Condivergence: Strategising finance in national development

This article first appeared in Forum, The Edge Malaysia Weekly, on December 14, 2020 - December 20, 2020.
Mumbai, India ... India and Latin Americans preferred the self-help strategy, supplemented by an import-substitution industrialisation strategy

Mumbai, India ... India and Latin Americans preferred the self-help strategy, supplemented by an import-substitution industrialisation strategy

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After the Second World War, development strategy came into the fore as many independent nations had to think about how to deliver better jobs and incomes for their citizens.

There were essentially three schools of thought. The first was the Adam Smith-inspired neoliberal free market philosophy that was pushed through the Bretton Wood institutions, International Monetary Fund (IMF) and the World Bank. Second, Mahatma Gandhi in India and Latin Americans preferred the self-help strategy, supplemented by an import-substitution industrialisation strategy. The third path, which the Japanese led with the backing of America, was the export manufacturing model, which East Asia followed with great success.

Finance theory was also American-driven. The most influential was Gurley and Shaw’s work on financial deepening (Money in a Theory of Finance, 1959), influenced largely by statistician Raymond Goldsmith’s study of American savings and financial intermediaries, including the first Flow-of-Funds System of National Accounts, 1939-54.

Money and finance cannot be separated from the real economy. By the 1970s, the most influential finance work was Ronald McKinnon’s Money and Capital in Economic Development (1973). When the US dollar was de-linked from gold in 1971, the growth of flexible exchange rates and free markets opened up the risks of inflation, credit expansion and financial crises.

In 1978, the economic historian Charles Kindleberger warned about Manias, Panics and Crashes in his great work on the relationship between domestic monetary and financial policy within a US-based international financial system.

Notice that finance theory and practice revolved essentially around an American theory of how finance works. This may well be changing in a multi-polar world.

In the 1970s, Asian finance was still local banking-based, with the British banks, Hong Kong and Shanghai Banking Corporation and Chartered Bank having the largest branch network across the region and doing mostly trade finance. Even though the Japanese banks were the largest in the region, they mainly stayed home.

American banks like Citibank began to expand their operations to follow American multinationals, and to facilitate US dollar business. They went after corporate banking, foreign exchange trading and private banking areas that the British and local banks neglected. As the four Dragon economies (South Korea, Taiwan, Hong Kong and Singapore) prospered, the local companies began to engage more in international trade and needed dollars.

By the 1980s, as Japanese growth peaked and their outward expansion moved beyond the Four Dragons to invest in the Four Tiger economies (Malaysia, Thailand, the Philippines and Indonesia) for cheaper labour, the East Asian region became more internationalised. The outflow of capital from Japan accelerated after the Plaza Accord (1985) when the yen appreciated against the US dollar, helping to make Hong Kong an emerging regional financial centre.

Malaysia became the darling of the emerging stock markets when oil and gas went on-stream even as palm oil and electronic assembly exports rose. British investment banks like Barings, Jardine Fleming, and a new Hong Kong house called Peregrine, made their names in the stock markets and mutual funds, and by financing Hong Kong tycoons to take over British firms.

During this period, Japanese banks became big financiers of Japanese manufacturers and their local suppliers as their supply chains moved to Thailand, Malaysia and beyond. South Korean manufacturers also borrowed aggressively to expand their market shares. Property markets boomed across Asia with the increase in liquidity. When the Latin American debt crisis erupted in the 1980s, global investors shifted their attention to East Asia. European banks also arrived to participate in the Asian growth story.

Attracted by new Asian wealth, the leading American investment banks made their presence felt, led by Goldman Sachs, Morgan Stanley and Merrill Lynch. Asset managers such as Fidelity succeeded in selling mutual funds to middle-class Asian investors. Asian policymakers developed their institutional investor base too late to capture the demographic savings dividend. Long-term institutional funds are the “spare tyre” that could have softened what came to be known as the 1997 Asian financial crisis (AFC).

Most observers missed the fact that the AFC was the first modern global financial crisis. In 1991, hedge fund manager George Soros made US$1 billion speculating against sterling. In 1994, the Mexican crisis happened when the peso was devalued sharply after large capital outflows.

The “carry trade” enabled speculators to borrow heavily in one currency and invest in another on a highly leveraged basis, taking advantage of interest differentials and betting on central banks maintaining fixed or pegged exchange rates. When they suspected that the rate could not be defended, they shorted the local currency and assets, making a fortune, but sometimes triggering off a systemic crisis.

One fundamental weakness of the Asian supply chain was that it was dollar-based in operations but funded through Japanese yen credit. Thailand was the classic beneficiary of Japanese investments and credit, as locals used the inflows to invest in stocks and real estate, repayable through higher asset prices.

It was a Ponzi cycle, borrowing until you reach too-big-to-fail status. The corporate sector went on a debt binge, and everyone profited as long as the asset bubble kept on going up. When the music stopped, no one had dollars to repay the debt and the asset bubble became an asset bust. Bad borrowers ended up killing bad finance companies and their bankers.

The AFC was a combination of at least three mismatches — maturity, foreign exchange and leverage (debt/equity). Asian corporations borrowed short to invest long. They borrowed foreign exchange on the basis that the exchange rate would be stable. They were hugely leveraged because equity was more expensive than debt and they did not want to lose corporate control to outsiders.

