In my last article “Enduring financial distress and delivering a successful restructuring” (Issue 1318, May 11), I alluded to the fact that successful business restructuring is dependent on the recovery of the economy and resolution of the economic crisis. We observe that economic crises differ from one another in respect of source, severity and duration but there are common themes and past solutions that are worthy of consideration. Evaluating the relevant lessons from economic history provides useful clues for resolution of the current economic crisis.
Japan during The Great Depression
The proponents of Rethinking Economics initiate the discourse in this article with a lesser-known lesson from economic history — that of Japan’s following The Great Depression, an unconventional choice as Japan is today associated with failed economic policies following the bust in the 1990s.
Japan experienced the deepest economic downturn in modern history during 1930 to 1932. The earlier government had deliberately adopted a deflationary policy in order to eliminate weak banks and firms to prepare the nation for the return to the pre-war gold parity (fixed exchange rate in today’s context). On Dec 13, 1931, finance minister Korekiyo Takahashi completely reversed earlier government policies by taking the following actions and policy responses:
• Ending the gold standard and the fixed exchange rate, and floating the yen, depreciating it.
• Fiscal expansion financed by government bond issues with monetisation of the fiscal deficit whereby the Bank of Japan bought up newly issued government bonds.
• Monetary expansion and low interest rates.
As a result of the above, the Japanese economy began to recover in 1932 and expanded relatively strongly. Takahashi is called “Japanese Keynes” and had adopted Keynesian policies even before John Maynard Keynes wrote the famous General Theory in 1936.
Malaysia and the Asian financial crisis
Similar patterns as in Japan during the early 1930s can be discerned in Malaysia’s response to the Asian financial crisis (AFC). At the initial stages, there were missteps beyond the well-documented issue of defending an overvalued currency and increasing interest rates. Among them was the prediction of the depth of the recession. A leading economist recently shared that he was called for a meeting with the then minister of finance to discuss economic projections and he recounted the forecasts were completely overoptimistic and the recession was far worse than anticipated.
The proponents of Rethinking Economics have pointed out that advanced models used by economists, though touted to be dynamic, in reality tend to be linear and do not address the effects of changes in the outputs on inputs — they do not have feedback loops. Additionally, they do not model an important component of the capitalist economy — the banks.
Similarly, there was overconfidence in the strength of the banks based on the reforms carried out following the mid-1980s crisis and also the strong profits banks enjoyed in the 1990s. An important lesson here is not to be overconfident in historical data when the situation unfolding is vastly different from the period the accounts were produced and there is a lag between the time of business failures and the onset of the crisis.
Unlike Japan, a fixed rate was eventually applied but it was not the earlier unsustainable exchange rate of US$1 to RM2.50. The currency was substantially depreciated to a fixed rate of US$1 to RM3.80, which reversed the trade deficits. Today, the concept of the impossible trinity is better understood — that is, the relationship of free flow of capital, independent monetary policy and stable exchange rate. In Malaysia, we have now accepted the notion that we cannot have fixed/stable exchange rates or absolute free movement of capital. The approach that works for us is an independent monetary policy and free movement of capital but it can be controlled to limit excessive volatility of the floating exchange rate.
Fiscal policy and sociopolitical stability
During times of economic crisis, sociopolitical stability and safety is paramount not just purely from a humane but also an economic perspective. If this is lost, then the business environment and confidence would be severely harmed.
To appreciate this point, during the AFC, the government managed to ensure that political stability was maintained and also prevented massive unemployment, riots and protest, unlike in neighbouring Indonesia. To a great extent, the democratic institutions worked well and provided political stability. The parliamentary process continued throughout, which provided legitimacy for government action.
Monetary policy and liquidity
During the AFC, the Malaysian banks did not collapse as a result of a liquidity crunch as the banks did not have significant US dollar exposure and issues. Any liquidity issues were in ringgit. Therefore, the liquidity issues then were manageable and Bank Negara Malaysia could inject the necessary liquidity into the banking system as a lender of last resort.
