~~~~~~~~1 Malaysia Malaysia manufacturing index U.S. dollars in billions June 1997 =100 8.0 120 110 Exports v ~~~~~~~~100 6.0 mpo~~~~g 5.0 80 4.0 70 Source: BLoomberg, MaLaysian, and Philippine authorities. in part, because the corporate and financial sectors in ployment is at a 20-year high. In some countries, the the East Asia 5 are hobbled in distress. With interest unemployed have suffered in relative silence; in others, burdens too heavy to service, the corporates are in no the contraction has led to social protests. position to invest, even in potentially profitable export The silver lining of these dark clouds is that financial industries. The financial sectors, already under cash stability may be taking hold everywhere. Except for flow pressures as deposits are withdrawn and loans are Indonesia, exchange rates hovered within a relatively going unserviced, have to rebuild their capital to stay in narrow band for the first semester of 1998 and even business. Confidence among external investors and appreciated since January. domestic investors with holdings abroad has yet to Macroeconomic policy, in the meantime, has to carc- return. fully balance the provision of liquidity to a distressed Unemployment has risen as the economies have con- corporate and financial sector with the need to main- tracted. In virtually every country in the region, unem- tain some degree of stability in the exchange rate. East Asian Crisis: An Overview 15 Indonesia responded to this dilemma in late 1997 by rates to assume unhedged foreign borrowing posi- providing liquidity to the banks. When combined with tions and maturity mismatches that left them vul- the failure to follow through on policy actions, the nerable to sudden currency fluctuations. result was a 50 percent in a drop in the value of the * Companies, without alternative sources of financ- rupiah, which left the country on the verge of hyperin- ing, borrowed heavily from banks to finance their flation (see box 1.4). Most other countries have been rapid expansion, and in the process became very able to reduce interest rates, and they have eased down- highly leveraged, which opened them to interest rate ward in Thailand, Malaysia, Korea, and the other surges. major markets of unaffected countries. Nonetheless, It is important to note that domestic policy failures the presence of an open capital account and potentially explain only part of the emergence of these vulnerabili- huge pools of capital just offshore undercuts the effec- ties and subsequent crisis. Failures in international tiveness of the domestic monetary policy in any one financial markets in the boom part of the cycle, as well country. as during the crash, were no less pivotal; herd instincts in financial markets have not served East Asia well. Conclusions and organization of this Arguably, investors' expectations were made more study volatile by the absence of certified data on corporate finance, banks' portfolios, and even the reserve position East Asia's downturn has mixed currency and banking of the central banks; during the boom years, the absence crises with regional financial panic into a particularly of data militated against prudential caution, and then virulent crisis. This threatens the very financial viabil- during the crash, it fed panic. Similarly, private credit ity of its banking and corporate sectors, and dampens rating agencies and regulators in the OECD, particu- prospects for a quick recovery. To be sure, deep-seated larly Japan and Europe, failed to raise red flags that structural problems evident prior to 1997-in the might have braked the momentum of overlending. financial sectors, the social safety net and environ- Also, questions have arisen about the early rescue pack- ment-required attention if the progress were to be sus- ages led by the multilateral institutions; with benefit of tained. But countries were working on these problems, hindsight, were they overly contractionary and did they (albeit too slowly in retrospect), and the depth of dev- inadvertently push the economies deeper into reces- astation stemming from the economic unraveling that sion? Were programs too comprehensive and did they has occurred since July 1997 has gone far beyond what overload the capacity of domestic policy-making? could be attributed to these structural trends. Definitive answers to these questions and others await The inflows of capital, often without due diligence more research. Nonetheless, it is clear that different and beyond prudence, were intermediated through behavior of private agents and different policies domes- poorly regulated domestic financial systems, and fueled tically in the one or two years before the crisis might a domestic credit boom. This was a series of bets that well have pre-empted the crisis or contained it at an ear- paid off initially in the form of more rapid growth. But, 1ier stage. The crisis was not pre-ordained. as inflows pumped up asset prices and increased corpo- The more urgent agenda lies ahead. This study rations' leverage, they exposed the region to the shocks focuses on two questions: of changing investor expectations. In retrospect, rapid What policies can the region adopt to overcome its growth had spawned structural weaknesses in three severe problems and firmly establish recovery? East dimensions: Asia's crisis is best seen as a story of rapid growth built * Large current account deficits, financed with short- on an incomplete foundation, which was left exposed to term flows, exposed East Asian economies to sud- the winds of international capital markets. Now that den reversals. the financial earthquake has occurred, it will have to * Domestic financial markets' growth and integration rebuild its success on new foundations in its trade com- with global markets outpaced domestic regulation, petitiveness, in the financial sector, and in the gover- and exposed banks to asset-liability mismatches. nance and financing of its corporate sectors. The Inadequate regulation allowed banks and corpo- following three chapters go into greater depth, paying 16 East Asia: The Road to Recovery particular attention to the links between macroeco- 5. This section benefited from P. ALba, A. Bhattacharya, S. nomic and microeconomic policies. Each chapter Claessens, S. Ghosh, and L. Hernandez, "VoLatiLity and Contagion in a traces the fundamentals of the problem, presents a FinanciaLLy-Integrated World: Lessons from East Asia's Recent progress report on actions taken during the first years Experience. Paper presented to the PAFTAD 24 conference "Asia following the crisis, and offers a view of future policies. Pacific FinanciaL LiberaLization and Reform," May 20-22, 1998, Once in recovery, how can countries ensure its sus- Chiangmai, Thaland. tainability? Even prior to 1997, deep-seated structural 6. Kaminsky and Reinhart, 1997 confirm this finding for a wider set problems-in the corporate and financial sectors, the of countries. social safety net and environment-required attention 7. Macro and currency risk factors constituted 16 percent of the if the progress was to be sustained. Low-income groups total of the average nominaL interest rate of 16 percent over this and the environment are clearly suffering. While gov- period, whiLe the base U.S. risk-free rate represented on average 28 ernments have been working to address these problems percent of the nominal interest costs. for years, the depth of devastation stemming from the 8. With the possible exception of ThaiLand, foreign investors appar- economic unraveling that has occurred since July 1997 ently did not pLay a Large role in triggering the crises. Data on mutuaL has made their resolution them more pressing. Chapters and pension funds' hoLdings of equities and other assets in East Asian 5 and 6 focus on the social sectors and environment, countries do not suggest a massive outflow of foreign capital during and the last chapter speaks to the region's strategy for the July-December 1997 period. Foreign investors appear to have recovery and economic forces shaping its prospects. reduced their hoLdings prior to the crisis, particuLarLy in case of ThaiLand, and increased their hoLdings, particuLarLy in the first few Notes months of 1998. Hedge funds and other short-term investors played a Limited role in triggering the crisis (see Eichengreen and Mathieson). 1. The international poverty Line is one doLLar a day measured in The massive reversaL in capital fLows arose mainLy from (a) the reLuc- constant 1985 purchasing power parity terms. tance of foreign Lenders to roLL over short-term cLaims after September 2. Other factors were aLso important: high government and corpo- 1997 (causing an outflow of about US$50 biLLion for the affected coun- rate savings, macroeconomic stabiLity, demographics, and other gov- tries), and (b) the purchases of foreign exchange by Local corporations ernment poLicies. to cover open positions, and in Indonesia capitaL flight. 3. Among others, see WorLd Bank, The East Asia Miracle, 1993; Asian 9. Itis importantto distinguish pure spiLLoversfrom co-movements Development Bank Emerging Asia, 1997. that are due to simiLarities in changes in underLying fundamentals. In 4. Estimates of TFP growth in Asia differ among recent studies, cho- practice, however, this is difficuLt. Asset prices, for example, refLect sen depending on the methodoLogies, countries, and time periods: market expectations of future reaL returns, which depend on expecta- tions about fundamentaL economic variables and the market percep- Estimates of TFP Growth in East Asia tion of risks and its willingness to absorb them. If expected fundamentaLs and risks changed in simiLar ways for all East Asian coun- Bosworth Young East Asia SareL tries during this period, co-movements may arise as rational, market & Collins (1995) MiracLe (1997) (1996) (1993) responses. SimiLarLy, capital flows may exhibit co-movements due to Hong Kong (China) 2.3 3.4 similar changes in fundamentaLs. Indonesia 0.8 1.5 1.2 10. McKibbon and Martin, 1998, conclude from their modeLing that MaLaysia 0.9 1 .7 5 2. 0 ... contagion did not arise through direct trade or capitaL account PhiLippines -0.4 -0.8 Linkages" (1998:43). See also Hoekman and Martin, 1998. Singapore 1.5 0.2 2.1 2.2 11. See CaLvo and Reinhart for evidence on Latin America following Taiwan (China) 2.0 2.1 2.7 ThaiLand 1.8 1.3 2.0 the 1995 Mexico crisis. East Asia 1.1 United States 0.3 0.3 Other IndustriaL Countries 1.1 Source: Bosworth and ColLins (1996), TabLe 7 (covering the period 1960-94), Young (1995), Table 15 (covering the period 1966-90), East Asia MiracLe (1993), covering the period 1960-85, and Sarel (1997), coveing the period 1978-96. East Asian Crisis: An Overview 17 18 East Asia: The Road to Recovery Trade and Competition Two freighters carrying logs from the Weyerhaeuser Corporation in the Pacific Northwest steam idly at sea near South Korea, their cargoes undelivered-perhaps undeliverable. Just as the ships approached port, the Korean buyers refused to pay for wood they no longer needed to build homes and furniture they can no longer sell while Asia's financial crisis spreads. Tiffany & Co., enjoying brisk jewelry sales on Fifth Avenue, is hurting in Hawaii; the Japanese tourists who normally visit and buy there are doing neither lately. And Reebok International, the shoe giant, reports that its sales to Asia's consumers are way off. Take the Rockport shoe boutique, a Reebok subsidiary, in Seoul's upscale Myondong neighborhood. With few customers to serve, sales clerks spend their time shining the shoes on display.-Louis Uchitelle, "Dim Asian Economies Casting Shadows in the U.S.," New York Times, December 14, 1997. T rade has been the engine of growth for East Asia's 30-year rapid expansion. To promote export development, governments in East Asia initially provided various incentives, such as duty rebates, input, and credit facilities with preferential lending rates. These policy interventions were motivated by the belief that shifting industrial structures toward newer and more modern sectors increases the opportunities for capturing dynamic scale economies. Later, reliance on more generalized incentives grew, which included reforms of trade and investment regimes, appropriate exchange rates, and macroeconomic policies. Correspondingly, trade as a share of gross 19 domestic product (GDP) increased considerably, from tively quickly through exchange rate adjustments or is 15 percent in 1970 to over 50 percent in 1995. Exports it a deeper structural problem? Can exports lead the grew by over 10 percent per annum in virtually every recovery if the region remains mired in recession? quarter. Between 1970 and 1995, per capita exports increased from US$100 to US$400 in the Republic of Causes of the 1996 export slowdown Korea and from US$80 to US$850 in Thailand. Then, in 1996, trade crashed. The magnitude of this The recent slowdown in export growth reflects forces deceleration was unprecedented in recent history. From that largely are cyclical in the world and within the the first quarter of 1995, when export growth among regional economy. These include: the East Asia 5 (Thailand, Korea, Indonesia, Malaysia, * A large fall in world trade growth and the Philippines) and other East Asian countries * Yen depreciation in Japan reached a peak, growth started to decelerate dramati- * Real effective exchange rate appreciations in some cally (see figure 2.1). By the first quarter of 1996, East Asian countries and export growth fell to zero in the East Asia 5 countries * Significant price declines for major export products and to negative rates for other East Asian countries, in some countries in the region. including China and the Newly Industrialized The fall in world export growth from its cyclical peak Economies (NIEs). As noted in chapter 1, these events in 1995 was the largest in the past 15 years-from coincided with rising external and internal vulnerabili- about 20 percent to about 4 percent in U.S. dollars in ties in these countries. As the news spread of slowing just one year. Within East Asia, export growth fell by export growth in all East Asian countries-a region the same proportion, although the extent of the slow- where trade was a more important engine of growth down varied across countries (see table 2.1). Within the than elsewhere in the world-the fears about external East Asia 5, Thailand was the worst affected, recording conditions and competitiveness issues became more sig- negative export growth in nominal terms in 1996, fol- nificant. lowed by Korea. Since 1996, export growth has This chapter asks the questions: Is the downturn in remained slow throughout the region, with the excep- exports a cyclical problem that can be resolved rela- tion of the Philippines and China. FIGURE 2.1 TABLE 2.1 Recent export slowdown in East Asia World, East Asia, and countries' growth (dolLar percent) 1982-97 (dollar, percent) 1994 1995 1996 1997 Thailand 19 20 -1 3 80 Korea, Rep. of 14 23 4 5 Indonesia 8 12 9 7 70 East Asia MaLaysia 20 21 6 1 60 East Asia 5 PhiLippines 17 24 14 21 China 25 19 2 21 50 - WorLd Hong Kong (China) 11 13 4 4 40 Singapore 24 18 5 -1 Taiwan (China) 9 17 4 4 30 EA9 19 21 4 8 20 &- t- Japan 9 10 -8 2 20 United States 9 12 7 10 lo A 1 \ A / 0 WorLd 14 20 4 4 0 / V V aV - Source: IMF, IFS, staff estimates. -10 The sharp depreciation of the yen in 1995 com- -2.0 pounded the negative impact of the slowdown in world 82q1 85ql 88ql 91ql 94q1 97ql exports on many East Asian countries. Japan is both a Source: IMF, IFS. major market for other East Asian producers and a competitor in export markets. Although the previous 20 East Asia: The Road to Recovery appreciation of the yen sent import growth soaring between 1992 and 1994, the subsequent reverse sharp depreciation sent the real value of imports plummeting. Export prices for East Asia dropped more This has mainly affected regional countries whose sharpLy than other regions export structure is similar to Japan's, such as Korea and (Based on U.S. import price by origin, 1991 100) Hong Kong, China. In 1996, Japan's imports from 120 M~~~~~~~~ Korea's real export growth mirrors changes in strial the yen-dollar exchange rate 1990-97 (Percent) 100 40 35 DC 30 25 20 Korea's real export growth 15 80 1991 1992 1993 1994 1995 1996 1997 1998 10 5 Source: U.S. Department of Labor. 0- ,,Changes in the -10 - r 1; Yen-DoLLar rate -15 FI&eU=mRE 2f -20 90ql 92ql 94ql 96ql 97q4 World prices of high-tech products have sharply Source: IMF, IFS, declined, while those of labor-intensive products were unstable (Based on U.S. import price, 1990 = 100) 120 Real effective exchange rate has slightly appreciated in recent years (1990= 100) 110 150 PhiLippines 100 Thailand ALyi ku, 120 9o CN XTextiLe yarn, fabrics, and made-up articles 80 AppareL and ctothing accessories 90 Machinery and transport equipment :: Korea, _ ELectronic equipment Indonesia Rep. of Computer eqaipment arm office macnines 70 Telecommunications Electrical machinery and equipment 60 1990 1991 1992 1993 1994 1995 1996 1997 60 9Oql 90q4 91q3 92q2 93qL 93q4 94q3 95q2 96qL 96q4 97q3 Note: An increase indicates an appreciation. Source: IMF. Source: U.S. Department of Labor. Trade and Competition 21 Korea fell by 8.5 percent and imports from Hong Kong, cyclical factors, there may have been additional struc- China fell by 6.6 percent, while its imports from labor- tural or competitiveness problems underlying the slow- intensive China rose by 10 percent and from the down. When the composition and evolution of the Philippines by more than 23 percent. The depreciation export system in East Asia is studied, some fragilities of the yen also significantly affected regional industrial are revealed. exports to the markets of underdeveloped economies, One of the most remarkable aspects of East Asia's where the more industrialized countries of East Asia- export performance has been the rapid shift in the com- Hong Kong (China), Taiwan (China), Singapore, and position of exports from resource- and labor-intensive Korea-compete against Japan. This was especially industries to more skill- and capital-intensive industries true with Korea, whose real export growth has tended (see figure 2.6). In 1990, most East Asian countries to mirror changes in the yen-dollar exchange rate, ris- were still heavily dependent on resource-based exports, ing with an appreciation of the yen and falling with its which accounted for about 40 percent of total exports depreciation (see figure 2.2). in China, Thailand, and Singapore; 54 percent in Although effective exchange rates were stable in the Malaysia; and as much as 72 percent in Indonesia. region during the 1990s, certain East Asian countries Hong Kong (China), Korea, and Taiwan (China) started to experience some appreciation of the real depended heavily on low-technology products-about effective exchange rate beginning in mid-1995 until the 60 percent of their exports. At the same time, about 30 second quarter of 1997 (see figure 2.3), including the percent of Malaysia's and Singapore's exports were in Philippines (15 percent), Thailand (12 percent), and high-technology products, whereas China did not Indonesia (11 percent). This appreciation may have hurt exports in those particular countries. FIGURE 2.6 Some Asian economies were also hit with significant The dramatic change in export composition in price declines of their major export products. Based on East Asia U.S. import prices by origin, the sharpest fall in prices (change in shares of exports by category in total exports was for imports from Asian countries, which dropped between 1990 and 1996) by 25 percent relative to industrial country import * HI LT prices (see figure 2.4). Within East Asia, only the MT RB 36 Philippines had rising export prices at the onset of the ThaiLand 15 36 14 crisis. Korea, 28 27 The largest price declines occurred in the electronics Rep. ofM 60 industry, especially for computers, semiconductors, and MaLaysia 13 15 telecommunications, in which East Asia specializes. Indonesia 8 9 42 Korea was particularly hard hit when the 16MB China 14 13 21 DRAM chips, which account for a large share of its 10 56 electronics exports, fell from a peak of about US$150 Singapore 13 14 20 29 per unit in 1993 to less than US$10 in 1997. Prices of Hong Kong 19 labor-intensive manufactured goods, such as textiles (China) 41 Taiwan 3 and apparel, have been more stable-one important (China) 5 37 reason that China's export growth, which is still heav- Mexico 7 21 ily based on labor-intensive manufacturing, remains -50 -40 -30 -20 -10 0 10 20 30 40 strong (see figure 2.5). Note: Resource-based (RB) products refer to processed foods and tobacco, simpLe wood products, refined petroleum products, dyes, Leather (not Leather products), rubber products, and organic chemicaLs; Low technoLogy (LT) products refer to Cyclical or structural? textiles, garments, footwear and other Leather products, toys, simpLe metal and pLastic products, furniture, and gLassware; medium technoLogy (MT) products refer to automotive products, chemicals, industrial machinery, and simpLe Although the sharp decline in East Asian export electrical products; high technology (HT) products refer to fine chemicaLs, pharmaceuticaLs, compLex electrical and eLectronic machinery, and precision growth in 1996 and later can be attributed largely to the instruments. The numbers near the bars refer to the actual share in totaL exports unusual and unfortunate confluence of several adverse of the corresponding category in 1996. 22 East Asia: The Road to Recovery export such products. By 1996, there was a dramatic Competition from China and other change in the export structure in East Asia. Singapore low-cost exporters and Malaysia doubled their share of exports in high- technology products, while Thailand almost tripled its China's rapid entry into world markets may have accel- share of exports in high technology. Indonesia reduced erated the early exit from labor-intensive exports of its share of resource-based exports but is still low on the lower-income Asian countries. Structural reforms that technology ladder for most exports. In comparison, China has undertaken in recent years, together with the Mexico's export structure changed little during the self-reinforcing effects of foreign direct investment and same time period. exports, have significantly improved China's interna- This situation is not a picture of a collapse in com- tional competitiveness and export performance. petitiveness or other structural problems; it is a picture Exchange rate policies, however, did not cause any of rapid trade- and investment-led gains in market share notable difference in competitiveness (for China, see and convergence, exactly what would theoretically box 2.1). occur. What is unusual about it is the speed of the trans- Figure 2.7 shows China's share of the world market formation of the export structure. for those product groups (measured as two-digit What is behind this phenomenon? Although rapid Standard International Trade Classification [SITC] cat- structural transformation in East Asia has been associ- egories) that were the top 10 manufactured exports of ated with a much faster accumulation of human and Indonesia, Malaysia, and Thailand, respectively, from physical capital per capita than other developing coun- 1988-90. Malaysia and Thailand continued to increase tries, in recent years both "push" and "pull" factors their world market shares of their top 10 exports but at have operated to hasten such structural transformation a much slower pace than that of China. Indonesia lost in East Asian countries compared with other develop- world market share in those products. ing regions. First, competition in the labor-intensive The decline in the growth of market share for goods market from low-cost producers such as China Indonesia, Malaysia, and Thailand's top products may may have been an important push factor, especially in be due to several factors. It could reflect a normal tran- recent years. Second, foreign direct investment from sition to higher-end products, which would have hap- industrialized countries was the driving force behind pened independently of China's actions, or it might the pull factor in the second generation of East Asian truly represent a market displacement by lower-cost NIEs. Third, the relocation of the production bases of competitors. While it is difficult to distinguish between the first generation of NIEs (Korea, Hong Kong, China, these two effects, statistical analysis shows that during Taiwan, China, and Singapore) to neighboring coun- 1989-92, increases in China's world market shares tries in the late 1980s as their wages and costs rose also were not significantly associated with declines in world reinforced the pull factor. market shares for these products in Indonesia, As a result of these factors, export structure in East Malaysia, and Thailand; however, recent growth of Asia has become characterized by (a) early exit from China's market share in its top 10 manufactured low-skill labor-intensive exports; (b) specialization in exports was associated with a small decline in the mar- high-technology exports, mainly electronics; and (c) ket share of these products for Malaysia and Thailand strong intraregional links. These characteristics have (see table 2.2).' caused East Asian economies to become increasingly TABLE 2.2 dependent on one another and on fewer products as East Asia makes room for China their exports. Although these countries have demon- (eLasticity of East Asia's market share to China's) strated the ability to adapt to external changes in past 1989-92 1993-96 decades, this new export structure may have exposed Indonesia 0.167 (3.98) -0.070 (-1.01) them to greater risk of export instability and "conta- Ma[aysia -0.041 (-1.24) -0.087 (-2.99)* gion." Thailand -0.091 (-1.11) -0.128 (-2.57)* Note: t-statistics in parentheses. * Denotes significance at 5 percent LeveL. Source: Bhattacharya, Ghosh, and Jensen, 1998. Trade and Competition 23 Thailand, in particular, is losing competitiveness in FIGURE 2.7 low-cost exports. More than 35 percent of Thailand's Competition from China exports still consist of low-technology products such as Export performance of Indonesia and China in products which were Indonesia's top 10 exports of manufactures in 1988-90 BOX 2.1 (share of world exports of these products) Did China's 1994 devaluation precipitate the percent crisis? 8 Many analysts argue that the 1994 Chinese devatuation was a 7 primary cause of the economic crisis now engulfing East Asia. 6 China This argument is too simplistic. First, the actual nomina 5l excharge rate devaLuation was much smaller than implied by the Indonesia official exchange rate devaluation, primarily because it mereLy 4 unified the duaL exchange rates then prevailing. The 1994 3 Chinese devaLuation was part of a program of exchange system 2 reforms and currency adjustments, which integrated various for- eign exchange markets, consoldated a multiple exchange rate 1 system, and aboLished the Foreign Exchange Certificate (FEC), a 0 1988-90 1992-93 1995-96 special currency for tourists and foreign residents. The complex and disorderLy exchange rate system was uniffed at the 'swap," Export performance of Malaysia and China in products orfree market, rate of RMB 8.7 to the U.S. dollar. Since the mid- which were Indonesia's top 10 exports of manufactures 1980s, as part of the government's gradual market liberalization in 1988-90 poLicies, China has created more than 100 local foreign exchange (share of world exports of these products) swap markets where foreign-funded firms could trade their for- percent eign currency export proceeds at a market-determined swap rate. 5 This system was intended to baLance the foreign exchange needs of foreign-funded enterprises within the group of enterprises so 4 China that they would not disturb official foreign exchange reserves, which were hetd for the state economy. Localswap markets were 3 poorly integrated and foreign exchange rates differed among MaLaysia them. Originally, domestic firms (mostly state-owned) had to 2 surrender alltheir export proceeds to the government at the offi- ciaL rate and could buyforeign exchange at this rate for approved 1 imports. These two systems were gradualLy integrated over a decade from 1984 to January 1994 by giving domestic firms O access to the swap markets in exchange for a gradually increas- 1988-90 1992-93 1995-96 ing proportion of their export proceeds. In December 1993, Export performance of Thailand and China in products these so-called "retention rights" stood at 80 percent. which were Indonesia's top 10 exports of manufactures Consequentty, the bulk of alL Chinese exports were already sold in 1988-90 at the swap marketexchange rate priorto the exchange rate uni- (share of world exports of these products) fication in January 1994. The weighted net devaluation for all percent exporters is estimated at only 7 to 8 percent. Also, contrary to 6 popular perceptions, Chinas exchange rate has appreciated in China real terms since January 1994. According to Internationat 5 Monetar Fund (IMF) estimates, between January 1994 and 4 June 1997, the RMB reaL effective exchange rate appreciated by about 3f0 percent, reflecting rapid inflation in China during 3Thailand this perod and a moderate nominal devatuation. (The nominal exchange rate was RMB 8.2 to the U.S. dollar in June 1998.) 2 Therefore, itis difficulttoarguethat China's devaluation had any significant damaging effects on its neighboring economies. 1 Source: World Bank. 0 1988-90 1992-93 1995-96 Source: Bhattacharya, Ghosh, and Jansen (1998). 24 East Asia: The Road to Recovery Unit Labor cost is much higher for Thailand East Asia's big bet on electronics than for its competitors (share in total exports in percent, 1990 and 1995) (index of intemational unit labor cost, 1973 = 100) 60 120 50 , 10040 80 4 30 1 O1990 60urce: Andersenandothers,199.1995 20 40 20 _ _ _ _ _ _ i ii0 In onesia - chin ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ___0 J C- r-,~ C. C- ;8 CoO Co Co Co Co Co C CoC oC oC C o0 Note: The index measures Labor cost of wages in doLLars per dollar of value added per worker. Source: UN Comtrade. Source: Andersen and others, 1997. textiles, garments, and toys. This exposes a large share factor behind East Asia's rapid rise in electronic of its exports to growing low-wage competition from exports.2 Thus, 64 percent of the world's production of countries such as China, where low-technology prod- hard disk drives (HDD) now takes place in Southeast ucts comprise more than 50 percent of its exports. The Asia, with concentration in Singapore, Malaysia, and unit labor cost in Thailand has been much higher than Thailand, and 38 percent of global production of semi- its close competitors without a corresponding increase conductors takes place in East Asia. in productivity (see figure 2.8). In apparel manufactur- Price wars and intense competition are two features ing, the hourly labor cost was US$0.25 in China in of the global electronics industry that arise from (a) 1995, whereas it was US$1.11 in Thailand. standardization and mass production, leaving less room for product diversification; and (b) a persistent trend Narrow specialization in the toward over-capacity problems. East Asian countries etectronics industry have been aggressive in expanding capacity and captur- ing significant market shares, but in the process, thcy One of the more striking aspects of East Asias chang- also became more vulnerable to terms of trade declines ing export structure and its increased specialization and over-capacity problems.' The Korean strategy (see between 1990 and 1995 has been the dramatic growth box 2.2) is an extreme example of risk taking by in the electronics industry in all East Asian countries, national firms as part of an industrial development and especially among the East Asia 5. All of these coun- strategy. Thailand represents a more intermediate case tries showed a significant j'ump in the share of total than Korea, as easy money and financing from abroad exports, including electronics: more than 50 percent of encouraged local firms to bet big in the electronics total exports in Malaysia, over 45 percent in the industry as independent second-tier suppliers to multi- Philippines, close to 40 percent in Korea, and nearly national corporations. Howevet, it exposed them to one-third in Thailand (see figure 2.9). China and over-capacity problems, intense price wars, and vulner- Indonesia showed far smaller shares of total exports, ability to large risks. but the rapid rise in their shares were also impressive. Korea and Thailand developed national firms in the Globalization of production-reducing of the value electronics industry, but Malaysia and the Philippines chain to discrete and specialized steps-has been a key had a safer strategy: to be part of a more diverse inter- Trade and Competition 25 national production network through direct connec- development (R&D) capabilities, and access to global tions with multinational firms. Multinational compa- capital, all of which cushion them from market risks. nies have global brands, their own research and But Korea and Thailand's national firms were exposed to problems of massive investment requirements for FIGURE 2.10 entry, over capacity, and price risks. Some indirect evi- Comparison of Philippine, Thai, and Korean dence for these problems is shown in unit price trends export prices for overall exports (see figure 2.10). Since 1995, Korea (1990 100) has experienced the largest declines in the unit price for 200 its exports, followed by Thailand. The Philippines, in contrast, actually showed a sharp improvement in the unit prices of its exports before a recent downturn. The Philippines has had rising export earnings because it has 150 relied heavily on foreign investment of multinationals, PhiLippines whereas Korea and Thailand chose not to do so and 7;˘\ consequently, now face serious economic problems. 1Thai land 100 Intra-Asian trade: The domino effect Korea-, Rep. of > For decades, trade has been the engine of growth in 50 East Asia and, more recently, intra-regional trade has 90ql 91ql 92ql 93ql 94ql 95ql 96ql 97ql 90q3 91q3 92q3 93q3 94q3 95q3 96q3 97q3 made an increasing contribution to growth. In 1996, the share of intra-regional trade accounted for about 40 Source: IMAF, IFS, Datastream. percent of total exports, up from 32 percent in 1990 BOX 2.2 Korea: Big bets, big tosses Korea's success in the global electronics industry has been U.S. import deflator of 16 MB DRAM chips largely due to big bets by national firms and is cLoseLy tied to the 180 semiconductor industry deveLopment, the roLe of chaebols, and industriaL polcy. In the 1990s, Korea's semiconductor industry grew dramaticalLy, expanding the country's share from virtually 140 nothing to one-third of the gLobaL DRAM market. However, its 1ZO rapid expansion aLso created severaL vulnerabitities: (a) 80 per- cent of Korea's total semiconductor production was narrowly 100 focused on DRAM chips, (b) the industry relied heavily on 80 Japan imported manufacturing equipment and intermediates, and (c) it - --Korea, Rep. of reLied on massive invesbtents through major chaeboLs' access to 60 easy credit from the domestic financial system. 40 By 1996, the 4MB and 16MB DRAM chips suffered a price col- Total - lapse brought on by Korean firms' over-investment and over- 20 capacity, in addition to technologicat advances in higher memnoty 01_ chips. Prior to the coUapse, Korea heavily increased capacity, 91ql 92q1 93ql 94q1 95ql 96q1 97ql ignoring the softening demand, emerging suppLy surpls, and 91q3 92q3 93q3 94q3 95q3 96q3 97q3 arrival of next-generation chips. A distinguishing feature of Soure: U.S. Bureau of the Census, 1998. Korea's strategy was to combine high investment threshoLds with extremely volatile income streams, leading to b b t l nalLy, but in the end, big bets in a narrow product range of DRAM extremety volatite income streams, Leadirng to boom-bust r-yctes. - ' - ~~~~~~~~~chips led to major losses. The chaebols could embark such a strategy because they had access to cheap capital and presumed abiUty to bear risks inter- Source, Kish moto, Nonrnia Researct Institute, 1995. 