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The Impact of Financial Liberalization on East Asian Financial Crisis during 1990s: Lessons for Pakistan

Chaudhry Mazhar Hussain Assistant Professor International Islamic University, Islamabad, Pakistan E-mail: [email protected]

Syed Zulfiqar Ali Shah Chairman (HS&R), Assistant Professor International Islamic University, Islamabad, Pakistan E-mail: [email protected] Dr.Nadeem Sohail Principal, College Of Commerce G.C. University, Faisalabad ,Pakistan E-mail: [email protected] Iqbal Mahmood Ph.d. Scholar ( Corresponding Author ) International Islamic university, Islamabad, Pakistan. E-mail: [email protected]

ABSTRACT

We have found abundant literature on Asian Financial Crisis which highlights the reasons for such crisis and about financial liberalization. However, this research analyzes the impact of financial liberalization on the East Asian financial crisis during the era of 1990s. Furthermore, East Asian countries rose as a role model for other developing countries like Pakistan, India and Vietnam because of their financial prosperity. Nevertheless, what went wrong with Malaysia, Indonesia and Thailand’s financial system which collapsed in 1997 is also the subject matter of this paper. The central notion of this research is to make a comparative analysis between Malaysia, Indonesia, Thailand and Pakistan. This analysis identifies the similarities and differences based on which we can conclude that Pakistan did not experience the same financial crisis. However, it should learn some lessons from the crisis. Moreover, it should not repeat the same mistakes while liberalizing its financial system and adopt the appropriate policies to avoid the recurrence of the pattern witnessed elsewhere.

Keywords: Financial Liberalization, East Asian Crisis, developing

countries, Lessons for Pakistan 1. INTRODUCTION Financial reforms were undertaken by most of the developing countries after the seminal work of McKinnon-Shaw (1973) which analyzed theoretically that liberalization and development of the financial sector could promote economic growth. Cole and Slade (1996) define financial reform as a reduction in direct government controls over finance and a shift to greater reliance on market forces to determine the prices and flow of financial services. There was a belief that once financial system is liberalized, it would evolve in a wealthy and efficient manner to serve the needs of the developing economy. The East Asian countries liberalized their economies but they experienced financial crisis. What went wrong with these reforms and what are the lessons for other developing countries is the main concern of this research paper.

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In 1990, Pakistan started financial institutional reforms which included privatization of state owned banks, strengthening of banks and development financial institutions( DFIs), opening of private banks, autonomy of the State Bank of Pakistan and legal environment and incentives for loan recovery. The other financial reforms were debt management reforms promoting intermediation, encouraging foreign investment, liberalizing forex market and capital market reforms. Furthermore, the impact of these reforms was not very productive, because Pakistan could not achieve the objective of attracting foreign investors. The main reason was that despite financial liberalization and reforms, it did not have appealing infrastructure for investors. Additionally, due to political instability, the pace of financial reforms was slow. The East Asian countries started financial reforms in the 1980s and 1990s. They achieved the maximum benefits of these reforms afterward. These countries rose as a role model for other developing countries like Pakistan, India and Vietnam because of their financial prosperity. However, the main causes of East Asian’s financial crisis were globalization and domestic weaknesses, microeconomic factors accentuated the crisis, inappropriate regulations and supervision, political uncertainty especially in Indonesia and Thailand, the Thai Baht crisis and Non-performing loans. The characteristics of the crisis seem to have been different in each country. However, they faced the same problem of deterioration of foreign investor confidence, reduction in exports and increase in external debt, which led to vulnerability to foreign exchange liquidity problem. The non-performing loans also contributed to make the financial sector fragile. These problems were the same in Pakistan. Nevertheless, Pakistan did not experience the same crisis due to three main reasons. Pakistan’s foreign currency exposure particularly that of the private sector was much lower than the East Asian countries. Second, in 1996/97, the government just initiated a comprehensive reform program supported by the IMF’s Enhanced Structural Adjustment Facility (ESAF)/Extended Fund Facility (EFF) arrangements before the crisis. Third, substantial progress had been made in implementation of banking reforms and stemming further increase in bad loans. Nevertheless, I conclude this paper with the lessons to be learnt by Pakistan from this horrible episode. 2. APPRAISAL OF PAKISTAN’S FINANCIAL REFORMS DURING 1990S

