The role of China and Japan in the post-Asian crisis era (or solution)

Asian financial crisis: The role of China and Japan in the post-Asian crisis era (or solution)

Pettway, Richard H

This paper reviews what happened to create the Asian Financial Crisis, updates some of the economic facts, and comments on the role of China and Japan in the solution to the crisis. Japan will not be helpful in the short-term as it is currently too preoccupied with its own problems. China will play an increased role, both politically and economically, by maintaining the peg to the end of 1999. By that time, a few countries (Thailand and Korea) will be on the road to recovery and Japan may begin to play a stronger role in 2000.


Movements in Exchange Rates

The Asian financial crisis began in the summer of 1997 and became clear to the world as Asian currencies started to come under increasing pressure. To understand the movements in exchange rates, observe the percentage changes found in Table 1. In the first column, the movements in exchange rates versus the U.S. dollar over the period 12/23/96 and 12/22/97 are reported. It is very clear that the largest declines in exchange rates occurred in Indonesia, South Korea, Thailand, Malaysia, and the Philippines. Note that there is almost no change in the Hong Kong exchange rate as China maintained the peg of their currencies against the U.S. dollar. All of the Asian countries at the bottom of the table were forced to give up their dollar peg and float their currencies.

The second column of Table 1 contains the percentage changes over the period 12/23/97 to 09/02/98, during the nine months just prior to the FMA meeting. There are some notable changes from the previous year. The Indonesia rupiah continued to suffer a dramatic decline again. However, the South Korean won and Thai bhat showed some signs of appreciation and reversing their declines of the previous year. Also Malaysia, Philippines, and Singapore currencies appear to have much smaller declines than in the previous period. Interestingly, Mexico and Canada currencies appeared to have suffered from some of the Asian currency difficulties as their currencies declined as much as 18.5% during early 1998. It looks like some of the so- called “Asian Contagion” has spread to Mexico and Canada. On the other hand, Hong Kong has maintained the peg of its currency against the U.S. dollar and is the most stable of Asian currencies during the entire period.

Fixed or Pegged Rates vs. Floating Exchange Rates

In international trading prior to the summer of 1997, it was quite popular for governments in Asia to maintain fixed exchange rates of their currency to the U.S. dollar. It was thought that fixed exchange rates lead to a credible monetary policy, low inflation, and predictable exchange rates enhanced trade and investment. The disadvantages of a pegged currency were that it was often very expensive to protect the peg and it surrendered policy-making flexibility to a fixed exchange-rate policy.

In fact, during the period of the 1960s, 1970s, and early 1980s, the Asian countries actually benefitted from the peg of their currency to the U.S. dollar, because the U.S. dollar was the reserve currency of international trade. This advantage was especially true during the period when the U.S. dollar was depreciating relative to the Japanese yen. As the dollar depreciated, the Asian currencies pegged to the dollar also depreciated relative to the yen, thus, making their goods cheaper than those from Japan. This led to significant increases in exports from Asian countries and increased the economic growth rate of the countries in the area.

However, after the Japanese stock prices and land prices peaked in 1989-1991, the Japanese bubble burst, and the yen began to depreciate relative to the U.S. dollar. This caused fundamental changes and Asian currencies began to appreciate along with the dollar against the yen, reducing the previously favorable price advantages of non-Japanese Asian goods. Other researchers and financial economists have suggested that some of the key elements to the Asian financial crisis were: (1) a decline in economic growth, (2) a high degree of financial leverage (debt), (3) a pegged exchange rates, and (4) a weak financial system with weak bank supervision. For a good analysis of the causes of the Asian Financial Crisis, see Sen (1998).

In fact, the trend has clearly been to give up pegged exchange rates that were so prevalent previously. Finland, Sweden, Norway, Britain, Italy, Spain, Portugal, Mexico, and the Czech Republic have all given up their fixed exchange rates since 1992. In Asia, Thailand, Indonesia, Malaysia, Philippines, South Korea, Taiwan, and Vietnam dropped fixed exchange rates in favor of floating exchange rates since the beginning of the crisis in the summer of 1997.

What have been the impacts on capital markets of the world?

