Some of the most important economic problems in the world in recent times have been posed by 'financial liberalisation', with the rise of 'finance capital' in the last two or three decades.

The deepening of financial markets, especially after the demise of the Bretton Woods system, closely associated with the post-war Golden Age when there was relatively rapid growth, and some decline in inequality, not only internationally, but also within most economies, partly due to social policies in Europe and Japan.

The promotion of financial liberalisation has had very serious adverse consequences for the developing world, undermining financial arrangements, institutions and relations conducive to overcoming economic backwardness and market failure problems, as suggested by Alexander Gerschenkeron and others.

This would also contradict the Keynesian dictum that where industry leads, finance follows. To make matters worse, the current advocates of financial liberalisation have ignored the warnings of the gurus of financial liberalisation.

For example, McKinnon emphasised that correct sequencing is of the essence in pursuing financial liberalisation, and capital liberalisation should come last, rather than first - as has happened in some economies including those in East Asia before the 1997-98 debacle.

Impact of devaluation

Financial liberalisation seemed attractive because of its apparent association with the regional boom from the late 1980s. In much of Southeast Asia, a series of devaluations in the Malaysia-Indonesia-Thailand (MIT) economies and some financial liberalisation in the mid-1980s was followed by a decade-long boom from the late 1980s until the 1997-98 crisis.

There were three devaluations in Indonesia, one in Thailand, and another in Malaysia - with its devaluation against the US dollar reducing the value of the Malaysian ringgit by half against the Japanese yen. This series of devaluations made production costs much cheaper in the MIT economies , and provided one basis for the boom.

But the US dollar pegs of the MIT currencies became much more problematic after mid-1995, when Eisuke Sakakibara, then Japanese Vice-Minister for International Affairs in the finance ministry, and then US Deputy Treasury Secretary Larry Summers agreed to let the US dollar appreciate against the Japanese yen.

Devaluation as well as its consequences and other policy changes accompanying devaluation were also important for the boom in this region. The Japanese Ministry of International Trade and Industry adopted a new Asia Industrial Development regional policy, encouraging Japanese firms to relocate, not only in the East Asian newly industrialised economies of South Korea, Taiwan, Hong Kong and Singapore, but especially in the Southeast Asian MIT newly industrialisng countries as well as China.

Towards the end of the Chiang Ching-kuo era and with Lee Teng-hui's presidency in Taiwan, the Taiwan government encouraged Taiwanese companies to 'move south' to Southeast Asia, instead of the mainland, fearing problems from closer integration with the mainland.

Korean efforts to relocate in Southeast Asia were much more modest and largely limited to Indonesia and Vietnam. Singapore's Sijori (Singapore-Johor-Riau) growth triangle initiative with neighbouring Johor in Malaysia as well as Riau in Indonesia from 1986 was followed by other efforts to integrate with China (e.g. Suzhou) and India (e.g. Bangalore) with rather mixed consequences. Meanwhile, Hong Kong was de-industrialising, with manufacturing relocating to the Pearl River delta and beyond.

The impact of financial liberalisation in East Asia has proved to be disastrous, starting with the fall-out of the Big Bang in Japan in the late 1980s and the moribund economy which has emerged in the decade and half since.

Korea accelerated capital account liberalisation to join the Organisation for Economic Co-operation and Development (OECD) in the early 1990s, distorting the financial incentives for Korean conglomerate or chaebol behaviour, again with disastrous consequences. In Indonesia, bank proliferation from 1988 undermined monitoring and supervision with cataclysmic consequences. In Thailand, the post-coup 1993 Bangkok International Banking Facility and its 1994 provincial counterpart had problematic consequences culminating in the 1997-98 regional crisis.

After a serious banking crisis in the late 1980s, when the share of non-performing loans reached 30 percent of the total commercial bank loan portfolio, the Malaysian authorities became more cautious with bank regulations. While cautious with foreign bank borrowing, the Malaysian authorities promoted its stock market, especially after the break with the Singapore stock exchange in 1990.

These successful efforts to promote the stock exchange in Malaysia attracted tremendous inflows of portfolio investment funds, particularly in the 1992-93 period, which were subsequently reversed with adverse consequences at the end of 1993. In early 1994, the Malaysian government - with Anwar Ibrahim then the finance minister - introduced capital controls on inflows. These were subsequently removed after intense lobbying leading to a new stock market bubble in 1995-96 attracting fresh inflows.

Adverse effects

But has international financial liberalisation delivered on its own promises rather than by developmental criteria? Advocates of international financial liberalisation have made three major claims.

