On 2 July 1997, the Thai government abandoned its efforts to defend its country's currency, the baht. Pressures on many fronts had become unbearable. Following a period of massive inflows of short-term private capital, asset prices were declining and construction was slowing. Export growth had decelerated too, in part reflecting the sharp downturn at the time in world demand for semiconductors. Also, with the baht tied to the buoyant dollar, its value was rising against the ailing yen. It was the nail in the coffin for Thailand's exchange rate policy, destroying any argument there might have been for protecting the baht's link with the dollar. Investors initially cheered when the link was abandoned, reversing a prolonged slide in share prices. But their enthusiasm was short-lived. Rather than float steadily, the baht sank. By January 1998, when it bottomed, it had lost more than 50% of its value. The crisis was not limited to Thailand. Similar pressures affected Indonesia, the Philippines and Malaysia, with similar results. The horror arose of a contagion that would envelop an ever-widening number of countries, both regionally and at a global level. Korea succumbed in late 1997. Russia fell prey in August 1998. Brazil followed suit in January 1999. But was the crisis only a financial one? The financial aspects of the crisis have received most of the attention, the accepted diagnosis being that the domestic financial institutions in the affected economies in Asia were not sufficiently developed to respond to either rapid globalisation in financial markets or the periodic whims of investors. Most policy strategists have focused on reforming the international financial system, to make it less vulnerable to "hot" or sudden short-term capital flows. There has also been some focus on developing and improving domestic financial institutions.
But the crisis was far more than a financial phenomenon. It had a fundamental industrial dimension as well. Key structural weaknesses had developed, which had been mostly concealed in the vaporous heat of some extraordinary economic performances in Asia. Yet, a closer examination shows that signs of strain were becoming increasingly evident in 1996 and early 1997.
The first sign was growing over-capacity, in numerous sectors. Several Asian economies had for a long time been pursuing ambitious development programmes that targeted investment in heavy and high-tech industries, such as steel, automobiles, and electronics. Relatively little regard was given to the effect all this targeting was having on the sectors themselves. The additional capacity, combined with declining trade barriers world-wide, intensified competitive pressures. Moreover, the enthusiastic efforts governments were making to lead their economies into high-tech businesses often occurred before acquiring the necessary technical expertise to support the new enterprises. The result was a heavy reliance on imported inputs and technology. This lack of technical expertise resulted in many new facilities operating at below their potential. It also made it difficult for firms to innovate, which is the life-blood of today's knowledge-intensive, high-tech sectors. At the same time, competitiveness began to slip as rising economic activity put upward pressures on wages, while real, dollar-tied exchange rates became overvalued as the dollar rose.
With easy access to credit and weak loan criteria, companies found it easy to borrow money for good and bad projects alike. This contributed to highly leveraged industrial conglomerates. Prior to the crisis, debt for non-financial corporations was two to three times higher than equity in Indonesia and Thailand, with the ratio generally rising during 1995 and 1996. The debt-equity ratio in Korea at the end of 1997 was over 500% for the 30 largest conglomerates (or chaebols). This high-debt leveraging was sustainable as long as capacity utilisation was high but when utilisation tumbled, over-extended firms found themselves in serious financial trouble, with many falling into bankruptcy. In Korea, for example, corporate insolvencies soared from 9,500-14,000 per year during 1992 to 1996, to close to 23,000 in 1998.
Poor corporate governance
Corporate managers had an inordinate amount of discretion to grow their businesses in a highly independent fashion, often with cosy political support. There was a distinct lack of sufficient oversight by banks and regulatory authorities, and little accountability to shareholders. The owners valued expansion more than profits, a strategy which was strongly supported by workers, clients and suppliers. The closed nature of the firms slowed the transfer and adoption of foreign technology and management know-how. There was a general lack of transparency, with minority shareholders given little attention. As a result, a good number of low-quality investments gradually worked their way into the portfolios of companies.
SMEs lost out
The emphasis of targeting larger industries came at the expense of small and medium-sized enterprises (SMEs) and the linkages between larger and smaller enterprises which underpin industrial development in most OECD countries failed to develop. Larger firms had to rely even more on expensive imported technology and, with SMEs out of the picture, the deficiency in innovative capacity worsened. Both targeted firms and smaller firms could only suffer from this dichotomy in industrial policy and they began to lose competitiveness, as evidenced by slowing exports. With general wage levels rising, these economies may simply have lost their comparative advantage in low-wage industries too quickly.
The financial crisis was a systemic shock that devastated well-managed and poorly run companies alike. Domestic and regional demand for goods and services collapsed. The cost of imports rose sharply in domestic currency, as did debt payments on foreign-denominated loans. Interest rates rose as governments took action to bolster their currencies, while credit availability was reduced because of cautious lending, particularly to SMEs.