Asian financial crisis also had dramatic impacts upon equity markets around the world. The data in Table 2 provide evidence over the same two periods used in Table 1 in terms of the percentage change in equity values in dollars. In the first column is found the percentage change over the 12/23/96 through 12/22/97 period using Morgan Stanley Capital International monthly returns. It is quite notable that the largest declines in equity values are in the same countries that had the largest declines in exchange rates, namely Indonesia, Malaysia, Thailand, Philippines, South Korea, and Singapore. Also note that the U.S. equities gain 31.73% and the Morgan Stanley World Index gained 14.17% over the same period. However, it is clear that the pegged currency of Hong Kong did not protect its equity market from a significant decline of average share values at 25.81%.

The second column of Table 2 contains the stock market change for the first 9 months of 1998. There were some dramatic reversals in equity values in Thailand and South Korea compared with the year earlier. However, Indonesia and Malaysia continue to suffer steep declines in equity stock prices. Also, there appears to be a strong reversal in the fortunes of the equity markets in Canada and Mexico compared to the previous year. However, the equity market in Hong Kong did not improve, even though they maintain the peg of their currency to the U.S. dollar.

In the far right column is shown the percentage change in equity values from 12/23/96 through 9/2/98, again in U.S. dollar terms. It is clear that the U.S. and European equity values gained dramatically during this period and out performed the return on the World Index for the period. However, dramatic and quite large declines were suffered by most of the Asian equity markets as all exhibited declines when the World Index showed a gain of 14% for the period. The largest decline in equity values again occurred in Indonesia, Malaysia, Thailand, Philippines, South Korea, Singapore, and Hong Kong with each losing over half of their value from the period before the Asian Crisis.

In summary, it appears the declines in equity values were similar to the declines in currency values, except for Hong Kong. There appears to be some evidence of declines in the equity market values in 1998 in some non-Asian countries like Mexico and Canada which might be associated with some form of contagion effect in the countries that had large trading relationships with the affected Asian countries.

Japan’s Role in the Solution

My objective is to review the economic health of Japan and China and comment on the role that these countries might play in the solution to the Asian financial crisis. I will start with Japan as its economic health is an important key to Asia’s recovery. However, my conclusion is that Japan is too preoccupied with domestic economic and political problems to play an important role in the solution. Let me give a few reasons why I draw that conclusion.

First, Japan’s large trade and financial commitments to Asia has hurt Japan: increased financial troubles, reduced exports, lower consumption, and, initially, strong downward pressure of the yen in U.S. dollar terms. In the post-bubble era in Japan, the economic growth has been very weak and the Asian financial crisis has further hurt Japan as most of her trading partners significantly reduced their demand for Japanese goods.

These economic impacts were especially felt in Japan as it was the largest source of direct foreign investment into Thailand. Thus, the decline of the Thai economy was particularly hard for Japanese firms and banks that had invested so extensively there. Also in the post bubble era, the government had not followed a pro-growth policy with regard to domestic demand. Consumer confidence and demand were particularly hard hit by a digressive sales tax on consumer goods. Recently, the government increased the tax rates further hurting consumer demand.

In addition, there have been some major political scandals that have led to the arrests of key government agents at the Bank of Japan and the Ministry of Finance. This has almost been unheard of in postwar Japan. The government desperately needs to restore trust in government officials and their actions. Japan has many problems that need complete economic restructuring.

In a recent book, Katz (1998), calls Japan a “deformed dual economy” with very competitive exporters, but backward and protected sectors like agriculture. Further, he believes that Japan’s savings rates are too high, causing domestic consumption to be less than total production. Together, these stifle economic growth as Japan must continuously run a trade surplus and budget deficit to maintain economic growth.

Japan needs a truly representative political system, a modern financial system, competitive industries free of collusion, and more transparency in trade and investment. The current political system is often paralyzed and can not move forcefully and decisively. Further, the existing parties are not representative of the people who live in urban areas and are too affected by just a few favored constituencies (i.e., agriculture and construction). The financial system is not modern and not internationally competitive and needs to be dramatically modernized. The lack of transparency in trade and investment is dramatic and has been maintained by a large protective government bureaucracy.