The result was a perfect storm when the baht was devalued, as the Bank of Thailand did not have enough foreign exchange reserves to defend the exchange rate. A rise in the interest rate to defend the currency caused the stock market to crash, which then pricked the asset bubbles. Everyone ran to hide in US dollars, but the US Federal Reserve, as lender of last resort for dollar operations, was not willing to supply dollars until 1998, when it became clear that even the US would suffer if the AFC got out of control.

When the IMF was called in, it did not realise that the AFC was a network crisis, because the Thai crisis triggered crises in Indonesia, Malaysia and South Korea, and also impacted Hong Kong. Furthermore, the orthodox medicine of cutting budget deficits and devaluing only exacerbated the deflation, because reduced fiscal spending worsened the liquidity shortage.

Mentally, the IMF was still advocating liberalisation of the capital account as a matter of official policy. As long as the economic orthodoxy was free markets, there was little collective understanding of how market forces created havoc in a situation of hugely flawed balance sheets.

Although the popular press blamed hedge fund speculators, half the outflows were due to Japanese banks cutting their dollar positions as their own balance sheets were suffering from capital inadequacy due to loan losses in their home market. Since dollar borrowers could not repay their loans, everyone scrambled for dollars by selling local currency, causing very tight liquidity and higher interest rates. Confidence could not be restored when capital flight was more profitable than staying in over-priced local currency assets.

When the panic was over, many large borrowers bought back their debt at huge discounts.

To sum up, there was a fourth strategy mismatch, in the sense that markets had become so inter-connected and interdependent that local businesses, banks, financial regulators, and even the IMF or World Bank did not understand that these markets and business models were unsustainable, and that could only end up in crises. As my book, From Asian to Global Finance Crisis (2009) revealed, financial crises also had political origins. If vested interests controlled the politics, the mindset was not to rock the boat, and instead of preventative regulation, everyone drifted towards crises.

The same mistakes were repeated in the 2007/09 global financial crisis, when the advanced countries did not appreciate how leveraged and inter-connected their financial systems had become. The Americans underestimated the scale of greed and leverage in their sub-prime mortgage crisis, but were quicker to recapitalise their banks. The Europeans thought the crisis was American-based, forgetting that it was their banks that borrowed US dollars to fund their American derivatives.

Then the Southern European debt crises erupted, exposing the frailties of a fixed exchange rate system where the deficit countries could not devalue their way out of trouble. With Northern European surplus countries refusing to bail out their deficit member countries without austerity, the European crisis turned out to be longer and deeper than everyone expected.

All four mismatches were present. Essentially, the best and most advanced regulators and policymakers had little appreciation of how interconnected their financial markets had become. But then they discovered quantitative easing (QE), the capacity of central banks to expand their balance sheets and create “magic money”. The cure, creating more debt to solve excessive debt, was to expand even more debt leverage, bring interest rates to the lowest levels in history, create asset bubbles and exacerbate social inequality. This sowed the seeds of today’s political crisis.

Politicians missed a golden opportunity to reform because central bankers gave them a blank cheque and easy way out. Everyone drifted and patted themselves on the back until 2016 saw Brexit, Donald Trump, and the rise of populists. With divided politics, weak governments relied on central banks’ “whatever it takes” to keep the economies afloat, but there was only anaemic growth and little good job growth. And then the pandemic hit in 2020.

We are now in a triple political, medical and economic crisis, overlaid with disruptive technology and serious climate change issues. The geopolitical situation is very tense, but may improve with the incoming Biden administration. However, even with the vaccine, the pandemic peak is not over, whilst many economies are in deep trouble.

The pandemic has moved activities online faster, worsening the digital divide, as many workers and small businesses are simply not equipped to do so. In the meantime, we are undergoing the hottest years on record, which means climate change will lead to more natural disasters and viral or disease outbreaks.

The only institution that stands between the abyss and survival currently are central banks. At zero interest rates, retail investors are shifting out of deposits and bonds into speculative equity, with stock prices at valuations that are high by any standards.

Complexity scientist Eric Beinhocker argued in Origin of Wealth (2007) that wealth creation is the product of three factors — physical technology (science), social technology (institutions, networks or social organisation of human activities) and business models. For each part to work requires good strategy, but we are operating in huge unknowns, because we lack data and models that takes into consideration fickle human psychology.

Technology is disruptive, because with the rise of cyber-currencies (private technology-based money), no one is clear how retail and institutional investors will manage their portfolios. At zero or negative interest rates, the price of money is no longer an efficient allocator of resources because central banks are now the largest buyers of government securities, mortgage and corporate paper, and the financial markets depend more on central bank policies.

But central banks claim that they do not want to get involved in resource allocation, as this is a ministry of finance or political prerogative. So, if politics drive US-China relations, will global markets still be allocated according to market forces? For example, with US-China thinking of supply chain and technology decoupling, how will asset managers cope if investors and intermediaries are subject to sanctions for geopolitical reasons?

What I do know is that having a good flexible strategy and business model that can operate under these uncertain conditions will perform better than just thinking that the market knows best.

Asian financial regulators and policymakers will need to understand much better how financial markets and investors are responding in this complex environment to prevent or manage the next crisis. This is where large, long-term pension and insurance funds will be important spare tyres in future crises.

Crises behave like the coronavirus. Either control the virus, or be controlled.


Andrew Sheng is a former central banker and financial regulator. The views expressed here are his own.

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