26 East Asia: The Road to Recovery TABLE 2.3 East Asia's intra-regional exports by country, 1996 (Share of total exports in percent) Hong Kong Korea, Taiwan China (China) Indonesia Rep. of Malaysia Philippines Singapore Thailand (China) Japan East Asia China 0 24 1 4 1 1 2 1 2 19 56 Hong Kong (China) 27 0 1 1 1 1 5 1 3 5 47 Indonesia 4 4 0 6 2 1 8 2 4 27 58 Korea, Rep. of 7 8 2 0 2 1 5 2 3 14 45 MaLaysia 3 5 1 3 0 1 20 4 3 13 53 PhiLippines 1 5 1 2 2 0 5 5 3 16 40 Singapore 2 9 1 3 19 2 0 6 4 8 53 Thailand 3 5 1 1 3 1 14 0 2 17 48 Taiwan (China) 13 23 2 2 3 1 4 3 0 12 63 Japan 5 6 2 7 4 2 5 4 7 0 42 EastAsia 5 10 2 4 4 1 6 3 4 9 49 Source: U.N. Comtrade. TABLE 2.4 Export share correlations in intra-regional and extra-regional trade, 1996 (above the diagonal: correLa- tions in world market; below the diagonal: correlations in regional market). Hong Kong Korea, Taiwan China (China) Indonesia Rep. of MaLaysia PhiLippines Singapore (China) Japan China 1.00 .85 .53 .35 .40 .54 .26 .41 .29 Hong Kong (China) .81 1.00 .72 .23 .31 .58 .16 .25 .63 Indonesia .20 .34 1.00 .18 .34 .31 .10 .16 .17 Korea, Rep. of .35 .69 .28 1.00 .67 .72 .50 .55 .80 MaLaysia .36 .69 .37 .78 1.00 .82 .76 .74 .77 PhiLippines .32 .64 .14 .76 .92 1.00 .64 .65 .73 Singapore .36 .66 .32 .79 .91 .88 1.00 .94 .79 Taiwan (China) .43 .70 .32 .90 .77 .72 .76 1.00 .81 Japan .15 .06 .01 .78 .43 .38 .44 .48 1.00 Source: U.N. Comtrade (three-digit SITC, 174 product categories). (see table 2.3). If Japan is included, the share of intra- The magnitude and interdependency of these trade regional trade rises to 50 percent. This concentration of links was one of the features of the "Asian Miracle" trade within East Asia reflects an ongoing process of that fueled rapid regional growth. But after the 1997 specialization among countries in the region. The coun- crisis, these links became a liability because they pro- try with the lowest dependence on trade with other East vided a perfect channel for the contagion to spread Asian countries is the Philippines, which sends only 25 swiftly throughout East Asia. It is essential that intra- percent of its total exports to the other Asia 9, which regional trade links once again become both an asset explains the Philippines' stronger export performance and a means to spread economic recovery. after the crisis. Singapore, Hong Kong (China), and To what extent do East Asian exports compete with Malaysia have the greatest dependence, 40 to 45 per- each other and to what extent do they complement each cent, on trade with other East Asian countries. Japan is other? Export share correlations reveal a mixed picture a major market for most of the East Asian economies, (see table 2.4). Low correlations reflect different with the exception of Hong Kong (China) and endowments of natural resources and patterns of spe- Singapore. cialization, whereas high correlations reflect similar export structures. Indonesia and China have low cor- Trade and Competition 27 relations with the rest of the region. Japan exhibits a percent in Malaysia between July 1997 and July 1998 high correlation with Korea because the two countries (the exchange rate continues to fluctuate in Indonesia). compete with each other in the regional market and in Part of the explanation for this difficult recovery lies in the world market. On the other hand, exports of China the structure of intra-regional trade. Because East and the Philippines have very low correlations with Asian countries compete with and complement one those of Japan and thus, are complementary. This another, the devaluations did not have the expected explains why China and the Philippines have continued effect. to export to Japan after the depreciation of the yen, Export volume response. A 40 percent depreciation whereas Korea's exports to Japan have decelerated. should have increased export volume in the crisis coun- High correlations among some countries, such as tries by 20 to 30 percent based on typical elasticities.5 Hong Kong (China)-China or Singapore-Malaysia- Until April 1998, only Korean export volumes have Philippines, are more likely to reflect intra-industry matched this expectation, expanding by about 30 per- trade than competition. About three-quarters of intra- cent (annualized rate). Export volume growth in both regional trade is in intermediates and capital goods,4 the Philippines and China has held up at above 20 per- suggesting that a significant part of the trade is comple- cent (annualized rate). However, the overall response mentary. This is a reflection of the first generation of of Thailand's export volumes has been disappointing, NIEs relocating to neighboring countries, which should despite an initial spurt. In the first half of 1998, they make intra-regional trade more resilient to domestic were estimated at only 7 to 8 percent; Malaysia's demand shocks than if it were oriented to final goods. exports were estimated at similar levels. By way of But by the same token, these characteristics have ampli- comparison, Mexico's export volume growth was in fied the susceptibility of intra-Asian trade to world excess of 30 percent following the peso devaluation of demand shocks. Because significant parts of each coun- a similar magnitude. try's trade also competes with one another in world The mixed picture of the expected versus actual markets, a downturn in world export growth (com- export responses can largely be explained by the com- bined with recent large depreciations) makes it more plex intra-regional links. As seen in table 2.4, Thailand likely that large terms of trade losses can occur. and Malaysia depend heavily on Singapore as an export To the extent that intra-regional trade was driven market, Korea is competing with Japan, and the largely by a common export platform-based process Philippines is only moderately dependent on the region. linked to relocation of labor-intensive industries, and Because approximately 50 percent of export is intra- not by a deeper process of true economic integration, regional, the temporary collapse in growth within East the gains from intra-regional trade were less than their Asia caused a significant loss in export volumes. Import potential. A particular aspect of this weakness in intra- demand fell by 25 percent in crisis countries, became regional trade is that all East Asian countries have negative in Japan, and slowed sharply elsewhere, even maintained selective and highly protected domestic in China. As a result, intra-regional export volumes industries, such as petrochemicals, steel, and automo- have actually shrunk by about 5 percent. biles, that have discouraged deeper economic integra- Other factors have influenced the sluggish response, tion. These factors may explain the weakness of some resulting directly from the crisis and others intra-Asian trade flows, especially in 1996 and more already existing but only now becoming apparent. The recently. credit crunch in the crisis countries and the loss of trade credits associated with the financial crisis would also be Asian exports in the aftermath of the expected to affect the supply response (and import crisis demand) in the crisis countries. In a survey of export- ing firms in Thailand, other constraints have been East Asian exports, especially in the crisis countries, unveiled: physical infrastructure limitations and a have turned out to be sluggish even with the stimulus of skilled labor shortage (see box 2.3). real depreciation-about 40 percent in Thailand, 57 Export prices. The volume gains in Korea have been percent in Korea, 46 percent in the Philippines, and 55 almost fully offset by price declines in the unit value of 28 East Asia: The Road to Recovery :6g exports by about 20 percent of the annualized rate. export growth and the main effect would be lower Overall, U.S. import data show that the pace of decline export prices. This may be a significant factor in the cri- in prices from Asian NIEs is accelerating-from 6 per- sis countries, especially in the electronics sector. A sim- cent annually in the third quarter of 1997 to 12 percent ilar effect is observed in agriculture exports (see box annually in the first quarter of 1998. A significant part 2.5). Of this decline is due to the rise in the dollar's value, In contrast, following the 1995 peso crisis, unit which is dragging down all export prices in world trade, export prices did not decline significantly during not just Asian export prices.' As counterpart to this, the Mexico's phase of rapid export volume growth. There fall in the value of the yen against the dollar affects are three reasons for this occurrence: (a) the dollar value prices in the Asian countries and, most directly, Korea. of world trade was expanding rapidly in 1995, unlike The fall in Asian export prices also could be due to now; (b) much of Mexican rapid export growth was competition in relative prices. Asian countries tend to intrafirm exports to the United States from compete more intensely with one another than with maquiladora factories; and (c) there was no severe gen- other world exporters, partly because of greater simi- eralized regional crisis, as in East Asia. larity of export structures.7 This implies that if all East Asian countries lowered their export prices simultane- ously, no one country would increase market share or Trade and Competition 29 BOX 2.4 Singapore's crucial rote in the East Asia crisis ALthough Singapore has weathered the regional currency crisis Indonesia's; Some exports are consumed locaUy, but a large reasonably well, the sharp fall in economic activity in the rest of chunk is being re-exported-about half of Singapore's totaL the region has begun to take its toll. GDP growth is expected to exports. Singapore is among the largest investors in Malaysia, slow significantly in 1998 from a high of 7.8 percent in 1997. In Thailand, anid Indonesia and, in 1996, its share of foreign direct the first quarter, real GDP fell by 1.4 percent compared with the investment in those economies was estimated to be 14 percent. Last quarter of 1997; this reflects a steep decline in manufactur- In MaLaysia, Singapore's investment is equal to that of Japan's. ing and commerce. In Late June 1998, the govemment revised its As a resuLt, since the crisis broke in Thailand and spilled over to official forecast substantialLy downwards, from -0.5 percent to Malaysia and Indonesia, Singapore has been working cLoseLy with -1.5 percent. To stimulate the economy, the govemment has the crisis-stricken countries. It proposed to create a muttiaterat announced property tax rebates and an increase in infrastructure forum to guarantee Indonesian banks' Letters of credit. In April spending. 1998, Singapore detailed a pLan to extend a US$5 billion trade Singapore's future is closeLy bound with that of its neighbors'. finance guarantee to Indonesia. To continue ptaying the role of It is a highty open economy; its trade is more than four times its a regional hub providing trade, shipping, and port services, GDP, and its nonresident consumption is 20 percent of its total Singapore may find it beneficial to expand its coordinating rote. private consumption. Singapore receives about 20 percent of MaLaysia's exports, 14 percent of Thailand's, and 8 percent of Soier: Word Bank. Prospects and policies to boost growth and imports. The speed and success of recovery in East Asia critically depends on the ability of Near-term prospects and issues. Given the sluggish Europe, the United States, and Japan to accommodate growth in nominal dollar world trade, the continued large trade imbalances. strength of the U.S. dollar, the slowing of both growth Trade credits may also help to establish a recovery and imports in Japan, and the collapse of intra-Asian and would likely increase intra-Asian demand. Japan trade, exports are unlikely to recover quickly. Indeed, and other high-income countries in the region, such as there may be further adverse shocks that could destabi- Singapore (see box 2.4), could help to implement these lize the region's economy. This risk calls for urgent initiatives. Encouraging foreign direct investment attention at the highest policy levels within the region. inflows to the crisis countries, especially in the tradables Asian exports depend directly or indirectly on world sectors, would be a vital domestic policy instrument to trade growth. Any additional shocks to the value of the spur exports and trade. Resolving the financial crisis dollar against other currencies would cause increasing and banking system problems is essential, especially to instability. Any strengthening would tend to drive dol- ensure access to loans by credit-worthy firms in export- lar prices further down. The yen-dollar exchange rate ing sectors. is also of special interest, and any shocks to it would In the medium term. Even when cyclical conditions adversely affect recovery prospects. improve in world trade and the exports from East Asian In addition to exchange rates, measures are required countries recover, underlying core policy issues will still to revitalize real world trade and import demand in require attention. First, there is the need to avoid industrialized countries. It is vital to follow the policy implicit industrial policies and to improve not only of global opening of markets rather than regionalism, financial sector discipline but also corporate accounting especially in Western Europe, where the emerging and governance rules. Second, domestic policies should recovery would strengthen world demand, but only if it try to attract foreign direct investment back into export were open to all markets in the world. The United sectors, not only for immediate capital investment, but States is already helping to maintain open markets and also to reduce risks and to increase success in operating sustain a larger volume of imports, which is crucial to in the new global production climate. Third, to encour- recovery in Asia. Japan has announced a fiscal stimulus, age deeper and less vulnerable intra-Asian trade, trade but it must ensure that the stimulus is effective in order barriers among countries need to be lowered sharply, 30 East Asia: The Road to Recovery Thailand's agriculture: Producing more, eating less Pnor to the East Asian crisis in 1997, Thailand's terms of trade not change, the quantity exported may increase substantially as were generally robust. Since the outbreak of the crisis, however, a consequence of reductions in domestic demand following the it appears from the limited available data that the overall terms sharp rises in consumer prices. of trade have deteriorated sharply. k .Vh-e export volume was esti- A simple initial indication of the nature of the price and quan- mated to have grown by 16.6 percent between March 1997 and tity responses to the crisis was obtained by exanining the March 1998, export value decli ied by 3.5 percent because of a changes in agricultural export voluimes and prices between the decline in unit pnces of 16.6 percent (Bank of Thailand, 1998). first quarters of 1997 and 1998. The results (shown in the ta-i e This detenoration in the terms of trade makes it more difficult for below) reveal a substantial increase in the volume of Thailand's ThaiLand to achieve the turnaround in its current account needed crop exports since the cnsis. The average increase of nearly 40 as part of the adjustment to the crisis. percent is the result of rises in the volume of exports of all com- Much of the price decline for manufactured items that are dif- modities considered, except for tobacco. Some of these ferentiated products presumably results from the need for increases-for example, 76 percent for nce, 99 percent for fresh exporters to acce;.t lower pnces if they are to increase their own fruits, and over 200 percent for maize are remarkably large. The share of world markets. Bulk agricultural products such as rice, average volume increase is more than twice the volume raiowth of rubber, and maize are typically viewed as homogeneous goods exports as a whole. that trade at more or Less the same prices worldwide, -xcept for The,,e increases in volumes were, however, offset by substan- differences resulting from transport costs and other factors. tial declines in the dollar prices ;ur most of these goods. The However, the East Asian crisis has been such a shock to the entire decLine in the world prices of these same commodities can explain world economy that it has had a large impact on world pnces for the decline in the prices of these exports. However, the declines a number of commodities, such as rubber, where the crisis coun- in prices were particularly large relative to world prices for com- tries are important producers. Furthermore, even commodities modities, such as rice, fruit, and maize, in which Thailand greatly that appear to be homogeneous frequently include a variety of expanded its export volumes. Although these volume-induced characteristics that allow for substantial differences in the prices increases are undoubtedly important, it appears that about 80 of the goods in world markets. percent of the decline in the prices of these ac:ricultural goods The quantity adjustment in Thai agncultural exports is also an can be explained by developments in world pnces. important aspect of the country's terms of trade. Since the cnsis The future performance of Th- agricultur-l exports will be of began in the second half of 1997, there has been little opportu- critical impor-.nce. Irnproveo baht prices will undoubtedly nity for producers to adjust their output decisions in response to increase production of agricuc -ral commodities, leavirng more the new price incentives. Substantial increases in inputs, such as crops availa.ole for exports. It s, ems unli the amount of foreign exchange exposure they could assume and it was the corporate sector that borrowed Increase in Credit channel o Lending boom ] large amounts offshore. In Korea and Thailand, NBFIs short-term debt and foreign had relatively free rein to borrow abroad. In Malaysia, exchange exposure following large borrowings in the early 1980s, both financial institutions and corporations were limited in Macroeconomic vuLnerability increases the degree to which they could take on foreign exchange whiLe bank portfolios becomTe riskier exposures, thus foreign claims were relatively small in Source: ALba and others, 1998. mid-1997. Financial systems in the East Asia region generally did Financial boom and bust a poor job in intermediating capital. In fact, those countries, most notably Thailand, that relied most As noted in chapter 1, the high growth rates in the region, partly the result of sustained structural reforms, BOX 3.2 led to demand pressures which were largely investment- Is liberalizatton playing with fire? driven. Although inflation increased in some countries, demand pressures were manifested primarily in a A recent study by Demirguc-Kunt and Detragachia (1998) 'demndn pressurrest weroundefniftst. pImariyie analyzed the empirical relationship between banking crises widening of current account deficits, Inflows of pri and financial liberalization in 53 countries for the period capital contributed to, and reinforced, demand pres- 198M95. Their results show that banking crises are more tikely sures. Private capital flows added to domestic macro- to occur in liberalized financial systems, especiaLly those with economic pressures for three reasons. First, as countries weak institutionaL environments. In particular, respect for the had undertaken significant capital account liberaliza- rule of law, the tevel of corruption and the extent of contract enforcement are relevant insttutionat characteristics. Examination of the behavior of bank franchise vatues after tib- date demand pressures. Second, East Asian countries eralization and of the relationships among financial liberaUza- became more attractive to investors as their growth tion, banking crises, financial devetopment, and growth accelerated. Finally, asset price inflation already under- supports the view that financial liberalization should be way was fueled by private capital inflows. As a result, approached cautiously when the institutions necessary to capital flows to East Asian countries tended to move ensure law and contract enforcement and effective prudential very much in tandem with domestic macroeconomic regulation and supervision are not fuiLy deveLoped, even if macroeconomic stabilization has been achieved. Nevertheless, cycles-particularly in Indonesia, Thailand, and Korea. in most countries with severely disturbed interest rates finan- The macroeconomic policy mix used to deal with the ciat liberalization has had positive impacts on growth, but overheating pressures and capital inflows in the 1990s (further) liberalization is needed to be accompanied by a added impetus for further inflows-and for the accu- strengthened institutionalized environment in order to main- mulation of short-term, unhedged external liabilities, in tain these gains. particular. Exchange rate policies played a large role in Source: Demirguc-lunt and Detragachia, 1998. motivating capital flows. The perception of reduced 38 East Asia: The Road to Recovery heavily on their banks, rather than foreign investment, lowing the surge in capital inflows. This high growth were the most vulnerable.5 As reviewed in chapter 1, rate strained banks' capacity to adequately assess risk. implicit government guarantees, high domestic funding In Indonesia, in contrast, the growth in bank and non- costs, and the creation of offshore banking centers all bank credit to the private sector was lower during the created incentives for excessive borrowing abroad. inflow period than in the years prior to the surge in for- Foreign investors were partially to blame for the over- eign capital, in part as it has undertaken extensive borrowing, as they did not always adequately price financial reform before the inflow period (see figure risks, or perform full evaluations of countries or indi- 3.5). vidual borrowers. Spreads for non-sovereign borrowers The increasing financial sector fragility was not in East Asian countries, which were already lower than detected during the lending boom because the growth in for other emerging markets, declined even faster rela- banks' loan portfolios was accompanied by rising mea- tive to borrowers from other emerging markets during sured profits. Figures 3.3 and 3.5 show that in countries the 1990s, and in late 1996 and early 1997 were often with high credit growth-except the Philippines-mea- only marginally above those for long-maturity loans to sured profitability of the banking sector increased con- U.S. corporations. This decline in spreads was often sistently across all indicators. Conversely, in countries accompanied by poor evaluations of risk and perfor- where the lending boom was smaller-in absolute mance; as late as May 1997, for example, investors terms or proportional to GDP-profitability increases were buying large amounts of short-term paper from were smaller or non-existent, depending on the prof- Indonesian corporations with only a few days of due itability indicator used. diligence. Real estate lending was high, and banking sector The reinforcing effects of high and rising investment exposure to real estate was greater in countries with levels, large private capital inflows and asset booms, larger rates of credit growth proportional to GDP combined with the underlying weaknesses in financial systems, led to the buildup of a number of vulnerabili- - 3" 5 - = - ties, including increased banking fragility, increased exposure to risky sectors, and increased borrowing Credit growth as a ratio of GDP growth short in foreign currency and lending long in domestic (annual averages) currency. As seen in figure 3.4, these effects not only 6 reinforced macroeconomic policy, but they reinforced each other. There were, however, differences between 5 * Pre-infLow period ', -mInfLow period -- - countries that played important roles in both triggering o piod the crisis and in the evolution of the crisis once it was 4 m under way. Throughout East Asia, financial liberalization, 3 increases in financial savings, and surges in capital inflows led to increases in monetary aggregates. In 2 turn, as governments failed to make the judgment that monetary and credit growth, as well as capital inflows, _ were excessive, the increased liquidity and monetiza- Oi l Mai 0 tion of these economies resulted in a generalized surge c "p 145 N in bank and NBFI lending, although the amplitude and ° Sss!' D' <&' .e" o $ duration of these cycles, plus their apparent relation- 'O' ship with financial liberalization and the surge in capi- Note: The period of high inflows vary for each country: China (1993-96), tal inflows, varied from country to country. For India (1992-96T , Indonesia (1990-96), Korea (1991-96), Malaysia (1989-96), example, in Malaysia, the Philippines, and Thailand, Pakistan (1992-96), PhiLippines (1990-96), ThaiLand (1988-96). Pre-infLow period refers to the 5 years pror to each inflow period. bank and non-bank credit to the private sector began Source: IMF International FinanciaL Statistics. Rates of growth are caLcuLated on an annual bases in reaL terms. growing at higher rates and on a sustained basis fol- The Financial Sector: At the Center of the Crisis 39 FIGURE 3.6 Indonesia, the variability of real estate prices was lower, with high to low ratios of 1.25 and 1.32, respectively. eor sector However, vacancy rates in 1996 were relatively high, at Percent around 14 percent and increasing. In the Southeast 20 B Property sector/totaL Loans Asian countries, especially Thailand, the amount of 18 construction at the end of 1996 already suggested a sig- 163 g nificant oversupply of real estate for the following two 14 years (1997-99). 121 | But, differences among countries were significant. Korean banks, for example, did not have large property 10l l ; exposure. Korean banks did, however, increase the 8 share of bonds and other securities in their portfolios to 6 almost 20 percent (in addition, Korean banks extended 4 large amounts of guarantees to securities issued by cor- 2 porations). Except for the Philippines, countries gener- o ally increased their exposure to bonds and other 4tb N&@ Wa 9t 0 banks' foreign exchange exposure was significant 16 U * 1991 1994 1995 through 1994, when there was a slight decrease. During the same period, commercial banks in Korea did 14 not show a large increase in foreign exchange exposure, 12 1 | . | unlike Korean merchant banks and the corporate sector 10 both of which increased foreign exchange exposures 8 significantly. 6 Maturity mismatches created another vulnerability, 4 especially on the external financing side. Initial levels of 2 1 | - | --- < | - Q | -- | * | -- external debt in East Asia were low by international 0 l * * ~ | - * -- b v v -:-< < \ standards (see figure 3.7), with the exception of -S' .@ Wa >St g +0 09 vB ,a v RS' R't9 external liabilities accumulated rapidly (see figure 3.9) *Data for first year of Indonesia is 1992 instead of 1991. and most of this borrowing was unhedged. In Source: Goldman-Sachs, Banking Research, September 1997. Thailand, the Philippines, Korea, and Malaysia, short- term foreign liabilities of banks grew extremely rapidly. growth (see figure 3.6).6 This created risks, as both the Indonesian banks' short-term foreign liabilities did not real estate and securities markets have been very volatile increase rapidly, but that of Indonesian corporations in East Asia. Real estate price fluctuations during the did. The crisis itself has revealed that short-term bor- 1990s were the highest in the Philippines and Malaysia, rowings were even higher than these figures suggest with a ratio of highest to lowest prices since inflows because much non-bank liabilities and borrowing started of 3 and 2, respectively. Still, in both countries, escaped national and international (BIS) coverage. vacancy rates in 1996 were relatively low at around 2 The strongest indicator of vulnerability was the ratio percent (and the banking sector exposure to real estate of short-term external debt to external reserves prior to appeared to be low in the Philippines). In Thailand and the crisis (see figure 3.10). In June 1997, short-term 40 East Asia: The Road to Recovery J IGIJR~ g inflows of private capital. However, the expansion of Banking sector external exposure international integration, and easy access to private (foreign siabilities/foreign assets) capital flows became catalysts which increased the mag- (orcegnt liabilities/foreign assets) nitude of vulnerability. Nonetheless, there were impor- Percent 700 tant differences among countries. Malaysia and the Philippines were less exposed; in Thailand, finance 600 * Indonesia companies and real estate lending created large risks; in - Korea, Rep. of 500 SMaLaysia Korea, merchant banks were the main source of short- 500 1 Phiippirnes term foreign exchange claims; and in Indonesia, corpo- 400 rate lending was large. The differences in vulnerability between countries 300 were influenced significantly by the sequencing and 200 i$0 : 00000 0 ;; ;d 000 00 process of financial liberalization. In Korea, for exam- ple, corporations were limited in the degree to which ioo they could raise funds abroad or sell domestic-currency denominated securities to foreign investors. Merchant 0 1989 1990 1991 1992 1993 1994 1995 1996 1997 banks, however, had carte blanche to borrow abroad, and were subject to only limited supervision. Many of Percent the merchant banks were under de facto control of the 300 chaebols, and were able to channel foreign funding to 250 m China them. 250 Vietnam The fact that very few observers predicted the crisis iS Pakistan 200 Pakisn corroborates the view that the source of the crisis lies 200 with the vulnerability of financial structures, impor- 150 tantly, rather than with fundamental weaknesses in the financial sector alone (see box 3.3). 100 From bust to reconstruction: Moving 50 ~~~~~~~~forward and rebuilding 1989 1990 1991 1992 1993 1994 1995 1996 1997 Improving the regulatory framework Source: IMF, IFS. Since the onset of the crisis, countries in the region have begun to improve the regulatory and supervisory debt in Korea, Thailand, and Indonesia exceeded exter- framework for financial institutions. They have recog- nal reserves by a large margin-greater than that of nized the need to improve standards for capital ade- many developing countries. This high ratio of short- quacy, loan classifications, and loan provisioning in term obligations to liquid foreign exchange assets ren- order to move closer to international practice. Not all of dered these countries much more vulnerable to a these requirements are immediate, and some will be potential run on their currencies, which could arise phased in over time to give banks time to adjust and from a loss of investor confidence. build up their capital. Some countries have enhanced Riskier investments, together with the banking sec- disclosure requirements, increased the (legal) responsi- tor's growing fragility and the accumulation of short- bilities and duties of managers of financial institutions, term external liabilities, culminated in increasing macro and promoted greater roles for outside investors. and financial vulnerability. The underlying process of Countries have made progress in putting in place the vulnerabilities may have occurred even without the tools for financial sector restructuring, including the The Financial Sector: At the Center of the Crisis 41 TABLE 3.2 Indicators on accounting and prudential standards Non-performing loans (NDL)definition GeneraL provision Loss provision CapitaL-asset ratio (Number of months overdue) (percent loans) (percent of NPL)' (percent) MaLaysia 3 1.5 1.5, 20, 50, 100 8 now; 10 by year 1999 Indonesia 3 by year 2001 1.0 5, 15, 50, 100 4 now; 12 by year 2001 Korea, Rep. of 3 0.5 2, 25, 75, 100 8 PhiLippines 3 1.0 (raised to 2.0 by Oct. '99) 2, 25, 50, 100 10 Thailand 3 by year 2000 1.0 2, 25, 50, 100 8.5 'Special mention, substandard, doubtful, loss provision standards. Source: WorLd Bank staff. development of the institutional and legal framework restructuring agency. The government of Korea has for resolving distressed financial institutions and deal- taken control of two insolvent commercial banks, ing with non-performing assets. recapitalized them, and expects to sell them to foreign investors in the near future. It also shut down 16 of its TABLE 3.3 30 merchant banks. The governments of Korea and Foreign ownership limits for existing institutions Indonesia have provided support to commercial banks Indonesia No Limits by taking over distressed loans and providing balance MaLaysia 30% of tota[ equity sheet support In Thailand several commercial banks PhiLippines 60% of tota[ equity Korea, Rep. of 10% of total equity; have received some infusions of new capital through 25%-33% with speciaL permission new issues and as manv as four Thai commercial banks ThaiLand 1000/0 for 10 years have had some foreign investor equity participation. Source: Various government pubLications. l4Malaysia is in the process of restructuring its finance All countries have opened up their markets to foreign companies' industry through mergers and closures- investors to greater degrees through more liberal rules involving 31 finance companies-and has created an for purchases of domestic assets (both capital markets instruments and foreign direct investment) and by eas- FIGURE 3.8 ing local establishment rules. Korea, for example, has Total externaL debt to export ratio (1996) completely liberalized foreign purchases of domestic bonds and has abolished most previous ownership restrictions for foreign investors. Thailand now allows foreign ownership of banks and corporations (albeit 250 with some limits), and Indonesia has, with a few excep- 200 tions, liberalized foreign ownership of all types of finan- cial institutions and corporations. 150 Restructuring the financial sector 100 Most important, countries have implemented some 50 financial sector restructuring measures (see table 3.4). Thailand has closed more than half of its 91 finance 0 companies, while Korea has closed about half of its R , ,9' - merchant banks. Indonesia has set in place a process for , e 5'R's dealing with insolvent banks: It has closed 16 financial institutions and has put another 54-including several Source: Debt Reporting System, InstitutionaL Investors of it largest banks-under the control of its bank 42 East Asia: The Road to Recovery Did anyone foresee the crisis? Is a recession in the next year likely? Who did a better job of predicting the East Asian crisis: local businessmen, analysts and forecasters, or rating agencies? A 7 One stancaro deviation recent study by Kaufmann, Mehrez, and Schmukler (1998) looked * Country/regional mean at various indicators of market expectations based on the Global 6 Competitiveness Survey (GCS), Standard & Poor's, McGraw-HiLl GlobaL Risk Service, Moody's and Standard & Poors (S&P) ratings. 5 Only businessmen and local investors seem to have foreseen the crisis in ThaiLand and Korea, and to a lessei degree in Malaysia. 4: No one predicted the crsis in Indonesia. In contrast, interna- tional anaLysts and forecasters, and internationaL financial mar- kets did not clearly foresee a crisis in any of the four countries. 21 Rating agencies thought highly of East Asia . . . 1 Bceiaber Decmrner Dee- Le- iceribeD Drcamnu Dece. be, Uermbe until JuLy 1997 5 Ct 07 5B; a) '7 1 St 97 95 06 97 95 96 97 95 uO 97, 9t 97 Standard & Poor sovereign ratings Indoresia Korea, Malaysia Thailand Other Latin OECD Rep of Soutn Amrerica Foreign currency long term East Asia A Is the exchange rate of your country expected MaLaysia Korea, Rep. of to be very volatile? BBB 7 One standard deviation Thaitandd Indonesia * Country/regional nmean B 6 B 5 B 4 4 l lil 11 1 1 1 ~~~~~~CCC -__________________-_______ 2 S1||rce r'uar'an-i Maehie and Schmukier 1998 Deiana Dee, ciDe' Dc-tmber Deaemar, DareriLe' December Dec mae 05 96 97 rr B 1, q5 9t 97 55 96 'J7 QB 9r 97 s5 55 6/ g5 96 °a li,donesia Kocea, Ma-aysia Thailand Other Latin OECD Rep of South America East As,a agency that will take over non-performing assets from the solvency of their financial systems. Thailand, banks and finance companies. Korea, Indonesia, and Malaysia have all issued formal On the other hand, countries have also limited the guarantees. The Indonesian guarantee is the most com- number of options for dealing with distressed financial prehensive as it covers all deposits and creditors, both institutions.7 Most importantly, in attempts to restore in rupiah and foreign currency and for on- as well as confidence, among both domestic and foreign off-balance sheet liabilities, with, among other things, investors, most governments have issued statements on equity and subordinated debt not covered. In the case The Financial Sector: At the Center of the Crisis 43 FIGURE 3.9 are furthering the highly decentralized SOE reform and privatization tasks that lie ahead. The government has Short-term debt flows, 1989-92 and 1993-96 announced that it will provide US$32 billion to its state- banks to raise capital adequacy as to step toward com- China plying with Basle standards. This is a small amount Indonesia * 1989-92 relative to the reported size of non-performing assets in Malaysia 1993-96 China's financial system, and more fiscal resources are likely to be required. The government may establish Philippines one or more Asset Management Corporations to help ThaiLand dispose of state-owned commercial bank assets associ- Argentina ated with non-performing SOE loans. However, the BraziL Chinese government faces the dilemma of the compet- ChiLe ing priorities of preserving social stability versus restor- ing financial sector health. The pace of reform will be CoLombia determined by how these two are balanced. Solid eco- Mexico nomic growth requires gradual, but firm, reform. 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 To date, very few East Asian corporations have been Percent of GDP restructured. All East Asian countries have recently Source: IMF, World Economic Outlook Database. tried to facilitate enterprise restructuring by creating an enabling environment, which includes better account- ing and disclosure standards, bankruptcy and foreclo- of Korea, the government has guaranteed a substantial sure processes, and taxation and accounting rules. amount of the external debt incurred by merchant Indonesia adopted a new bankruptcy code in August banks and other financial institutions; these claims have 1998, Thailand revised its bankruptcy law in March been restructured into loans with higher spreads and 1998, and Korea introduced some revisions to its cor- maturities up to 10 years. As a result of these guaran- porate reorganization procedures in February 1998. tees, governments have limited the degree to which pri- But workout mechanisms are relatively poor and vate creditors of financial institutions can be asked to untested, and local skills in restructuring are limited and share the burden of financial restructuring. inefficient. In many East Asian countries foreclosure of Governments have become the de facto owners of many collateral is particularly weak-in the past it often took insolvent financial institutions, which has become an several years. Large-scale technical assistance is being important factor in determining the scope of financial provided, including foreign auditors and consultants to restructuring options. Most countries are planning to evaluate asset portfolios and financial institution reha- phase out these guarantees in lieu of more limited, for- bilitation plans. mal deposit insurance schemes, but this will be gradual in order to maintain general confidence in the financial TABLE 3.4 Indicators on consolidation progress system. Bought by InitiaL CLosed NationaLized foreigners, Responses elsewhere in East Asia financial or or under To be joint inst. suspended supervision merged venture The East Asian financial crisis has led to intensified Indonesia 222 16 54 4 0 Korea, Rep. of 169 16 2 5 0 global efforts to develop more robust financial systems Malaysia 90 0 4 31 0 in emerging markets and developing countries. China is ThaiLand 142 53 18 0 4 accelerating the process of enterprise restructuring and PhiLippines 56a 2 0 0 0 financial sector reform. Many unsound state-owned Note: a. Excludes thrift and ruraL banks. enterprises (SOL) have been closed and their assets dis- Source: WorLd Bank staff based on government publications. posed of. Resolution Trust Company-type operations 44 East Asia: The Road to Recovery Countries have encouraged capital market develop- The short-run agenda: Restoring credit ment by removing regulatory and tax impediments and flows enhancing the institutional framework for primary and secondary markets. The need to raise public resources The growth rates of loans, adjusted for inflation, in for the restructuring of the banking system has pro- Indonesia, Korea, and Malaysia has declined sharply vided the impetus to develop bond markets. The gov- since the crisis (see figure 3.11). This is consistent with ernments of Korea and Thailand have announced they firms' complaints, especially in early 1998, about the will issue bonds equal to about 15 percent of their lack of credit to finance their production and exports. respective GDPs. Initially, these bonds will be placed The growth rate of real loans in Thailand is an anom- with financial institutions to strengthen their income aly, and may be explained as banks extending lines of and asset portfolios, and secondary market trading is credit to existing clients, although they face financial likely to be limited. Over time it is expected that gov- difficulty, in order to prevent a further increase in the ernment bonds will become a benchmark for corporate volume of non-performing loans. The evolution of bonds, thus fulfilling a function that was previously aggregate loans should be interpreted with caution missing when public domestic debt was minimal. In when assessing credit conditions. When the economy is addition, countries like Korea will standardize and hit by a negative shock, it is often impossible to distin- rationalize the issuance of government bonds. As a guish whether the usual deceleration in bank lending result of these actions, governments have built a base stems from a shift in demand or rather in supply. On for more balanced financial systems which rely less on the one hand, the corporate sector may be demanding bank financing, more adequately diversify risk, and less credit because they are undertaking fewer invest- allow for better monitoring of corporations. But many ments; on the other hand, it could be that banks are less impediments remain, most notably for corporate willing to lend and, therefore, charge higher interest bonds. rates or decline more credit applications. Analysis of credit aggregates and relevant spreads indicate that credit conditions were indeed tight in Indonesia, Korea, fZGLL 3.1 r - and Malaysia in the first quarter of 1998 and less so for Short-term debt as a percentage of gross Thailand and the Philippines (see box 3.4). reserves Because of large uncertainty, many banks have pre- (June 1997) ferred to cut back on lending and invest excess liquidity in less risky assets, such as government securities. As 250 aggregate domestic demand has contracted and exports have not yet increased in value terms, the rate of 200 increase in demand for credit has fallen. Also, corpo- rate balance sheets and profitability have deteriorated, 10 - and collapsing asset values have cut collateral values. As a result, lenders are less willing to extend new credit. Banks are even more reluctant to lend; their financial 100 positions have weakened due to losses on foreign exchange and deteriorating asset portfolios, and pru- 501 I I . dential regulations have been tightened. These micro-factors behind a credit crunch also pre- 0 dominated in many other episodes. In the mid- to late C (D. 9 $a 40g9.oS<+,t459 ~>-3, > at t, =B> Bmz E =>e = RM3 ,l, Eta Xx= tary> anciasotks ^eTeeluK &t A[M I 3 d 1 ie a~qgt~ ~ iino ---= X e -' v --- ---~ --^t~ W ^ 3 ,, , = - -- - -- a --- -- --- ---- --- --- - - =)S h l-t iEs u,@--e--a, WtM1'_---1 2 <33) M--)Aji-) 33-) tE g~~~~~~~~~~~~~- - - - - - - - -E' t--eg '_CW , iii i~ p Me~ i~s ei ihi i i s inceae --- - ------ ~~ ~ ~ ~ ~ ~ -dets =~ b& epeoddot a =. Ia~=C 4SM;" '-,ia^,3 ega ?