This section explains the objectives and nature of reforms in the financial sector of Pakistan during the 1990s. It assesses the impacts of these reforms on financial sector due to which Pakistan’s financial sector remained fragile. The points will also be highlighted on the bases of which Pakistan did not face the same experience as faced by East Asian crisis 2.1 Institutional Reforms

In order to address the issue of political interventions in the sanction of banks loans in Pakistan, the Bank (Nationalization) Act of 1974 was amended in 1990, empowering the Federal Government to sell all or any part of the share capital of Nationalized Commercial Banks (NCBs)1. Two commercial banks namely, the Muslim Commercial Bank (MCB) with 25% government ownership and the Allied Bank Limited (ABL) with 40% government ownership were privatized as part of financial sector liberalization. While, the privatization of other state owned banks i.e. United Bank Limited (UBL) and Habib Bank Limited (HBL) was also being considered for privatization. These measures were started in 1990 to improve the level of competition and efficiency in the financial system. (Mohammad Zubair Khan, 2000) Since NCBs had focused more on increasing their branch network to far-flung areas of the country, their efficiency began to decline with rising cost, oversized workforce and growing non-performing loans. This scenario could lead to systemic risk to the financial system, if significant restructuring was not suggested. That is why, NCBs were asked to prepare

1 Economic Survey of Pakistan, 1989-90


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restructuring plans to rationalize their workforce strength and size. (Mieko Nishimizu and Joseph Del Mar Pernia, 2001) In September 1997, NCBs introduced various redundancy schemes for employees. Work force size in banking sector was reduced from 99954 to 81079 till end of the year 1999 and banks were given permission to wind up their branches which were not feasible to run on commercial basis. 718 branches of various banks were closed keeping in view this aspect till June 1997.(SBP Annual Report 1999-2000). Opening of banks in private sector was allowed in 1991 in order to increase competition and efficiency among various banks. For this purpose, necessary amendments were made in Banks Nationalization Act, 1974. Resultantly, ten licences for operating banks in private sector were issued in 1991. Licence of commercial banking were also given to 11 new banks in later years. (Economic Survey of Pakistan, 1989- 1990) The autonomy had been given to the State Bank of Pakistan to perform the functions of Ministry of Finance and Pakistan Banking Council. In this connection, the State Bank had issued guidelines regarding the monetary and credit policies to Non-Bank Financial Institutions (NBFIs). However, leasing and Modaraba companies would be controlled by Corporate Law Authority (CLA). The SBP also introduced market-oriented policies. The two major developments in this regard were the abolition of the credit deposit ratio as an instrument of credit control in October 1995 and removal of lending rates as an instrument of credit control so that these could be determined by market forces. Clearing of cheques payments though clearing house needed to be improved because of joining of Society for Worldwide Interbank Financial Telecommunication (SWIFT). New systems of making payments through ATM and credit cards were becoming more common in the market and various non depository firms were not able to have access to such systems. (Chaudhry, S.I, 1994). As a part of reform to improve the legal environment for loan recovery, Banking Companies (Recovery of loans, advances, credits and finances) Act 1997 was enacted in the country. Banking courts were established under the provisions of this Act in order to increase the settlement rate of bad loans. These courts were given the power to issue interim decrees as well as to settle the issues with in 90 days. (IMF Staff Country Report, 1997). 2.2 Impact of Institutional Reforms Low rate of real GDP becomes the cause of poor debt service by the domestic borrowers and increase the loans default rate. Thus, it increases the credit risk and same problems were also faced by the Pakistani borrowers due to drop of real GDP rate in the country from 6.1% to 4.4% in spite of introduction of reforms and liberalization of financial sector. 2.3 Other financial reforms Debt management reforms were introduced to promote primary and secondary securities markets. The prudential supervisory framework had been established to foster sound credit decisions. (Buhkari, N.A.S 1994) In order to promote foreign remittances from those Pakistanis who were maintaining bank account in foreign currencies in abroad, they were given permisiion to maintain foreign currency accounts in Pakistan. Amounts in these banks were transferable to any other country and were exempt from any type of taxes. (SBP Annual Report various issues) Inflow and outflow of capital was liberalized with a view to increase foreign investment in the country in the year 1994. Hundred percent equity of the industrial companies could be purchased by the foreign investors without prior governmental permission. Moreover, proceeds of dividend, disinvestment and shares held by the non residents could be exported without any approval of State Bank of Pakistan. (SBP Annual Report various issues)


