Asia needs policies to avert crisis
The last 20 years have been eventful for “Emerging Asia” in terms of policy management as the region survived two major financial crises while seeing the risk of yet another one looming large. Policy-makers in Emerging Asia need to carefully calibrate policies to steer away from crisis risk and at the same time look to deepen intra-regional collaboration and collectively raise the region’s abilities and effectiveness to deal with capital flows and spillovers.
In particular, they need to learn three crucial lessons from previous financial crises that are particularly relevant for Emerging Asia, going forward. The first is that no country is above crisis. The financial crisis in East Asia in the late 1990s and the recent global financial crisis show clearly that this can happen in any country if the conditions exist. Domestic conditions for a crisis include fiscal and financial sectorled crises, while external conditions relate to balance of payments and foreign exchangeled situations.
Typically, key external risks arise from sharp changes in terms of trade — especially the oil price, collapse of global demand, threats to financial stability from large and persistent capital inflows, and sudden stops and reversals of foreign capital linked to extreme financial markets uncertainty and volatility. These risks are inevitable products of a deepening global financial integration with unfettered and foot-loose capital. As for the internal source of risk, the past crises have clearly demonstrated how poor policies can sow seeds of crisis through a build-up of financial imbalances and how sound policy can help avoid major imbalances and build greater resilience against shocks and sudden capital outflows. In short, crisis is highly correlated with policy.
The second lesson is that a financial crisis is, without exception, rooted in excessive debt and leverage. This places the public sector and the financial system at the forefront of policies to minimise and manage risk of a crisis. Public debt-induced crises are typically the result of a poorly-managed fiscal policy, which invariably leads to unsustainable debts of central government or state enterprises.
Private debt-induced crisis, on the other hand, is linked to excessive credit extension by domestic and foreign financial institutions, leading to currency mismatch and the unsustainable debt positions of firms and households.
Excessive growth in domestic credit is often caused by a combination of large and persistent capital inflows, loose monetary policy, misaligned incentives in the financial industry through taxes and subsidies, and lax financial regulation and supervision. Signs of financial stress preceding the crisis often manifest in large and persistent current account deficits, an over-valued exchange rate, high and rising inflation, and ballooning asset prices. A crisis usually breaks out when market confidence in debt serviceability or macro policies deteriorates.
The third is that policy can play an important role to help the economy avoid a buildup of large imbalances and improve its resilience and capacity to deal with shocks. To this end, there are four areas on which policy is most crucial.
The first is greater economic flexibility — including exchange rate, price and the labour market — through a more extensive use of market mechanisms rather than regulations or controls. This will provide the economy with means and ability to adequately adjust to shocks.
The second area is a sound external position via a sustained current account balance, low levels of external debt, and sufficient levels of international reserves. For Emerging Asia, strong reserve positions had proven to help it absorb shocks from the global financial crisis. An effective regional safety net arrangement — such as regional bilateral swap arrangements under the Chiang Mai Initiative Multilateral — can provide a supportive line of defence amid the vagaries of international capital flows and limitation of the international safety net.
The third area is the resilience and the efficiency of the domestic financial sector, considerably vital in coping with shocks and defusing threats to financial stability that are a precursor to a financial crisis. Policies must ensure good fundamentals in the financial system including adequate profitability, strong capital base and effective risk management practice of banks, as well as robust financial regulation and supervision frameworks.
The fourth and final area is the disciplined conduct of fiscal and monetary policies, sine qua non for ensuring a sustained economic growth with stability. The key challenge here is to balance policy focuses between growth, price and financial stability, while keeping in sight longer-term implications of short-term stabilisation policies.
These three lessons put policy at the heart of efforts to prevent and manage financial crisis risk. Emerging Asia has made considerable progress on policy reform, allowing regional economies to weather the impact of global financial crisis and maintain growth. Nonetheless, reform in most countries, including Thailand, remains incomplete and efforts need to continue to sustain growth and manage risk of future crises.
Policy-makers in Emerging Asia need to carefully calibrate policies to steer away from crisis risk.
Bandid Nijathaworn is president and CEO of the Thai Institute of Directors and visiting professor, Hitotsubashi University. This is an abridged version of an article featured in the book ‘Bretton Woods, The Next 70 Years’, published by the Reinventing Bretton Woods Committee, 2015.