~nei-s ifrad4ihtat--? al -- a --n ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~--- -- --- i- ---O3,E --- --- ---- )K-- --__ a c&it suyq r~,"˘_ b2 accmpisdhed i pare theot gh n& thieBrtady ptlanforndevel viblatu financat lyoveaextendedwt h ocr and -the buildtp-of eapnital eromrnetaineds earnings.spssso,rreDP fnnig&ssanadpaciei lises inthe fiaalecatos asimilhr patern o -w 300 2 200 %li2h_ 100 1sden_M 0 High sales growth Low sales growth -1 0 1 2 3 4 5 6 7 8 Retum on assets Note: CLassifications of High and Low is done according to the average of the median over 1993-96. ROA is return assets. Source: WorLd Bank staff calculations. Source: World Bank staff calculations. tions. Provident funds for employees in both govern- ernance, is still limited. Asian countries stand out from ment and public companies have only been established other emerging markets because of the relatively low recently and are still largely restricted to government share of the market held by foreign banks. This is partly paper and cash. because foreign bank entry is restricted; most East Third, the role of foreign banks in funding East Asian Asian countries have a policy of protecting domestic firms, and in imposing international standards of gov- banks from foreign competition by severely limiting the Corporations in Distress 57 FIGURE 4.5 FIGURE 4.6 Interest coverage deteriorated in some ... and the share of troubled firms rose East Asian countries... Interest/profit Share of firms with interest costs exceeding profit (in percent) 100 * 1991 35 1992 8 1993 30 - * 1991 80 N 1994 1992 * 1995 11993 1996 25 E 1994 60 2 - >. 1997 2 1995 2 0 1996 A X - > ri1997 40 1s 5 X 1 5 1 0 20 0 Source: World Bank staff calculations. Source: WorLd Bank staff caLcuLations. FIGURE 4.7 FIGURE 4.8 Leverage varied across sectors in East Asia ... ... and so did profitability Debt/equity (1996) Retums on assets (1996) 800 8 700 * construction 7 U construction 700 textiles~~~~~~txtle textiles ~6 chemicaLs 600 chemicals machinery machinery 5 * eLectronics 500 U electronics 4 400 3 300 2 200 1 100 0 0 -1 b9 @°'°n k? Pb Source: WorLd Bank staff caLculations. Source: WorLd Bank staff caLcuLations. number of new banking licenses granted to foreign have the same monitoring impact as a foreign bank banks. In addition, foreign banks that do have a pres- located within the country. ence in East Asian countries are often content to lend Fourth, foreign institutional investors have not been only to the best firms and for the safest purposes, such insistent on corporate disclosure and governance. as trade finance. In some countries like Indonesia, a Foreign investors may have believed, as many domestic large share of foreign funding was off shore and did not participants in East Asian financial markets apparently did, that states had a "too-big-to-fail" policy for all 58 East Asia: The Road to Recovery Corporate governance in East Asia and other emerging economies (ppnor to Jul1997) Variables Description/Effect Indonesia Malaysia Philip- Th;aitad Mexdico India Pakistan pines Right to Call Emergency Facilitates shareholder controL. YES YES YES YES E YES YES Shareholder Meeting (percent 10 10O 10 - 0 33S 10 10 share capital to caLl meeting) Right to Make Proposals at Facilitates shareholders contrl; increased YES YES YES NA NA Shareholder Meetings. opportunity to prevent biased decisions by insiders. Mandatory Shareholder Protects against abuse and squandering of YES YES YES YES NA NA Approval of Interested company assets by insiders. Transactions. Preemptive Rights on New Protects against dilution of minority share- YES YES YES NA NA Stock Issues holders; prevents insiders altering ownership structure. Proxy Voting Facilitates shareholders controL NO, YES YES- YES NO YES YES Alternative Dispute Resolution Facilitates shareholder controL. YES mechanism Mandatory Reporting by Large Disclosure of transactions by large sharehold- YES YES YES YES YES Shareholders ers protects against abuse by insiders. Ownership concentration in the 62 NA 64 43 49 10 largest private firms (per- centage owned by the 3 largest shareholders) Penalties for Insider Trading Protects against use of undisclosed information atYES YES YES YES the expense of current and potential shareholders. Provisions on Takeovers Protects against violation of minority share- YES YES YES Legislation holders' rights. Mandatory Disclosure of Non- Both financial and non-financial information YES YES YES Financial Information data are important to assess a companys prospects. Mandatory Disclosure of To protect against abuse by insiders. YES YES Connected Interests Mandatory Independent If composed of independentdirectors, auditand remu- YES YES Board Committees neration committees prtect against insider abuse. Mandatory Shareholder Protects against abuse by insiders. Protection YES YES YES YES YES YES Approval of Major Transactions can be enhanced through supra-majority voting. One Share-One Vote Basic ight;someshamholdersmaywaivetheirvoting NO YES NO NO YES NO NO rights for other benefits such as higher dividends. Allow Proxy by Mail Facilitates shareholder control. NO NO NO NO NO NO NO Shares Not BLocked Before Mandatory depositing of shares prior to share- YES YES YES YES YES YES YES Shareholder Meeting holder meeting makes shareholder control more difficult. Cumulative Voting for Directors If shareholders can cast all of their votes for NO NO YES YES YES NO NO Allowed one candidate, it increases probability of out- side directors. Automatic Stay on Assets if Shields shareholders from creditors NO NO YES NO NO YES NO filed for bankruptcy Oppressed Minorities Sharehoiders right to a judicial venue to chal- NO YES YES YES YES NO NO Mechanisms lenge insider decisions or to request company purchase their shares if they object to funda- mental changes. C.orporations in Distrcss 59 large domestic firms, and thus were more confident pursue personal nonprofit maximizing objectives, and about the threat of losing their money than they would it may impede the development of professional man- have been otherwise. Moreover, the fast real growth agers, who are required as economies and firms mature rates and rapid upward movement of stock prices in and become more complex. Empirical evidence shows East Asian countries may have created a euphoria an inverted "U"-shaped relationship between the among international investors that caused them to degree of ownership concentration and profitability.4 overlook or disregard the deficiencies in governance TABLE 4.1 practice in these countries. Ownership of Korean business groups by insiders Fifth, market and regulatory institutions that play an (percent of common shares held) important role in industrial countries in facilitating and Member creating incentives for market discipline are not yet fully Business group Founder Relatives companies Total developed. For example, Thailand's single credit-rating agency TRIS was established in the 1990s and is still Hyundai 3.7 12.1 44.6 60.4 agency TRIS was ~~~~~~~~~~~Samsung 1.5 1.3 46.3 49.3 considered by the market to be developing expertise. LG 0.1 5.6 33.0 39.7 The nascent regulatory framework further aggravated Daewoo 3.9 2.8 34.6 41.4 Sunkyong 10.9 6.5 33.5 51.2 this lack of market institutions. A modern Thai legisla- Sangyong 2.9 1.3 28.9 33.1 tive regulatory framework was promulgated in 1992. Hanjin 7.5 12.6 18.2 40.3 . . ~~ ~ ~ ~~~Kia1710442 1. the same time that the Securities and Exchange 17.1 0.4 4.2 21.9 Commission (SEC) was established. By 1997, Thailand Source: Lae H. Chung, Hak Chong Lee, and Ku Hyun Jung, 1996. built the legal and regulatory basis for modern capital Correlation of leverage on initial ownership concen- markets, but this process has been gradual. During the trations among Thai corporations for 1992 and 1996 transition period, capital markets did not adequately shows a perverse effect in both years (see table 4.2): perform their signaling and monitoring functions.3 Firms with more concentrated ownership have higher Ownership structure also led to high leverage. The leverage, even when adjusted for cross-sector and size most common organizational form in East Asian cor- differences. This effect almost doubled in magnitude porations is the diversified conglomerate that is closely between 1992 and 1996, suggesting that corporations held, controlled, and managed by a family. In Korean with high initial ownership concentration crowded out "chaebols," as these diversified conglomerates are known, families own far less than 50 percent of chae- FIGURE 4.9 bol-related companies, but they have almost total con- The share of troubled firms varied across trol over their business groups. Interlocking ownership sectors in East Asia allows them to control related companies with very lit- Shore of firms with interest costs exceeding profit (1996) tle equity of their own: with each member company 20 holding every other company's shares, the percent own- * construction ership of a chaebol family (in relation to total outstand- textiles Kchemicals ing capital) increases. Although the founder of the 15 4 chery company and their immediate relatives may hold a U eLectronics small percentage of outstanding shares (between 3 and a 15 percent) of the chaebol business groups, the inter- corporate ownership of chaebol member companies increases the total inside ownership to 30 to 60 percent (see table 4.1). Ownership concentration has benefits and costs. On r the benefits side, it has been associated with firms h 0 enhancing their efficiency of operations and invest- *, 9> ei , ment. On the costs side, it may lead controlling owners ra * to expropriate other investors and stakeholders and Source: Wored Bank staff calcuLations. 60 East Asia: The Road to Recovery the less-connected firms. Correlation of ownership How many firms will go out of business in the crisis concentration and profitability were positive in 1992 countries? As a result of the interest rate and exchange but turned negative in 1996 (although these numbers rate shock, corporations throughout East Asia now face were not significant). The costs of concentrated own- a substantially higher leverage and share of foreign ership in East Asia were further exacerbated by the rela- debt. A simulation of the impact of these shocks shows tionship between corporations and banks, particularly that leverage is 50 percent higher and the share of for- corporations owned by families that had controlling eign debt is 30 percent larger without changing the interests in banks. This relationship increased the pos- financial structure of the corporations.5 On average, sibility of easy borrowing, thus leading to higher lever- firms lost about half of their equity as a result of these age without a direct link to performance and to a slower shocks, and for almost one-third of them, losses response to changing market conditions, which exceeded their equity. Their return on assets dropped increased the risk of expropriation. from 3 percent to -4 percent (see figure 4.10), and two- TABLE 4.2 thirds of them now have negative returns on assets- Ownership concentration has a perverse relation- four times more than before the crisis. ship with profitability and leverage in Thailand The extent of the damage has reached systemic pro- (correlation coefficients) portions in most crisis countries. Indonesia suffered the Profit Profit Leverage Leverage most, with nearly two-thirds percent of its corporations 1992 1996 1992 1996 declaring bankruptcy (see figure 4.11). This is due Ownership con- 0.202* -0.063 0.151* 0.287* more to the magnitude of the exchange rate shock than centration, 1992 (0.084) (0.090) (0.044) (0.072) to the financial performance of the corporate sector R-squared 0.176 0.163 0.265 0.322 prior to the crisis. Korea came second. Prior to the cri- Note: (1) ProfitabiLity is EBIT (earnings before interest and taxes) over saLes; own- sis, Korean corporations were highly exposed to risks ership concentration is the share of top five owners, Leverage is debt over equity; (2) sector dummies incLuded for profit correlations, sector and size dummies because of their high leverage and low proftability. incLuded for Leverage correlations; (3) number of observations is 236; (4) standard Malaysia has suffered much less, as its initial conditions errors in parentheses; (5) * denotes significance at 5 percent Level. Source: Alba, Claessens, and Djankov, 1998. were better. Thailand and the Philippines were in- between. After the crisis: Assessing the damage After the crisis, bankruptcies spread throughout the - region. Indonesia was hardest hit, followed by Korea; Profitability before and after the shock has Malaysia and the Philippines suffered less, and deteriorated drastically Thailand was in the middle. Several shocks affected Retum on assets East Asian firms' ability to service their debts and access 5 new financing. First, international investors lost confi- dence and retrieved their capital; from a net inflow of 0 US$97 billion in 1996, foreign capital dropped to a net outflow of US$12 billion in 1997. Second, unprece- 05 < on dented exchange rate devaluations of about 40 percent aggravated the debt service burden and created exten- sive losses. Corporate foreign debt was largely -10 unhedged because firms believed that the exchange rate would remain stable, as it had for the past decade (see -15 f 1996 1996 with shock box 4.3). Third, tight monetary policies, enacted to preempt further devaluation and avoid hyperinflation, -20 created an unprecedented 5 to 10 percent hike in inter- est rates. This was particularly damaging to the highly Source: WorLd Bank staff calculations; see endnote 5. leveraged corporate sector. Corporations in Distress 61 The immediate agenda: Restructuring Financial restructuring determines not only the allo- banks and corporate systems cation of current losses but also the distribution of own- ership and future control in the economy. In seeking a The breadth and depth of corporate distress in East Asia solution, the involved parties have to address a range of is unprecedented in recent economic history. The level questions: Who will bear the costs of restructuring? and structure of corporate debt, the number of debtors How fast can a solution be implemented? How can the and creditors involved, and the weak legal environment survival chances for viable enterprises be maximized? make corporate restructuring a daunting challenge. At The answers to these questions determine the extent of the same time, financial resources are scarce: The bank- government involvement in the restructuring process. ing system is distressed and stock markets are Whatever the approach, the government has to ensure depressed, thus offering little hope for a quick resump- that any solution contributes toward improved enter- tion of financial flows to enterprises. Solving this sys- prise governance, thereby reducing the chances of temic crisis requires a comprehensive strategy in which repeated financial sector bailouts. Each country in East enterprises, financial institutions, and governments Asia is going through a process of political and eco- work together. nomic choices toward these outcomes. History is a poor guide to finding a solution, but it BOX 4.3 offers useful lessons. The experience in Latin American Which firms borrow in foreign currency? countries in the 1980s (see box 4.4) and the transition economies in the 1990s shows that managing a crisis of A l997surveyof840firmsinThailandshowedthatlessthan the magnitude that the five East Asian countries now 4 percent of firms with foreign currency debt were fully hedged face is fraught with problems, often is expensive to the and only 17 percent were partiaLly hedged. However, the results of the survey suggested that the probtem of unhedged taxpayer; and often leads to repeated problems after borrowing was not as extensive as might be feared. The Large only a few years. The experience of the Nordic coun- majority of firms borrowed only in baht, and those that did tries provides another example. These countries borrow in foreign cufrrency were generally the more efficient resolved their crises relatively quickly after their finan- ones (they are predominantly large exporting firms vith ties to cial system weakened in the early 1990s. Their prob- foreign companies, and they have better adjusted to the crisis lems were confined to only part of the banking system, with higher capacity utitization and cuts in employment). The issue is more severe in the private banking sector than in the FIGURE 4.11 manufacturing sector, particularly with financial institutions that borrowed from foreign irnvestors and then loaned this The extent of bankruptcy is systemic money to domestic companies and assumed the exchange risk Shore offirms with losses from the shock greater themselves. than equity (in percent) Profile of Thai firms that borrow in foreign _ currency Thailand Firms that Firms that do borrow not borrow Korea. Frequency 25%/a 75% [ Financial indicators Short-term debt/total debt 77%° 85%/ Indonesia Long-term debt/total assets 15% 10%Q: - Debt-equity ratio 312% 236% Firm characteristics Number of employees gig 139 Malaysia Share that export 88% 46% Share that are joiht ventures 60% 6% I _ Response to the crisis Philippines current capacity utilization 70% 610/I Share with fewer workers 48% 57%2 Optimistic for future growth 37% 19% 0 10 20 30 40 50 60 70 Source: Dotlar and HaUward-Dneimeier, 1998. Source: World Bank staff caLculations. 62 East Asia: The Road to Recovery whereas the corporate sector remained, with some based approach, the recapitalized bank-led approach, exceptions, largely viable. Nevertheless, it cost Sweden and the government-led approach. 5 percent of GDP and Finland 10 percent of its GDP to The market-based approach. The market-based support their banks.' approach alms to use mainly market forces to restore enterprise profitability and bank capital. Measures Options for restructuring include operational restructuring of enterprises, leading to higher efficiency and profitability; foreign inflows for In general, solutions have worked bcsr if the costs to new investments; asset sales to foreign and domestic taxpayers were minimized, shareholders were hit hard- investors; offshore and domestic equity issuance; and est, banks did most of the enterprise restructuring, and debt restructuring. Most of these approaches arc cur- the government did not end up as the owner of a large rently being used on a case-by-case basis in East Asian number of banks and enterprises. There are three countries. Governments have also undertaken several approaches that governments can consider: the market- steps to enhance the enabling environment, including allowing hostile mergers and acquisitions and tiberatiz- Corporations in Distress 63 ing rules pertaining to foreign investment. important concern among foreign investors). As several Furthermore, East Asian governments have promoted East Asian governments have already guaranteed the capital market development, such as through the adop- liabilities of banks and other financial institutions, tion of a mutual funds law in Korea. recapitalization by the government would only formal- The market-based solution limits the burden on tax- ize this process without additional costs. Provided payers, reduces the likelihood that governments end up recapitalization is accompanied by substantive changes as the primary owner of banks and enterprises, and in the corporate governance and operations of banks, it helps deepen capital markets. But for many East Asian can be an up-front investment that may ultimately lead countries, the market-based solution is unlikely to to lower costs. reduce debt to sustainable levels for many companies in Yet, the recapitalized bank-led approach has risks. the next few years. In Korea, for example, a purely Experience shows that governments routinely inject market-based solution will result in an average debt- capital into insolvent institutions without creating suf- equity ratio of the largest chaebols of over 400 percent ficient change in the bank's governance and operations. in the year 2000. Although Korean firms traditionally To date, most bank recapitalization programs instituted have had high debt-equity ratios, this 400 percent ratio by governments have been generally unsuccessful. is above historical levels and much higher than is com- When facing the trade-off between maintaining confi- mon in market economies. Similar analysis applies to dence and preserving incentives for good banking (that other East Asian countries. is, minimizing moral hazard), most countries have This high debt burden leaves enterprises vulnerable to favored maintaining confidence by extending large- fluctuations in the interest rates and market conditions. scale guarantees or continuing to recapitalize banks. In Also, the market-based solution cannot fully resolve East Asia, the previous role of the government in the non-performing loans of the banking systems in the real and financial sectors and the large problems in cor- next few years. This could aggravate the lack of confi- porate sectors give little guarantee that recapitalization dence among investors and the credit crunch felt by will be either sufficient or occur only once. firms. The market-based solution also is unlikely to lead The recapitalized bank-led approach has additional toward a more balanced corporate financing structure, disadvantages for the East Asian crisis countries. First, which relies more on capital markets and improved cor- the very high debt-equity ratios require substantial porate governance. Policies involving accelerated debt-equity swaps. But if banks end up holding large restructuring tackling stocks, that is, restructuring of amounts of equity, they can become more vulnerable to liabilities, are probably necessary in most East Asian stock market fluctuations. Second, many East Asian countries. banks also lack the technical capacity and skills to The recapitalized bank-led approach. The recapital- restructure a large number of enterprises. Although ized bank-led approach recapitalizes banks that then technical assistance is rapidly improving the banks' take the lead in corporate restructuring, including restructuring capacity, it will take time before they can financial restructuring. Under this approach, the gov- effectively restructure enterprises. Third, banks may be ernment recapitalizes banks based on an ex-ante assess- too weak vis-a-vis corporations in restructuring negoti- ment of their losses. Individual banks or groups of ations. Some enterprises, such as the chaebols in Korea, banks then work out the problem debts and take charge may be too big to fail because restructuring would have of the operational restructuring, possibly providing many social and political consequences. This may working capital during restructuring. The government result in weak corporate restructuring plans and ulti- does not intervene directly in corporate sector restruc- mately larger fiscal costs. turing. Most transition economies used this approach, The government-led approach. Under a government- with the most notable success in Poland. led approach, the government or a government agency The recapitalized bank-led approach has several ben- takes over a large share of distressed assets from the efits. It can be relatively fast and can signal to the mar- banks and replaces these assets with government bonds ket that the problems are being resolved (dissatisfaction or other safe assets, thereby recapitalizing the banking with the slowness of the current approach has been an system. The government then tries to restructure the 64 East Asia: The Road to Recovery claims and to force corporate restructuring. The main adopted more aggressive frameworks for corporate advantage of a government-led solution is that it can be debt workouts going beyond market-based, establish- fast and create clarity as it segregates bad bank loans ing corporate debt restructuring (or arbitration) com- into a new agency. It can also shift the balance of power mittees based on the "London rules" so as to give to creditors in the case of large corporations. creditors and debtors sufficient incentives to implement The government-led approach also has risks. First, voluntary workout. However, the actual process of cor- the transfer of loans breaks the links between banks and porate workouts has yet to begin. Elements of the corporations, links that may have positive values bank-led and government-led restructuring approach because of banks' privileged access to information. have also been established. In Korea, a fraction of the Thus, large transfers without bank involvement in the banks' domestic nonperforming loans have been trans- restructuring process may create asset value losses. ferred to the government-owned Korean Asset Second, a nonbank entity like an asset management Management Company (KAMCO), which will restruc- company (AMC) may not have the capacity for the ture them. A bridge bank has further assumed dis- working capital lending that is often required during tressed assets of some merchant banks. In Thailand, the debt restructuring. Third, and most important, a gov- government-owned Financial Restructuring Authority ernment-owned agency may have poor incentives to (FRA), in competition with the private sector, has restructure corporations. Even though private man- acquired assets from defunct finance companies and agers could run AMCs with various incentive programs has been selling some of these assets at auctions. An built in, the risk of poor management remains. Past AMC has also been established to purchase impaired experiences, particularly in countries with weak institu- assets. In Malaysia and Indonesia, an AMC also has tions, suggest that many times an agency "sits" on its been set up. To date, the AMCs have been largely inac- loans, often in fear of antagonizing the "powers that tive in forcing restructuring throughout East Asia. be," the same powers who often contributed to the bad Progress in dealing with external debt restructuring loans in the past. has been achieved in several East Asian countries. Korea was the first crisis country to restructure its exter- Progress in corporate debt restructuring nal debt in addressing private sector debt issues. Korean among East Asian countries banks converted US$24 billion in short-term nontrade debt of commercial banks into new loans with maturi- Most East Asian countries have yet to complete the for- ties between one to three years guaranteed by the mulation of a comprehensive framework of corporate Korean government. The chief motivation for public restructuring. Such framework depends not only on the intervention was to avoid severe disruptions that fail- magnitude but also on the characteristics of corporate ures could cause, because commercial banks form a indebtedness--debt to local banks and debt to external large portion of the domestic payment system. In addi- creditors, mostly foreign banks. The relative weight of tion, the government was willing to intervene because these debt components varies considerably across coun- there were only a limited number of creditors and few tries. In Indonesia, the bulk of external borrowing by debtors. Some of the key features of the Korean restruc- the private sector was undertaken directly by the non- turing plan are (a) the new loans bear interest of 225, financial corporate sector. In Korea, where corporate 250, and 275 basis points over a six-month London regulations hampered such borrowing, a much larger interbank offered rate (LIBOR); (b) each bank is proportion of external debt was taken on by local allowed to swap up to 20 percent of its eligible loans for banks for lending on to local corporations. In the new one-year loans, and the new two- and three- Thailand, both banks and corporations were significant year loans will carry call options permitting penalty- external borrowers, while in Malaysia, external debt is free repayments at six-month intervals; and (c) the new relatively low. loans are in the form of transferable certificates. Compared to banking sector reforms, corporate The Indonesian external debt restructuring agree- restructuring is largely at the beginning stage. ment resembles Korea's approach, in which bank debt Thailand, Korea, Indonesia, and Malaysia have would be rolled over with a government guarantee.7 Corporations in Distress 65 The agreement comprises three components: a frame- A possible approach for East Asia: The blend work for restructuring the external debt of corporates, variant a scheme to repay interbank debts, and an arrangement to maintain trade finance facilities. In addition, it Current approaches for solving the economic crisis in entails the introduction of the Indonesian Debt most East Asian countries straddle the market-led, Restructuring Agency (INDRA) to implement a volun- bank-led, and government-led approaches. Banks are tary program for the provision of foreign exchange partially recapitalized and left to work out the dis- availability to Indonesian corporate debtors and their tressed assets, particularly the medium-sized and small foreign creditors. The government guarantee of foreign loans, whereas some larger loans are transferred to exchange risk will form the core framework for corpo- AMCs and other agencies, with the AMC leading the rate debt restructuring. Participation in the agreement restructuring. This approach may work in countries in is voluntary and decided on jointly by debtors and cred- which the problems are predominantly with smaller itors. INDRA will provide a real exchange rate guar- corporations which banks can be expected to restruc- antee and assurance that foreign exchange will be ture, or the problems are with a few number of large available to service debts without assuming commercial enterprises, which are difficult to restructure and risk. Each debtor and creditor will be expected to rene- require government involvement. However, for most gotiate the debt, agree on possible debt reductions, East Asian countries, none of these conditions may debt-equity swaps or other debt-reduction techniques, apply. It is also not clear that these approaches alone and lower the repayment stream within this frame- will achieve a necessary change in corporate control. In work. To participate, the terms of renegotiated loans particular, the shortage of equity capital means that in must have minimum maturity of eight years with a the financial restructuring of enterprises, existing share- three-year grace period. The agreement also could holders cannot be completely eliminated, otherwise include other concessions from lenders on existing debt banks or the government will own much of the corpo- and efforts by the borrower to repay the debt, including rate sector. Some involvement of current owners may through the sale of assets. actually help solve the crisis, because they have propri- In contrast, the Thai authorities preferred to encour- etary information. But leaving current shareholders in age debtors and creditors to negotiate obligations control may perpetuate the weak governance that led to through voluntary arrangements. The external debt the problems in the first place. structure of the Thai financial sector is skewed mainly Coordination among the government, banks, and toward commercial bank loans along with loans corporations. Corporations in the East Asian crisis booked through the Bangkok International Banking countries are institutionally stronger than banks and Facility (BIBF). A large portion of the BIBF loans were have shown better management. They likely face better on-lent by domestic banks to the finance companies. incentives than banks in restructuring their businesses. Efforts to resolve problems included closing 56 finance Therefore, they could play an important role. One companies plus initiatives by the government to restruc- approach for large, difficult restructuring cases would ture the banking system. The restructuring process to be building on the strengths of banks, corporations, and date differs by type of financial institution: for insol- governments in an arbitration process. Corporations vent finance companies, closure and disposal of their could be forced to apply to this process by the govern- assets; and for severely distressed banks, nationaliza- ment limiting any new lending to an enterprise with tion and eventual privatization. For the corporate sec- debt-servicing problems. In the process, an enterprise tor, the government has stated that no public support would have its obligations restructured, providing it will be rendered to the bulk of obligations. However, undertakes the necessary operational restructuring. there are several regulatory impediments to voluntary The arbitration process would lead to an operational restructuring in Thailand, which are currently being restructuring plan that would be presented to a com- addressed (see box 4.5). mittee consisting of creditor banks, the government as represented through an AMC, and other independent members (with various consultants and staff to support 66 East Asia: The Road to Recovery such a committee). The plan should indicate the savings bank restructuring (see table 4.3). First, it would deal achieved through operational restructuring, the selling with the stock problem within the framework and con- of assets, the contribution in new equity by the existing text of financial sector restructuring, where the govern- shareholders, and the degree and modality of financial ments have already committed resources. Specifically, relief sought. If the plan is not acceptable, the corpora- it would set up improved mechanisms for loss-taking tion would be subject to a standard bankruptcy process. which are insufficient even under London-based The form of financial relief provided by creditor approaches. Second, it would not break the link banks could include extending maturities and interest between banks and enterprises, as banks remain signif- relief but would contain only limited debt-equity swaps. icant lenders to viable firms, which may have a positive Banks may provide working capital but under strict value, given banks' privileged access to information. conditions (for example, only highly collateralized cap- Third, it simultaneously includes all parties involved ital). The AMC or other funds would be allowed to (banks, governments, AMCs, and corporations) and take over some loans from creditor banks and swap incentives are balanced with an emphasis on corpora- some of these claims into equity. By substituting equity tions to create credible operational restructuring plans. for debt, the government would provide the corpora- Fourth, by undertaking debt reduction and debt-to- tion time to overcome its financial problems. equity swaps by the AMC or other funds and debt The AMC as a shareholder, perhaps the largest single restructuring and new money by the banks, the power one, would have the responsibility to ensure that the of creditors over the corporations is enhanced. Finally, corporations are properly managed. It is not desirable, if debt-equity swaps are linked to the creation of equity however, for the government to become a permanent funds (pension funds, mutual funds, etc.), and if foreign owner of enterprises. Disposal of the securities investment is encouraged, the creation of a large set of acquired-through sales to strategic or portfolio active, outside owners will strengthen corporate gover- investors-as quickly as possible would be desirable, nance. but this will be difficult given the limited supply of equity capital. There are several options. Equity could