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Investment made by the foreign investors in the country was treated as just it has been made by the local citizens for tax purpose. There was no difference in its treatment from this aspect. There was no restriction imposed on the inflow and outflow of foreign currency. Avoidance of double taxation of amounts from the investors of those countries having such agreements with our government was also applied in the country. Reforms of capital sector of the economy are considered to be an important part of the financial sector reforms, so a great deal of attention was therefore given to stabilizing and strengthening the supervision and governance structure of the financial sector. Market infrastructure was also improved and modernized through several reforms and Term Finance Certificate (TFC) promotion was part of these reforms to improve the condition of corporate debt market. (Burton, N, 1994) 2.4 Impact of other financial reforms The impact of these reforms was not very productive because Pakistan was not succeeded in attracting foreign investors. The inflows in the form of portfolio investment were peaked only in 1994 of opening of capital market for foreigners which was $1,090 million. Furthermore, Pakistan received higher foreign direct investment amounting to $1,546 million in 1994-96 as compared $670 million in 1990-93. Nevertheless, foreign investors were interested to invest in East Asian countries because of higher return on portfolio investments and foreign direct investments. A low level of international reserves is seen particularly by investors as a major indicator of vulnerability. Banking business gets badly affected due to low level of foreign exchange reserves because of limitations faced by them for foreign exchange transactions and during the time span of this study, there were foreign exchange reserves in Pakistan on average equivalent to six weeks imports. A stress on external sector of the economy is depicted if in relation to nominal GNP, the present value of external debt is very high. (Table 4.13). A nominal amount is left for the financial system operations domestically, if there is increase in the demand for servicing of debt accounts. The debt management reforms were not effective because in 1990s, the inflation rate in Pakistan was high at around 10 percent on the average (see Table: 4.16). Another factor due to which people remained reluctant to invest in securities markets was the political and economic instability. Furthermore, due to political instability the pace of financial reforms was slow. In 1996/97, Pakistan’s government initiated a comprehensive reform program supported by the IMF’s Enhanced Structural Adjustment Facility (ESAF)/ Extended Fund Facility (EFF) arrangements. These comprehensive reforms were just initiated before the year of Asian crisis and it has been observed that Pakistan was still liberalizing its financial sector in 1997-98. 3. CAUSES OF THE CRISIS

In this section, we have discussed the causes due to which East Asian countries financial sectors collapsed. These countries faced horrible experience of financial crisis, which is the lesson for other developing countries. The combination of global capital market push and interaction of poorly and imprudently regulated domestic financial system in order to exacerbate credit expansion domestically resulted in over investment in non tradable sector of the domestic economy. Consequently, companies already having high levered position further increased their debt from financial institutions due to easy availability of capital at the cheaper rate. The behavior of investors changed due to this vulnerability in many of the East Asian countries. At the time of crisis, East Asian Countries were suffering from very high debt position. Financial institutions in Thailand extended loans in the country at very low rate in the projects like real estate and construction sector where rat of return was very low after availing these funds in foreign currencies at low rate of interest. Resultantly, this policy enhanced the net foreign liabilities in that country from 6 percent to 30 percent during six