The upshot of all this was to drive sales lower and costs higher. Domestic demand, for example, declined by 8.0% in 1998 in the Philippines, and by 20% or more in Indonesia, Malaysia, Korea and Thailand. By mid-1998, large parts of the corporate sector were either insolvent or suffering severe losses. Faced with a slump in domestic and regional demand, companies in such situations would generally try to increase exports, as in Mexico in the mid-1990s. In the case of Asia, trade shifts occurred too, but not to the extent needed to offset the crisis. While export volumes rose, their value actually fell somewhat in dollar terms. At the same time, the dollar value of imports plunged by about a third. The net result was a hefty US$130-US$135 billion shift in the five countries' combined trade balance, which swung a merchandise deficit of US$50 billion in 1996 into a trade surplus of about US$80-85 billion in 1998.
While the financial crisis initially had little effect on most OECD countries, its broadening scope and depth eventually took its toll. Economic growth in the OECD area fell from 3.3% in 1997 to 2.3% in 1998, due largely to the crisis. Growth in trade also slowed markedly, with sharp downturns occurring in exports to the crisis economies, particularly those to Asia.
There have been notable effects on some sectors, such as commodities. While there has been significant recovery in recent months, metal prices, already under pressure, fell by as much as 45% between July 1997 and December 1998, while oil prices fell by about 40% over the same period. In addition to commodities, the crisis has had a pronounced effect on the steel and shipbuilding industries. In steel, sliding prices and shifts in trade flows have heightened trade tensions, giving rise to an increase in anti-dumping and related restrictive trade measures world-wide. In the European Union, for example, imports rose by 43% in 1998, to 23.4 million tonnes, while exports eased by 15%, to 24.0 million tonnes. Similarly, in the United States, imports surged by 33%, to a record 37.7 million tonnes, while exports slid by 8.5%, to 5.0 million tonnes. As regards prices, spot quotations for imported and exported hot-rolled sheets, which is a major item in international commerce, fell by about 30% during the crisis (through the end of 1998). In shipbuilding, order books have been full, but low prices are putting strains on companies. With shipowners advancing their purchases to take advantage of the low prices, the strains could well increase significantly, when new orders slow.
The crisis has had positive effects too. It has no doubt played a role in accelerating the restructuring of several industries, through mergers and acquisitions. This is the case of the oil industry, where the sluggish market has become a driving force behind a wave of major mergers (for example Exxon-Mobil and BP-Amoco-Arco). The decline in commodity prices has also helped to keep OECD inflation in check, and has had a favourable effect on some companies' costs. Consumer prices in 17 OECD countries, for example, rose by less than 2% in 1998, which is noticeably below prior levels. But there are risks that deflationary pressures, which are already present in Japan (and China), may expand. If this occurs, competitive pressures would intensify in a growing number of sectors, which could precipitate a rise in corporate failures, job losses, and intensified pressures for more profound industry consolidation and restructuring. In the wake of the crisis, the five Asian economies have taken steps towards impressive reform programmes, including financial sector reform, privatisation, and liberalisation of investment regimes. They are also working to improve corporate governance by strengthening rules to improve disclosure and to protect shareholders, while exploring ways to resolve the corporate sector's debt problems. Reforms have been made in the weak bankruptcy laws of Indonesia, Korea and Thailand. Finally, governments have started to pay attention to the importance of SMEs. Credits have been channelled to them in order to mitigate the consequences of the credit crunch, and there is a new commitment to strengthen this sector.
With the improvement in general economic conditions now under way, there is still the danger that the reform process will slow. Governments should act quickly to prevent this from happening, by ensuring that reforms are fully implemented, while they still have the leverage to do so. The guiding principle should be for governments not to micro-manage change, but to put in place framework conditions that encourage market-led change. At the same time, industrial policy will have to be adapted in the light of shifts in the structure of the economies. While traditional manufacturing will remain important, the driving force for future growth and job creation lies to an increasing extent on knowledge-based activities, and in services. Governments should take this on board and adopt policies to promote innovative SMEs and improve their links with larger corporations. They should broaden policies with respect to innovation so as to extend beyond traditional R&D in manufacturing, and strengthen the interface between science and industry. Governments should also seek to make labour markets more flexible, foster upskilling and life-long learning and improve conditions for entry in product markets.
One of the most important challenges will be for governments to resist protectionist pressures. That implies enhancing policies to facilitate industry's adjustment to the global economy by, for example, developing effective programmes to retrain and re-deploy workers whose jobs are at risk because of restructuring. It also means sharpening up co-operation between OECD and non-OECD countries in areas ranging from corporate governance to fostering innovation, entrepreneurship and the development of SMEs. In the final analysis, the crisis has reminded us that if something looks too good to be true, it probably is. The Asian miracle produced remarkable results over an extended period of time, but when the bubble burst, the signs of underlying weaknesses became apparent. What is encouraging is that global co-operation is playing a major role in facilitating a recovery, and that the reforms being made in the crisis economies will lay the basis for more open, competitive markets -- which is a "win-win" proposition both for them and the countries they trade with.
©OECD Observer No 217/218, Summer 1999