Malaysia was able to sharply reduce interest rates without causing further volatility to the ringgit, due to the implementation of capital controls (the fact that no black market arose points to reasonableness of the pegged exchange rate and confidence in the value of the ringgit). Additionally, the high interest rate regime at the beginning of the crisis was eliminated, enabling more businesses to survive and not be crushed by high interest rates. There was lesser incentive for borrowers to pare down their debt and this incentivised investment. Further, within a short period, private sector debt grew owing to the growth in the mortgage market.
The increased exports following the currency depreciation and tightening of import and capital outflows resulted in an increase in forex reserves and conversion of net inflows into ringgit, which added liquidity into the economy. Of note, the creation of Danaharta and Danamodal injected additional liquidity into the economy (and is discussed below in detail).
The end result was the growth in money supply, which has a positive correlation with growth in aggregate demand. The government significantly increased the deficit and debt-to-gross domestic product (GDP) ratio, notwithstanding the sovereign rating being near junk bond status as ratings were not of the highest priority. This offset weak private sector consumption and investment. A senior civil servant then in the powerful Economic Planning Unit (EPU) under the Prime Minister’s Department recounted to us how government departments that had not utilised the budget to ensure the full impact of the government’s effort to stimulate the economy were admonished.
The role of the EPU under the PM’s department cannot be underestimated in terms of authority and leadership in resolving the crisis. Further, it is inexplicable why today, despite the success of fiscal policy in addressing crises, there are those who harp on severe concerns that the government has no money and argue their point by referring to borrowing by governments with central banks as being similar to that of businesses and households! Those with the dogma continuously ignore the fact that a government deficit really ends up as private sector savings, thus one must conclude they are ignorant of logic and data. In this regard, we should not forget the much-touted quote during this pandemic, that is “In God we trust, rest bring data”, attributed to W Edwards Deming, the father of modern quality management.
Additionally, the recovery was aided by mortgage lending increasing on the back of low interest rates, which significantly increased aggregate demand. Importantly, it was fortuitous that exports grew sharply due to the decline in the ringgit, hence increasing aggregate demand, which led to the V-shaped recovery.
To fully appreciate the point on effective government response, one only needs to compare Malaysia’s policy response to the crisis in Indonesia, granted our neighbour was disadvantaged by poor International Monetary Fund/World Bank advice and weaker institutions of government there. In the end, it took Indonesia nearly a decade to recover from the AFC.
The critical success during the AFC was a result of clear coordination in implementing the crisis response. The diagram illustrates the approach during the crisis.
As businesses failed, banks turned inward to reduce the increasing losses by recovery action. This would have dire consequences as the liquidity and credit growth would have been choked. The formation of an asset management company, Danaharta, was conceived as a specialist centralised debt resolution agency. However, as Danaharta bought the loans at commercial rates, the banks suffered deterioration in capital as well as due to more stringent impairment criteria. The banks became insolvent, but shareholders were unable to recapitalise; therefore they sought assistance from the recapitalisation agency, Danamodal. Corporate debtors (subject to qualifying criteria) sought the Corporate Debt Restructuring Committee’s (CDRC) help to mediate in negotiations with lenders for a voluntary debt workout. The CDRC initiative had two major benefits. Firstly, it helped rehabilitate borrowers, thus reducing business failures and, secondly, it reduced the amount of loans Danaharta had to acquire, reducing taxpayers’ cost for the debt resolution.
As to capital and liquidity injection into the banking system, it is easy to appreciate Danamodal’s role but Danaharta also played a significant role, which is not generally known. Danaharta effectively bought/managed loans, resulting in AAA bonds replacing non-performing loans (NPLs) in banks, which the banks could then discount with the central bank, and being traded easily as all the bonds issued were AAA. The total value of the Danaharta-related bonds was about RM38 billion (with RM9 billion purchased using zero coupon bonds and an estimated RM28 billion issued in respect of managed loan portfolio size) compared with Danamodal’s RM6.4 billion capital injection.
The large-scale collapse of businesses and liquidation of assets were avoided with the joint restructuring efforts by the Ministry of Finance (MOF), Danaharta and CDRC. These efforts were essential in halting the worst effects of the AFC. Not surprisingly, Malaysia’s efforts during the AFC were commended by international observers and analysts covering the crisis.