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years period ending in 1996. Corporations in Indonesia were the prime borrowers of getting foreign sources loan which had also not utilized these resources in economic productivity. Malaysia had low external debt than Indonesia and Thailand but it was also affected by the crisis of investors and lenders confidence and it also led to vulnerability to foreign exchange liquidity problem. (World Bank, 1998) It is evident that in retrospective, development of supervisory and regulated structure was not fully integrated with global external finance as inflow of capital was very rapid. Inconsistency in reforms structure and liberalization created vulnerable situation in Thailand. Supervisors did not give proper attention and time for screening of such loan applicants who were not having proper profile for getting loan. In Indonesia, there was lack of monitoring of international flow of capital and consequently, the regulatory bodies did not work on collecting information of those companies which were involved in external borrowing in order to use that type of information in macroeconomic management perspective. Malaysia also adopted inappropriate policies regarding liberalization due to which it could not manage to match the pace of capital inflows. (Radelet, Steven, and Jeffrey Sachs, 1999) The political uncertainty was another factor which resulted in reduced willingness of foreign investors to invest particularly in Thailand and Indonesia (Cole, David C. and Slade, Betty F, 1998). The unwillingness of foreign investor caused the outflow of portfolio investments in 1996-97(see table: 4.5 and 4.6). According to Kawai, Masahiro, and Kentaro Iwatsubo (1998), growth in export started slowing down in 1996 after growing at 20 percent in 1995. In the same year of 1996, export of Thailand declined by 1 percent. Although, all the countries of East Asia suffered badly due to decrease in export demand by the world but, Thailand was the most affected one. It was due to loss of wage competitiveness in relation to Thai currency on real effective basis, decrease in demand of Thai products in the world market economy and suffering of Japanese economy in recession position being the substantial buyer of Thai products. In this situation, first of all, the equity investors withdrew and it resulted in drop of stock market at the end of year by thirty percent in spite of being at peak in the month of February of the same year. It was perceived in the market that exchange rate was not properly aligned in spite of increase in interest rates. There was no exit policy for the public and private sector banks and private banks were greatly protected from bankruptcy if owned by politically influenced persons. This policy continued till crisis. Non performing loans of the banks increased substantially due to involvement of government officials in the credit advancing decisions of the state owned banking organizations. Even, implementation of financial reforms could not improve this condition. The non-performing loans also contributed to fragile the banking sector of Thailand. (Chang, R and A. Velasco, 1998) 4. COMPARATIVE ANALYSIS After examination of the causes of financial crisis in East Asian economies and impact of financial reforms in Pakistan, we are now in a position to make a comparative analysis between Malaysia, Indonesia, Thailand and Pakistan. East Asian countries crisis of 1997-1998 resulted in devaluation of currencies in these countries, steep downward slope of the stock prices in these countries and heavy increase in interest rates. This also resulted in decrease of net capital inflows of these countries and thus economic growth slowed down. 4.1 Similarities in the economic scenario Pakistan also faced such difficult economic conditions which were faced during the crisis by most of the East Asian countries. However, following are some parameters based on which we can make a comparative analysis of Southeast Asian countries: a- Unprepared for liberalization


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According to Masuyama (1999) and Radelett and Sachs (1998), the East Asian countries liberalized their financial sector without due consideration for readiness, sequencing and making their economies vulnerable to a rapid reversal of international capital flows. The same was the case in Pakistan and it was not prepared for liberalization and in particular lacking an adequate prudential regulatory and supervisory structure. Therefore, Pakistan’s banking sector experienced an increase in non-performing loans (NPLs). Indonesia’s non-performing loans stood at 10 percent in 1996 which became to the level of 11.5 % in 1997. 1.5 % of these loans were belonging to the listed banks. (East Asian Executive Reports, June 1997). Table: 4.1 Non-Performing loans as share of Total loans (as announced by the respective authorities)

Countries 1996 1997

Indonesia 10% 11.5%

Pakistan 18.5% 16.7%

Thailand 7.73% 8.15%

Sources: East Asian Executive Reports, June 1997 State Bank of Pakistan Annual Report, 1996-97 & 2000-2001 As shown in the table, the Bank of Thailand released non-performing loan figures of 7.73 percent of total loans as on June 1996 and 8.15 percent as June 1997. According to State Bank of Pakistan Annual Report, 1996-1997 and 2000-2001, the total non-performing loans of all banks were 18.5% in 1996 and 16.7 percent in 1997. Among domestic banks, the highest NPLs ratio occurred in case of nationalized commercial banks (29.4% of total loans) followed by specialized banks (17.4%), privatized commercial banks (11.3%), private banks (5.7%) and foreign banks (4.1%) as on calendar year 1997. In our point of view, non-performing loans of the financial institutions developed over time and emerged as a complex phenomenon in these South East Asian countries. Here it suffices to mention that corruption was primarily responsible for the situation but other factors had also contributed to make the financial situation worst. Those included: bad politics of financial institutions, carelessness in supervision and regulation of these institutions, weak corporate culture and policies like debt-equity ratio and non-issue of debt instruments by the corporate sector. b-Vulnerability to foreign exchange liquidity problems

In 1996, foreign exchange reserves of Thailand were more than Malaysia. It grew from 17287 million US $ in 1991 to 37192 million US $ in 1996. There was an increase of 11.5 percent in it in the same time period. Foreign exchange reserves of Malaysia increased from 10421 million US $ in 1991 to 26156 million US $ in 1996. Thus, there was growth of 151 percent in it during this period. Indonesia had smaller foreign exchange reserves than Thailand and Malaysia. However, it had higher foreign exchange reserves than Pakistan, growing from US$ 9150.7 million in 1991 to US$ 17,820.4 million in 1996. There was an increase of 95% in it during six years. In case of Pakistan, a marked fluctuation had been observed in the foreign exchange reserves. These were US$ 583 million at end June 1991 and as on 30 June 1995, it stood at US$ 2,737 million. On 30 June 1997, the reserves fell to US$ 1,219 million, registering a decline of about 41% over the level of US$ 2,065 million recorded at end June 1996 (see Table 4.2).


