More Lessons From East Asia

I would certainly support the proposition that there are implications relevant to India in the recent East Asian crisis. However, to look for these independently of the factors that led to the high-growth performance of these economies raises the possibility of being misled. Instead, I would argue that the reasons for the success and the crisis are inter-related. And, despite the differences between the Indian and East Asian (I use this collective term purely for simplification) development strategies, there are some structural outcomes common to the two systems, which should cause us some concern about our own vulnerability.

To elaborate, let me invoke the distinction between the financial and real (or production) sectors in the economy. The function of the former is to allocate financial resources across different activities, based on some considerations of risk and return. The role of the latter is to deploy these financial resources into production activities from which the earnings generated are consistent with the financial sectors views on risk and return. The relationship between the two, in the absence of any intervention, is reflected in short-term movements in asset prices and long-term movements of capital in and out of production activities, depending on changing profitability of activities, and changing perceptions of risk-return relationships.

Intervention changes the nature of the relationship. Both the East Asian and Indian development strategies were premised on scepticism about the financial sectors abilities to allocate resources in consistency with national economic objectives. Thus, in both situations, governments suborned the financial sector to the production sector, in terms of whose performance the national objectives were stated. In the East Asian case, these eventually converged on exports, and the benefits flowing from the focus explain in large part why those economies grew so rapidly. In the Indian case, they stayed with self-reliance and diffusion of asset ownership, which may have had something to do with our growth performance. Either way, the point is that in both systems, the financial sector was viewed and treated as an entity subordinate to the real sector. Objective risk-return considerations were not, in this scheme of things, the primary basis of its decision-making; National goals were not

to be evaluated in terms of banalities like risk and return.

To make a long story short, the financial sector that emerged in this common, subordinated scenario was characterised by three attributes of importance to this argument. First, partly because the pricing of duration and risk, which are the most important functions of financial markets, were not particularly important, bank intermediation hugely outweighed market intermediation, as everybody knows by now. Second, banks were conditioned into lending money based on signals received from people who were close to the national agenda-setting process, in whatever way. And third, partly as a consequence of the first two, banks did not either have the means or feel the need to effectively hedge their loan exposures.

The point here is that it takes a combination of factors to keep a banking system solvent; adherence to commercial principles of lending; credible monitoring of such adherence; and, low cost hedging opportunities. In the absence of this combination, banks will do stupid things and eventually suffer for it. This is not a uniquely Indian or Asian trait, as the international debt crisis of the early 80s or the US savings and loan crisis in the mid-80s will attest to.

For a long time, the system survived in East Asia, despite its potential vulnerabilities, because of the credible weight given to export performance as a criterion for lending. Despite diversion of funds let for promised export activities, by and large, the governments close scrutiny of export performance made lending to such enterprises a less risky affair than it otherwise would have been. In India, banks exposure was, to an extent, mitigated by fragmentation of their loan portfolios; countless numbers of small loans made to small farmers and businesses, spread across regions and activities. This was, of course, combined with budgetary support to ensure that loss-making banks remained solvent.

What made the edifice crumble in East Asia? The specifics would depend on which country we are talking about, but there were several common elements. A weakening of government security of exports as the economies went through structural changes, allowing the banking system to be captured by other objectives, e.g. the conglomerates in Korea or the cronies in Indonesia; a falling off of export earnings in most of the East Asian countries, because of Chinese competition, rising wages, and other factors; and, related to the first two, a propensity for speculative lending by the banks. Indian banks are somewhat better off in this respect; they are not as exposed to one single activity like exports, as the East Asian banks were, and (with certain well known exceptions), have not generally financed extremely risky activities like films. But that doesnt mean that they are not vulnerable to a shock; drought, oil prices or any other recessionary impulse.

The underlying cause of the East Asian crisis was the inability of the previously subordinated financial system to transit to a regime in which the terms of its relationship with the real sector had changed. It suffered from two problems; incomplete markets and inadequate supervision. From a policy standpoint, there are two problems; incomplete markets and inadequate supervision. From a policy standpoint, there are two alternative positions stemming from this. One, we can accept these problems as binding, as persisting in the long run, and condition our other policies around this fact. Which would imply, among other things, protection and continuing budgetary support of financial institutions, and insulation from foreign resources. Or, we could make this the direct target of policy by trying to fill in the gaps; creating and nurturing the markets that would support the banking system and removing the discretionary element from the supervisory system.

The basic message from the East Asian crisis is that we cannot have a financial sector that is too far out of line with the real sector. It is illogical to be increasingly subjecting the real sector to market forces on the one hand, while on the other, to be expecting that a non-marketised financial sector will be able to cope with changing conditions and changing demands for its services. If we accept the proposition that increasing marketisation is the only possible long-term trend for the real sector, then we must accept that this is the only possible trend for the financial sector as well.