“Malaysia has achieved considerable progress in implementing these reforms in comparison to other crisis countries. The approach adopted by Malaysia (and also South Korea) in resolving bad loan problems and restructuring banks involved a high degree of government involvement, which had the advantage of speed and coherence.” (Malaysia: From Crisis to Recovery by Kanitta Meesook, II Houng Lee, Olin Liu, Yougesh Khatri, Natalia Tamirisa, Michael Moore, and Mark H Krysl, Pg 74).
More importantly, the coordinated response was widely communicated, fuelling the return of confidence that is essential for economic recovery. Finally, a key takeaway was the formation of Danaharta brought in fresh talent to assist the government in resolving crisis problems with new ideas.
In the long run, the policies that are implemented during the current crisis need to be assessed because the pandemic has changed the world substantially and business models need to adapt to the post pandemic world. In the short term, Keynesian policies are required as there will be portions of the economy that are both illiquid and need to be in place to prevent a disorderly collapse and prop up aggregate demand through stimulus packages.
However, economies need to avoid the effects of zombie businesses (those that fail to adapt) in the long term and avoid experiencing a lost decade similar to Japan’s in the 1990s. In this respect, the works of Schumpeter and the process of creative destruction he refers to are pertinent. (Crisis Economics: A Crash Course in the Future of Finance by Nouriel Roubini and Stephen Mihm, 2011).
Though there is much discussion on Malaysia’s successful response to the AFC, there should be soul searching on the long-term effects of the policies whereby some industries continue to be riddled with failed business models, including airlines, steel mills, oil and gas companies and the automobile industry. Some continue to survive with state capital, protection from domestic competition through licensing and regulation, exploitation of land and cheap foreign labour. Therefore, it is important that there are plans to address these issues once the economy recovers. As a nation, we must be on guard and not let complacency set in once the crisis is over by being accepting of an underperforming economy.
Applying the lessons
In formulating a response to the Covid-19 pandemic, lessons in economic history merit serious consideration and discourse, and are summarised below.
(i) Appreciate that traditional economic models are not effective during the crisis period. We must be open to other sources of data. We must keep our ears on the ground through continuous dialogue with industries and those at the coalface. In short, there must be acceptance of the severity of the crisis.
(ii) The EPU, which is under the PM’s Department, must be fully responsible for coordinating economic crisis response, but they must work closely with the MOF.
(iii) There must be continuous communication that the response to the crisis is being implemented in a coordinated fashion as well as improvements in corporate governance and addressing corruption, which is critical to restoring business confidence.
(iv) The statutory limit of the federal government outstanding debt instruments should be increased from the current 55% of GDP to enable deficit spending until there is sustainable economic growth.
(v) There should be cognisance that when the crisis passes, there should be acceptance that creative destruction is required to allocate assets to the efficient sectors of the economy and zombie businesses should not be allowed to flourish.
(vi) There should be loosening of monetary policy until economic growth is reinstated and sustained.
(vii) Revamp bankruptcy legislation as well other enabling legislation to ensure that the legal system is suited to deal with issues arising from the crisis.
(viii) Act swiftly and decisively, but consider a variety of viewpoints as the solutions can come from multiple sources. Therefore, create teams with diversity and not just from the usual suspects.
We as humans have the ingenuity to solve problems and overcome them but if we underestimate the problems (better to be prudent) and ignore the lessons of history, then we are headed for failure. There is now, more than ever, an urgent need to consider and discuss how policymakers rethink economics in this crisis with reference to economic history. Paul Samuelson, widely recognised as one of the greatest economists of the last half century, said:
“Have a very healthy respect for the study of economic history, because it is the raw material out of which any conjecture or testing will come from.”
Datuk Mohd Anwar Yahya is a partner and an executive director at Sage 3, a boutique corporate finance advisory, and currently serves on the boards of directors of several Malaysian public and private corporations. He has over 25 years of experience in public policy, corporate finance and strategy at a Big Four accounting firm.