The current financial crisis is very real. First, there are banking problems associated with baddebt beginning with the recently announced bailout of Long-Term Credit Bank. The total bad-debt problem has been estimated to be over $575 billion. In early October 1998, the political debate about using tax-payers funds to address this problem has not yet been completely resolved with the new bill submitted by the Liberal-Democratic Party (LDP), the ruling political party in the Japanese Diet or Parliament. These problems have caused the Nikkei in September to set numerous new 12.5 year lows. The index has closed under 13,000 recently. The Nikkei went up over 6% on Monday (10/5/98) when the banking reform bill was presented (it passed the upper house Monday, 10/12/98). The Nikkei went down 6% Thursday (10/8/98) when the yen appreciated dramatically against the dollar.

There is great uncertainty about the speed of recovery of the Japanese economy. Currently, Japan is in recession with forecasted 1998 economic decline of at least 2%, historical high unemployment, and record levels of bankruptcies and credit contractions. Numerous fiscal plans have been suggested and even implemented; however, they have been mostly ineffective at stimulating the economy and restoring consumer demand. In my view, too much of the fiscal efforts have been on building infrastructure projects like bridges and roads that are under utilized. These projects are aimed more at satisfying the construction industry, that is one of the main supporting groups of the LDP, than in stimulating domestic demand for goods and services that will improve economic growth.

Even with a banking reform bill finally passed, there is still some uncertainty about the total funds available and with implementation details. However, we do have some ideas about the Heisei Financial Revitalization Corporation described in Figure 1. This figure was sent to me by Professor Takashi Kaneko of Keio University in early October 1998. It must be said that the schematic shown in the figure is how the process was viewed as of early October 1998. The final resolution scheme currently is being decided. However, it appears that there will be a bridge bank plan that will separate sound borrowers and provide them new loans while loans to unsound borrowers will be transferred to a private receiver bank and the Resolution & Collection Bank. Thus, Japan has finally begun “the long march” to address its banking and economic problems. However, recovery will not be quick, as the banking problem will take several years to solve.

The necessary economic and government restructuring may take even longer.

With banking reform begun, I am now more concerned about the lack of economic growth. The past fiscal plans have not increased domestic demand. Even a permanent tax cut may just increase the already excessive savings. Also the very strong yen recently, will further reduce exports. In my view, the Bank of Japan (BOJ) must increase the money supply and other measures must be taken to stimulate consumption. I was very happy to notice that the BOJ had started buying Japanese commercial paper in addition to their purchase of Japanese government bonds. This move will provide a market for commercial paper or loans to Japanese business firms and adds liquidity to the business loan market. Basically, both fiscal and monetary policy need to work vigorously to solve the banking and economic problems to increase Japan’s economic growth rate.

In summary, Japan will not be helpful in the solution to the Asian Crisis in the short-term. The old “Industrial Policy” models of mandarin government edicts, excessively high savings, and a deformed dual economy are no longer effective. There needs to be a new model for the future, but Japanese politicians appear to be having great difficulty thinking radically about a new system, much less passing and implementing significant reforms. Yes, initial steps have been taken, but the current process is too slow to provide any economic help to Asia before mid 2000.

China’s Role in the Solution

Since it appears that Japan will not be a major player in the solution to the Asian Crisis, what about the role of China in the solution? In my view, China will gain “political capital” by showing effective leadership as it maintains the peg of its currency to the U.S. dollar and tries to stabilize Asian trade and investment flows. China hoping to gain WTO membership and to avoid another round of reactive devaluations in Asia, will continue the peg until the end of 1999. Further, the sudden strength of the yen recently versus the US dollar (if it holds), will help relieve some of the pressure on the HK dollar and the renminbi. A strong yen will make China’s exports appear not to be so highly priced. Estimates of the Chinese growth rate still remain positive in the 5-7% range. If these growth rates are maintained, China will continue to be a positive engine moving towards a solution to the crisis.

However, China has significant economic problems that may yet put the HK dollar under extreme pressure. Some of these economic problems should be described. The first and most important is the attempt of the Chinese government to privatize the state-owned industries in China. These industries are very large, employ many citizens, and are very inefficient. Thus, the privatization scheme will have to be managed very carefully as it will increase unemployment. Thus, if the pace is too fast, unemployment will rise causing unrest and potentially reducing the economic growth rate.

In August 1998, there were huge and disastrous floods in two separate parts of China. The government will have to make large expenditures to replace the damaged infrastructure destroyed by these climates. Further, the government now acknowledges that some of the negative aspects of the floods were caused by the government’s own deforestation projects in the upper portions of the Yangtze water shed areas. They have made promises to plant a significant number of trees in the area to reduce future flooding. Thus, the government has committed significant financial resources to offset the damages of the devastating floods that occurred in August.