1) There should have been flows of funds from capital rich to capital poor economies. But for most of Latin America, Africa, Asia, and the so-called 'transitional economies', the net flow of funds has actually been in the opposite direction, from the poor to the rich economies. East Asia was an exception in the early and mid 1990s, as finance followed investment and growth.

2) Financial liberalisation promised to lower the cost of funds. However, the cost of funds has not gone down, but has actually gone up, increasing financial rents in the OECD economies at least.

3) Financial liberalisation also promised lower volatility and greater stability with financial deepening, especially with the development and availability of new financial derivatives.

However, although some new financial derivatives have reduced some old sources of the same, they have also induced new sources of volatility and instability. The most well known example has of course been the consequences of hedge funds, particularly in this region (Brouwer, 2001).

Two other adverse implications of international financial liberalisation should also be mentioned here. Financial liberalisation has generally meant that financial interests - which, by nature, tend to be antagonistic to inflation - have become far more influential. They have influenced public policy, with typically deflationary consequences.

The fad over the last two decades for having more ostensibly 'independent central banks' has actually reduced the monetary policy powers available to governments, besides reducing financial policy instruments for economic development.

The recent emphasis on 'inflation-rather than growth or employment-targeting' has also resulted in employment expansion and slower growth by prioritising deflationary macroeconomic policies. The demise of financial 'industrial policy' instruments with financial liberalisation has also been crucial as they have been important for accelerating industrialisation and other desired structural transformations. Such instruments and institutions would basically be eliminated by financial liberalisation.

Massive capital inflows associated with financial liberalisation are often presumed to somehow have desirable consequences for economic growth. However, there is little empirical base for believing this. By their very nature, short-term inflows rarely contribute to real capital formation, and hence, investment and growth. Many countries have adopted monetary policies (e.g. 'sterilisation') to limit the adverse consequences of massive capital inflows into their economies, but these also reduce possible gains from the inflows of funds into a particular economy. The claim that massive capital inflows would be desirable for economic development is thus grossly exaggerated.

Instead, they have often had adverse consequences. First, there have been asset market bubbles - mainly stock market bubbles and property market bubbles - and associated construction booms, which have often worsened trade deficits. Second, consumption binges may be fuelled by cheap credit, e.g. the number of BMWs and Mercedes-Benzes sold in Thailand during the mid-1990s rose by leaps and bounds. Not surprisingly, the elite and middle classes like and support such financial policies, which basically do not contribute to the long-term development of these economies. Third, the availability of more and cheaper funds may have resulted in some misallocation of investment funds. While this may be true in some instances, their actual significance is often greatly exaggerated by casual commentary citing misleading anecdotal examples.

Build-up to crisis

Various circumstances contributed to the build-up to the 1997-98 crisis, including international financial liberalisation and the mid-1995 Sakakibara-Summers reversal of the previous decade's rising yen. With this realignment, currency speculators began to look for new opportunities to take advantage of. With foreign credit cheaply available, powerful vested interests in Southeast Asia wanted their currencies still pegged to the US dollar, although such pegs now rendered the Southeast Asian economies less competitive.

The foreign debt building up was mainly short-term, rather than long-term, primarily due to the Bank of International Settlements' capital adequacy regulation encouraging short-term lending. Stock markets all over the world, especially in 'emerging markets', are especially fickle and vulnerable to 'herd behaviour'. Significant build-ups of foreign assets in regional markets increased the likelihood of contagion from abroad. In Southeast Asia, such 'external shocks' were exacerbated by the official policy responses of the authorities in the region, compromised by influential vested interests. 'Cronyism' alone could not have caused the debacle.

Vulnerability to market forces had greatly increased with ill-considered economic liberalisation policies, especially financial liberalisation. Also, the initial policy responses in the region were 'pro-cyclical' as recommended by the international financial institutions, especially the International Monetary Fund (IMF) and desired by 'market' pundits in the business media.

Such pro-cyclical policy responses exacerbated the situation in Southeast Asia. Western-trained economists had grown up on currency crisis theories which do not take cognition of the different circumstances which existed in the region, in contrast, for instance, with Latin America. Also, many policies recommended to - or even forced upon - governments in the region were politically biased. For instance, the IMF favoured the Berkeley mafia in Indonesia, and acted largely on their advice rather than on the basis of an informed independent assessment of conditions in Indonesia.

By early 1998, however, it was clear that IMF 'solutions' were part of the problem, and there was a significant shift away from the original 'currency crisis' diagnoses of the Asian crisis. Instead, Asian values and business practices were blamed, especially poor 'corporate governance'. Thus, social capital and corporatism became cronyism, and profit maximisation became rent seeking, as the earlier alleged bases for the East Asian miracle was turned on its head.