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Table: 4.2 Foreign exchange reserves (US $ million)

Countries 1991 1992 1993 1994 1995 1996

Indonesia 9,150.7 10,181.2 10,988 11,819.9 13,305.6 17,820.4

Malaysia 10,421 16,784 26,814 24,888 22,945 26,156

Pakistan 583 839 1,371 3,177 2,737 2,065

Thailand 17,287 20,012 24,078 28,884 35,463 37,192

Sources: Asian Development Bank, Bank of Negara Malaysia Annual Report, Bank of Thailand and Economic Survey of Pakistan Graph: 4.1

As shown earlier, Thailand had excessive funds from foreign resources. Bad debts of Indonesia and Thailand grew at faster rate due to imprudent regulations and control system regarding liberalization of financial sector in these countries. When, the process of such irregularities started showing its economic effects, the exit of foreign investors from these countries added in to it in the form of more severe adversities. It led to vulnerability to foreign exchange liquidity problems. The foreign reserves in Pakistan were already very thin and East Asian crisis had increased the vulnerability to foreign exchange liquidity problems. Following are several reasons which were similar in Asian countries regarding foreign exchange liquidity problems. Deterioration of foreign investor confidence

In the region, inflows picked up first in Thailand (1988), followed by Malaysia (1989) and Indonesia (1990). (Bercuson and Koening, 1993). In table 4.3(a) and 4.3(b), a comparison of various types of inflows of capital has been compared in 1990- 1993 as well as before the start of crisis period i.e., 1994-1996.These capital inflows have been divided into two forms as presented below

Table: 4.3 (a) Net Capital flows, 1990-93 (US $ million)

1990-1993 Foreign Direct Investment

Portfolio Investment

Malaysia 16,519 12,6931

Thailand 6,725 5,164

Indonesia 6,356 1,612

Pakistan 6702 4263


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Table: 4.3 (b) Net Capital flows, 1994-96 (US $ million)

Note: 1Portfolio investment is for 1991-93. 2 Foreign Direct Investment is for 1992-93. 3 Portfolio Investment is for 1992-93. Sources: Banks Negara Malaysia, Asian Development Bank and International Monetary Fund, SBP Annual Report: various issues Sustainability of these inflows is dependent on factors which becomes the cause of their attraction. If, interest rate in the host countries are low and economic conditions are also vulnerable, it will result in out flow of capital from these countries. Investors particularly the portfolio investors prior such investments which provide return in the short run instead of long run and if there is uncertainty in the host country’s economy, such portfolio investors will fly from there . It was observed in case of East Asian crisis. The financial crisis in these countries really deteriorated the confidence of foreign investors. Tables 4.4, 4.5, 4.6 and 4.7 show the inflow and outflow of capital in Malaysia, Thailand and Indonesia. Portfolio investment was easily reversible in these countries and consequently foreign portfolio investment of these countries flied during the financial and currency crisis of 1997. Net capital outflow became at the level of 8640 million US $ during 1997. Likewise, net capital inflow also dropped in Thailand from 65116 million Bhat to 5771 million Bhat in 1997. Such down fall was also observed in Malaysia during the same time period. For Indonesia, the net outflows of private capital came suddenly in the third quarter of 1997 with US$ 8,640 million suddenly leaving as compared to the earlier net inflows. For Thailand, there was a huge drop in net inflows of foreign portfolio investment for equity securities from B 65,116 million in the third quarter of 1997 to B 5,771 million in the last quarter. Malaysia also experienced massive net outflows of portfolio investments in 1997. The peak happened during the third quarter of 1997 with a net outflow of RM 17,458 million. As shown in Table: 4.6, Pakistan received large amount of portfolio investments in 1994 as compared to the subsequent years. However, inflows reduced from US$268 million to US$204 million in 1997. Table: 4.4 Indonesia: Net flows of private capital (US$ million)

Source: Bank Indonesia Table: 4.5 Thailand: Net flows of private capital (Baht million)