Improving corporate governance be transferred to taxpayers to compensate for the taxes necessary to finance the bank and corporate restructur- The main lesson from the East Asia crisis is that it is ing, or the shares could be transferred to an institution important to take an integrated approach to the issues that promotes public benefits. For example, the shares of corporate governance and financing. The poor sys- could become the basis of privately managed, funded tem of corporate governance has contributed to the pre- pension programs. Other programs would include cit- sent financial crisis by shielding the banks, financial izens being encouraged to purchase shares through companies, and corporations from market discipline. advantageous financing plans. Rather than ensuring internal oversight and allowing There are several potential advantages of the blend external monitoring, corporate governance has been approach for the combined problems of corporate and characterized by ineffective boards of directors, weak TABLE 4.3 The impact of restructuring options Incentive for Long-term effect Demand on Legal Limiting enterprise on corporate and regulatory Speed fiscal costs restructuring governance environments Market solution * *-S- @1 *- S Recapitalized solution *- *-0 00@02 000 *000 Government-Led solution @000 0 00/SOS 0 *-0 Blend 0@06 0 00/-00 6006 06 Assuming cLose ties between banks and enterprses. Provided sufficient incentives for banks' performance. Note: More dots shouLd be interpreted as "better." Source: Staff evaLuation. Corporations in Distress 67 BOX 4.5 Removing regulatory impediments to voluntary restructuring: Lessons for Thailand and other crisis countries The most important regulatory policies are to expand the role into account the charactenstics of different businesses (cyclical- of foreign investment in the corporate sector; to review tax rules ity) and their ability to service debt. Thresholds for nonallowance that may discourage debt restiuctunng, debt-equity swaps, of interest expense deductions might be Dhased in (progressively mergers, and acquisitions; and to review bankruptcy legislation towered) over a twvo- to three-year period. so as not to discourage new money to firms in financial distress. A/low conversions of debt to equity. This technique, presently Regulatory reforms needed to promote voluntary reorganizations prohibited in East Asian countries such as Thailand and of illiquid but viable corporations include the following steps: Indonesia, should be avaiLable outside court-supervised reorga- Elmninote tax disincent7ves to equity restructunng (that is, n7erg- nizations or liquidations To allow it as part of volunitary reorga- ers andacquisitio`s). An asset transfer or share acquisition in the nizations, it would be necessary to amend company laws to course of corporate reorganization should not be treated as a tax- permit debt-to-equity conversions foi both public limited com- able event if the corporate setter (or its shareholders) receives not panies and private limited companies. cash but only the nevwly issued shares or the existing shares of the Liberalize the legot framework for foreign investment. In acquirer. Similarly, a merger should not be a taxable event. Taxes Thal[and, the Alhen Business Law is an impediment to strategic would be paid only on sale of the acquired shares. In addition to foreign investment that could facilitate the restiucturing of Thai relaxing the tax treatment of noncash corpoiate reorganizations, corporations. At the same time, investors may circumvent this it would be useful for governments to consider allowing the trans- Law by using nominees and shell corporations, which incleases fer of tax-Loss carry-forwards to an acquirer or postmerger entity. costs and risks for investois while failing to protect the interests Temporanly reduce or eliminate tax disinrcentives to debt restruc- for which the law was designed. Hence, the government could tunng. Currently, a creditor could not discharge debt without cre- consider reforms to promote strategic foreign investment, protect ating taxable income (that is, the debt forgiven) for the debtor Thai national interests, and provide greater transparency in direct in Thailand. This reduces the incentive to discharge debt. It is foreign investment. Similaily, in Indonesia, a shorter negative not clear how current tax laws v'ould treat other techniques of list on foreign investment could be put into place. debt restructuring (for example, term extensions or rate reduc- Liberalize the legal fiamework for property owners/hip. tions). Because debt restructuring is likely to be a crucial ele- Restrictions on foreign ownership of nonagricultural land are an ment of corporate restructunng, governments should identify impediment to foreign ownership of commercial real estate, resi- possible tax disincentives and remove them, at least temporariLy. dential property, and manufactunng facilities. At greater cost Governments also need to develop criteria for providing tax relief and risk, foreign investors may circumvent prooerty ownership for debt restructuring to discourage tax evasion and avoid pro- laws through the use of nominees and heavily taxed long-term viding tax rehief for corporations that do not need such relief or Leases. Current problems in the financial sector in Thailand that are candidates for court-supervised reorganization or bank- largely were caused by an oversuppLy of residential and commer- ruptcy (that is, liquidation). cial property. Additional opportunities for foreign ownership Ehrrrinate interest ceduct7br/hty an excessive debt. Because cur- would reduce this oversupply. Hence, some liberalization of prop- rent tax Laws may encourage corporations to borrow too much, it erty lawvs could achieve a better balance between supply and would be useful for governments to develop a "thin capitaLiza- demand of developed real estate and promote strategic foreign tion" rule. Such a rule would prohibit interest expense deduc- investment wvhile protecting national Thai interests and provid- tions on debt above a specified threshold (for example, a ing greater transparency in real estate tranisactions. debt-equity ratio of 200 percent). This threshold needs to take Tchuw L'cri, lcwrN internal control, unreliable financial reporting, lack of through extreme crises have been able to quickly alter adequate disclosures, lax enforcement to ensure com- governance and distribution of control of the real and pliance, and poor audits. These problems are evidenced financial sector.8 Although investors have neglected by unreported losses and understated liabilities. corporate governance, since the onset of the crisis, they Regulators responsible for monitoring and overseeing have become aware and sensitive to the need of reform. such practices failed to detect weaknesses and take Most East Asian countries have embarked on reforms timely corrective action. in their corporate governance (see box 4.6). There are Improving the framework for corporate governance six areas of specific importance to change the corporate and financing takes time and requires considerable governance in East Asia, which are described below. behavioral changes. Only countries that have gone 68 East Asia: The Road to Recovery Enhance enterprise monitoring. The role of commer- and overseeing the accounting and auditing practices cial banks in enterprise monitoring and corporate gov- and profession; (b) establishing an independent and ernance will have to be enhanced through a self-regulating national professional body for setting comprehensive program of bank restructuring and accounting standards; (c) strengthening the financial institutional development. Banks, which in the short- oversight functions of boards of directors and improv- run will dominate East Asian financial sectors, need to ing the effectiveness of audit in listed companies by become more effective monitors of firms' management establishing audit committees of boards of directors. in an ex-ante, interim, and ex-post sense. At the same Strengthen the enforcement of corporate governance time, banks need to develop an arms-length relation- regulations. The formal corporate governance frame- ship with corporations. This will require stricter work in most East Asian countries is not different from enforcement of limits on lending to connected firms and the standards used by developing countries with similar insiders, the violation of which has contributed to the income levels. But the practice and enforcement of cor- recent financial crisis and poor intermediation. In those porate governance in East Asian countries are weak. cases where banks and firms are effectively controlled Important changes in the capital markets as well as in by the same shareholders, increased transparency is the judicial system are needed such that minority share- required, which could take the form of more disclosure holders' rights are better protected. The main lead for or the requirement of a formal ownership relationship, improvements will have to come from stock market such as through a holding company. Other financial watchdogs. Extra tools to enforce regulations and dis- institutions and agents involved in disciplining firms cipline members may be needed to make these improve- should be encouraged to enhance their role. For exam- ments more effective. It may be useful to review the ple, bond investors can play an important role in disci- process for appointing commissioners and board mem- plining managers, but this requires some changes in bers of the stock exchange monitoring bodies. relevant commercial codes. Improve the corporate governance framework. In Improve disclosure and accounting practices. the more medium-term, a number of improvements in Although disclosure and accounting rules are becoming the corporate governance framework are desirable. For increasingly consistent with international standards in example, the 1997 proposal by the Stock Exchange of East Asian countries, the application of these rules Thailand for self-regulation on corporate governance of appears to be hindered by the limited role of self-regu- listed firms could be made mandatory (the proposal latory agencies (SROs) in raising standards and prac- was to adopt standards regarding the roles, duties, and tices and imposing sanctions on irregular behavior. A responsibilities of the directors of listed companies). larger role for SROs that is backed by increased legal Generally, countries could benefit from a broad public powers to discipline violators may be needed. In addi- discussion on the topic of corporate governance, simi- tion, the market structure of the accounting industry, lar to what happened in the United Kingdom and other with limited participation by foreigners, may have been developed countries in recent years.9 In the end, the a hindrance to upgrading practices. Improved reliabil- issue of corporate governance concerns the distribution ity and integrity of financial reporting and disclosures is of control in the economy over the real sector. A dis- the prerequisite for reforming the corporate sector and cussion of the preferred evolution of the real or indus- restoring market confidence. Corporate management trial sector should form the basis of the desired must exercise its responsibility for preparing financial evolution of the corporate governance framework. The statements that are transparent and in accordance with process of consultations used for the 1998 standards that are easily understood, not only by the Organization for Economic Co-Operation and management, but also by regulators and the general Development (OECD) report on corporate governance public. Introducing truly transparent accounting and provides a good starting point on how this discussion auditing systems, consistent with international best might be conducted. practice, would require (a) reducing the role of the gov- Facilitate equity institutions. As external financing ernment in regulating and overseeing the accounting needs are high, particularly for new equity, attracting Corporations in Distress 69 BOX 4.6 World Bank support of changing corporate governance Along with its loans, the WorLd'Bank provides technicaL advice Economic Reconstruction Lnan of December 1997, supported on policy, often expressed asagreed conditions in Loans. Here's improvements in the governance structure of banks. The loan was a sampling, also designed to help the government improve the reliabiity of In Thailand, a US$350 million finance Companies key financial information provided by banks and corporations to Restructuring Loan in December 1997 hetped conduct in-depth regulators, sharehoLders, and the generaL public; promote effec- assessments of the financial condition of the nonsuspended tive monitoring of corporate performance by boards of directors finance: companies and helped rehabilitate these institutions. and shareholders; and facilitate efficient Liquidation of insolvent The loan aLso heLped strengthen prudential regulation and the corporations. supervisory regime. The Economic and Financial Adjustment Loan In Malaysia, the Jtune l998 US$300 million Economic Recovery hetps with financiaL sector reform and corporate recovery. and Social Sector Loan had the objective of improving account- In Indonesia, the Bank provided a US$1 biltion Policy Reform, ing standards of the International Accounting Standards Support Loarn in Juy 1°998 to help cLarifyj governance and super- Committee and suspending of stockbroker companies for failure vision of banks and to set up an Indonesian Bank Restructuring to comply with capital adequacy standards. Agency. Saur. 0Word Bank Lan docunerts. The March 1998 US$2 biLlion StructuraL Adjustment Loan to Korea, following up on actions p-romised under the US$3 billion new investors will be important. To facilitate the ular surveys, which should be a joint effort of private, process of new equity infusions, it will be necessary to semi-public, and public organizations. provide new investors with a more direct role in moni- toring and disciplining managers. This will require a Notes representation of minority shareholders on the board of directors, which in turn may ensure broader application 1. All computations in this section, unLess otherwise stated, rep- of the one-share, one-vote principle and use of cumula- resent the median firm based on the Financial Times Extel and tive voting for the appointment of directors. It also may Worldscope databases, which include al[ firms listed on the stock be useful to introduce supermajority voting rules for exchange in their respective countries. fundamental corporate decisions, such as acquisitions 2. Based on simpLe Pearson correLation tests. and major investments. Some market participants and 3. One particuLar aspect of concern are discLosure rules. Regarding analysts even have suggested that new equity infusions what to discLose in developing countries, whereas most deve[oped may require a more-than proportional representation markets rely on market practice and due diLigence obligations to on the board of directors by new equity owners, at least ensure discLosure of aLL materiaL information, it is prudent for the until ocher investor protection mechanisms are authorities to be more proactive. In severaL East Asian countries, how- strengthened. Improving corporate regulations will ever, markets still were struggling to define precisely what this meant require enhancing the role of institutional investors in in practical terms. Disclosure systems were aLso weak in how informa- monitoring firms, which will have to begin with tion was disseminated through pubLic repositories and mandated improving the regulations of the investors. requirements for pub[icly held firms. This weakened market incentives, Strengthen instituttions. In terms of institutional particularLy for financial intermediaries and for firms issuing short- development, it is clear that data availability and analy- term paper. sis of corporate financing and governance represent 4. Morck, Sh[eifer, and Vishny, 1988. major weaknesses in East Asian countries. Not only are 5. The impact of two financial shocks faced by corporations in each the data on corporations, especially on small and of the five crisis countries is considered: (a) the increase in financiaL medium enterprises (SMEs), incomplete and of poor obLigations implicit in the devaLuation of the exchange rate, and (b) quality, there are also institutional gaps as the responsi- the increase in financial outLays caused by rising borrowing rates. For bility for monitoring firm performance and behavior is each country, the first shock was approximated as the increase in the scattered. Follow-up work should aim at systematizing vaLue of foreign debt in domestic currency determined by the devaLu- data collection on firms and performing more and reg- ation recorded on average over the first two weeks of September of 70 East Asia: The Road to Recovery 1998 with respect to the precrisis (March 1997) value of the U.S. dol- 7. The scheme is modeled on the Fideicomiso para La Cobertura de Lar (in revising ROA, onLy one-third of this shock was deducted from Riesgos Camiarios (FICORCA) pLan to faciLitate restructuring of Mexican actual net income). The second shock was approximated by the private corporate external debt in the aftermath of the 1982 debt cri- increase in lending rates in the first few months of 1998 with respect sis. to their LeveL observed in the equivaLent period of 1997. These shocks 8. ChiLe is an example of a country that achieved significant own- were then applied to the balance sheets of each firm as of end 1996. ership and control transformation of its economy following its finan- Thus, a '1996 with shock" is obtained and compared with the "1996 ciaL crisis of the early 1980s. The transformation involved a reduced actual." Because many of the ceteris paribus assumptions made for role for conglomerates, the privatization of state enterprises, a fully simplicity have changed, the "1996 with shock" is obviously just a funded pension system, and various other tools. Many transition reasonabLe first-cut approximation to what may be happening. The economies also have been able to achieve a rapid transformation. results are provided for the median firm based on a sample of nonfi- 9. ForexampLe, the Cadbury (1992) and Hamel (U.K., 1998) report, nancial firms listed on the stock exchange in the respective countries. the Toronto Stock Exchange (Canada, 1994) report, the Peters report For more detail see Claessens, Djankov, and Ferri (1998). (Netherlands, 1997), the Corporate Governance Forum (Japan, 1997), 6. Dress, B. and C. Pazarbasioglu, The Nordic Banking Crisis, Pitfalls the Statement on Corporate Governance (U.S., 1997), and similar in Finonciao Liberalization? IMF OccasionaL Paper 161, April 1998. efforts in a number of other countries. Corporations in Distress 71 72 East Asia: The Road to Recovery From Economic Crisis to Social Crisis It was the rich who benefited from the boom ... but we, the poor; pay the price of the crisis. Even our limited access to schools and health is now beginning to disappear. We fear for our chil- dren's future" said Khun Bunjan, a community leader from the slums of Khon Kaen, northeast Thailand and her husband, Khun Wichai. Khun Wichai recently lost his job in the local factory and his wife is selling less at the local market. As a result they took both their son and daugh- ter out of school and put them to work. "What is the justice in having to send our children to the garbage site every day to support the family?" questions Khun Bun/an. But Khun Wichai thinks he is lucky. His neighbors are sending their children to beg and some girls became pros- titutes. Among the older male youths, drug dealing has become an increasingly attractive source of income. Increased competition for survival, frustration and psychological stress are all lead- ing to heightened household and community tension. This tension has led to increased domes- tic violence and with fewer jobs, neighbors who once cooperated are now competing. Stealing, crime, and violence are on the rise. People are feeling unsafe and insecure. "This breakdown of our community's networks will affect stability," added Khun Bunjan. -World Bank staff interviews. E;"I ast Asia's economic and social structures are under strain, and decades 0 of unparalleled social progress risk being undone. In country after AL-4 country growth is declining-from historical average per capita increases of over 5 percent per annum to negative levels over the next year- with especially sharp contractions expected in Indonesia, Thailand, and the Republic of Korea. The poor are being hit hardest during the crisis as demand 73 for their labor falls, prices for essential commodities Progress and vulnerabilities rise, social services are cut, and crop failures occur in countries experiencing drought. The combined macro- East Asian countries have achieved spectacular welfare economic and agricultural shock undercuts fragile cop- gains in the last two decades.' Consistently high growth ing mechanisms, especially in Indonesia, and could be rates have been translated into quantifiable welfare life-threatening if consumption levels drop sharply. improvements primarily because growth has largely Widespread economic hardships are tearing at the fab- been inclusive. Public provisioning of social services has ric of society: food riots and ethnic tensions in been widespread and the productivity of the poor and Indonesia, farmers are protesting in Thailand, and their employment opportunities have increased enor- workers are voicing discontent in Korea. These signs of mously. The number of poor has fallen and the severity stress on social systems are politically worrisome. of poverty has declined. Life expectancy at birth, infant Moreover, the increasing tensions at both the house- mortality, and literacy have all improved. These hold and community level are equally damaging, espe- achievements are even more impressive when compared cially for women and children. Children are being with social developments in other regions or other pulled out of school and put to work; food is being developed countries during their decades of industrial- rationed within the household, and women and girls are ization. frequently the first to sacrifice their portions; and vio- lence, street children, and prostitution are all on the Impressive measures of social development increase. This is the human crisis. A rapid return to macroeconomic stability and Between 1975 and 1995, poverty in East Asia dropped growth through distributionally favorable adjustment by two-thirds according to the region's head-count policies is the only way to begin to put a floor under the index using the constant US$1-a-day poverty line (in falling incomes of the poor. In the meantime, govern- 1985 purchasing power parity [PPP] terms). This pace ment action can curb the welfare losses of the poor in of poverty reduction was faster than in any other devel- the short-term, and help protect their human resource oping region. In 1975, six out of ten East Asians lived investments. It is essential to ensure that food markets in absolute poverty according to this standard; by 1995, work, to augment the purchasing power of vulnerable the ratio had dropped to two out of ten (see table 5.1). households, to cushion the impact of price increases, This means that the number of poor people in the and to preserve the poor's access to health and educa- region was more than halved, from 720 million to 345 tion. Strengthening public and private institutions million. Further, the rate of decline accelerated after responsible for service deliverv is also crucial in both the 1985. The number of people in poverty fell by 27 per- short- and longer-term. cent between 1975 and 1985; the decline was 34 per- East Asian countries encountered important social cent between 1985 and 1995. challenges before the crisis. In most of East Asia, social Changes in poverty levels and rates varied across the policies developed against the backdrop of political sta- region. In 1975, 92 percent of the region's poor lived in bility, full employment, high household savings, and China and Indonesia, primarily because they were the relatively strong community ties giving governments lit- two most populous countries. Since then, however, tle reason to plan for downside risks. But even during both countries have seen substantial declines in poverty: times of economic growth, three issues challenged by 82 percent in Indonesia and 63 percent in China. In social policies in East Asia: persistent pockets of poverty absolute terms, the number of poor was more than and rising inequality, outmoded labor market policies halved in China, and fell by almost three-fourths in and industrial relations, and rising needs for formal Indonesia. As a result, by 1995, the two countries' share mechanisms to support household security. Growth of the region's poor had dropped to 84 percent. masked those problems but when the crisis stripped this Although Indonesia's record is remarkable-the head- mask away, the region's persistent social vulnerabilities count declined from 64 percent in 1975 to 11 percent in were sharply revealed. 1995-Thailand had the largest proportional reduction 74 East Asia: The Road to Recovery TABLE 5.1 Poverty in East Asia, summary statistics: 1975-95 Number of peopLe Head-count index Poverty gap Economy in poverty (milLion) (percent) (percent) 1975 1985 1995 1975 1985 1995 1975 1985 1995 East Asiaa 716.8 524.2 345.7 57.6 37.3 21.2 n.a. 10.9 6.4 East Asia (exc. China) 147.9 125.9 76.4 51.4 35.6 18.2 n.a. 11.1 4.6 MaLaysia 2.1 1.7 0.9 17.4 10.8 4.3 5.4 2.5 < 1.0 ThaiLand 3.4 5.1 < 0.5 8.1 10.0 < 1.0 1.2 1.5 < 1.0 Indonesia 87.2 52.8 21.9 64.3 32.2 11.4 23.7 8.5 1.7 China 568.9b 398.3 269.3 59.55 37.9 22.2 n.a. 10.9 7.0 Philippines 15.4 17.7 17.6 35.7 32.4 25.5 10.6 9.2 6.5 Papua New Guinea n.a. 0.5 1.0 n.a. 15.7 21.7c n.a. 3.7 5.6r Lao PDRd n.a. 2.2 2.0 n.a. 61.1 41.4 n.a. 18.0 9.5 Vietnam n.a. 44.3e 31.3 n.a. 74.0e 42.2 n.a. 28.0e 11.9 MongoLia n.a. 1.6 1.9 n.a. 85.0 81.4 n.a. 42.5 38.6 na: not avaiLabLe. Notes: All numbers in this table (except for Lao PeopLe's Democratic RepubLic) are based on the internationaL poverty Line of US$1-a-day per person at 1985 prices. a. IncLudes onLy those countries presented in the tabLe. b. Data reLates to 1978 and appLies to ruraL China only (World Bank 1996d). c. Data reLates to 1996. d. AvaiLable data on PPP exchange rates and various price defLators for Lao People's Democratic Republic (LAO PDR) are not very reLiable and Lead to anomaLous resuLts. The poverty numbers for Lao PDR in this table are based on a nationaL poverty Line which is based on the LeveL of food consumption that yieLds an energy LeveL of 2,100 caLories per person per day and a non-food component equivaLent to the value of non-food spending by househoLds which are just capabLe of meeting their food requirements. The US$1-a-day poverty Line is based on characteristic poverty Lines in low income countries that have comparable basis in food and non-food consumption needs; the poverty numbers for Lao PDR are, therefore not strictLy comparable to those for other countries. e. The figures refer to 1984. "Household WeLfare in Vietnam's Transition" in Macroeconomic Reform and Poverty Reduction, edited by D. Dollar, J. Litvack, and P. GLewwe. WorLd Bank RegionaL and SectoraL Study, 1998. Source: Everyone's Miracle?, WorLd Bank, 1997. TABLE 5.2 SociaL indicators in East Asia: 1985-95 Life expectancy Infant mortality rate Primary net enrollment Secondary net enrollment Country at birth (per 1,000 [ive births) (percent) (percent) 1970 1995 1970 1995 1970 1995 1970 1995 East Asia 59.4 68.8 76 34 na na na na Taiwan (China) 69.0 74.8 69 6 na > 99 75.0 87.4 Korea, Rep. of 60.6 72.0 46 10 > 99 > 99 45.4 93.4 MaLaysia 61.6 71.8 45 12 84.1 88.7 25.5 55.9 ThaiLand 58.4 69.0 73 35 78.6 88.2 18.2 34.9 Indonesia 47.9 63.7 118 51 75.6 > 99 13.0 55.0 China 61.7 69.4 69 34 75.9 > 99 34.7 50.7 Philippines 57.2 66.5 71 39 > 99 > 99 40.4 75.5 Papua New Guinea 46.7 58.5 112 68 30.8 70.0 3.7 13.3 Lao PDR 40.4 52.8 146 104 na 60.0' na 15.0'o Vietnam 49.36 67.5 111 42 na 91.0d na 45.0'd MongoLia 52.70 66.4 102 55 na na na na na: Not avaiLabLe. Notes: a: Source: ROC, various years. b. 1993, Source: World Bank, 1995a. c. Lower secondary. d. Source: WorLd Bank, 1996. Source: Ahuja and Filmer (1996), for net enroLLment rates; World Bank data for life expectancy and infant mortaLity. From Economic Crisis to Social Crisis 75 between 1975 and 1995, from 8 percent to less than 1 significant expansion of basic health services, percent. including key preventive services such as immuniza- Between 1973 and 1990, the region saw substantial tions and basic curative care. gains in life expectancy and declines in infant mortality * "Flexible" labor markets and lowv labor market (see table 5.2). Similarly, access to education dualismi. East Asian labor markets are fairly flexi- expanded-China and Indonesia reportedly joined ble, with fewer institutional or policy-driven rigidi- Korea and the Philippines in achieving universal pri- ties than European or Latin American mary net enrollments. In those four countries, plus markets-minimum wage policies are limited, wage- Malaysia, secondary net enrollment also expanded setting practices are flexible, and wages and pro- beyond 50 percent of children in the eligible age group. ductivity growth are closely linked. As a result, Five major factors contributed to the region's social fewer sharp contrasts existed between formal, priv- progress and inclusive development.2 Some could be ileged workers and rural, informal workers. jeopardized by the crisis. * Upgrading work force skills and investing in educa- * Small bolder-based rural development. In most East tion ahead of demnand. In Korea, education expan- Asian countries, small-scale family farming has sion effectively anticipated the changing demands of dominated agricultural production, and government modern industries and services. Young people with policies have contributed to an equitable develop- a primary school education were the core of the ment path by supporting productivity growth on work force for the early phases of labor-intensive family farms though infrastructure (notably in irri- industrialization. As productivity and wages rose- gation and roads), appropriate pricing and other driven by high levels of capital investment and tech- market policies, and new technologies. nological advances-demands shifted first to * Rapid grotvth in demand for non-agricultural labor. secondary and increasingly to tertiary graduates. In all of the region's major economies, except the Meanwhile, schooling expanded rapidly enough Philippines, the past few decades have witnessed a that skills supplies actually surpassed demands. massive labor shift-out of agriculture into more Between the early 1970s and the late 1980s, this productive work such as rural non-farm activities, prompted a decline in wage inequality among work- urban industry, and services. This shift was driven ers with college, secondary, and primary schooling.4 by many factors: agricultural incomes rose, spurring While young school graduates tended to enter and demand for rural non-farm employment, internal remain in industry, older workers were moving out economic integration increased, overall capital of agriculture directly into services. Rural produc- deepened, and industrial employment grew rapidly. tivity rose rapidly and the unskilled labor market In Malaysia, the share of wage workers in industry tightened, prompting a convergence of rural and and services rose from 30 percent in 1960 to more urban incomes.5 than 60 percent in the 1990s.3 Since the early 1980s, It would be easy to overstate the factors which sup- rural, and then urban industry and service employ- ported social and economic growth. For example, ment, has expanded enormously in China. Such Thailand's sharp rise in inequality appears to be partly changes have been accompanied by large increases related to slow growth in secondary education; China's in real wages-and by large increases in the incomes unusually small tertiary education sector could cause of self-employed workers. future problems. In Indonesia and the Philippines, * Widespread public provision of basic education and there are concerns about education quality. Some East health services. Rapid growth in the public provi- Asian countries have done very well in raising people's sion of schooling was a major element of the region's overall level of health, but, by some measures, unusu- human resource strategy. Primary schooling ally high levels of child mortality still exist in Indonesia, expanded rapidly, followed by growth in secondary Korea, and the Philippines.6 In some cases, labor mar- and then tertiary education. These efforts con- ket policies have been overly restrictive, especially in tributed to the early achievement of almost univer- Korea and China, where insiders are highly protected sal primary education, complemented by a and state intervention in employment is pervasive. 76 East Asia: The Road to Recovery Some countries strive to avoid insecurity-Korea is fol- cent in the southeast to 77 percent in the north-central lowing Japan toward a European style, pay-as-you-go, region. welfare state; China is providing cradle-to-grave pro- Are some regions poor because they contain a high tection for state sector employees and their families; concentration of households with characteristics that Malaysia and Singapore are running large-scale, state- are strong indicators of poverty? Or are there purely managed provident funds. geographic effects? Jalan and Ravaltion (1997) suggest that in China geographic effects remain strong even Pre-crisis challenges and emerging vul- after controlling for household characteristics: house- nerabilities holds with identical characteristics experience different or even diverging consumption growth depending on Even before the onset of the crisis, three issues location.8 This finding suggests that policies to augment emerged to challenge social policies: protracted poverty geographic and community capital are essential to help and rising inequality; concerns about labor rights; and alleviate poverty. rising demands for formal mechanisms to offset house- hold insecurity. The crisis has aggravated conditions Rising inequality underlying each of these issues. East Asia has been credited with achieving "growth Persistent poverty and vulnerability with equity" but the facts are more varied. On average, East Asia's income distribution has remained largely Despite tremendous gains, poverty continues for many unchanged in the last 15 years, either in absolute terms in East Asia. Poverty is still high in Indochina and or relative to other regions. An aggregate index of Mongolia, reflecting slower growth and recent systemic inequality finds that East Asia is more egalitarian than transition. In high growth countries, vulnerabilities also Latin America or Sub-Saharan Africa but less egalitar- remain considerable given the large numbers of house- ian than former socialist countries in Eastern Europe, holds just above the poverty line. In Indonesia, a 25 per- high-income countries, and South Asia (see table 5.3). cent increase in the poverty line results in more than doubling the head count index, from 11 to 25 percent An is n .An international comparison of inequaLity in 1996. Moreover, absolute poverty persists in certain (averaged Gini coefficients) areas or among certain groups. The poor tend to live in rural areas, have less education and live in households Region 1980s 1990s Eastern Europe 25.0 28.9 headed by farmers. In addition, some ethnic minorities High-income countries 33.2 33.8 are disproportionately poor and girls appear to get South Asia 35.0 31.9 East Asia and the Pacific 38.7 38.1 shortchanged in household resource allocation-par- MiddLe East and North Africa 40.5 38.0 ticularly in poor households.7 Sub-Saharan Africa 43.7 47.0 Reductions were not uniform across these economies, Latin America and the Carbbean 49.8 49.3 and poverty remains acute in some regions. For exam- Note: The total sampLe inccudes 108 economies. Although Gini coefficients come ancl poverty remains acute in some regons. For exam- from househoLd surveys that satisfy comprehensiveness criteria in terms of both ple, in 1990, poverty incidence in Indonesia ranged geographicaL coverage and income sources, they nevertheless incLude unadjusted data from both expenditure and income distributions. The proportion of income from 1.3 percent in Jakarta to 46 percent in West Nusa Gini coefficients vary across regions, hampering comparability. RegionaL averages are unweighted, and changes across the two decades may be due to changes in the Tenggara. In the inland province of Guizhou in China, composition of the sample. The numbers mereLy suggest broad orders of magni- tude. the incidence of poverty in 1992 was 20 times that in Source: Deininger and Squire (1996). the booming coastal province of Guangdong. In Thailand, the northeast has the highest incidence of Within East Asia there was significant variation poverty and the highest concentration of poor people. among countries (see table 5.4).9 Inequality has clearly Even in Vietnam and Lao PDR, where poverty is much risen in China, Hong Kong (China), and Thailand. It more widespread, regional variation is substantial. In also appears to have inched up in the Philippines Vietnam the incidence of poverty ranges from 34 per- between 1985 and 1994, and recent data for 1997 sug- gest a sharper increase."O Only Malaysia shows a slight From Economic Crisis to Social Crisis 77 decline in inequality, although this reflects earlier gains credit markets or political economy channels. Social which were partially reversed by a significant rise in tension can result when the benefits of growth accrue inequality in the 1990s. With the exception of China, unequally to easily identifiable groups-for example, all four countries now have inequality rates well above certain regions, ethnic groups, or men and boys-even the regional average. if these are not major factors in overall inequality. TABLE 5.4 Japan, Korea, and China are notably homogenous soci- Inequality in East Asia eties, but Indonesia and Malaysia have major divides across ethnic lines that have spilled over into significant Economy Period Measured Gini coefficient conflicts in the past-into the bloodbath of 1965 in variabLe (percentage points) First Year Last Year Indonesia and periodic violence against Chinese- Indonesians since. Yet, both countries achieved suffi- Hong Kong (China) 1971-91 I/H 40.9 45.0 cient social understanding and stability to foster high Singapore 1973-89 I/H 41.0 39.0 Taiwan (China) 1985-95 I/P 29.0 31.7 levels of capital investment, notably by ethnic Chinese Korea, Rep. of 1970-88 I/H 33.3 33.6 groups. In Malaysia's case, there was a highly managed MaLaysia 1973-95 I/P 50.1 48.5 Thailand' 1975-92 E/P 36.4 46.2 process of affirmative action for the ethnc Malay pop- Indonesia 1970-95 E/P 34.9 34.2 ulation, or Bumiputra (see box 5.1). Managing Chinab 1985-95 I/P 29.9 38.8 inequality is a challenge both for rich and poor coun- PhiLippines 1985-94 E/P 41.0 42.9 Papua New Guinea 1996 E/P 50.9 tries, as they attempt to balance incentives for superior Lao PDR 1993 E/P 30.4 individual performance with acceptable levels of Vietnam 1993 E/P 35.4 Mongolia 1995 E/P 33.2 iequalty which foster poverty reduction and growth. Note: I/P is per capita income, E/P is per capita expenditure, and I/H is income per househoLd. The numbers in this tabLe may be marginalLy different than those reported in other World Bank reports based on unit record data. For the sake of BOX 5.1 consistency across countries, we only report Ginis based on grouped data, except for Korea, Singapore, and Hong Kong, China, which are from Deininger and Squire Malaysia's NEP and sociat inequatity 1996. a. ThaiLand is the only country for which we can present Ginis based on both Ethnic rioting came to a head in Kuala Lumpur in May 1969 expenditure and income distribution. The per capita income-based Gini (I/P) was 42.6 percent in 1975 and 54.6 percent in 1992. after the Chinese-dominated opposition party won many par- b. Because of China's size, as well as with valuing home production of grain for tiamentary seats from the MaLay-dominated ruling coaltition. owni consumption, controlling for spatial price variacions, and valuing in-kind transfers, the uncertainty associated with Chinese Ginis may be even greater than Matays, most of whorn were impoverished, reacted violentLy in that for other economies (see World Bank 1997c for a detailed discussion). fear of losing their poLitica[ influence. To confront and com- Source: Deininger and Squire (1996), and World Bank staff caLcuLations. . fear for thir prWng, the govemment and the bwat the causes for this uprising, the government launched the Research on China and Thailand suggests two expla- New Economic Policy (NEP), an affirmative action plan nations for rising inequality. First, the returns to higher designed to pull poor MaLays into the mainstream of the coun- levels of education have increased, which is driving a trls economic system. wedge between highly skilled workers and those with The NEP introduced a series of government regulations, quo- primary or lower-secondary education. Second, spatial tas, schoLarships, and other privileges designed to help Malays. primary or lower-seondary eduction. Secndspatat The results have been impressive: Malay's share of national disparity in economic prosperity is growing because weaLth jumped to 20.6 percent in 1995 from 2.3 percent in activity is concentrated in certain areas. The current cri- 1970. Much of the NEPs success is attributed to education as sis may increase inequality in access to education and the number of Malay doctors, Lawyers, and engineers increased also affect areas within the region differently, further dramaticaLly. MaLaysia's affirmative action polices have not aggravating skills- and geography-based differentials. been without controversy. Some have observed that the poLi- High inequality negatively effects society in three cies helped Foster faoritism and inefficincy. Even so, the I . ,, , overal approach clearly succeeded in supporting high LeveLs of dimensions: undermining poverty alleviation, impeding investment, low levels of intemal conflict, and rapid advance- growth, and contributing to social tension. For a given ment of alL Malaysians, especialLy the Bumiputra, for more than growth rate, an increase in inequality tends to lead to two and a haLf decades. slower poverty reduction.11 Greater initial inequality Source:f M ray Heibert 'Lessons From Malaysia, Frc Eastern Economic can reduce economic growth because of imperfect Revierw,May 28, 1998. 