Causes and Prevention of External Debt Crises

8/3/2019 Causes and Prevention of External Debt Crises

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Causes and Prevention of

External Debt Crises

Yen Kyun Wang

Department of Economics

Chung-Ang University, Seoul

July 6-7, 2004

UNESCAP, Bangkok


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Introduction Asian financial crisis was a debt

crisis (over-borrowing by private

firms).


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Many changes after the crisis.

-But slow structural adjustment -Directions for reforms on corporate

governance, and conglomerate

(chabol) are debated: Western styleor Traditional style?

Not adequate measures yet against

volatile short-term capital flows-receiving, source country or globallevel


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In Korea: per capita income:$10,000 in2003, same as that of 1996

A Author: Causes- weak fundamentals and

policy distortions, aggravated by herdingand contagion


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Will Discuss

Over-investment mechanism New method of calculating real

effective exchange rates: showing

large degree of overvaluation in EastAsian currencies before 1997

Others

Crisis prevention measures


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Causes of external debt crisis in East

Asia Mechanism of over-investment and

over- borrowing : a mix of

export-oriented , conglomerates-based economies, excessivegovernmental intervention


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Boom period: rapid expansion ofinvestments of large corporations andchabols

Downturn period: further expansion,and nocontraction of facilities of firms due to

- implicit government guarantees, too-big-

to-fail legacies to large firms and banks

- Government rescuing failed large firm

- loans based on mutual payment

guarantees among chabol affiliatecompanies

- no strict screening by banks of investmentprojects


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- Weak corporate and financial

governance system-smallshareholders with no voice

- Convoy-style management of chabol:

saving weak firms,setting up newfirms by funds of strong firms

- Lay-off was illegal, weak socialsecurity net

- Strong labor unions


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Desire of large shareholder to prevent

dilution of ownership: prefer debt to othermeans

Average debt/equity ratio, 1988-1996

- Indonesia, Thailand, Japan 200%.

Korea 347%- in manufacturing sector in 1997:

Korea 396%. Japan 200%, US 150%,

Taiwan 82%


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Bank loan growth GDP growth:

-Korea 17.1%, Phil. 22.8%, Thailand10.4%, Indonesia 5.8% Singapore2.8%,Japan 1.28%

Bank loan growth

industrialproduction growth:

- Indonesia 22.0%, Korea 9.4%,

Singapore 6.9%, Japan

1.1%


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Growth rates (total assets, share

capital, sales) of firms of Korea muchhigher than those of Taiwan

Net Profits of firms of Korea: a

quarter of those of Taiwan, half ofthose of US.

Investment rates of East Asiancountries: 30-40% of GNP

-Philippines, Taiwan: 20-25%


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Incremental capital output ratioincreased substantially in theregion,1987- 1992 to 1993-1996

Interest Coverage Ratio less than1(business profit before tax andinterest payment is less than interestcost) in Korea: 11 out of 30 top

chabols


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In 1979-1980, external debt crisis

occurred in Korea, due to over-investment in heavy and chemicalinvestment projects by government

during 1973-79,aided by oil shocks, high interestrates, internal political turmoil

-19.7% depreciation, industrialrestructuring and economicStabilization programs


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Overvaluation and large current accountdeficits

-Many writers(e.g., Ann Krugman, RonaldMackinon, Roubini): no overvaluatin in EastAsia before 1997

- they used CPI or WPI as deflator in

calculating real exchange rates- years before 1997, export prices did notincrease much, low inflation, but rapidincrease in wage rates in East Asia due to

boom and shortage of skilled labor-New calculation of real effective exchange

rates using unit labor cost( baseyear=1985)


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Exchange rates in Korea: 30%overvalued in 1996 (pegged nominal

rate, 59% increase in ULC) using ULCas a deflator

-If WPI is used, 6% overvalued.

-if CPIs are used, 16% overvalued:similar in other countries

In China in 1994, 50 depreciation

In Japan in 1996, 16% depreciation- eroding competitiveness of exportgoods of EA countries


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Current A/C deficits/GDP(dangerlevel: 4-5%): 9% in Thailand in 1995and 1996

- Malaysia: 10%and 3.7%in 995,1996.Korea 5% in 1996.

Indonesia 4%, 1995-97.

Philippines 5-7% , 1993-97


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Conventional rules of thumb for dangerlevels: external debt: should not exceed of

40% of GNP or 200% of exports, and debtservice ratio not exceed 25%

Foreign /GDP: Indonesia 56-69%, Phil.