Years Quarterly

96Q1 96Q2 96Q3 96Q4 97Q1 97Q2 97Q3 97Q4


13,813 3,575 1,553 6,311 10,629 22,946 65,116 5,771

Source: Bank of Thailand

1994-96 Foreign Direct

Investment


Malaysia 13,372 10,252

Thailand 3,527 9,744

Indonesia 12,651 12,982

Pakistan 1,546 1,560

Years Quarterly

96Q1 96Q2 96Q3 96Q4 97Q1 97Q2 97Q3

Direct Investment

1,024 1,640 1,540 2,342 1,267 1,392 -298

Others 1,403 1,192 2,272 2,075 1,316 1,296 -8,640


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Table: 4.6 Malaysia: Net flows of private capital (RM million)

Years Quarterly

96Q1 96Q2 96Q3 96Q4 97Q1 97Q2 97Q3 97Q4


4,078 2,257 -66 2,497 1,771 -10,561 -17,458 -5,390

Source: Bank of Negara Malaysia Table: 4.7 Pakistan: Net flows of private capital (US$ million)

Years 94 95 96 97

Portfolio Investment 1,090 205 268 204

Source: SBP Annual Report various issues Reduction in exports

The massive downward adjustment in exchange rates in the affected countries had eroded Pakistan’s external competitiveness. To the extent that Pakistan competes with these countries in international markets, its exports were bound to suffer. Furthermore, Japan and Hong Kong were the two largest importers of Pakistani cotton yarn, accounting for 53% of total cotton yarn exports in 1996-97. These countries were having trouble since Japan’s economy had slowed down and Hong Kong was experiencing both direct and indirect effects of the East Asian crisis. Their demand for Pakistani yarn declined resulting into a fall in Pakistan’s exports earnings.(Economic survey 1997-98). The East Asian countries devalued their currencies (Table 4.8), which affected key Pakistan’s exports like textiles, rice and cotton group and reduced the export earnings. Although, Pakistan has benefited to some extent from lower import prices, this would be relatively small as compared to the potentially large adverse effect on exports and capital flows. Table: 4.8 Exchange Rate Depreciation of Each currency against US$

Currency Depreciation Jan97 to Jan98

Exchange Rate Jan1998

Exchange Rate July1998

Indonesia rupiah 76.5% 5,495 14,650

Thai baht 49.5% 51 41

Malaysia 38.7% 4 4

Source: Extel Compact Disk Indeed the exports of Malaysia, Indonesia and Thailand had significantly dropped in the period of Jan 97 to Jan 98 (see table 4.9). One of the reasons was that in 1994, China devalued Yuan, which enabled China to increase its exports in competition with those produced in the East Asian economies. This was equivalent to a negative productivity shock on the other East Asian countries which faced falling quantity demand and/or a falling price for their exports. Another explanation focuses on the prolonged recession in Japan and the shock caused by the devaluation of the Yen. Japan was an important import market for East Asian exports and recession in Japan had acted as a significant export market shock. (Jenny Corbett and David Vines, 1999). At that crucial time when these countries desperately needed foreign exchange, the deterioration of their exports contributed to the foreign exchange liquidity problems. Table: 4.9 Total Exports from Jan-97 to Jan-98 (US$ billion)

Countries Jan-97 Mar-97 May-97 July-97 Sep-97 Nov-97 Jan-98

Thailand 4.5 4.80 4.70 4.80 4.90 4.80 4.20

Indonesia 4.30 4.10 4.60 4.60 4.70 4.70 3.80

Malaysia 6.80 7.00 6.90 6.70 6.90 6.50 5.20

Source: East Asia: The Road to Recovery 1998, p.14-15


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External debt Pakistan’s fragile external reserve position was compounded by the accumulation of short-term foreign currency liabilities by the banking system mostly residents’ and nonresidents’ foreign currency deposits (FCDs). With a stock of public and publicly guaranteed external debt amounting to Rs 25,183 million at the end of 1998, Pakistan might be regarded as a highly indebted developing country.(Economic survey of Pakistan 1997/98 and State Bank of Pakistan Annual Report 1997/98). The forward cover scheme of SBP for FCDs provided an explicit guarantee against foreign exchange losses which encouraged the accumulation of these liabilities to finance persistent trade deficits in much the same way as the implicit guarantees associated with financial institutions in East Asia encouraged excessive foreign funding. Therefore, accumulation of external debts accelerated in the 1990s in these four countries. Furthermore, the present value of debt as percentages of nominal GNP in 1996 was over 50% (see Table: 4.10). Moving ahead with unsustainable low priority infrastructure projects financed partly with foreign funding exacerbated external imbalances and exposed Pakistan to similar risks as those faced by East Asian countries. Table: 4.10 External Debts