78 East Asia: The Road to Recovery Labor relations Urbanization, aging, and Labor force Most countries in the region sought to maintain rela- adjustments in East Asia tively unfettered labor markets during the early stages East Asia's popuLation is urbanizing ... of economic development at the expense of granting workers the right to bargain collectively. Until the late Percent of population living in urban areas 1980s, labor conditions in Korea, Malaysia, the 60 with China Philippines, Taiwan, China, and Thailand were deter- 50 without China _ 2 mined unilaterally by employers with or without the 40 NOA assistance of government.'2 However, in the late 1980s 40 changes began to affect unions with shifts toward more 30 democratic governments, pressures for modern indus- 20 trial relations brought about by tighter labor markets, 20 and more sophisticated production processes. 10 Failure to modernize worker-management relations in countries with sophisticated economic and political 0 1990 2020 structures can become costly, as Korea's experience since the late 1980s has shown. If there is no industrial graying rapidly relations system to allow workers to air grievances and - resolve disputes, strikes and other forms of job actions, sometimes violent, can become common. One of the *ggo challenges facing maturing economies in East Asia is to Indonesia - 2 2020 manage industrial relations to protect workers' legiti- mate rights, while avoiding granting entitlements that Korea, result in resource inefficiencies. Rep. of HousehoLd risks MaLaysia I 0 2 4 6 8 10 12 14 16 Most East Asian households have few formal mecha- Percent of population over 60 years of age nisms to protect them from risks associated with job ... and increasingly working in the formal sector losses, disabilities, and aging. Instead, most rely pri- as incomes rise. manly on personal savings and informal family and Percent of population in industry and services community links. A few countries in the region have set wage employment up formal schemes to address household insecurity, but 100 these cover small portions of the population (state workers in China, large enterprises in Korea, partici- 80 Hong Kong pants in the state provident funds in Malaysia and Singapore). The current financial crisis makes glaringly MaLaysia evident the absence of formal provisioning for house- 40 hold security. PhiLippines In the face of the crisis, the demands for safety nets are 20 C ThaiLand urgent, but they will be far more dramatic 25 years R'China from now because East Asian societies are undergoing 00 5000 10000 15000 20000 25000 a rapid demographic shift. East Asian populations are PPP GNP per capita aging, moving into cities, and increasingly working in Source: United Nabons (1995), WorLd sank (19i4), 11995). From Economic Crisis to Social Crisis 79 the formal sector (see figure 5.1). In France it took 140 Effect on househoLds years for the proportion of the population over 60 to double-from 9 to 18 percent. By contrast, in Korea, The economic crisis is having four severe effects on people over 60 will double their share in the population households: falling labor demand, sharp price shifts, a in only 30 years-between 1990 and 2020-and in public spending squeeze, and erosion of the social fab- China the portion of people over 60 will rise from 9 per- ric. In addition, some countries have been simultane- cent to 16 percent of the population during the same ously hit by drought. period.13 These changes reflect a swifter demographic Falling labor demand. Economic decline, the corpo- transition, and in China, they demonstrate the com- rate crisis, and a credit squeeze are causing lay-offs, real bined effects of early gains in rural health status and an wage declines, weak demand for new labor market activist population policy. All three trends will strain entrants, and falling margins in the informal sector. informal family-based mechanisms of household pro- Whether the impact in a given country is primarily tection, and will increase demands for formal, govern- through higher unemployment or lower wages depends ment-mandated schemes. on societal and economic structures. In Thailand, unemployment has increased by 50 percent since the The social impact of the crisis start of the crisis to 1.5 million in February 1998, and is expected to exceed 6.0 percent by year-end. In Korea, The economic contraction is affecting the lives of mil- unemployment reached 7.0 percent in June 1998 and lions, and aggravating social vulnerabilities. It is likely may affect as many as 2 million people during 1998, up to have many dimensions-falling incomes, rising from 0.5 million in 1997 (see figure 5.2). In the absolute poverty and malnutrition, declining public Philippines, 1 million additional people joined the ranks services, threats to educational and health status, of the jobless between April 1997 and April 1998, rais- increased pressure on women, and increased crime and ing the unemployment rate to 13.3 percent. In violence. In Indonesia there is also a radical breakdown Indonesia, where some 4.5 million people (4.9 percent) in social order as an increasingly fragile social equilib- were already unemployed in 1996, official estimates rium was brought under intolerable stress by the col- suggest an additional 10 million may lose their jobs by lapse in economic confidence and fall in incomes. early 1999, although it is likely that many of them will The effects of the crisis are acute in Indonesia, and move into low-paying urban and rural informal sector severe in Thailand, Korea, and Malaysia. The work. Philippines has been less affected, but also shows signs This is not essentially an urban shock, despite the of worsening social conditions. After declining steadily high profile of urban unemployment figures. Rural for five years, in September 1997 there was a rise in self- areas will also be seriously affected by labor move- reported poverty. 4 Trade, capital flow, and migration ments, production linkages, and intra-household rela- linkages among countries are hastening the transmis- tionships because of the highly integrated nature of the sion of economic and social effects across the region. urban and rural economies and the declining demand in While China remains largely insulated, falling regional urban areas. Increased under-employment and falling demand and slowing intra-regional foreign investment wages may be more widespread and valid indicators of are aggravating domestic difficulties. Countries in a decline in well-being than unemployment statistics. In Indochina are experiencing growth downturns and Korea, unemployment has increased sharply; however, financial difficulties as the impact of the regional crisis there has also been an increase in the number of family unfolds with a depth and intensity far exceeding previ- and agricultural workers and in the number of labor ous expectations. The Pacific Islands have also been hit; force drop outs, suggesting substantial increases in by far the worst affected is the Solomon Islands where underemployment. Data from western Java, in gross domestic product (GDP) is expected to shrink by Indonesia, point to a decline in rural real wages by 10 10-12 percent, driven by a collapsing log export mar- percent between August and December 1997. Available ket in which export prices have halved. information in both Indonesia and Thailand suggests that workers are returning to their villages from the 80 East Asia: The Road to Recovery UnempLoyment is on the rise 1l~S 4ll ~f~ ~ms JobLessness in the Philippines is high and edging upward ... Korea it i l b h o e Percent s P ply s asic 14 exchang rt dvl ti 12 w te sd a 10 ~ShS 8 / 0ecen sinc Julty5 19 tepice fatioti cs dou 6~ ~ ~ ~ ~ ~~~/be ewenOtbr19 n ac 1998 an te 3 t\ J than 50~~~~~~~~± pecn bewepue 199 sand Mac 98 2 _ Throughou~~~~rtthe reion pries of drug hav rse 2 ... while in Korea it is Lower but sharpLy on the rise.of ic Percent Sharp prkes PrIcS paticularly tho of basic 7 necessities such as food and medicine, have risen dra- matically because of exchange rate devaluations. In 6 Indonesia, where the exchange rate has depreciated by 5 80 percent since July 1997, the prices of antibiotics dou- bled between October 1997 and March 1998 and the 4 consumer price index (CPI) for food increased by more Malaysia,than 50 percent between June 1997 and March 1998, compared with a 38 percent rise for the general CPI. 2 Throughout the region, prices of drugs have risen sharply-most dramatically in Indonesia, where there w are already reports of households postponing vaccina- 0 tions or use of other drugs. The high cost of medication Jan-97 Apr-97 JuL-97 Oct-97 Jan-98 Apr-98 also makes HIV/AIDS patients in the region particu- Source: Korean and Philippine authorities. larly vulnerable. The longer-term effect of these price changes is difficult to predict because in most countries the exchange rate appears to have overshot an equilib- urban centers of Jakarta and Bangkok. There is an rium position, and it is hard to know how much will be international dimension as well: migrant workers in inflated away or reversed by increased demand for local Malaysia, notably those from Indonesia, are also losing assets once confidence recovers. But there will clearly their jobs or are suffering real wage declines. The be short-run price effects. These will squeeze profits in Philippines is also vulnerable because of large numbers much of the informal sector, which is, in general, of overseas workers. Finally, there is evidence that already facing weak demand in the domestic market. women are disproportionately targeted for lay-offs (see Public spending squeeze. Public spending is being box 5.2). constrained by revenue falls, the effects of exchange rate changes on interest bills and the need to finance the From Economic Crisis to Social Crisis 81 increasing liabilities of the government in financial sec- ularly among unpaid family workers and independent tor and corporate restructuring. Budgets were cut ini- farmers. Households that have suffered from repeated tially in all of the affected countries as part of the droughts for the past several years-for example, in macroeconomic adjustment process. While fiscal tar- Indonesia's Eastern Islands-are particularly vulnera- gets have since been adjusted in some countries, public ble as they are likely to have used up stores of assets and services may still suffer cutbacks, creating both short- stocks to keep consumption rates constant. The extent and long-term impacts on households. Of particular of crop failure varies widely and food price rises are concern are potentially irreversible effects of cutbacks magnifying these distributional effects. While higher on investment in human resources. Budget constraints prices help farm households as they are able to raise sur- may also mean funding is cut in specific areas which plus food to sell, they also hurt long-term food deficit benefit relatively poor households (such as small holder households and other farm households that are tem- treecrop investment). porarily without food because of the drought. Erosion of the social fabric. Economic stresses are These shocks will affect incomes, well-being, and leading to social and political problems. The rapid access to services, and will interface with the coping development which brought rising incomes to most strategies that households adopt to protect their con- East Asian households in the past decades, has also led sumption levels (see box 5.3). The effects on the poor to rapid social change, urbanization, migration, and will depend on the depth and duration of the macro- expansion of education. The sudden stop to this rapid economic recession and on whether distribution wors- growth is expected to disturb the social equilibrium. ens or improves during the crisis. Both dimensions are Social unrest in Indonesia vividly showed how fragile uncertain. Other episodes of economic contraction pro- this equilibrium was, and how quickly socially vide limited insights into expected trends in distribu- repressed societies can be thrown into upheaval once tion. In many Latin American countries, distribution civil society begins to question the central source of worsened during the economic difficulties of the 1980s, political legitimacy, leadership's ability to deliver con- but in Malaysia's most recent contraction in 1984-87, tinued improvements in economic well-being. On a less distribution improved enough to prevent a rise in dramatic but nevertheless significant scale, social poverty levels.16 stresses are mounting at both the household and com- munity levels in all crisis countries. Focus group discus- Future impacts of the crisis on poverty sions suggest that households with falling incomes are coping by increasing the workload of mothers and by Forecasting poverty is hazardous enough in condi- taking children out of school and putting them to tions of stability; therefore the following discussion work."5 Economic stress brought on by the crisis may only seeks to illustrate potential outcomes for the poor also be leading to increased domestic and community under alternative assumptions on growth and distribu- violence and illegal activities such as prostitution and tion for four affected Southeast Asian economies.17 drug trade. Results are shown based on two commonly used Drought. Parts of Indonesia, the Philippines, and poverty lines: US$1 a day per person (in 1985 purchas- Thailand have been hit by an El Nifno-induced drought. ing power prices), which is close to poverty lines used in While the effects appear to be less serious than origi- poorer countries (and close to the Indonesia poverty nally feared, in some areas the combined macroeco- line) and US$2 a day per person, which is closer to nomic and agricultural shock makes coping with the national lines used in middle-income countries. In drought particularly difficult. Consumption drops can Malaysia and Thailand there are few people living on be life-threatening, especially in Indonesia where distri- less than US$1 a day, but as many as 15-20 percent sur- bution channels and markets have been damaged and vive on less than US$2 a day. In contrast, half of the foods stocks have dwindled. In the Philippines, the populations of Indonesia and the Philippines still live on large increase in unemployment between April 1997 less than US$2 a day. and April 1998 was entirely due to the sharp drop in The first scenario simulates the effect on poverty of a agricultural employment as a result of El Nifio, partic- 10 percent decrease in aggregate consumption or 82 East Asia: The Road to Recovery income between 1997 and 2000 using a poverty line of to be ht hard wh a 20 percent increase i the head- US$1 a day for Indonesia and the Philippines, and US$2 count index. Malaysia and the Philippines are pro- a day for Malaysia and Thailand. With no change in jected to show milder effects although simulations point distribution, poverty would double in Indonesia, and to a deceleration of gains in the Philippines, and a rever- increase by 35 to 50 percent for the Philippines, sal of a long-term trend of poverty alleviation in Thailand, and Malaysia. Changes in inequality have the Malaysia. Any worsening in the distribution would potential for an additional impact on poverty. A 10 per- aggravate poverty outcomes. cent rise or fall in the Gini coefficient-a significant The scenarios show the powerful influence of overall change by past standards-in the distribution of economy-wide performance on poverty through its income illustrates the possible orders of magnitude, and impact on both average incomes and inequality. But would have a maj'or influence on projected poverty out- what can be said about actual short-term distributional comes (see figure 5.3). In Indonesia, for example, a 1 0 outcomes? percent worsening in inequality would cause poverty It is difficult to draw general lessons from past incidence to almost triple-from less than 7 percent episodes. But, it is possible to explore the relationships (estimated) for 1997 to almost 20 percent in 2000. between short-term sectoral growth expectations and However, if inequality improved by 10 percent, poverty the structure of poverty. This has been done for would remain largely unchanged. Indonesia by applying projected sectoral growth rates A further scenario illustrates the impact on poverty of to the structure of household incomes available from the most likely growth scenarios for each country for the consumption survey.'8 The simulations assume the period between 1998 and 2000 (based on consensus major declines in construction (-35 percent), commerce forecasts) with no change in inequality. Country-spe- (1 8 percent) and financial services (- 18 percent), and a cific annual growth rates are used for th's exerc'se to drought-induced slowdown in agriculture (1 percent), calculate poverty incidence in the year 2000. For yielding a 12 percent decline in aggregate GDP. They Indonesia, the large expected declines in aggregate examine only impact effects, and do not take account of growth will force an additional 10 percent of the popu- either household responses or second-round effects, lation into poverty by 2000. Thailand is also expected notably in the labor market. From Economic Crisis to Social Crisis 83 FIGURE 5.3 Poverty projections with a -10 percent growth and changing inequality (poverty, incidence, percent) Indonesia (US$1 per day) Philippines (US$1 per day) 1997 6.7 1997 23.5 2000 2000 -10% growth -10% growth 10% increase 19.8 10% increase 36.3 in inequatity in inequality No change 1339 No change 31.7 in inequatity in inequality 10% decrease 7.3 10% decrease 25.7 in inequaLity in inequality Malaysia (US$2 per day) Thailand (US$2 per day) 1997 13.6 1997 - 11.1 2000 2000 -10% growth -10% growth 10% increase 25.9 10% increase 24.6 in inequality in inequaLity No change 19.2 No change in inequaLity in inequaLity 16.8 10% decrease - 10.6 10% decrease 6.3 in inequaLity in inequality Note: A 10 percent contraction in aggregate GDP between 1998 and 2000 would add miLions to the ranks of the poor. Beyond growth, distributionaL changes aLso strongly infLuence poverty outcomes. But, even with no change in inequaLity, the most LikeLy growth scenarios (19880-2000) impLy a halt or a sharp reversaL in a 20-year long trend in poverty alleviation. Source: RavaLLion and Chen 1998. ignored, most poverty in Indonesia would remain rural. TABLE 5.5 Yet the immediate effect of the crisis is expected to be Impact effects on poverty in Indonesia Y t i e (percentage of popuLation) more acute in urban areas, resulting in a significant scale of urban poverty-8 percent in 1999-for the first BaseLine Forecast 12 percent January 1996 contraction time in many years (see table 5.5). Some groups would March 1999 be particularly hard hit: the construction industry col- Rural 15.0 17.6 lapse would push poverty incidence among workers' Urban 5.0 8.3 families from 8 percent to nearly 31 percent; however, Total 11.3 14.1 the actual number of people involved is relatively small. Of course, workers and households will respond and In Indonesia, a 12 percent decline in aggregate GDP move into other labor markets. Java in particular has a in 1998 is estimated to increase poverty from 11 percent high degree of inter-connectedness between rural and in 1996 to 14 percent in 1999, affecting both rural and urban areas. If agricultural incomes remain stable, as urban residents. Even if second-round effects are the scenarios now indicate, there could be a rise in rural 84 East Asia: The Road to Recovery inequality: those with land would gain in relative terms, * The policy and institutional framework for labor as those without land suffer from the general collapse in markets and income security labor demand. * The level and pattern of economic and social services What is the cost of eliminating the crisis-induced * The interrelationship between corruption, institu- increase in poverty through public transfers? Indonesia tions, and the social fabric is used as an example in order to illustrate magni- * The central role of public information. tudes.19 In Indonesia, the increase in the poverty gap between 1996 and 1988-89 is estimated to be about 1.2 How economic poLicies affect the poor trillion rupiahs, or about 1 percent of 1988-89 bud- getary revenues (see table 5.6). Restoring the poor's All the East Asian crisis countries are experiencing consumption to its 1996 levels would require a transfer sharp drops in domestic demand. This is especially true of this amount. There are many ways this could be of investment which is expected to fall by 10 percentage done, ranging from a universal (that is, untargeted) cash points of GDP per year, or more. This raises two ques- transfer to various targeted schemes, including some tions: will future poverty reduction be jeopardized by commodity subsidies and employment programs. An the loss of productive investment and would compen- untargeted cash transfer, assuming no administrative sating expansionary policies help the poor? expenses, would cost about 8 trillion rupiahs; the Protect investments that help the poor. An "invest- increased costs reflect the substantial leakages to the ment pause," is a rational response to a shock. In times non-poor. But is possible to do better. Analysis done of significant drops in incomes, smoothing consump- for Indonesia puts the cost of transferring US$1 tion over time, allowing more consumption now, at the through public employment (padat karya) programs at cost of less in the future makes sense. This is of partic- US$3.8-US$5.3; transfers through such programs ular value to the poor, or those at risk of large drops in would thus require 4.6-6.5 billion rupiahs or 3.5-5 per- income. Indeed, a pause in investment helps explain cent of budgetary revenues. These are small amounts why the contractions in Indonesia and Malaysia in (as they usually are), especially when compared with 1984-87 occurred without any rise in consumption- the costs of financial sector restructuring. But adminis- based poverty.20 However, there is a cost in lost future trative difficulties can be daunting. growth in incomes-high levels of investment were at TABLE 5.6 the center of the growth process that brought such Cost of selected transfers to eliminate crisis- extraordinary poverty reduction in the past. While induced poverty in Indonesia some investments, such as property development, were (in current rupiahs) unproductive, on the whole East Asian countries put Increase in poverty gap between their investments to good use.21 1996 and 1998-99 1.2 triLLion Different investment categories have different effects on the poor. To reduce poverty it is particularly impor- cost of closing the gap through: Universat cash transfersa 8 triltion tant to invest in building the capacity of poor children padat korya-type programs 4.6-6.5 triLLion that, if foregone, may be irreversible, economic infra- Note: a. Assuming no administrative costs. structure in rural and periurban areas, and private investment in labor-intensive activities. The poor have What can be done? a strong interest in overall policies that provide the con- fidence and financial sector preconditions for invest- There is an urgent need to reduce crisis-induced welfare ment, especially in labor-intensive manufacturing and declines. Much can be learned from successes-and services. They also benefit from the protection of pub- failures-in responding to past crises, notably in Latin lic spending for economic and social services that reach America (see box 5.4). Public action plays an important them, either directly as beneficiaries, or via the effects role in six areas: on labor demand during the construction phase. * The design of economy-wide policies From Economic Crisis to Social Crisis 85 BOX 5.4 What can East Asia [earm from the experience of Latin America? Latin America has experienced two major crises in the last 15 it set wages low to ensure thatthe most needy werethe main par- years, both began in Mexico and both involved substantial social ticipants. costs. In the 1980s, Mexico's debt crisis spread throughout Latin Cutting subsidies can fuel resistance to needed reforms, America on the back of trade shocks and weak pubLic finances. In especially of goods that are essentiat items to the poor, unless 1995, Mexico's liquidity crisis, with its roots in, excessive private effectiveLy targeted alternatives are offered. This was the case in tending, spread onty to Argentina. the Mexican -crisis. Latin America's two crises hit households hard. Int the 1980s, Maintain support for core education and heatth services, or reaL wages in Argentina ard Mexico felL by nearly 40 percent, risk irreversibLe losses in human capital investment. white poverty increased by more thanr 30 percent. n'C1hile, reaL Socat funds may 'be useful alternatives' to government wages shrank by about 15 percent and unemployment rose by 9 safety net programs, but only when the government reaLLy lacks percentage points within a year. In the 1995-96 crisis, real the cohesion or resources to make programs work. Poor target- wages in Mexico feUl by more than 30 percent. In Argentina, ing, lack of genuine community partidpation, and Long start-up unemploymeryt rose by 6 percentage points and remained at times plagued many of the funds estabLished in Latin America. around 18 percent of the work force for more than two years. As' There is now more knowledge on how to successfulty design such a resutt, poverty increased by more than 50 percent. Latin funds well. But if estabLished govermmental or nongovernmental 'American governments responded with a variety of prograrms, bUt institutions work reasonably well, as they did in the past in most with the partiaL exception of Chile, the overaLL response was too of East Asia, it is often better to work within that system. little, too late. What are the lessons? ' More democratic systems do not hinder reforms. The Latin SoLving social probLems means putting them at the top of the American debt crisis occurred as democratic rule was being agenda. Too often in the' Latin American crises, poticymakersf restored in many countries and there were fears that democracy ernergy was devoted to restoring macroeconomic stability and would' either hinder painful but necessary reforms, or that the impteTnenting structural reform. East Asia has the opportunity to social disruption and viotence 'associated with the crisis would avoid this mistake by putting social issues at the forefront. Drops hasten the return of authoritarian ruLe. Both fears proved ground- in income, employment, and pubLic services have widespread and 'ess. Although the adjustment process was slowed in some of the compLex social consequences. Therefore, it is important to take countries by :granting an independent voice to unions, legista- action on a wide range of fronts, and make every effort to antic- tures, and other actors, the policy measures that were finally ipate these consequences. undertaken worked precisely because they had been endorsed by Targetingis crucial Special funds set up in Latin 'America, a more open civil society. designed to cushion the socal costs of economic adjustment Source iwsal Hold Jwie, 5/29/98, "East Asia Can Lean From Latin measures, had mixed success, targely due to' poor targetirg. Aedca(s Travails," by tiara tustig and Mlet Watran. Chile's Large public works program was successful, in part because More expansionary macroeconomic policy can help Interest rate policies will have mixed effects on the the poor, but there are tradeoffs. The desire to reduce poor. High interest rates can moderate inflation, restore poverty provides a strong rationale to err on the side of capital inflows, and encourage more labor-intensive expansion. Deciding what scale of fiscal expansion is new investment, all potentially pro-poor. But in East desirable nevertheless, requires the assessment of other Asia in 1998, the short-term consequences of high inter- inrertemporal tradeoffs since a more expansionary est rates on output, and consequently on labor demand, position could reduce investor confidence, or risk are central issues to the welfare of the poor. higher inflation and lower future growth prospects. Real exchange rate depreciations may help the poor Moderating the economic contraction is important for in the long term, but short-term measures are important the poor, and may be distributionally favorable.'2 to cushion the effects of price increases. In an orthodox Equally important is how the fiscal expansion is analysis, real exchange rate devaluation helps the poor financed. Deficit financing would be particularly dam- because it favors agriculture-the most severe poverty aging as earlier evidence from the Philippines and Brazil is rural-and following a period of adjustment it suggests that the poor are the hardest hit by high infla- encourages more labor-intensive investment choices. tion.23 Evidence from the Philippines from the early 1980s, found that overall real exchange rate depreciation 86 East Asia: The Road to Recovery tended to help the poor. However, the effects of a depre- crisis for the micro-finance movement. A recent survey ciation are hard to generalize, and price effects are likely of micro-finance institutions found that in many, to be highly diverse across different groups in the pop- deposits continued to rise, possibly because those insti- ulation. Some of the poor are likely to benefit, such as tutions were sound and were benefiting from a shift by rice farmers in Thailand, small holder export crop pro- rural savers out of smaller rural banks.24 While some ducers in the Philippines and Indonesia. But many poor institutions enjoyed sustained high repayment rates, households and the large informal sector are net con- others suffered sharp rises in defaults. Efforts should be sumers of tradable goods and would lose out due to a made to avoid adverse effects of selective deposit guar- depreciation. The poorest groups in both Indonesia antees on rural financial services. While short-term and the Philippines are rural wage earners. Where measures may be needed to avoid the collapse of micro- drought has hit and surpluses declined, many more finance institutions, sustainability should remain an farmers are net-consumers of food than in normal important medium-term objective. years. All of these groups are vulnerable to the price Invest in institutional transparency and accountabil- shock: the next section discusses the role of measures on ity and in the skills of poor people to increase benefits the pricing and labor demand side to offset these effects. from globalization and temper inequality in the longer Financial sector bailouts should not spare equity term. The crisis has brought distributional struggles holders. Financial sector policy indeed matters to the into the open. Three areas are likely to be important to poor; particularly in terms of the management of tackle longer-term distributional concerns. First, a bailouts and effects it will have on microcredit avail- major societal concern is unfair or corrupt gains made ability. Dealing efficiently with a weakened financial by the wealthy and connected. Fostering sound corpo- system will require substantial infusions of public rate governance structures, open and accountable pub- funds-perhaps on the order of 30 percent of GDP. lic sector institutions, and competitive procurement and While this is manageable within prudent debt limits, bidding practices will all help, but this is a domain owing to low initial levels of public debt, it diverts vast where the issues are often deeply linked to political resources from alternative uses to finance unsound or structures and not amenable to technocratic solutions. even corrupt past lending. The money behind the loans Second, there is some evidence that the forces of global has mostly disappeared-whether to real estate follies integration and technological advance target the or foreign bank accounts-and while it is standard skilled, leading to widening wage differences between practice to protect small depositors who are mainly those with and without education.25 The appropriate middle income, few among the poor have significant response is not to withdraw from international engage- levels of deposits. However, protecting larger deposi- ment-countries that do this hurt themselves and their tors to avoid a collapse in confidence is costly. At a min- poor in particular-but rather to support inclusive and imum, distributional and political economy high quality educational systems. Third, in the past, considerations demand that owners of equity in the growth largely bypassed populations living in poor financial sector assume the losses before taxpayers. areas. Policies that augment not only human capital, This is also more efficient since it reduces incentives for but also community capital in these areas, may be help- owners to go for high-risk lending strategies in the ful, but in some cases outmigration may be the only future. effective strategy-as in the series of projects in inner East Asian countries have a wide range of financial China being supported by the World Bank.26 institutions operating in most villages. Indonesia's BRI Kupedes is one of the world's largest rural micro-say- Food, employment, and income security ings and credit programs. The Philippines has a wide array of small-scale programs, and there are significant, The economic crisis threatens the livelihood of the poor. if smaller, sectors in Malaysia and Thailand. While When growth resumes, income gains and employment many of these cater to better-off rural dwellers, they are opportunities will expand, but this may take several sometimes an integral part of the village economy. years and there may be other temporary pauses in There have been concerns over the consequences of the future growth. In the short term, the poor must be pro- From Economic Crisis to Social Crisis 87 tected against drastic declines in consumption. Policy villages, NGOs, or religious organizations, food-for- measures should aim at ensuring food security and pre- work programs, and vulnerable group feeding may be serving the purchasing power of vulnerable households. desirable. In the long-term, households will need assistance attain- ing income security during old age, and against health Sustaining the purchasing power of vulnera- and employment shocks. There is also a need to reform ble households labor market policies. Poor households are losing purchasing power due to Ensuring food security falling labor demand and rising relative prices of some commodities. The case for rice