In the first year of the crisis, the tendency among pundits, particularly in the international business press, was to blame the victims - to condemn the East Asian economies for alleged malpractices among others. After the first year, in the third quarter of 1998, then US President Bill Clinton and others started talking about the desirability of a new international financial architecture, recognising that the international monetary and financial system had developed in an ad hoc fashion since the Bretton Woods system was destroyed by President Richard Nixon in 1971.

This change of heart seemed to be encouraged by the apparent spread of the crisis to Russia in August 1998. The crisis in Russia precipitated the collapse of the Long-term Capital Management (LTCM), a hedge fund based on the 1997 Nobel economics laureate winning financial model. Fear that the LTCM collapse would have major repercussions on Wall Street encouraged the US Federal Reserve (Fed) to co-ordinate a bail-out of LTCM by private parties. The US Fed then lowered interest rates, reversing the outflow of funds from East Asia in the last quarter of 1998, helping economic recovery in the region.

Changing landscape

The economic recovery in the following period, especially in 1999 and 2000, was strongest in South Korea. In Southeast Asia, the recovery started later, but was stronger in Malaysia, compared to Thailand and Indonesia. When the Malaysian government introduced capital controls in September 1998, orthodox economists insisted that capital controls would be disastrous in consequence. Although it is not possible to definitively attribute Malaysia's stronger recovery to the capital controls, there is also no proof that the capital controls caused any significant harm to the Malaysian economy.

We now live in very different international circumstances from earlier times, particularly during the boom years in East Asia since the 1960s. In the 1990s, for instance, more than 80 percent of foreign direct investment consisted of mergers and acquisitions (M&As) - in this part of the world, it mainly consisted of acquisitions, rather than mergers. World FDI has also declined since the late 1990s. Much more FDI to East Asia now goes to China, with the proportion rising in less than a decade from under 40 percent to 70 percent.

China's labour surplus economy has meant productivity gains have translated into consumer price deflation there. Consequently, China has become even more competitive, especially with its better industrial policy initiatives. Thus, contrary to conventional wisdom, state-owned enterprise Bao Steel has become the most efficient steel producer in the world, overtaking Pohang Steel Corporation. China has thus become a diversely formidable and versatile economic force, not only in the region, but in the world.

A major problem in East Asia is our relatively poor understanding of past successes as well as failures. This has meant that post-crisis economic liberalisation policy reforms have continued despite increasing criticism of the Washington Consensus. There is still far too little meaningful regional co-operation in East Asia cognizant of the region's diversity, characteristics and environment.

We need to better understand our circumstances and conditions. We need to better understand our past in order to better comprehend the present and prepare for the future. To do so, we will not only need much more critical understanding, but also much more original and creative thinking to better chart economic policy for the region.

We need to create the conditions for continued economic growth and transformation to sustain economic development and to ensure greater justice in the region by reducing inequalities. With greater global awareness, we will need to address not only disparities within countries, but also among countries in the region, and between this region and the rest of the world.

Endnotes

1) An exceptional chapter - authored by Joseph Stiglitz, who won the Nobel Prize for economics in 2001 - acknowledged that 'directed credit' had succeeded.

2) In 1973, Edward Shaw and Ronald McKinnon developed their critique of 'financial repression' based on the case of Korea in the 1960s. Ironically, contrary to what their works suggest, savings and investment rates actually rose in the peninsula despite its ostensibly repressed financial system, which had emerged under the military dictator Gen Park Chung Hee.

3) The devaluation of the US dollar during the second Reagan administration is now being emulated by the second George W Bush administration in yet another attempt to try to devalue its way out of the current problems of the US economy following Nixon's withdrawal from - and destruction of - the Bretton Woods system in 1971 and the Plaza (Hotel) accord of September 1985.

4) In Singapore, which has not had much in terms of trade policy, financial policy has seen the emergence and growth of institutions such as the Development Bank of Singapore, in its early role, while other financial policies have also been important for 'catching up'.

5) It made sense to invest in D-RAM production in the late 1980s, when a unit price well over US$80. Not surprisingly, a great number of Korean and Taiwanese firms went into D-RAM production, driving down the unit cost to under $2 by the mid-1990s. With the benefit of hindsight, it is easy to criticise 'over-investment' or misallocation of resources, but that was certainly not foreseeable at the time of investment. In any case, pro-cyclical market tendencies (e.g. capital following growth, finance following investment) tend to exacerbate such problems.

Part 1 was published yesterday.

JOMO KS recently retired as an economics professor at Universiti Malaya to take up the post of United Nations assistant secretary-general. This article is based on a lecture he gave in November at the National University of Singapore's Asian Research Institute.