Country 1985 1990 1996 PV of debt (% of GNP*)

Indonesia 36,715 69,934 129,033 64

Thailand 17,552 28,088 90,824 56

Malaysia 20,269 15,328 39,777 52

Pakistan 7,024 28,107 124,467 51.5

* For year 1996 for all four countries Sources: Asian Development Bank, Key indicators of Developing Asian and Pacific countries 1998, World Development Report 1998/99 and State Bank of Pakistan Annual Report. 4.2 Differences in economic scenario Pakistan could not be affected by the East Asian countries crisis due to the following reasons: a- Financial Resources

According to the Global Financial Integration Index 1997 of The World Bank, two countries namely Thailand and Malaysia massively increased the level of financial integration between them during ten year period of 1980-1990. All the countries which were affected by this crisis were highly integrated with each other at the start of 1990 (Table 4.11). Private capital therefore started surging to the affected countries sometime in the late 1980s and the early 1990s. By contrast, Pakistan’s global financial integration was labeled as medium with global financial markets in the late 1980s and remained low in 1990s, because of very low capital inflow at that time as compared to Malaysia, Thailand and Indonesia. Table: 4.11 Asian Countries- changes in degree of Global Financial Integration 1985-87 to 1992-1994

Country 1985-1987 1992-1994

Malaysia High High

Thailand Medium+ High

Indonesia Medium High

Pakistan Medium- Medium


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b- Foreign currency exposure

Private sector in Pakistan could not get proper access to international sources of raising capital funds due to very limited exposure. By contrast, the foreign exchange exposure of banks in Malaysia, and Thailand increased significantly starting in the late 1980s. (World Bank (1998), p. 40) c- Foreign portfolio investment

Pakistan liberalized its stock market in 1994 and received peak level of foreign portfolio investment as compared to other years (see Table: 4.12). Nevertheless, Pakistan could get very limited inflow of foreign investment due to its instable political conditions, lack of proper governance as compared to other East Asian countries at the peak time of inflows into emerging markets. Table: 4.12 Foreign Portfolio investments in Pakistan (US$ million)

Years 1992 1993 1994 1995 1996 1997


137 289 1,090 205 268 204

Source: SBP Annual Report various issues d- Fragile Macroeconomic factors

Table 4.13 compares macroeconomic indicators which affected the financial sector of these four countries. Real GDP growth had been high for Malaysia, Indonesia and Thailand under study ranging from 6.2% to 11.6%. Pakistan’s real GDP was below 6.0% until 1996. Inflation had been the highest for Pakistan ranging from 6.0% to 13.0% in the years of study. Malaysia had a very good track record to control inflation as compared to Thailand. Inflation rate in Malaysia was ranged between 3.1percent to 4.8 percent as compared to Thailand’s inflation rate which ranged between 3.3 percent to 6 percent. Supply of money expanded due to surge of inflow of capital. M2 growth remained at the highest level in Indonesia all the years other than 1991. It happened in Indonesia every year except 1991 when Thailand had the highest. Resultantly, inflation rate in Indonesia was high but not higher than Pakistan. Malaysia had the highest M2 growth in 1995-96 as compared to Thailand and Pakistan. Higher rate of money supply depicts that lending rate to the private sector will be high which will become the cause of increase in inflation particularly when it will be used for non productive purposes. It happened in Pakistan and Indonesia in 1990s. Financial sector of Pakistan was more fragile as compared to Indonesia, Malaysia and Thailand and remained weaker. Despite the sincere efforts of government, bad loans recovery remained very poor and weakening of economy was further contributing in business failure in Pakistan. Table: 4.13 Macroeconomic factors affecting the financial sector (% growth)

1990 1991 1992 1993 1994 1995 1996

Malaysia

Real GDP 9.74 8.24 7.8 8.35 9.24 9.46 8.60

Money Supply (M2 growth)