subsidies was discussed Food prices have increased sharply in most countries above. Another major commodity, kerosene, is the most and there is evidence of food shortages in parts of relevant subsidized fuel for the poor and near-poor in Indonesia. Price increases on rice primarily affect the most of the region. Evidence from 1990 data for pOOL In Indonesia and the Philippines, rice accounts for Indonesia indicates that kerosene subsidies do not effec- nearly 20 percent of household expenditures for the tively target the poor, with an incidence roughly in line poorest one-fourth of households. In Indonesia, it with overall income distribution. Some phasing in of jumps to 30 percent of household expenditures for the price increases may be justified on political grounds, but poorest decile. A relative increase in rice prices could they should not compete with programs targeting the hurt some of the long- and short-term poor and the poor. non-poor hit by drops in labor demand; but it would There are two possible approaches to addressing protect households and villages that remain in food sur- employment and income losses due to falling labor plus. demand: stimulating demand for labor through labor- Managing rice supplies to smooth price adjustments intensive public works programs, or providing income and avoid major price hikes may be desirable in the support for the unemployed. The question is how to short-term-especially in light of the substantial over- target scarce resources and reduce leakages due to poor shooting of the exchange rate. This could moderate administration, graft, and access by non-targeted short-term inflationary and political shocks, and would groups.28 A combination of targeting techniques will help smooth consumption of poor, food-deficit house- need to be used, including geographic, household- holds in rural and urban areas. But it is costly. In based, and self-targeting. Indonesia, the cost of transferring one dollar to the Promoting public works. If designed properly, poorest 15 percent of households through the rice sub- employment programs can help sustain the purchasing sidy is estimated at US$8.20-no better than a univer- power of households in the short-term, and address sal cash transfer.'7 If subsidies were limited to long-term issues of declines in seasonal labor demand, low-quality foods, the poor would benefit and rice as seen in parts of Indonesia. Indonesia is already transfer costs would be reduced to US$3.60 in expanding padat karya schemes and new programs are Indonesia. Beyond the short term, there is a case for being launched in Thailand; there is also a long tradi- exploring additional mechanisms for targeting food tion of public employment in the Philippines. subsidies-for example, through food stamps. While Effective targeting depends on the wage. To ensure shifting to targeted subsidies is good policy in general, that the neediest choose to participate and to generate the Latin American experience shows that it is best not information on where demand for low-wage work is done during times of crisis. greatest, local market or lower wages should be used.29 Policies to keep food affordable are only useful if food In Indonesia, for example, ongoing public works pro- is readily available. Ensuring that food markets func- grams use a standard Rp7500 wage (in early 1998) that tion is fundamental to managing the effects of the is often above local market wages, especially in drought. But, where markets are breaking down-as in depressed labor markets. Under these conditions, there parts of Indonesia-there is no alternative to direct is a greater risk that poor households will be rationed food distribution. A combination of direct delivery to out of the programs. Finally, it is not clear whether 88 East Asia: The Road to Recovery women have full access to manual work in East Asian ing religious organizations or NGOs, are probably the public works schemes. This is in contrast to many South best source of support for these groups. Asian schemes, which often have high female participa- Unemployment benefits. With the exception of tion. These concerns emphasize the need to include an Korea, countries in the region do not have unemploy- overall monitoring and evaluation system and to con- ment insurance schemes which could help sustain indi- duct a continuing assessment of short-term transfer and viduals temporarily out of work. But this is not the targeting objectives. appropriate time to introduce insurance-type unem- Public employment programs have dual objectives- ployment benefits schemes in the crisis-affected coun- to transfer income and improve infrastructure. Chile in tries: benefits cannot be awarded immediately as the early 1980s, and Korea in the late 1980s, are exam- insurance schemes generally require minimum periods ples of public works programs that were allowed to of prior contribution and a waiting period before bene- fade away as demand fell.30 Indonesia also has a history fits can be paid. Furthermore, the introduction of pay- of using food and cash for work during periods of roll taxes, individual contributions, or both would adverse shocks, then phasing them out. Experience increase the cost of labor (or the reservation wage) and from these and other programs provide insight into rel- hence depress labor demand (supply). New entrants to evant design issues: the labor market who are unemployed would not qual- * Balance urban and rural programs. Both programs ify for benefits. Finally, the scheme would largely bene- are effective but an urban bias misses the majority fit formal sector employees. Such schemes can be of the poor and may also increase commuter migra- introduced upon a return to more stable economic con- tion, or decrease return migration to rural areas, ditions, but then attention should be paid to design fea- slowing efficient responses to the shock. tures that reduce labor market distortions (see box 5.5). * Balance cash transfer and productivity. In the short In the short-term, a system of unemployment assis- term, cash transfers achieve the primary objective- tance benefits may be more appropriate. It would aim to increase security. But over time, programs may at alleviating poverty among the unemployed by pro- become more focused on infrastructure production viding, for a limited time, limited income transfers in or maintenance. the form of flat benefits at or near the poverty line. This * Balance between male and female beneficiaries. scheme would have a better distributional impact than Programs should be open to participation by women an insurance scheme and would also improve efficiency, but special efforts may be needed to publicize pub- as the low benefit level would motivate an early return lic works programs, review contracting procedures, to the labor market and have little impact on the reser- and monitor the number of jobs given to them. In vation wage. Initially, this benefit could be provided to addition, certain design features-for example, the unemployed without any means-testing. Later this piece rate payments instead of daily rates so women feature could be adjusted or supplemented by means- can work in groups and organize childcare-can tested family, health, and educational allowances. encourage greater participation by women. Unemployment assistance benefits can begin to be dis- * Workfare for the non-poor does not alleviate bursed as soon as they are introduced and would be less poverty. Workfare programs for laid-off factory demanding to administer than an insurance scheme. workers or young work force entrants with sec- Nonetheless, targeting is a concern, especially if infor- ondary or higher education who may choose not to mal sector workers are to be included, and decentral- take traditional manual work are counter to the ized mechanisms for administration, including the use rationale of workfare programs and do not alleviate of NGOs, will need to be explored. poverty. Training programs also provide some income support Some individuals and households, especially the dis- during the period of professional reorientation and skill abled and households without adult labor, will fall acquisition, even though this is not central to their through the safety net of public employment programs. objectives. However, this is a costly means of transfer- In the short term, existing community channels, includ- ring incomes with unclear distributional effects. From Economic Crisis to Social Crisis 89 Reforming labor market policies BOX 5.5 Unemployment insurance lessons of interna- The question of international competitiveness may tional experience. Minimizing labor market seem moot after the large exchange rate depreciations. distortions But these exchange rate movements have been driven by Unemployment insurance schemes are not effective at capital flows and are likely to reverse once confidence is addressing structurat unemployment issues or large Labor capital f s ademand shocks. They are more suited to conditions of fric- restored. The more fundamental issue is productivity tional or cyclical unemployment which aford possibilities for growth which is linked to the work force skill level. In pooling risks across individuals or time. However, it s mpor- order to bolster skills levels, the education system must tant to minimize labor market distortions by: support increasing access to secondary education, but labor market policies are also important: * Observing strict eligibility criteria-prior contribution * Encourage private job placement services to supple- record, nvoluntary dismissal, proven willingness to work, ment iniadequate capacity in the public sector. There acceptable travel time, and regional mobility, etc. has been rapid expansion of public employment * Creating a governance structure to preverit poLitically-dri- offices, from 53 in 1997 to 113 in 1998, with plans ven generosity in benefit levels and raiding of the reserve to reach 162 in 1999. This risks undermining the fund during good times role of private employment services. In 1997, pri- * Limiting bernefit duration (for examples, a maximum of 6 vate employment services placed 1.8 million work- months) ard referrat to social assistance schemes there- ers compared to with 0.3 million by public after employment offices. * Risk-rating unemptoyment insurance contributions by eco- . Exercise caution in launching or expanding active nomic sector, enterprises, or both, thereby aLLowing con- labor market programs. International experience tribution rates to vary as a function of past unemployment shows that these programs have little effect on rates. employment probabilities or on future wage pro- Source- WDLd Bard staff. files. Some programs may be effective for particular categories of workers. Programs should undergo rigorous monitoring and evaluation and respond to inefficiencies or crippling inflexibilities. This frame- feedback on effectiveness. work is likely to result in a more neutral role for gov- * Chanige the government's role in vocational educa- ernments-essentially setting the rules of the game. It tion and training. The private sector can also pro- should also encourage the primary locus of union activ- vide both pre- and in-service training. Increased ity to be in the enterprise in which collective action is competition among training providers should most likely to help increase productivity and less likely increase quality, and the government can ensure reg- to command monopoly wage increases.31 There is a ulatory oversight and increased choice for con- role for union confederations in situations where infor- sumers-through vouchers, for example. mation or dialogue is necessary at a sectoral or national One of the most controversial issues in the labor mar- level. Developing effective mechanisms for industrial ket is the role of unions. This is because most East relations is complex; therefore, workers and employers Asian countries have restrictive policies toward them, must collaborate, often with state support, to design a and there is considerable government involvement in sound and neutral regulatory framework. industrial-labor relations. Korea was particularly repressive in the pre-democracy period, and reaped a Managing household insecurity in the longer- bitter harvest in antagonistic labor relations. This expe- term rience carries lessons for other countries in the region. A key challenge for most East Asian societies is As the financial crisis demonstrates, temporary down- designing a regulatory and institutional framework that turns in economic activity can lower living standards provides strong rights for freedom of association and for most households. Unemployment, disability, and avoids granting entitlements that can cause resource old age contribute to poverty in both industrial and 90 East Asia: The Road to Recovery developing countries, and worsen poverty among peo- embody this design feature; however, matching contri- ple who are already poor.32 In most societies, coping butions directly to benefits is not always feasible or with insecurity involves some combination of private desirable. For example, most societies choose to pro- savings, informal support, and employer obligations. vide for the poorest people far in excess of their poten- Governments step in when these prove insufficient. tial to contribute-so the protection schemes Households may find it difficult to borrow to cover incorporate an element of income redistribution. temporary drops in income; community support is inef- Socialized public action could be considered for core fective when there is an economy-wide shock; and pri- pensions for the long-term poor, to cover catastrophic vate markets for unemployment, disability insurance, health risks, and to provide social assistance for the des- and old-age pensions are often limited or absent. titute. East Asian countries have relied on informal income security systems for most households, especially the Maintaining economic and social services for poorest. Private transfers help reduce inequality by pro- the poor viding old-age support, and alleviating the effects of dis- ability, illness, and unemployment. Increasing During the crisis, the poor stand to suffer the most- urbanization and the growing importance of formal especially from irreversible losses in potential education employment have eroded the informal support mecha- and health that will impede their participation in future nisms. In addition, there is rising demand for social recovery. Efforts to maintain purchasing power will insurance to deal with household insecurity. A rapidly help, but additional measures are needed to focus on aging population further strains family-based support. keeping schools and health care affordable for poor These trends, plus rising incomes, suggest a much households and quality of services intact. greater role for formal insurance in the future. Education. Studies find that public spending on pri- What kind of model should East Asian society follow mary schools benefits the poor. Beyond the primary to balance caring and competitiveness? The welfare level, incidence depends on the coverage of the educa- state, created in Europe, is under attack because gener- tion system. In low- and middle-income countries, ous benefits and high taxes are associated with lack of spending on junior secondary schools is often distrib- competitiveness, slow employment growth, weak uted roughly in line with income. Spending on senior incentives for work, and high unemployment. In secondary and tertiary education tends to be unequally European and Central Asian transition economies, uni- distributed, and can be even more unequally distributed versal cradle-to-grave security is waning, while in than income, as is the case in Indonesia.33 However, China, the system for state workers is in need of urgent marginal changes in spending for junior secondary reform. In many South Asian and Latin American schools-and in richer societies, senior secondary developing countries, the model of employment protec- schools-are likely to benefit the poor. Moreover, tion for formal workers is also under attack because job analysis has found that in the late 1980s, cuts in educa- security regulations appear to protect insiders at the tion spending were associated with significant drops in expense of comprehensive unemployment insurance, secondary enrollment. However, primary enrollment which encourages the growth of informal employment. remained virtually universal. Since the current eco- Countries in the East Asia region have an opportunity nomic crisis looks much worse than the late-1980s to develop schemes that avoid the labor market rigidi- slowdown, there is a strong chance that children in the ties, inequalities, and fiscal problems associated with region will be pulled out of school because of the actual some models of social security, and they can learn from and opportunity costs of schooling. Focus group results the abundant array of reforms being undertaken world- from Indonesia and the Philippines show that this is wide. The central principle is to minimize adverse labor already happening. Also, there is a risk that for some market and fiscal effects by linking contributions to children-especially of poorer households-this shift benefits. Most old-age pensions, certain health risks, will be permanent. These factors suggest the need to: and short-term unemployment can be covered under * Preserve real spending on primary schools, and seek publicly-mandated insurance and savings schemes that to maintain non-salary spending. In past episodes of From Economic Crisis to Social Crisis 91 adjustment in other countries nonsalary spending is unequally distributed. There are concerns that price has been the most vulnerable to cuts during a fiscal hikes on imported drugs will lead to postponing or cur- squeeze, with potentially high costs in quality. tailing drug use, including vaccinations and HIV/AIDS Increase targeted subsidies to encourage students to drugs, and that sharp cost increases in private medical stay in secondary school, linked as closely as possi- services are inducing greater demand for public services ble to income level. Subsidies could be structured as (see box 5.7). This suggests three measures: scholarships for the poor-perhaps using a village * Preserve real spending on public goods or health level mechanism for determining poverty-backed activities with high externalities, such as vaccina- by broader loan-programs to finance fees for the tions and vector control non-poor (see box 5.6). * Maintain spending for health centers and sub-cen- Beyond the crisis, the education system will shape the ters, especially for non-salary items region's future work force and the competitiveness of its * Provide temporary subsidies for essential drugs, dur- economies. Sustaining high quality and broad-based ing a transitional period of exchange rate disequi- educational expansion is central to equipping workers librium. Such subsidies will likely be weakly targeted with the skills for high productivity manufacturing and to the poor, but they may still be justified in terms of service industries, and to train them over the course of protecting overall human resources. a working life. As noted above, Korea has done exceptionally well in this respect, although recently it has been reassessing its Institutions, corruption, and the social education strategy with the goal of developing more fabric creative and flexible skills. The pressure points in the region probably lie elsewhere, for example, in the rela- East Asia's reputation as a model of reasonably efficient tive neglect of secondary education in Thailand, upper institutions and social stability has been shattered by secondary and college education in China, and in poor the crisis. These important questions have arisen as a quality education in Indonesia and the Philippines. result: These issues are only partly a question of government * Are public sector institutions so riddled with cor- spending priorities, as illustrated by Korea where sec- ruption and cronyism that they can no longer deliver ondary, and especially tertiary education is mostly pri- results? vately financed. Institutional and policy reforms are * Is there potential for irreversible social breakdown required to foster the high quality schooling which including rising ethnic or other factional violence, includes the skills that will propel East Asian countries and destruction of community and family behav- into the knowledge economy of the next century. ioral norms? High quality schooling requires reforming curricula Promoting effective institutions. Corruption and at the primary and secondary levels to emphasize team poor institutional performance shoulder much of the building, flexibility, and adaptability which are built on blame for the crisis. Corruption is a long-standing fea- a foundation of literacy and communication skills, plus ture of most East Asian societies but its profile is on the numeracy and analytical skills. To move their rise with increasing public attention to international economies forward in the early 21st century, East Asia's corruption rankings, and high-profile scandals from young people will have to master the multitude of Japan to Vietnam. In the decades of extraordinary worldwide sources of information and be able to aggre- growth, corruption coexisted with reasonably effective gate this knowledge to analyze and solve local eco- institutions, from core macroeconomics management nomic and social challenges. Thailand and Malaysia are bodies to schooling services. Now most observers are working to reform their education system to provide concerned that public institutions are largely ineffective those skills, and China is also moving in that direction. and driven more by private gain than the public good, Health care. Analysis from Indonesia and Malaysia especially in Indonesia. indicates that spending on health centers, particularly Institutional capacity to deliver resources or services sub-centers, benefits the poor, but spending on hospitals effectively is linked to broader governance concerns. 92 East Asia: The Road to Recovery Preserving the poort's human capital during economic crisis: Indonesia's "back-to-school" campaign Impact of the crisis. In April 1998, focus group discussions of the school year. This is intended to cover school costs such as and school visits already indicated that poor schooLs and chilrlren notebooks, uniforms, transportation costs, and schooL fees. were feeling the impact of the crisis. Reduced public funding for Nationally, 2.6 million junior secondary students will benefit education, higher prices of schooling, and lower family incomes (about 17 percent of enrollment). Forty percent of primary and are expected to Lead to declines in primary and junior secondary junior secondary schools serving the poorest communities will school enroLlments among the poor. Estimating the impact of the receive grants of Rp 2 million (US$250) and Rp 4 million economic crisis on enrollment is difficult as the crisis is unprece- (US$500), respectively. A total of 82,000 primary and junior sec- dented in terms of magnitude and depth. Econometric techniques ondary schools will benefit from block grants each year. SchooLs have yielded relatively low impact effects ranging from an addi- can use the grants to s..urchase instructional materials and other tional 115,000 to 260,000 7-12 year olds, and 173,000 to teaching-lea ii ig sup-lies, undert.ke minor repairs, and support 270,000 13-15 year old chi[drci dropping out over time as a poorer students by waiving formal aid informal school charges. resuLt of a 10 percent fall in per capita income. Estimates from Mass media and social mobilization effort. A nationwi'le TV, the Government of Indonesia (GOI) point to much larger radio, and print media campaign was Launched to ensure that par- effects-an additional 890,000 and 640,000 children dropping ents and communities are aware of the program, to emphasize the out of primary and junior secondary schools, respectively, in just importance of remaining in school, and to facilitate transparency one year. in the use of funds and selection of recipients. Whatever the precise figures, there is general agreement that Targeting and election. Scholarships and grants will be allo- the impact of the crisis on poor children will be severe. The cated according to the poverty incidence of each district. Given strongest evidence comes from the much smaller economic shock the limitation of the quantitative data, this information will be of 1986-87 when education expenditures dropped and there were coupled with local knowledge and the participation of NGOs and no special efforts to keep children in school; gross enrollment other members of civil society in the selection at the LocaL level. rates fell from 62 peicent to 52 ,ercent 3t the junior seconcary Recipients will be selected by com ittees at district, sub-district, Level and took almost a decade to recover. VirtuaLLy the entire and school Leve s, which consist of parents, NGOs, other members decLine came from poor househoLds. Also, non-saLary spending of civil society, and government representatives. per pupil feLl sharply from Rp 23,000 (US$18) to Rp 6,000 (USS3) Ensuring funds reach recipients. In order to ensure schoLar- in real terms. ships and grants reach intended beneficianes, the program The response. On July 20, the government launched a 5-year includes the following features: (i) funds wiLl go directly from the national program to provide scholarships for poor children in (local) bank to students-schools-no intermediaries; (ii) a mass basic education and block grants to schools serving poor commu- media campaign at the village level wiLl inform communities and nities. A coalition of ministers was fornied to support the pro- parents of the program and procedures; (iii) an independent gram. The WorLd Bank is leading a muLti-donor effort, which agency wi0l carry out quarterly monitoring; (lv) NGOs-civil soci- includes the Asian Development Bank (ADB), UNICEF, and bilat- ety members will monitor the prog'am; and (v) the government, eral agencies-AusAID, and Asia Europe Meeting (ASEM)-to the World Bank, aid the ADB will evaluate the impact of the pro- support the program. TotaL cost of the 5-year program is approx- gram on school enrollments and transition through focused sur- imately US$362 milion, with an ADB contribLtion of US$85 mil- veys and the use of SUSENAS (Survey Economi N isioral). lion, and the remairmer from the World Bank. Seventeen percent of the poorest students will receive a schol- Source W'o d Saik staff. arship of Rp 240,000 (US$30) in voucher form at the beginning Indonesia has a reputation for institutionalized corrup- mixed picture. A comparison of public irrigation work- tion. Evidence of institutional weakness is scattered, ers in Korea and India found sharply better perfor- but it ranges from the low quality of education, health, mance irs Korea.34 Recent research on local institutions and other services to the widespread concerns over graft in Indonesia finds reasonable performance of public and the view that local resource allocations are deter- institutions at the village level-although they are sig- mined by political power, rather than developmental nificantly worse than genuine community organiza- and social needs. However, East Asia could not have tions.35 enjoyed the massive advances in social conditions if Institutional reform is a complex and long-term government services-a major part of this effort-were process and decentralization, though often desirable, is useless. Careful micro studies are scarce, but reveal a not a panacea, especially during the crisis when effective From Economic Crisis to Social Crisis 93 BOX 5.7 genuine participation of communities in the choice, The crisis and heatth: Common set of problems design, implementation, and evaluation of projects. Social funds were much used in Latin America and Sub- Medical costs are increasing. Exchange rate depreciations Saharan Africa in response to adjustment. There is also have meant Large increases in medical costs given the high increasing evidence that they perform best when there is import content of pharmaceuticats, including vaccines and con- genuine participation of local communities.38 Finally, traceptives. In Indonesia, imports account for 60 percent or public and independent information, including moni- more of the pharmaceuticals used in the country, and drug toring by civil society organizations, is a potentially prices have reportedly increased two- or three-foLd. This change bl sourc ofieae accontability. - . . ~valuable source of increased accountablhty. in relative prices is unlikely to be fuLLy reversed, and wilt require Long-term adjustments in drug consumption patterns. Responding to a deteriorating social fabric. Private consumption expenditure is faLling, particularly Responses to the added pressure on social relations among the rising numbers of unemployed. Many households are within the family and the community vary across dif- less able to pay for the out-of-pocket cost of medical care, ferent societies (see box 5.8). It is too early to assess the whether provided by the private sector or by public sector faciL- consequences of social changes, but there are parallels ities that typicatly charge user fees. This is important because in other communities under economic crisis. Economic private spending finances approximately 50 percent of aggre-, gate health expenditures in East Asia. There is already evidence decline contributed to rising violence in urban Latin that private sector users are switching back to the subsidized America in the 1980s. Even though much of the region pubLic sector, while some potential users-especiatly among recovered economically in the 1990s, violence remains the poor-may have to switch to Lower quality providers, or high, with widespread economic and social costs. even fioreg,o medicaL care entirely. Studies in poor urban communities in Ecuador, fPublic heaLth expenditures are dedining. Budgetary pres- Hungary, Zambia, and the Ptittppines found:9 sures can reduce public subsidies, which protect the poor itom the increased financiaL risks of illness. This either increases * Increased work for women and children financiaL hardship, or reduces use of medical services. * Increased pressures on women and older girls- Moreover, increased demand for public services from former mothers work more, so girls must care for younger users of private faciLities couLd divert public subsidies from the children poor. In the long-term, cuts in operations and maintenance * Increased substitution of private for public ser- outLays wilL atso undermine the productivity of the publicinfra- structure. Reduced public expenditure also threatens pfiority vices-including in health and education pubLic health programs, such as immunization against child- * Increased street violence, especially amongst young hood diseases and TB controL. Indonesia's past experience with males fiscaL adjustment in the mid-l98Os demonstrates the vuLnera- * Increased domestic violence, especially in house- bility of pubLic health programs to pubic expenditure cuts. holds hit by falling employment or declining Source: World f3ank staff. incomes. The study found varied effects on informal commu- nity functioning. Moderate pressure could lead to delivery is unusually urgent. In fact, decentralization of heightened mutual support-increased use of social power to local elites can make things worse, in part capital-whereas severe pressures were more likely to because they generally have weaker technical resources breakdown community-based coping mechanisms. at their disposal.36 These substantial costs underline the importance of Evidence from reforms in Latin America and else- restoring the national and local economic environment where has emphasized both giving more choice and crucial for social functioning. Specific responses could more voice to the communities who use services.37 In include: particular, a diversified approach to delivery of trans- * Identifying the vulnerable groups and focusing fers, involving government, civil society and religious action to respond to their needs. For example, institutions, can help reduce the risks of relying on only heightened pressures on women can be relieved by one delivery channel. Restrictions on local associations reducing the demands on their time, such as improv- should also be lifted to encourage entry and competi- ing water supply or childcare facilities. tion. This can be complemented by measures to foster 94 East Asia: The Road to Recovery * Facilitating participatory processes mediated by countries, such short-term information is incom- government, NGOs, or religious institutions-both plete. The Philippines has a Social Weather Station to set local priorities and to support informal net- system based largely on subjective assessments. works. Indonesia recently dropped the quarterly version of * Supporting innovative action to reach groups at high its labor force survey because there was little sea- risk. For example, concerted action by civil society sonal variation. Thailand still has a quarterly labor is often the only way to reach children forced into survey and Korea's labor survey now takes place exploitative work. In Brazil local groups use theater, monthly. music, and other forms of community engagement * Conduct complementary assessments of household to reach kids on the streets, diverting them from and commentary conditions using participatory gangs to more productive forms of social capital. techniques which substantially enrich the under- standing of coping strategies. These assessments Increasing monitoring, diagnosis and pubLic should form part of the ongoing interaction between information hypotheses and data, and could influence the design of survey questionnaires. Assessing public actions will provide information * Use existing data sets to match economy-wide which will be included in ongoing redesign of these pro- trends to the structure of income and spending, and grams. Public information will provide checks on trans- to analyze past household responses to changes in fers and strengthen an informed public debate on specific parameters, such as price elasticities of developments, effects of programs, and tradeoffs. schooling costs. In most countries, existing data Programs that monitor overall welfare should rely on a includes consumption or income surveys. mix of instruments. Monitoring and evaluation of public action are * Conduct regular surveys of living conditions and important short-term goals to ensure that intended vulnerability covering wages, unemployment, rela- effects reach targeted groups and to redesign programs. tive prices, food prices, drought effects, social indi- In the medium to long term, monitoring and evaluation cators, and nutritional levels. In many East Asian help to bring poor regions and groups into the develop- ~~ F p~~~~~~ ~~ t pts~~~ro EcnmcCii oSca rss9 _a p kmd o _EgWZ~~~~~~~~~~~~ ade W i :|=--- s w--- From Economic Crisis to Social Crisis 95 BOX 5.9 The World Bank's efforts to help the poor The World Bank is helping governments re-initiate growth to In the Philippines, three new loans (US$79 million) to increase manage the social consequences of the crisis; protect public expen- the incomes of the poor and to provide basic services were approved ditures targeted for the poor; enhance the quality of social services; in March 1998. Two other Loans totaling USS130 million are sched- improve design and financing of social funds; strengthen social uled for approval in the second half of 1998; these projects finance security systems for the unempLoyed and the eLderly; and address infrastructure development and vill increase job opportunities and key institutional issues. The World Bank's most important activities access to basic services for relativeLy poor Local government units. include: The World Bank has carned out a rapid social assessment to gauge In Thailand, a US$300 million loan for a social investment pro- the effects of the cnsis and understand household coping strate- ject will fund job creation for the poor and the unemployed through gies. Poverty work scheduled for fiscaL 1999 will have access to the existing labor-intensive government programs; expand training for resuLts of the 1998 Income and Expenditure Survey (FIES is carned the unemployed; support low-income health insurance schemes, out every three years) and contribute to the early implementation small-scale community projects, and larger municipal projects; and of the Annual Poverty Incidence Survey. This will provide a usefuL set up a monitoring system to evaluate the impact of the crisis and analysis of ie short-term impact of the crisis, evaluate the effec- of public action on the poor. The Loan is expected to create roughly tiveness of government poLicies to alleviate poverty, and provide one million months of jobs and an equivalent aniount of training. policy directions for the future. ALso, a national poverty map will be drawn based on available sta- In MaLaysia, a USS300 million Economic and Social Sector Loan tistical data and a nationwide systematic participatory assessment approved in June 1998 will support a reduction in the fiscal surplus which will be an important input for the policy debate on safety net from 2.5 to 0.5 percent of GDP by increasing public expenditures for mechanisms the social sectors. The loan seeks to protect budgetary spending for In Indonesia, the World Bank has restructured some of the exist- education, heaLth, rural infrastructure, and to increase expenditures ing portfolio to redirect savings to support income generation and on social safety net programs aimed at providing direct support to meet basic needs (about US$320 million). A Structural Adjustmient the poor (free housing and food supplements) and income genera- Loan (SAL) of USS1 bl[lion includes a component to Drotect the poor tion through small grants. Longer-term issues about the adequacy through expanded labor-intensive public works programs; actions of formal safety nets and the governance structure of the Employee to ensure the continued avaltabltity of key goods with only modest Provident Fund will be addressed through a Technical Assistance pnce increases; and initiatives to maintain access to quality basic Loan and economic and sector work. In addition, a CEM is nearing education and health. In particular. to ensure continued high completion-the first since 1993. It incLudes an overview of enrollment rates for chiltdren through the first nine years of school, poverty and the social safety net in Malaysia, analyzes how the poor the government is to provide scholarship funds for 2.6 million may be affected by the downturn, and recommends action to cush- needy junior secondary school students. A USS275 million poverty ion the impact of the crisis on the poor. project for rural areas (the Kecamatan Development Project) has In China, ongoing work in labor market adjustnent focuses on been approved, and a similar project is under preparation for the policies needed to address the un(der)empLoyment problem. While urban poor. Discussions are also underway regarding an agriculture the problem is becoming acute largely due to acceLerated reforms in sector adjustment loan to support reforms. The World Bank has aLso the state-owned enterpnse sector, the slowdown in aggregate intensified analytical and participatory work on poverty to help demand, which will be exacerbated by the impact of the regional underpin these two operatons and will help frnance a follow-up to cnsis, is aLso havinig an impact. A workshop will discuss the effec- the Indonesia Family Life Survey (IFLS). This will allow monitoring tiveness of active and passive labor market policies in addressing of the living standards of a sub-sample of households that were employment problems. already surveyed in 1993 and 1997 and help assess househoLd-level In Cambodia, a study is underway to examine the impact of the coping strategies in response to the crisis. regional crsis on Cambodia and Lao People's Democratic In Korea, the US$2 billion SAL approved in March 1998 includes Republic. including an analysis of the social inipact, in particular an iniportant program on laboi markets anid social safety nets. The through rapid social assessments. program incorporates measures to increase flexibility in the labor A region-wide initiative is being launched to anaLyze issues in market while extending coverage of unemployment insurance to pensions policy and administration. A November 1998 conference employees in small-scale enterpnses; improve poverty monitonng wil bring together countries of the region to explore common issues and protect poverty-related pubhic expenditures; and reform the and frame an agenda for future work. This would be folLowed by a pension system. A conference in July 1998 focused on lessons of conference in the spnng of 1999 on governance of pension funds in international expenence in labor market policies. Another confer- East Asia. ence will focus on pension fund investment policies. A second SAL Icrrce: Wcrd Bair co uments for US$2 billion will help deepen these reforms and start addressing issues in health financing and health caie. 96 East Asia: The Road to Recovery ment process. All programs can benefit from combined tabLe 5.4 which are Gini coefficients for expenditure per capita but the quantitative and participatory monitoring. Participatory trends and magnitude of changes are LikeLy to be similar. monitoring is particularly valuable for increasing effec- 11. It is possible to observe increases in inequality that Leave tiveness by strengthening community involvement, and poverty unchanged for a given leveL of average income. A mean-pre- increasing efficiency by scrutinizing the use and alloca- serving spread originating from a transfer from an individual above tion of funds. Public information strengthens account- the poverty line will increase inequality but not affect poverty. ability. For key programs, especially those with 12. GaLenson (1992). uncertain impacts, structured evaluation that uses sam- 13. WorLd Bank (1996a), Involving Workers in East Asia's Growth. ples of participating households and controls is also 14. Based on The SociaL Weather Station surveys of FiLipino's per- important for maximizing the benefits of scarce ceptions of their poverty. resources. For example, structured evaluation is likely 15. Robb, CaroLine M. "SociaL Impact of the East Asian Crisis: to cover the targeting efficiency of public works, the Perceptions from Poor Communities." Paper prepared for the East Asian incidence of new subsidies for education, and the effec- Crisis Workshop, IDS, University of Sussex, UK, June 1998. tiveness of geographic targeting to alleviate poverty. 