Further, the massive modernization expenditure plans that range from three gorges dam project to plans on recapitalizing Chinese banks may be too ambitious. The failure of the Guangdong International Trust & Investment Corp. ($2.4 Billion debt given to Bank of China to take care of) in October 1998 indicates potential problems with Chinese banks. The extent of the financial problems in the Chinese banking system is not well known, but the signs that are available are certainly ominous and suggest that the problems may be quite large.

There are some special concerns about Hong Kong that need to be mentioned. First, the Hang Seng Index of stocks listed in the Hong Kong Stock Exchange hit its peak of 16,000 in mid 1997 and has been in decline ever since. It traded below 8,000 (a 50% decline) in late August 1998. However, on August 28, 1998, the government purchased about $ 10 billion U.S. dollars of equities on the market to try to reduce the decline. It has not been considered to be a good policy for governments to try to stabilize equity markets by direct purchases of equity shares. Thus, this policy looks misguided. Hong Kong’s GDP had been growing consistently and reached a peak of more than 7% by mid 1997. However, the GDP growth rate declined dramatically in the 3rd and 4th quarters of 1997. In 1998, the Hong Kong GDP has been negative, clearly indicating a recession is occurring.

Finally, there are many cases of clumsy handling of problems by the new Chinese take-over government of Hong Kong. As everyone knows, Hong Kong reverted to Chinese territory in the summer of 1997. Under Chinese governmental rule, there have been many indications that the new government is not always up to the task of managing effectively. For example, in the fall of 1997, language education was quickly shifted from Cantonese, the major dialect of southern China and Hong Kong, to Mandarin, which is the dialect of northern China and the official language of the PRC. In early 1998, there was the famous avian flu scare that shook Hong Kong. The government perhaps over reacted and ordered every chicken to be killed in Hong Kong and would not allow the importation of chicken. Finally, in late July 1998, a new airport was opened in Hong Kong, but it was clearly not ready as there were immense luggage and cargo problems. This was particularly difficult as Hong Kong had made a good reputation on being the most efficient handler of air cargo in Asia. That reputation was lost and will require some significant time before it can be rebuilt. The first year after Hong Kong was returned to China has not been very smooth as there have been many cases illustrating that the new Chinese government has clumsily handled many of the problems that have arisen.

In summary, the Chinese government has many problems and issues to face and resolve. However, it has pledged to maintain the peg of their currency to the U.S. dollar and this has added some necessary stability to the region. As long as the peg is maintained, another sweeping round of currency devaluations in the region will be avoided. As time passes and the peg is maintained, the other Asian economies will be given some time of stability in which to repair their economy and to take the necessary steps to reestablishing the strong positive growth for which Asia has been famous for during the postwar era.

Summary and Conclusions

In my view, Japan will not be helpful in the solution to the Asian Crisis in the short term as it is too preoccupied with its own problems. It is clear that the economic miracle which had characterized Japanese economy up until 1990, has begun to sputter, indicating that it is in serious need of massive restructuring to return healthy economic growth. However, Japanese politicians appear to be having great difficulty thinking radically about a new system, much less passing and implementing significant reforms. Some initial steps have been taken, but the current process is too slow to be of any help to their Asian neighbors who are in most need of their assistance.

However, China will play an increased economic and political role in Asia, especially if they continue their positive growth and maintain the peg of their currencies to the U.S. dollar. It is my view that China will maintain the peg at least until the end of 1999, if not beyond. In conclusion, China will play an increased role, both politically and economically, to solve the Asian Crisis by maintaining the peg until the end of 1999. By that time, a few countries (Thailand and Korea) will be on the road to recovery and Japan may begin to play a stronger role in 2000.


Katz, Richard. Japan: The system that Soured, M. W. Sharpe, Armonk, New York, 1998.

Sen, Surya. “Analysis of financial crisis in Asia,” Chicago Fed Letter, December 1998, #136a, The Federal Reserve Bank of Chicago.

Richard H. Pettway

University of Missouri-Columbia

Copyright College of Business Administration. University of Detroit Mercy Fall 1999

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