50-71 in the 1990s. Malaysia 40%, Korea28% in 1996

Foreign debt/exports: 220% inIndonesia(danger). 127% in Thailand,

120% in Philippines Debt service ratio: 37% in Indonesia in

1996, Phil 14%


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Foreign liabilities/assets(relative toBIS reporting banks)

-1103% in Thailand. 400% in

Indonesia, 375% in Korea -Serious mismatch. Borrowed short,

lent long in foreign currency


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Boom-bust cycle, busting of assetprice bubble

-Asset price bubbling, buildingpermit declined drastically, manyconstruction companies bankrupt

-In South East Asia, drastic declinein asset prices,stock prices, property

stock prices,


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Poor corporate and financial governance -maximizing interests of chabol oweners

-group chairman had big power, but no

legal responsibilities, standing above law -financial institutions under direction of

the government, government-directedloans.


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Deterioration of terms of trade In Korea: -12% in 1996, -11% in

1997

Unit value index of electronic exports

: 100 in 1995, to 31 in 1996 Share of electronic exports in total

exports in 1996: 19%

UVI of total exports: 100 in 1995 to86.6 in 1996


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Lack of transparency in financial

statements of corporations and

banks

-Was different from westernaccounting practices: announcedbad loan rate-6%. Perceived rate-

30%


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High share of short-term debt in the total

Thailand 61-72% in 1994-95, Korea 50%in 1996 (58% end of 1996)

Short- term debt/foreign reserves:

-In 1996, 203% in Korea. -177% in Indonesia. 100% in Thailand.

Philippines 80%

(Short term-debt + debt service)/foreign

reserves in 1996: Korea 243%, Indonesia294%, Thailand 123%, Philippines 137%


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M2/foreign reserves, years before

1997: - Korea 6-7. Phil 5, Thailand 4,

China 9-26 Taiwan 5-6

Average annual ratio of Net FDI/GDPin 1992-96

-Korea 0.2%. 0.7% in Thail, 1.8% in

Indonesia, 1.7% in Phil, Malay 6.2%


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Rigid labor market and inadequateeducation system

-lay off was illegal

-enrollment in secondary school inthe same age cohort: in Thailand30%,, Indonesia 20%.


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Wrong sequence of liberalization

Capital liberalization first beforestrengthening financial institutions

Weak financial system, not exposed

to foreign competition, veryvulnerable to short-term capital flows

Low profit rates of banks, large badloans, large share of governmentdirected loans


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Poor supervision and regulation offinancial institutions - lack of information on transactions

of funds abroad, no limit to riskexposure of financial institutions

- no strict evaluation of lendingprojects


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Moral hazard on the side of

international lenders Over-lent, believing in bail-out by

the government

Gov. policy failure in handling failedcompanies

-direction to keep lending failed large

firms -Congress holding submitted laws to

allow firing by firms


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Prevention measures

Export-oriented growth Economic reform and market opening

-deregulation

-reducing government intervention Correction of over-borrowing mechanism -Ceilings on total investments (25% of net

assets) and maximum debt/equity ratio of

200% of chabol member firms - restrictinginvestments in Korea


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Strong corporate and financialgovernance

Transparency in business

management and accounting Correction of continuous current

account deficits and large debt

Managing boom: inflows of s-tcapital, macro and micro policy


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Exchange rate system

Flexible basket currency system, ensuringconstant real exchange rates and currentaccount balances would be better than

floating or fixed exchange rate system use unit labor cost indices as a deflator,

when calculating real effective exchangerates- better indicator of international

competitiveness of tradabe sector


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Control of excessive short-term

capital flows: Short-term loans, portfolio capital

-Impose tax such as Chilean reserve

requirement w/o interests Development of domestic demand

oriented and service industries

- deregulation, free economic zones,market opening and reforms.


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Structural adjustment Leave non-viable firms to creditors,

not government

Strengthening regulations andsupervision-limit exposure to risk

Competitive education system , more

investments by the government.


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Collection Action clauses andSovereign Debt Restructuringmechanism

Avoid moral hazard to international

lenders

Provide information on theinternational capital market to

developing countries


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Regional surveillance and financialcooperation

Real side: business tie-ups, FTAs in some

or all industries, education and training,environment, arms reduction

Financial side:

-Exchange rate cooperation

-Pooling some of international reserves atprivate banks and use it in need

-Asian Monetary Fund

-Establish a regional crisis preventionframework, conducting on-the groundanalyses using data collected within theregion

Documents

Causes and Prevention of External Debt Crises