16. See WorLd Bank (1990), World Development Report 1990. 17. Projections are from RavaLLion and Chen (1998). The method- Notes oLogy invoLved updating househoLd data to 1997using actuaL or esti- mated growth in average consumption or income per capita, but 1. This section draws on Ahuja and others. (1997). assuming no distributional changes since the most recent survey- 2. WorLd Bank (1993a), BirdsaLL and Sabot (1993); Teranishi in surveyyears are reasonabLy recent: Indonesia (1996), MaLaysia (1995), Aoki, and others. (1996). Philippines (1994), and Thailand (1992). Then a range of projections 3. WorLd Bank (1995), World Development Report; WorLd Bank for the entire distribution was developed by assuming aLternative vaL- (1996a), Involving Workers in East Asia's Growth. ues for growth in the mean Level of consumption or income and the 4. See Kim and TopeL (1995). degree of inequaLity. The change in inequaLity was estimated in terms 5. See Ranis (1995). of the shifts in the parameters of the Lorenz distribution to produce 6. After controLLing for incomes and other characteristics (though a certain percentage change in the Gini coefficient. in Indonesia this may partly refLect unusually rapid income growth, 18. This scenario was deveLoped by Benu Bidani, as part of ongo- and the slower response of mortality. See FiLmer and Pritchett (1997): ing work on poverty in Indonesia. The poverty Line used in this sce- Indonesia is a outLier (that is, had high child mortality) after con- nario is different from the internationaL poverty Line of US$1 per day trolling for incomes; the Philippines and Korea were negative outLiers at 1985 prices. For a fuLL discussion see "The Poor in Indonesia's after controlling for incomes and a set of other characteristics, incLud- Crisis," mimeo, WorLd Bank, 1998. ing femaLe education and inequality. 19. The Poor in Indonesia's Crisis, WorLd Bank, August 1998. 7. Vinod, and others. (1997), Everyone's Mirocie? Revisiting Poverty 20. See World Bank (1990), World Development Report 1990, and Inequality in East Asia. Chapter 7. 8. JaLan and RavaLLion (1998), "Spatial Poverty Traps?" 21. See SareL: that actuaLLy found rising investment efficiency in 9. These comparisons ignore issues such as equivaLence scaLes and Indonesia in the past decade. differences in regionaL cost of Living. In addition, the discussion 22. Work on the U.S. finds that unemployment disproportionateLy incLudes Ginis for both expenditure and income distribution. Since hurts the poor (Blinder and BLank). Similar effects may expLain some income distributions are generaLLy more unequaL than expenditure dis- of the recession-Linked increases in inequaLity in Latin America. tributions, comparisons are onLy valid across indices for the same con- 23. BLejer and Guerrero (1991); Ferreira and LitchfieLd (1997). cept (for exampLe, over time). Similarly, we include distributions per 24. Banking with the Poor Network Newsletter, Issue No. 11, June househoLd and per individual, which, once again, are not strictLy com- 1998, ppl-8. Foundation for DeveLopment Cooperation, Brisbane. parable. The figures merely indicate trends. 25. See Wood, Pissarides and Tan and papers in the WBER volume. 10. PreLiminary anaLysis of the 1997 survey yieLds an increase from 26. See Staff Appraisal Report for South West Poverty Reduction 45.1 in 1994 to 49.6 in 1997 in the Gini coefficient for family income. Project (May 1995) and Qinba Mountains Poverty Reduction Project The absoLute numbers are not to be compared to the data cited in (May 1997). From Economic Crisis to Social Crisis 97 27. This is because per capita rice consumption does not vary much 34. Robert Wade, 1994. "The Governance of Infrastructure: across expenditures cLasses (the bottom 15 percent of the popuLation Organizational Issues in the Operation and Maintenance of Irrigation consumes 13 percent of the rice). Therefore the proportion of the rice CanaLs." WorLd Bank. subsidy that goes to the poor (and the leakage to the non-poor) is no 35. PreLiminary work on the LocaL Institutions study from World different from that of a generaL cash transfer. Bank staff and the study team. 28. In some poorLy targeted Indian programs 6-7 rupees are spent 36. World Development Report, 1997. to transfer one rupee to a poor househoLd. Radhakrishna and Subbarao 37. CaroL Graham, Private Markets for Public Goods: Raising the (1997). Stakes in Economic Reform, Brookings Institution Press, Washington 29. See RavaLLion (1998), "Appraising Workfare Programs." D.C., 1998. 30. See Subbarao, and others, 1997. 38. See Narayan and Ebbe, 1998. 31. Pencavel (1995) and World Bank (1996a), Involving Workers in 39. "Confronting Crisis. A Summary of HousehoLd Responses to East Asia's Growth. Poverty and Vulnerability in Four Poor Urban Communities," ESD 32. WorLd Bank (1996a), Involving Workers in East Asia's Growth. Studies and Monograph Series No. 7, 1996. 33. See World Bank (1993), Indonesia: Public Expenditures, Prices and the Poor. 98 East Asia: The Road to Recovery Environment in Crisis: A Step Back or a New Way Forward? Bill Wong knew he was a pioneer when he opened a hi-tech plant in Malaysia's remote state of Sarawak, on Borne, early in 1996. He never guessed that 18 months later, his $115 million factory would be engulfed in smoke from some of the largest forest fires in history. Air pollution readings of over 500-on a scale on which readings above 301 are considered dangerous-kept half of Wong's 800 local employees off work. They weren't all needed anyway; thick smoke and haze closed the airport and port in nearby Kuching, making it impossible for Wong to get his products to customers. The plant cut back to a single shift, and the workers who did show up were given bonuses and free meals because food prices had jumped as much as 500 percent. Wong's prob- lems are just a small fraction of the mounting costs Southeast Asia faces from the envi- ronmental disaster created by the epic forest fires in Indonesia. The full impact of the damage probably won't be known for another decade or more.-Murray Hiebert and others, "Fire in the Sky," Far Eastern Economic Review, October 9, 1997. L n the years prior to the crisis, people in East Asia were beginning to see that a "grow now, clean up later" policy had resulted in high environ- mental costs. Many city dwellers were suffering from respiratory and related illnesses or dying prematurely as a consequence of poor air quality. The loss of forests destroyed natural habitats, contributed to soil erosion, and increased the severity of floods. Water pollution was threatening the produc- 99 tivity of irrigated agriculture and fisheries, increasing by other spending demands and expenditures for finan- the costs of industrial enterprises, and endangering the cial restructuring. population, especially infants and young children. Policy makers must give priority to restoring growth. Environmental problems grew worse in 1997 because Environmental improvements resulting from an eco- of a severe drought and the severe forest fires in nomic crisis and a slowdown of growth are realized Indonesia. Without radical changes it seemed certain only at a great cost. Restoring economic growth is that environmental problems would only increase as a essential in order to reverse the declines in incomes, result of continued economic growth and urbanization. reduce poverty, and establish a proper balance between This realization prompted efforts throughout the people and the environment. However, this priority for region to improve environmental management. The growth should not necessarily be incompatible with question now is will the financial crisis in East Asia cut plans to protect the environment. short these efforts, or will it provide an opportunity to follow a better path in the future? This chapter high- Environmental dimensions of the crisis lights the choices that East Asian countries face and sug- gests ways in which past trends can be reversed without The economic and financial crisis in East Asia has an jeopardizing the prospects for economic recovery and environmental impact larger than similar crises have future growth. had elsewhere in the world because of the cumulative The immediate effects of the crisis have been benefi- effects of serious natural resource mismanagement in cial for the environment. Sharp declines in incomes and the past and a severe drought in many parts of the industrial output have substantially reduced air and region. The effects of the drought have been most seri- water pollution caused by vehicles and industry. World ous in Indonesia, the most rural of the main economies market prices for timber and many other natural in Southeast Asia. Here crop failures and the resulting resources have collapsed, reducing the profitability of acute distress in many rural communities have exacer- current production and increasing the return that may bated the sharp decline in employment and income in be obtained by postponing production into the future. urban areas. Furthermore, the drought, combined with These short-run adjustments are consistent with what is mismanagement of forests in Kalimantan and Sumatra, known about the environmental impact of previous led to extensive and prolonged forest fires. These fires economic crises (for example, the Latin American debt have not only damaged forests but also spread air pol- crisis of the 1980s, the collapse of Eastern European lution over many areas of Southeast Asia, which is and Central Asian socialism at the beginning of the likely to have caused many deaths and even more cases 1990s, and the Mexican financial crisis of 1995). of respiratory illnesses (see box 1). However, many observers are concerned that a pro- Whether the economic and financial crisis was pro- longed recession will increase pressures on natural voked or exacerbated by deep-seated flaws in the resources. Fewer jobs and lower urban incomes will region's economic policies remains a matter of dispute. force marginal urban residents to move back to rural However, the combination of economic crisis, drought, areas, which will accelerate the conversion of forest and forest fires highlighted the weaknesses of existing land to agriculture and increase the stress on critical institutions and policies that address the management resources, such as fish stocks and water resources. The of natural resources and environmental problems. The consequences of poverty and desperation will be rein- following examples illustrate this problem. forced by shifts in relative prices if the crisis results in a * Parts of Indonesia, especially eastern Java and the large depreciation of exchange rates. A depreciation outer islands, have always been prone to drought. would increase the income obtained from exploitation Irrigation systems, grain storage and distribution of natural resources, such as forests and minerals, to networks, employment programs, and other mecha- pay debts or sustain consumption. Finally, public bud- nisms have been developed to mitigate the effects of gets for environmental management may be drastically droughts or to assist those affected. However, over- reduced as concern for the environment is crowded out use of water resources combined with reckless dis- charge of industrial and municipal wastewater mean 100 East Asia: The Road to Recovery have been expanded beyond their capacity into ----t-f-e--- --------------i-- - rivers to provide reliable supplies. Congested urban areas pollute the water supply needed by users downstream. In coastal areas, the loss of mangroves TheX S a rap=id==y ga41~JS7 ~i I Cand the misuse of pesticides threaten the future of mw<~I~ii~ the once-thriving shrimp industry. Drought and eco- "a- ' -'tg '-- - -ie Dr rt =as ~nomic shocks serve to reinforce these problems at a _ ~te be p on ni4ffj d~ time when the government and the Thai people wish -$ igeez-=et- 1 gnggs~ ea g- gia gi to rely more heavily on agriculture for income and MMi_ --- --- --- ---exports. Eg b ateggWg g g- i ===g gi g ggit'=BM' wig=M='=g=i g g * Many cities in Southeast Asia suffer from severe air ~gg2 g,e ==0==g gggggggg= g- ----- b' ggi- pollution. The main sources of particulate emissions are diesel trucks and buses, two-stroke motorcycles, gaigs'i> z eg g gre~e~e~ 6g iv-2ii~ ~nt~~fs f~and the burning of kerosene for domestic use. _ertosses dl Reducing air pollution requires a determined effort a-- --- --- T-- Q 4=g g g to penalize polluters, in addition to ensuring that j = W t =g W g W g fuel prices and other economic incentives correctly . 4.wiliamm-gg ig W ig gg tg Mt g=We incorporate the social costs of pollution. In the short tne==D-==i=ta E= pagki p>-ig gl asgr~ii ig= =grun, the crisis has resulted in a slight decline in traf- gg~E=fg e ,2sg g ~n)p s f~ es~ffr~ fic and pollution, a consequence of the decline in 1S tggMgg=g ::gg gWlq economic activity. However, long-term initiatives ~~ Th~ ~4 ~ l I r~~i 0 are stalled by a political reluctance to adjust fuel - ------ prices and insist on changes in behavior by vehicle Er& ggg« f f im g X g X operators, even though these changes could gener- slruC =tpugg ife gg- ^__ggi_,g e' ate a significant fiscal savings in the medium to long ==aIeaggd gg)W=S=mAt<>S>ezggwx'w>-v=eggggg eggowIggg ~ cterm . 3rs g;= = X = gg =d~fft gI =on the exploitation of such natural resources previ- ously have led to large-scale mismanagement. This gg¶grvg-Wgung=gg?g -~gS S 3 3g ggg ggS gggg g 3 ii problem may get worse as a result of short-term pressures for immediate revenues. that agricultural and industrial production has East Asia's financial crisis and environmental prob- become more vulnerable to water shortages. lems have similar roots: rapid growth without proper Programs and policies to alleviate poverty have been safeguards, policies, and controls (see figure 6. 1). In the disrupted by economic and fiscal stringency as well financial sector, the capacity of governing institutions as a lack of institutional capacity. and policies has been outpaced by the growth of capital * Mismanagement of water resources has become an flows and lending. In the environmental arena, growth increasingly serious problem in Thailand. In the has outstripped both the absorption capacity of the main watershed areas, deforestation has changed environment and the speed with which policies and seasonal patterns of run-off and irrigation systems institutions can respond to new challenges. Collusion Environment in Crisis: A Step Back or a New Way Forward? 101 FIGURE 5.1 ronmental policies and institutions, just as financial Common roots to East As' f l ccontagion has exposed the basic weakness of East Asian Common roots to East Asia's financial crsis and financial systems. Financial instability has had a direct and visibly large impact on economic activity and Poticy failures incomes. In comparison, the effects of environmental * Growth without Financal sector problems neglect are more insidious and will become evident over safeguards * Excessive exposure to risk * Lack of proper * Weak portfolios time, although they may be no less significant in the sector policies * Unsustainable business aggregate. Still, the short-term costs of the drought and practices the forest fires have been significant (see box 6.2). Market failures The weaknesses of environmental regulatory * Monopolies * Imperfect Environmental probtems arrangements in East Asia have been recognized for information * Excessive pollution some time, even if progress in dealing with the problems * Extemarities * Excessive natural is frustratingly slow. There is, however, another envi- resource depletion ronmental dimension to the crisis that could pose a Governance failures * Unsustainable industrial, * Lack of monitoring agricultural, and natural more serous obstacle to economic recovery and future and control resource management growth. * Weak management practices All of the countries in Southeast Asia historically have * Lack of transparency relied heavily on exports of raw or processed natural • Collusionprcse resources to import capital goods and support eco- Source: WorLd Bank staff. nomic growth. Rice, palm oil, timber, metals, oil, and gas have been and remain important or even dominant between segments of government and parts of the pri- sources of foreign earnings. Agricultural growth has vate sector exerts pressure on agencies to provide subsi- been supported by an expansion in the area of land dies, directed credit, and exemptions from regulations, under cultivation-from 15 percent to 23 percent of compromising their ability to enforce appropriate stan- total land area in Malaysia from 1980 to 1994 or from dards of prudence and good performance. 36 percent to 41 percent in Thailand over the same As an example, East Asia's forest sectors are poorly developed as defined by the degree of integration with FIGURE 6.2 the national economies, levels of technical and eco- East Asia is clearing its forests more rapidly nomic efficiency, environmental performance, and than elsewhere quality of governance.' Asia has lost more of its forest Percentage of tropicatforest cleared by region, 1960-90 area in the last 30 years than any other region in the world (see figure 6.2). Regional forestry policies fail to recognize the scarcity of forest resources and, hence, 25 provide inappropriate incentives to preserve them. The low stumpage fees, which should reflect the rents 20 earned by extracting timber, are the most serious prob- lem because they encourage deforestation and lead to 15 the impoverishment of forest-dependent communities. In Indonesia, the annual sustainable harvest is esti- 10 mated at 22 million m3, but the annual production of forest products is in excess of 40 million m3. 5 Furthermore, land management regulations, especially those related to the conversion of forests to other uses Asia Africa Latin America World such as tree and plantation crops, are largely ineffective. Thus, the combined effects of drought and economic Source: WRI, 1998. crisis have highlighted pre-existing deficiencies in envi- 102 East Asia: The Road to Recovery peio. t could ee tat th s i e eonmi s owdw is thtcnnyb financed eiter~~~ by foeign b$orowing o like mto h dimiising sc opete for exenivef growlth b ethe dpeino 1 lnaiturlcpta sefiue63.ti ~andafilur to used resource mor-fe prdutiely. f thi reasnalet assume tha he crisiswil restrictb acess istese, economica recovery and growthmaydepen to foreign capitalflows iat leatu temoraily, anta illignes to dacet greater ~oshexpp~~L~so dns~nLt~ipre, lsee~ onass wI lo'at'nso nat- ther are~ limie possuibiitie tohnease om esticfav- ural reores, vni only on temoray bstimas. in raes whx~ic havoe alwy been' relsativelyhigh faThera evdec coneringth exen to which ecoa Mitainin macroeonomi balda nci~e1 will, othen, nomic growhin EatAsias has been fiacedby delt- involv aomecombnatio of tw options: ing a turlapta is ixfed (stee boxv u6f3.Ntura ob Cuttigth leve of inestment, whicuhmean esither resoure rent rpent a loer sareofGD for couin- acetn a lowe1r~ rateo grotht &o r ensuritg tha tris i ~thergiorn -san averag of jest ov e~er 5 peret inves tm*ent~ oth~s resoucsaeusedmore productivel in incom~e onris Similarly, geuie savings ar much o~ Incfreasin th rateo natr~alt r s~ouredepletion. conris ltog in this respect the South peast Asa cern aboutwata r ma hap en e tnaulresourtes dur-t coun tries are slightly behind other East Asian countries. ing any economic recovery. EastA si an conres als ave bee trying toecetfr± financeh~~ar~wls veryhig leelsofinvestIment.-hisleavesn a savingst gap ~ te It#ea a~ W itnst fire ~ lieedt ~ect~ ~ 1. in Environmentf ~ inCii:ASe akoraNwWyFrad&0 a n coaga &if a < r~ enws ˘t , vrl a ret~ daa ue b~ ao -gie p Thd U _er~nee~~ TheX tueoft Iitnyav -U biVWtoS 5wih E:if arri, tr hi .~ .$ .b0 *_i *,,~ b Q_ t= Bcs a-~ -re Wt te1-$31W M=r-eca -=t-Lo e p av e-a att a s ofttdbo25p eo- ) 9a-e4c a-neJd3 a raaK;f VW~ g thrn mV _ fee ~ a2 va<~i =rtnXr e~n~a~ period. It could be that the economic slowdown is that can only be financed either by foreign borrowing or linked to the diminishing scope for extensive growth by the depletion of natural capital (see figure 6.3). It is and a failure to use resources more productively. If this reasonable to assume that the crisis will restrict access is the case, economic recovery and growth may depend to foreign capital flows, at least temporarily, and that on a willingness to accept greater exploitation of nat- there are limited possibilities to increase domestic say- ural resources, even if only on atemporary basis. ing rates, which have always been relatively high. The evidence concerning the extent to which eco- Maintaining macroeconomic balance will, then, nomic growth in East Asia has been financed by deplet- involve some combination of two options: ing natural capital is mixed (see box 6.3). Natural * Cutting the level of investment, which means either resource rents represent a lower share of GDP for coun- accepting a lower rate of growth or ensuring that tries in the region-an average of just over 5 percent investment resources are used more productively in during 1990 to 1994-than for comparable middle- the future; and income countries. Similarly, genuine savings are much * Increasing the rate of natural resource depletion. larger relative to GDP than for other middle-income These are the key macroeconomic issues behind con- countries, although in this respect the Southeast Asian cerns about what may happen to natural resources dur- countries are slightly behind other East Asian countries. ing any economic recovery. East Asian countries also have been trying to finance very high levels of investment. This leaves a savings gap Environment in Crisis: A Step Back or a New Way Forward? 103 BOX 6.3 Economnic growth or natural resource depletion? Many countries in Southeast Asia have reLatively large endow- ments of natural resources. These resources comprise a substan- 'Genuine savings" relative to GNP tial share of total exports either via the direct export of mineraLs, Percent of GOP fueLs, foods, and raw materiaLs or indirectLy through processing industries that export a large share of their output. 25 This high proportion of natural resource exports may be viewed in two ways. The figure presents estimates of 'genuine savings" 20 as a share of GNP. Genuine savings is the differernce between 2 gross savings and the depletion of naturaL capitaL, or rather a East Asia measure of net savings for the economy after aLLowing for nonre- 15 newable resource use. The resuLts show that genuine savings as a share of GNP is consistently higher for both the Southeast and 10 South East Asia East Asian countries than for other middLe-income countries. For the Southeast Asian countries, the share of genuine savings in 5 Higher middLe income GNP rose after 1980-84 and amounted to nearly 15 percent of GNP by the mid-1990s. 0 A second indicator is the "savings gapr as a share of GNP. the difference between gross investment and genuine savings (see - Lower middLe income figure 6.3). The savings gap measures the extentto which invest- 1970-74 1975-79 1980-84 1985-89 1990-94 ment has to be financed either by foreign borrowing or by the deptetion of natural capitaL. These may be regarded as inter- between the Southeast Asian countries and the higher middle- changeable actions because both are equivatent to the creation income countries is sLight, but it is much larger between the of claims on future income in orderto finance current investment. Southeast Asian countries and the group of Lower middle-income The depLetion of naturaL resources means that rents from such countries. This reflects the extent to which all middLe-income natural resources wiLL be lower in future, so income as conven- countries have come to reLy more heavily on foreign borrowing or tionaLLy measured wilL be Lower, Foreign borrowing is a commit- the depletion of naturaL capital to finance high Levels of invest- mentto make repayments out of future income, thus lowering the ment. net income avaiLabte for domestic consumption. The savings gap shows that the two groups of Asian countries S.wre. McMorran and Hamilton, 1996. have Lower savings gaps than the averages for the groups of atL lower and higher middLe-income countries. The difference Responding to the crisis industrial change on output and emissions.2 Discharges Pollution and economic growth. As a result of the from small sources-small and medium industrial financial crisis, many East Asian countries have experi- plants, vehicles, and households-have the most direct enced a fall in GDP in 1998 and will only recover grad- impact on average levels of exposure to pollutants. ually over the next two to three years. Lower levels of Hence, the analysis that follows will focus on trends in economic activity have reduced pollution from industry emissions from small sources. and vehicles, improving environmental conditions in The crisis is expected to have a significant impact on industrial and urban areas. On the other hand, emissions of the main air pollutants from small sources. new investment, which is typically associated with less- Figure 6.4 shows post-crisis projections for the two pol- polluting technology has slowed or ceased, causing the lutants that cause the greatest damage to human health: life of existing polluting industrial plants to be particulates and lead. In addition, this figure shows the extended. estimated changes in emissions due to the crisis. Many To examine these effects, projections of total emis- small sources emit particulates, largely as a result of sions of key pollutants under "pre-crisis" and burning various types of fuel, which provide the best "post-crisis" scenarios have been prepared using a indicator of air pollution in general. Lead comes pri- model that captures the effect of economic growth and marily from cars using leaded gasoline, so lead particu- 104 East Asia: The Road to Recovery The "savings gap" relative to GNP Small source emissions of key pollutants, Percent of GNP Indonesia 1995-2020 35 35 250 j30 30e income 200 TSS - with crisis Loe ide income 200 25 Higher middLe income 20 South East 150 Lead - with crisis Asia 15 East Asia 100 10 50 PM - with crisis 1970-74 1975-79 1980-84 1985-89 1990-94 Somrce: WRI, lss8. 1995 2000 2005 2010 2015 2020 lates can be used as a general indicator of traffic pollu- 10 tion. The immediate impact of the crisis should be a 0 _ _ reduction in emissions of particulates by the year 2000 I I I I by about 17 percent relative to the projected level had -10 I the crisis not occurred, and reduce lead particulates by -20 I l about 20 percent. These reductions are based on the - pi assumption that the growth that was lost during the cri- -30 sis will not be recovered.g The story is somewhat different for total suspended -40 solids (TSS), which are a general indicator of water pol- lution. As a result of efforts to reduce discharges of water pollutants by industrial plants and investments -60 20 1 1995 2000 2005 2010 2015 2020 to improve access to water and sanitation, the level of emissions was projected to fall significantly by the year M Change in TSS 2000 and in subsequent years. The crisis has had nega- Ch i led tive as well as positive effects because it will delay Change in PM improvements in environmental performance. There Source: WRI, 1998. will be a reduction in emissions of about 5 percent by 2000, relative to pre-crisis projections, but there will be a small increase in emissions from 2005 to 2015. unit of GDP by 5 percent to 10 percent in 2005. A sim- Economic recovery after 2000 will mean that emis- ilar concern about the impact of the crisis on environ- sions of air pollutants will soon exceed 1995 levels mental investments relates to the issue of access to unless measures are taken to bring about large improve- water and sanitation, a critical environmental priority ments in the average level of emissions per unit of GDP. for most countries in this region. The average life In this respect, the medium-term impact of the crisis will expectancy of people in the Asia and Pacific region is be detrimental because investments will be delayed, shortened by nearly two years as a consequence of the which will, in turn, increase the average emissions per lack of clean water and sanitation services.3 Hence, it is Environment in Crisis: A Step Back or a New Way Forward? 105 FIGURE 6.5 The long-term effects of the crisis will depend on the Log prices are faLling with declining East Asian nature and extent of changes in relative prices. Forest demand management and land-use decisions rest on the relative Intemational log prices 1995-98 values of both the capital stock and the flow of income US dotiars/m3 over time. An increase in the absolute value of the tim- 200 ber stock need not alter the relative return from cutting timber now rather than at some time in the future. This would onlv be true if the real price of timber were 150 expected to fall. Similarly, the returns from converting land from forest to plantation or agricultural land will depend on shifts in the relative prices of timber, peren- 100 nial crops, and agricultural products. All are traded items; therefore, exchange rate changes should not favor one form of land use over others. 50 X - Nonetheless, the level and structure of user fees for exploiting natural resources should be adjusted. These o | l - have been consistently set at a level well below what 1995 1996 1997 1998 would be justified by the resource rents. Increases in Source: WRI, 1998. user fees would enable the East Asian governments to capture a more reasonable share of the income that is important to protect public expenditures allocated for generated by logging, fishing, mining, and other natural this purpose, while in the long term, alternative sources resource activities. More important, the adjustments of finance linked to improvements in service efficiency would provide an opportunity to establish a more and greater cost recovery will be required. appropriate structure of incentives for the proper use of Shifts in natural resource prices. Despite environmen- natural resources. tal concerns about the impact of currency depreciations on logging, the demand effects of the crisis have, so far, swamped any response to relative prices. South Korea FIGURE 6.6 and Japan, two of the largest importers of forest prod- ucts, have reduced their demand for plywood by 30 per- Gas is cheap in developing Asia cent. Indonesia's Minister of Forestry has predicted that Relative automotive fuel prices in Asia , ~~~~Index with Tokyo gasoline price = 100 the country's wood-related exports will drop by 25 per- cent in 1998, from US$8.3 billion to US$6.2 billion.4 100 Many logging companies are in serious financial trou- Diesel ble. The Jakarta Post' reported that "at least 5.9 mil- 80 N Premium gasoLine lion cubic meters of cut logs remain in the forests because the timber estates have stopped operations." 60 Falling demand has reinforced the long-term decline in the world prices of logs and plywood (see figure 6.5), which will only reverse after a substantial shift in the 40 balance between output and demand. New markets for timber products may open in response to policy changes 20 or low prices. Even so, logging and production of wood products in the region are likely to continue to contract o Hong Kong KuaLa Lumpur iangkok ManiLa Jakarta as a result of tighter constraints on credit and the avail- (Cnina) ability of investment resources. Source: McMcrran and HamiLton, 1996. 106 East Asia: The Road to Recovery A sharp increase in user fees would discourage any lion (US$1.5 billion). It is difficult to reject the argu- short-term tendencies to harvest stocks of natural ment that such resources could be used more effec- resources in response to temporary swings in price rela- tively in other ways to alleviate poverty and to tive to domestic goods as a result of exchange rate mitigate the impact of the crisis. changes. However, compliance with such user fees, * Trying to change fuel taxes and subsidies very even at their current low levels, has been very poor; quickly is usually doomed to failure. Progressive increasing fees without devoting more effort to enforce- adjustments every quarter or half year will be more ment will only achieve more distrust and a further loss palatable, provided that the changes are signaled of confidence in the overall system of natural resource well in advance, so people have time to adjust. management. It may be appropriate to phase in higher * From an environmental perspective it is not critical fees over a period of up to two years, provided that the that prices should be adjusted quickly. Short-run required effort is devoted to improving collection rates, changes in the level and composition of fuel use in At the same time, regulations on harvest planning and response to price are modest; most estimates of oversight of concessionaires and other operators must short-run price elasticity of fuel demand fall between be enforced more uniformly. -0.10 and -0.20. Over a period of one year, income Eliminating subsidies. There are other distorted price changes are a much more powerful influence on con- incentives that result in significant environmental costs sumption than prices. However, the medium- and and should be eliminated as quickly as possible. In long-run responses to price changes are much larger, Indonesia, it is most important to eliminate subsidies typically four to five times the short-run elasticity as and highly discriminatory taxes that favor the use of people change their habits, buy more fuel-efficient kerosene and diesel fuels over other fuels. In other vehicles or equipment, and make the investments Southeast Asian countries, transport fuels are much required to switch to different fuels. Large increases cheaper than elsewhere (see figure 6.6). There is sub- in relative prices may dramatize the need for change stantial evidence showing that the fiscal impact of these but may be counterproductive if they are subse- pricing policies is regressive from a distributional point quently reversed. Thus, a more gradual approach to of view because they encourage the use of fuels that con- which the government is fully committed is likely to tribute heavily to local air pollution. be more effective. It may be argued that attempts to eliminate such sub- Changes in public expenditures. To date, there is no sidies have, in the past, provoked political unrest. evidence that environmental spending has been subject However, public resistance should be seen in the to disproportionate cuts. In the Philippines, for exam- broader context of fiscal policy and income distribu- ple, the budget of the Department of Environment and tion. Large increases in fuel prices or taxes may be dif- Natural Resources (DENR) has been affected by gen- ficult to implement on their own but are likely to be eral measures including a 25 percent mandatory reserve more acceptable if packaged with other tax changes on all expenditures other than personnel and debt ser- whose overall impact is seen as being equitable. Among vice, a 10 percent deferral in the revenue allocation for the issues that should be considered are: local government units, and the suspension of tax sub- * If taxes have to be raised or public expenditures sidies to governments units. Various new programs and reduced, is it better to increase fuel taxes or lower projects have been postponed, but the overall budget subsidies rather than, for instance, cutting back on allocation, before mandatory reserve requirements, was expenditures that directly benefit the poor and those increased in 1998. most severely affected by the crisis? It is important Tight fiscal discipline will complicate a critical transi- to distinguish between (a) resistance to changes in tion. It is essential to decentralize much of the respon- fuel taxes as a general protest against incompetent, sibility for environmental regulation, especially in large, corrupt, or inequitable economic policies and the (b) diverse countries such as Indonesia and China. self-interest of those who benefit directly from dis- Budgetary restraints may encourage central govern- torted prices. For Indonesia, government subsidies ments to delegate more responsibilities to regional and in the 1998-99 state budget amounted to Rp7.4 tril- local levels, which will achieve little unless additional Environment in Crisis: A Step Back or a New Way Forward? 