12.78 14.53 19.14 22.12 14.71 24.01 21.38

Inflation 3.1 4.4 4.8 3.6 3.7 3.4 3.5

C.A deficit/GDP

2.1 8.9 2.8 4.8 6.3 8.5 4.9

Foreign 9,327 10,421 16,784 26,814 24,888 22,945 26,156


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Reserves1

Thailand

Real GDP 11.63 8.41 7.77 8.27 8.78 8.65 6.40


26.68 19.84 15.58 18.38 12.86 17.01 12.57

Inflation 6.0 5.7 4.1 3.3 5.0 5.8 4.8

C.A deficit/GDP

8.3 7.5 5.5 5.5 5.6 8.0 7.9

Foreign Reserves1

13,247 17,287 20,012 24,078 28,884 35,463 37,192

Indonesia

Real GDP 7.24 6.95 6.46 6.50 7.70 8.21 7.82


44.16 17.05 20.19 21.96 20.19 27.58 29.64

Inflation 7.4 9.4 7.5 9.7 8.5 9.4 6.5

C.A deficit/GDP

3.4 3.8 2.1 1.6 1.7 3.6 3.3

Foreign Reserves1

7,352.7 9,150.7 10,181.2 10,988 11,819.9 13,305.6 17,820.4

Pakistan

Real GDP 4.6 5.1 8.2 2.3 4.5 5.3 5.5


17.5 17.4 26.2 17.8 18.1 17.0 13.8

Inflation 6.0 12.7 10.6 9.8 11.3 13.0 10.8

C.A deficit/GDP

-3.4 -3.0 -1.8 -6.4 -3.2 -3.5 -6.9

Foreign Reserves1

277 583 839 1,371 3,177 2,737 2,065

1 In US$ million Sources: Asian Development Bank, Bank Negara Malaysia Annual Report, Malaysia Treasury Economic Report, Bank of Thailand and SBP 5. CONCLUSION Lessons for Pakistan from East Asian Financial Crisis Comparative study of four South East Asian countries at the outset reveals that Pakistan economic structure is much similar to East Asian countries. Nevertheless, it had not experienced the crisis of the same nature as that in other three East Asian countries because of the differences in economic scenario discussed earlier. Prudence demands that Pakistan should pay attention on his own circumstances in more objective manner and should not adopt the policy of implementing those strategic financial measures which have been observed as favorable else where. Lesson 1: Financing of deficit in current account with the help of short term inflow of capital should be avoided The current account deficit of Pakistan was large. The foreign investment is being expected by financial sector of Pakistan. So, it should be prepared not to repeat the mistake to financing its current account deficits through short-term private capital inflows. Rather, it should consider enhancing foreign reserves by creating an atmosphere for the foreign investors to sustain its capital inflows as well. Lesson 2: Financial system should be properly supervised and regulated


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There was great mismatch in assets and liabilities of banks with regard to unhedged borrowing of foreign exchange which was invested in non trading sectors of the economy during the phase of East Asian financial crisis. Investment of short duration loand in real estate sector made the economic situation of the countries vulnerable. Furthermore, Pakistan’s banking sector is doing the same mistakes. Financial system of the country should be domestically strong enough. It can be made so with properly supervised regulatory system and effective monitoring but this thing was not there in the financial sector governance. Financial activities of the bank and DFIs’ should be properly monitored by an independent supervisory agency which should be free from any political influences. Credit extension policies of banks and DFIs’ to the private sector should base on their profitability and potential of repayment of these loans. Credit application should be evaluated on merit instead of being evaluated on political basis. A strict financial pattern should be laid to be followed by the personnel of such institutions and violators should be given some exemplary punishment. It will help in reduction of non performing loans. Lesson 3: The proper sequencing of financial and then capital-account liberalization Third lesson for Pakistan from the East Asian crisis is that capital-account liberalization should strictly follow the proper sequencing of financial and then capital-account liberalization. East Asian countries opened their capital-account before the crisis and they got the benefits of globalization afterward. However, these countries could not maintain these benefits. Furthermore, there was large reversal of international capital because of fragile financial system. Pakistan should not involve in hasty act of opening its capital accounts. Instead, prudential regulation system should be enforced first in order to create an atmosphere for its nourishing but, it does not mean that reforms process should be freezed in order to get the benefits of globalization. It means that there should be consistency in liberalization process and state of development in the economy. Lesson 4: Priority to long gestation infrastructure projects Public investment projects involving heavy capital expenditures and particularly those projects involving debt financing from external sources should be evaluated on cost benefit basis. The government should give priority to long gestation infrastructure projects for creating productive atmosphere for the domestic and international investors. CONCLUDING REMARKS Despite all the above precautions and pursuing sensible and prudent economic policies, it is hard to predict when a country is likely to face the crisis. Even when the economic fundamentals are strong such as in the case of Hong Kong, the markets have witnessed serious disruptions. Moreover, Pakistan should not repeat the same mistakes while liberalizing its financial system and adopt appropriate policies to avoid the recurrence of the pattern witnessed elsewhere.

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