107 resources are provided, at least during the transitional Yet, developed economies did address some of the period, to build up and sustain local administrative environmental problems associated with urbanization capacity. Thus, the pattern of government spending on and industrial growth. They invested heavily in devel- environmental protection must change to reflect both oping infrastructure for water supply and sanitation. new priorities and new approaches to environmental Within the limits of the technologies available, they also management. tried to mitigate industrial pollution. In some respects, Finding the resources to ensure that environmental Asian countries are still well behind the achievements regulation and enforcement can be effectively decen- reached 80 to 100 years ago by well-developed tralized must be the most important goal to ensure that economies. countries emerge from the economic crisis with a Advances in knowledge and technology mean that stronger capacity for environmental management. the trade-off between growth and environmental qual- Environment and poverty programs. Higher unem- ity also is very different. Often, the cost of reducing pol- ployment and lower real wages in urban areas have lution is low or negligible, because modern production either reduced migration from the countryside to cities techniques and capital are much cleaner as well as more or reversed the flow temporarily. If this persists, pres- efficient. All that is required is to ensure that plants and sure on rural resources, especially agricultural land and equipment they are properly operated and maintained, water, will encourage the conversion of marginal or for- something that is necessary if East Asian firms are to est land to agricultural land and may encourage rural compete in world markets. migration to frontier areas.6 Programs that provide A simple continuation of past policies for the next 25 employment opportunities, especially in rural areas, years would: will mitigate the risk that such adjustments will under- * Leave many households without access to clean mine efforts to better manage natural resources. water and decent sanitation; Such programs will yield positive environmental ben- * Worsen urban air quality in small and medium efits if money is allocated to improve rural infrastruc- Chinese cities as well as in cities such as Bangkok, ture or to protect the environment. For example, public Jakarta, and Manila; and expenditures on rural water supplies and sanitation, * Increase the risks posed by heavy metals and persis- planting trees, and soil conservation can generate sub- tent organic chemicals in rivers and water supplies stantial employment while improving the quality of life but improve other indicators of water quality, such and/or productivity of rural populations. Similarly, as suspended solids and dissolved oxygen. expenditures on improving water supply, sanitation, Measures requiring an investment of less than 1 per- and waste management in urban areas will help allevi- cent of GDP and with an annualized cost of 1 to 1.5 per- ate the poverty created by the crisis and will produce cent of GDP by 2020 will be sufficient to reverse the lasting environmental benefits for many urban resi- trends and improve the favorable ones.7 The main dents. expenditures relate to the goal of achieving full access to water within 10 years and to urban sanitation in 20 to A new path for the future 25 years, though in China the main goal is to deal with urban air pollution caused by burning coal for house- In periods of economic crisis, it is easy to assume that hold heating and in small boilers. The benefits of these attention to environmental problems is a distraction measures are five to 10 times higher than the costs from efforts to re-establish economic stability and involved for investments in water infrastructure and growth. This presumption reinforces a widely held two to three times higher for expenditures on reducing view in the Asia and Pacific region that environmental air pollution. concerns are something that should wait until income Following this new path will involve different combi- levels are much closer to those in developed economies. nations of incentives, regulations, and institutional The example of almost all industrial countries, includ- changes. However, the experience of economic crises ing countries that many seek to emulate, such as Japan, elsewhere suggests that it may be difficult to achieve an seems to support this position. appropriate balance when governments and the popu- 108 East Asia: The Road to Recovery lation at large are preoccupied by the immediate prob- transfer of better environmental practices without lems of either mitigating or adjusting to large economic jeopardizing prospects for economic growth and changes. Thus, the key question is how to identify the increased standards of living. The frequent sugges- steps that should be taken now to begin to establish a tion that liberalization of trade and investment will better framework for environmental management in generate pressures to lower environmental stan- the future. dards is, in almost all cases, incorrect. There are For this purpose, it is beneficial to learn from the trau- many lessons that may be learned from investment matic economic changes that have accompanied the and trading partners on how to improve both eco- transitions in Eastern Europe and the former Soviet nomic efficiency and environmental performance. Union. This transition will eventually lead to better * Make haste slowly. Improving environmental per- environmental policies and conditions. However, the formance will involve a commitment to trans- immediate economic costs have been so large in many parency and decentralization in the formulation and countries that it has proved difficult or impossible to implementation of environmental policies, such as in implement effective measures to correct the weaknesses the banking, corporate, and public sector gover- of the previous regimes. The most rapid progress on the nance. This will require a fundamental shift in gov- environmental front has been made by countries, such ernance and will succeed only if addressed over a as Poland, the Czech Republic, and Hungary, that expe- realistic time frame. It is easy to assume that the rienced the least economic disruption and were quick- main objective should be to transpose the formal est to re-establish economic stability. There are four superstructure-technical standards, legislation, main lessons that emerge from these experiences: and regulatory mechanisms-of environmental pol- • Re-establishing economic stability is an absolute pri- icy. However, real improvements in environmental ority even for economies concerned with improving quality are the result of a broad consensus about environmental performance. Without economic sta- environmental priorities and the measures necessary bility, it will not be possible to obtain the support to improve the situation. There is no such consen- from the public and businesses that is required to sus in most Asian countries. Thus, new governments implement effective measures to deal with environ- must build public support for tackling a limited set mental priorities. of priorities before attempting to introduce and * A clear public commitment to meet environmental implement appropriate measures. and other goals that are consistent with practices in The financial crisis is only a transient event. The crit- other countries or associations provides a reference ical question for the environment is whether resumed framework for all of the agents involved in environ- growth will be "business as usual" or will reflect fun- mental management. This does not mean that coun- damental reforms in both the economic and environ- tries should transpose European Union (EU) or U.S. mental spheres. The linkages between the economy and standards. Rather, it would be better for the the environment cannot be managed as directly as Association of Southeast Asian Nations (ASEAN) or financial problems. Solutions require the strengthening member countries to commit themselves to the goal of regulatory, institutional, technical, and managerial of developing environmental institutions and poli- capacity with an emphasis on cross-sectoral coordina- cies over the next decade that are mutually consis- tion and consensus. Building such capacity and foster- tent and are broadly equivalent to those of OECD ing change will require a prolonged effort and proper countries (allowing for differences in circumstances incentives. and resources). What matters is not the adoption of Environmental improvement in the region cannot be similar standards, but rather the development of rea- financed by the government. It is the job of the govern- sonable mechanisms for agreeing and enforcing poli- ment to establish rules and a clear regulatory frame- cies. work as well encourage those enterprises and agents * Openness to trade with and investment flows from with the maximum scope to achieve environmental countries that have devoted more attention to envi- goals. In turn, this means that the nature of environ- ronmental concerns is a powerful engine for the mental policies must change. There should be less focus Environment in Crisis: A Step Back or a New Way Forward? 109 on emission standards that promote the adoption of Public spending on basic water and sanitation infra- end-of-pipe pollution controls and more emphasis on structures has an immediate return in terms of the wel- pollution prevention combined with the adoption of fare of low-income populations and will lessen the cleaner and more efficient techniques of production. impact of the economic shock on employment. The In the immediate future, companies must be encour- costs of the lack of access to clean water in rural areas aged to achieve the best results by modifying their exist- represent a large fraction of the total health damage ing facilities. Two sets of incentives will tend to associated with environmental factors. Hence, there is reinforce this action. The large exchange rate adjust- a strong case for focusing spending on rural employ- ments will mean that the cost of new controls will be ment, social assistance programs, and investments in more expensive than before the crisis, so firms should the water supply infrastructure. The willingness to pay prefer to reduce emissions by adjusting their opera- for clean water is high, so it should not be difficult to tional practices, training staff, and ensuring that their establish mechanisms to ensure that the operational plants and equipment are properly maintained. costs of new systems are fully covered by modest user Furthermore, pollution represents a waste of raw mate- charges. rials and other inputs, so there will be strong economic reasons to minimize such waste. Notes In countries where state controls over the energy sec- tor mean that pricing issues are hotly disputed, there is 1. World Bank, 1992. great resistance to adjusting fuel prices in line with 2. The modeL is based on an input-output framework with sepa- exchange rate changes. Inflation is not especially sensi- rate matrices of coefficients for oLd and new capital (the coefficients tive to changes in the overall price of energy, whereas for old capitaL change gradua[ly over time). The basic assumption of the subsidies to hold down all or specific fuel prices are the model is that over the next two decades, Less-deveLoped economies almost invariably regressive. In fact, those subsidies are in Asia wilL converge toward economic performance and industriaL often simply a matter of special interests attempting to structures simiLar to middle-income countries. It is assumed that East protect valuable privileges. Asian countries wiLL graduaLLy adopt efficient techno[ogies and, as a Among the most important of those interests are result, energy and material inputs per unit of output wiLL decLine. energy-intensive industries whose profligate use of 3. World Bank, 1997. energy is almost always linked to heavy pollution. 4. Jakarta Post, December 30, 1997. Although there may be political constraints on rapid 5. Jakarta Post, January 15, 1998. adjustments in the prices paid by households for certain 6. Cruz and Repetto (1992) argue that such migration was a con- widely used fuels, there is absolutely no reason to pro- sequence of unempLoyment resuLting from IMF stabi[ization programs tect industrial and commercial users. Thus, at the very in the PhiLippines during the early 1980s. This interpretation is con- least, the wholesale prices of diesel fuel, heavy fuel oil, troversiaL because there were many other distorted incentives encour- gas, and coal should be brought into line with world aging agricuLturaL expansion in upLand areas and the trend was well prices within one year. estabLished before unemployment rose. 7. World Bank, 1997. 110 East Asia: The Road to Recovery Priorities for a Sustainable Recovery The ruins of crony banks and businesses built on corruption and special favors litter the devastated economies of Southeast Asia, making it easy to notice what went wrong. But buried under the rubble are a number of things that these societies did right-steps they took, or societal strengths they preserved, that may soften the trauma of the economic crisis they are going through. These values and accomplish- ments may well serve as a cushion on which the societies of Southeast Asia can bounce back once the economic panic recedes. -New York Times, May 31, 1998. E ast Asia is in its second year of economic crisis. The fires of instability -L& are almost contained in some countries, but are far from being under JL-4 control in the region as a whole. Not only could they erupt anew in any country, they still threaten to sweep into other emerging markets. Although it is still too early to predict their final course or when they will be extinguished, three facts emerge with stark clarity: *The level of devastation-in wealth losses, lost economic output, and in peoples' lives-is severe. Tens of millions of people are likely to be pushed below the poverty line and for millions more the climb out of poverty will be arrested, at least temporarily. * The crisis has taken on systemic proportions in Thailand, the Republic of Korea, Indonesia, and Malaysia. In these countries, many banks and firms have been forced into insolvency, and many more are hovering on the brink. The steady compounding of unpaid interest onto the balance sheets of the banks and corporations has created a growing mountain of debt. The rem- edy will go far beyond a macroeconomic adjustment to accommodate the III reversal of capital flows. It must extend to the vulnerable. Not surprisingly, the poor and politically microeconomic and institutional restructuring of disenfranchised, especially poor women and children, entire economies. ethnic minorities, and migrants, are suffering the most. * The recession has become regional in scope, making Though formal studies are just beginning, media it difficult for any one country, no matter how effec- accounts and interviews corroborate this conclusion. tive its policies, to escape the pressure of downward The El Nifno-induced drought and forest fires, in addi- forces solely on its own. One country's potential tion to and increased poverty have put added pressures export response is dragged down by its neighbors' on the environment, although, ironically, the recession import contractions. Credit contractions in domes- is forcing conservation that may countervail these neg- tic financial markets are magnified by credit con- ative effects. tractions in the financial markets of neighbors. The most urgent task ahead is to restore the condi- These events, left unchecked, threaten to engulf the tions for robust economic growth throughout the whole of East Asia and could even imperil the other-wise region, particularly in the most adversely affected coun- robust expansion of the world economy. Whether this tries of Thailand, Korea, Indonesia, and Malaysia. If comes to pass will depend on the way the region and the output were to fall by a cumulative 10 percent over the international community responds. next three years and income distribution worsens by 10 The stakes are high. Output in the East Asia 5 has percent, the number of poor people in Indonesia, dropped sharply in the first half of 1998. Because cur- Thailand, Malaysia, and the Philippines would more rent account balances have swung from negative US$27 than double-from approximately 40 million to over billion in 1997 to a projected US$40-50 billion surplus 90 million. For these reasons, establishing the condi- for 1998-a whopping 7-8 percent of gross domestic tions for renewed growth is essential to reverse recent product (GDP)-at a time when overall output was trends toward falling wages and growing unemploy- falling, the compression of consumption and invest- ment. Of the other developing countries in East Asia, ment has been even more brutal. For the remainder of China alone has some latitude to chart its own course, 1998, the consensus projections' paint a bleak picture: because of its size, credibility of its financial policies GDP is projected to decline by 16 percent for Indonesia, among its citizens, and semi-closed capital account. about 4.7 and 7.9 percent for Korea and Thailand, But, it too will have to work hard to avoid an excessive respectively, and by 3.4 percent for Malaysia. Even slowdown in its high growth momentum, as will all of Hong Kong (China) may contract by as much as 3 per- the smaller countries. cent. Of the East Asia 5, only the Philippines will record Restoring sustainable growth throughout the region marginally positive growth. The smaller economies of will not be easy. Recovery hinges upon: revitalizing the the region-from Mongolia to Papua New Guinea and banking and corporate sectors; reactivating aggregate the Pacific Islands-are experiencing economic con- demand; maintaining the pace of the structural reform tractions. Consensus forecasts are still strong for China agenda; ensuring low-income groups are protected dur- (7.2 percent), Vietnam (6.1 percent), and Taiwan, ing crisis and participate in the eventual recovery; and China (5.2 percent), but each is being pushed below its restoring international capital flows. These issues are trend-line path. inextricably related and require coordinated, consistent This grim reality in the contracting economies has approaches. Because countries confront quite different been accompanied by falling wages, rising unemploy- domestic economic circumstances, policy priorities ment, a shift of labor from high-wage to low-wage jobs, within the agenda will vary among countries. and sharp cuts in average per capita private consump- tion. In Thailand, for example, rice export volume is up Dealing with systemic banking and 76 percent in the first quarter of 1998 relative to 1997, corporate insolvency probably indicating that people are working harder and eating less. The economic expansion that raised the Throughout the region, the financial and corporate sec- incomes of the poor and effectively provided a social tors are trapped in debt. Except for China, highly lever- safety net has ended, leaving large segments of society aged corporations are caught between falling revenues 112 East Asia: The Road to Recovery and rising costs for interest service and imported mate- 16 percent of firms, respectively, have losses associated rials. Recession forces corporations to delay or default with the shock greater than equity, and their payment on bank payments, and, as the amount of non-per- record on debt is correspondingly better. In these coun- forming loans (NPLs) rises, banks' cash flows are tries, as with some of the small countries, restructuring squeezed. This forces the banks to contract new lend- may be able to proceed with less government coordina- ing to illiquid corporations and call in good loans to tion of the workout efforts. In China, the banking sec- raise cash, further deepening the recession. In addition, tor is also plagued by a high ratio of nonperforming tight monetary and credit policies have induced precip- loans (ranging from the official estimate of 20 percent itous declines in the volume of real credit, impeding cor- to private estimates of up to 40 percent). State enter- porate revival. To be sure, authorities' choices were prise profits have plummeted not because of external limited, and tight credit policies may have prevented the factors, as in the East Asia 5, but rather in response to volume of financial savings from falling yet further. In years of progressive exposure to new competition from any case, credit is scarce and many borrowers hover on the nonstate sector. Tight credit policies after 1994 the brink of default, so banks are unwilling to lend to all have induced reforms, but many state companies are but the most reliable borrowers. Getting accurate falling behind in their debt service to banks. At present, information on firms and financial entities is difficult the problem is large but manageable for several reasons: under conditions of exchange rate instability and fre- (a) depositors believe in implicit government guaran- quent variations in relative prices; this complicates the tees, and thus, the system is not exposed to panic-driven process of differentiating the good borrowers from the destabilizing outflows, and (b) the government has both bad, and underscores the importance of exchange rate the assets and borrowing capacity to finance a resolu- and price predictability. tion. The government has already adopted a limited In Thailand, Korea, and Indonesia, the abrupt change recapitalization of state-owned commercial banks and in economic conditions has produced a systemic crisis. implemented a new system of prudential regulation. Rising debts, plus capital losses associated with But it has to maintain a brisk pace of reform of both exchange rate depreciations, have pushed a large seg- state enterprises and banks-even in the face of consid- ment of the countries' banks and corporations into erable external economic uncertainty-to avoid sys- insolvency simultaneously. According to simulations in temic problems as the capital account gradually chapter 4, in Thailand, one out of four listed firms are becomes more open. estimated to have balance sheet losses greater than The pace at which countries reactivate credit flows to equity. When this is combined with falling demand, real economic activities will influence the speed of eco- NPLs are estimated to range from 20 to 35 percent of nomic recovery. In the financial sector it is urgent to total loan portfolios. In Indonesia, two out of three renew credit flows to exporters and to new investment. listed large firms are bankrupt according to this criteria, To reverse the microeconomic origins of high interest and non-performing loans may reach as high as 50 per- rates-eroded corporate balance sheets, deflated collat- cent. In Korea, two out of five corporations have eral values, and banks' aversion to accept risk when exchange rate and interest rate losses greater than they desperately need to rebuild capital-will require equity, and NPLs also range from 20 to 35 percent. time and a healthier economy. This will probably take Balance sheets and cash flow positions for the corpora- years rather than quarters (see box 7.1). tions are deteriorating to such an extent that, unless Prompt recapitalization of banks up to international restructuring and debt workouts are carried out up- standards, and enhanced monitoring of these would front, even a relaxation of monetary and fiscal policies help reduce the credit crunch and reduce uncertainty. is unlikely to produce the desired impact on corpora- Applying forbearance to stated capital adequacy targets tions' finance and operations. Each month that passes is not a wise policy. Most countries only saw their prob- worsens the situation because interest costs continue to lems increase when they allowed financial institutions mount. to violate prudential rules. Capital adequacy targets Countries farther from the epicenter of crisis are far- should be meaningful, however, and be made in line ing better. In Malaysia and the Philippines, only 5 and with the projected profitability of banks and the Priorities for a Sustainable Recovery 113 BOX 7.1 How long must East Asia wait to recover? A recent study attempted to estimate costs of lost output for occurred in most of the previous financial crises and has begun in banking and currency cnses by comparing GDP growth after a cri- Asia's crisis-stncken countries. Indeed, as a consequence of the sis with trend GOP growth for a group of more than 50 countnes increase in incremental capitaL output ratios (see chapter 1) and during 1975-97 (WEO, 1998). The study indicated that the cumu- significant investment in low productivity areas, adjustment in Lative toss in output pei episode for banking and currency crises investment in the face of a much higher cost of capital will be averaged some 14-15 percent of GDP. Average recovery was inevitable. shorter in emerging market economies (2.6 years) than in indus- trial countries (5.8 years) though the cumulative output loss was Larger, on average, for emerging market economies (18.8 per- centage points) than for industrial countries (17.6 percentage points). Investment to GDP ratio and financial crises Argentina (1981), Chile (1982), Sweden (1991), and Finland 0.30 (1991) offer useful compansons. Five years before and after the Argentina Finland crises, output growth, investment/GDP, and consumption/GDP ratios in these countries displayed common patterns of recession 0.25 and recovery (see figures below). In the years running up to the - crisis, the upvard trend of investment/GDP ratio provides some S2 eden support for the wideLy discussed boom-and-bust explanation of 0.20 financial crises. As the crisis ensued, the bulk of the adjustment felt on the investment ratio, which dectined dramaticatly. If gross 0.15 Chile national savings decrease owing to expansionary fiscal poticy and bank restructuring costs, and if countries can no tonger run cur- rent account deficits because of lowered capitaL inflows and 0.10 -5 -4 -3 -2 -1 0 1 2 3 4 5 reserves, the investment ratio must decline. This adjustment ReaL GDP growth and financiaL crises Consumption/GDP ratio and financiat crises 10 0.9s 0.8' nF, inland/ Xt Chlte -5, Swveden 0.7 -10 Argentina Argentina 0.6 Finland Chle -'I-I Sweden -20 -4 -2 -1 0 1 2 5 0.-5 -4 -3 -2 -1 0 1 2 3 4 5 Crsis year = 0 Crisis year = 0 Sour-e. WJorld Barrk s_a''. amount ot public supporr that is available. Banks may few, insrltutionally well-developed banks which are also be given some tax relief, importantly on the provi- kept to high standards, than to spread support over a sioning for non-performing loans, so as to increase their large number of financial institutions. retained earnings, and thus boost their capital. But, Ultimately the banking system is only as healthy as its when announced, banks should be held to standards, corporate borrowers. In the short term, two measures including through rigorous portfolio audits, and for- can help the corporations faced with financial restruc- bearance minimized. In the absence of sufficient public turing. Providing some (temporary) tax relief to corpo- support, it may be more effective to target support to a rations would improve their cash flow and credit 114 East Asia: The Road to Recovery standing. Also, providing limited guarantees for credit revised their bankruptcy statutes that will, among other for collateralized transactions can alleviate aspects of things, provide a credible impetus to voluntary restruc- the liquidity crunch. turings. For example, Thailand, Korea, and Indonesia In several countries, policies to encourage voluntary have introduced amendments to their bankruptcy laws restructuring of corporate debt are now gaining pri- to strengthen the capacity of the courts to approve reor- macy as an alternative to court-supervised bankruptcy ganization proceedings and to supply specific provi- proceedings. These include eliminating tax disincen- sions and rules that reduce the discretionary power of tives to equity restructuring through mergers and acqui- the court and increase the degree of transparency, cer- sitions. In Indonesia and Thailand, for example, an tainty, and efficiency in court proceedings. asset transfer is treated as a taxable transaction; how- While these measures may stave off bankruptcies in a ever exemptions should be allowed if the corporate fundamentally viable but illiquid system, they cannot seller does not receive cash. Similarly, removing tax dis- salvage a corporate and financial sector rendered tech- incentives to debt restructuring would speed voluntary nically insolvent by the new exchange rate/debt burden restructurings. The government should also encourage combination. If, under the new constellation of conversion of debt to equity as part of voluntary reor- exchange rates, the present value of corporate assets is ganizations. Moreover, liberalizing treatment of for- still less than the present value of liabilities, pervasive eign direct investment in selected sectors where it is now insolvencies will threaten to bring down the financial restricted and in the ownership of real property could system. In these circumstances, the government has no open up new sources of management and capital. In alternative but to play a strong leadership role to Korea, some important steps have already been taken quickly restructure the financial and corporate sectors. by the government to liberalize foreign investment (in Like Chile in 1982 and Mexico in 1994, Asian govern- both corporations and financial institutions), clarify ments may have to intervene to ensure the survival and Mergers and Acquisitions' rules, provide tax incentives restructuring of both the financial and corporate sec- and clarify tax and prudential treatment of restructured tors. The Chilean and Mexican governments made debt. More recently, the government has taken several depositors and lenders whole, restructured the compa- steps toward allowing takeovers by foreign investors, nies under new ownership, and auctioned off bad port- moving toward 100 percent foreign ownership, allow- folios and the newly restructured companies to preserve ing foreign investment in previously restricted business growing concerns. This decision requires governments areas, and liberalizing the real estate market, including to balance the burden on governmental management to foreigners. Finally, the government probably will capabilities against market-based reorganization and to have to help establish a framework for collective yet select the option that will produce the fastest recovery. voluntary negotiations between debtors and creditors, The history of restructuring offers some hope that including providing the criteria and financing to permit this process need not be a prolonged drag on recovery. companies access to foreign exchange at predetermined Chile undertook massive restructuring and, after only rates to service foreign debts. Most East Asian coun- three years, began its longest sustained expansion in this tries have yet to complete the formulatioin of a compre- century. Successful restructuring experiences around hensive framework of corporate sector restructuring. the world point to certain imperatives:2 Nevertheless, crisis countries like Thailand, Korea, * Conduct an early and systematic evaluation to Indonesia, and Malaysia have adopted a "London design a strategy (including differentiating viable Rule" type, voluntary approach to help viable compa- banks from those that are clearly bankrupt), and nies restructure their debts. The government can also then act immediately. allow regulatory authorities to treat new lending to * Adopt a comprehensive approach to repair the companies that have undergone restructuring as more immediate stock and flow problems of weak and secure than existing debts for purposes of provisioning insolvent banks; repair the shortcomings in account- thereby creating an incentive for firms to restructure ing, legal, and regulatory frameworks; and redress and for banks to lend. Virtually all countries have weak supervision and compliance. Priorities for a Sustainable Recovery 115 * Transfer nonperforming loans from the banks' bal- Privatization is not a panacea, and indeed the efforts to ance sheets to a separate loan recovery agency to mobilize private participation in some sectors have cre- alleviate the banks' stock problem. ated new problems, as contingent liabilities in contracts * Provide capital to viable banks during restructuring. with private producers have created increased new pub- * Set up mechanisms to compel operational restruc- lic debts because of exchange rate changes. turing so as to return banks and firms to profitabil- Nonetheless, in many cases, governments can achieve ity and sustained solvency. the twin objectives of garnering new capital revenues * Enforce exit policies for firms to allow owners to for the state and provide services more efficiently declare bankruptcy, and sell assets so they can be put through partial or complete privatization. back into production, albeit with reduced book val- ues. The need to restore growth in * Require loan workouts to recover some of the costs aggregate demand of bank restructuring and to send signals to delin- quent borrowers. Demand is depressed. At home, plummeting stock and A corollary problem is the restructuring requirements real estate prices brought about dramatic net-worth posed by public sector companies in the region. Power losses for households and businesses. Middle class sav- companies, water utilities, and other state companies ings have been decimated, and economic contraction have suffered the same interest and exchange rate has universally shrunk purchasing power Also, the loss shocks as private firms. On the one hand, this increases of investor confidence has sharply reduced investment demands on public finances already strained by new demand. Meanwhile, foreign demand has so far not burdens. But on the other, the crisis has created the compensated for falling domestic demand. opportunity to rethink the disposition of these public It is useful to preface the discussion with an assess- assets, the efficiency of public monopolies, and ways to ment of the relative magnitudes of the components of leverage new private capital into these sectors. demand, and their recent role in the region's growth. Governments should not hesitate to review the benefits Two factors distinguish East Asia-particularly the of privatizing state companies and reorganizing these East Asia 5-from other developing countries: very sectors to permit new entry from private firms. high investment rates, plus a large share of exports in TABLE 7.1 Contribution to GDP growth (1990-96) Private Government Net consumption Investment consumption exports Exports Imports Indonesia Contribution to growth 62.5 31.4 7.1 -1.0 27.8 -28.8 Share in GDP 57.7 33.0 8.6 0.8 27.0 26.2 Korea, Republic of Contribution to growth 55.3 40.1 11.3 -6.7 31.1 -37.8 Share in GDP 53.6 37.0 10.5 -1.4 30.2 31.6 MaLaysia Contribution to growth 42.7 49.6 9.7 -2.0 102.5 -104.5 Share in GDP 49.9 37.9 13.0 -2.5 86.5 89.0 Philippines Contribution to growth 78.0 26.9 12.9 -17.8 47.4 -65.2 Share in GDP 73.9 22.8 10.6 -6.6 32.8 39.4 ThaiLand Contribution to growth 52.0 44.4 10.7 -7.0 41.3 -48.3 Share in GDP 54.7 41.1 9.8 -5.5 37.9 43.3 Source: IFS. 116 East Asia: The Road to Recovery ment, easing the pressures on consumption; the flip side of the coin is that it will have to play an important role in recovery. As discussed above, this will be difficult as =.- long as the financial and corporate sectors are strug- A rnights Ł4 _ a, olcai :erit t&tKTh gling to restructure their balance sheets and teal credit c pr wdes tac Igrowth is paltry. Similarly, exports have accounted for tta large growth impulse-30 percent or more-offset in thisre ida: ~~~~~~~~ recent times by growing imports. This suggests that, if eakeii& ~~~~~regional and world market conditions were favorable, dto Chi-t __ k and the region lowers its import intensity in response to wps tlw @ S W- exceeded 20 p vcurrency depreciation, trade could play a more dynamic atid am in tils ovarseas~ do tassis- role in East Asia than in comparable crises elsewhere. It - .: a a a I ee 3,h a gost con eS-a- aa also suggests that, since investment demand is con- t ivte C 7> 7 falling incomes, we should look carefully at net exports GDP. Since 1990, on average, orvestmentspnding tioniniand government spending. aotfam t e nGX'DWPP growExternal demand: The regional export trap East Asia 5. This implies thatinthefirstphaseof effAlthough net exports have tended to be a drag on adjstent, crw acionG~ could fall heavily on invest- Tgrowth in the recent years of increasing current account mideficits, they could play a leading role in recovery pro- 44 aeo~ UQF >~~ std j~ fre tp~oak vi'ded the current robust global market conditions ~~