Creative Destruction? After the Crisis:
Neo-Liberal ‗Remodeling‘ in East Asia
by Jeffrey Stacey
From the mid-1990s forward, an array of states already exposed to the mixed blessings of financial globalization have been buffeted by a new threat to their economic security, viz. ―twin‖
2financial crises: comprising bank sector insolvency and balance of payments problems. Under
the permissive condition of high capital mobility and rapid reversals of short-term investment inflows—touched off by sizable oscillations in investor confidence and punctured asset market
3bubbles—have afflicted an array of states with contagion. This arguably novel phenomenon has
been correlated with numerous factors and the focus of a robust debate as to its precise cause;
4somewhat less in contention are its consequences.
Although few states are wholly immune to contagion, be its effect direct or more
5circuitous, emerging financial market states (EFMs) have proved the most vulnerable. The
1997-98 East Asian financial crisis was a marquee exhibit of this phenomenon, whose contagion spread as far away as Argentina, South Africa, and Russia. The so-called East Asian Five (Malaysia, Thailand, Korea, the Philippines, and Indonesia) bore the brunt of its effects, including sharply declining currencies, asset prices, and stock markets, as well as spiking
1 For their insightful comments on an earlier draft I would like to thank David Andrews, Leslie Armijo, Benjamin Cohen, Christina Davis, John Echeverri-Ghent, Jeffry Frieden, Patrick Leblond, Helen Milner, Louis Pauly, Mark Vail, and Shanker Satyanath. 2 Kaminsky and Reinhart 1998. 3 contagion: the spread of speculative currency attacks, short-term capital flight, declining equity markets, and deterioration in capital market borrowing terms, triggered by macroeconomic imprudence of other states and/or attacks on their currencies. 4 For scholars who view highly mobile capital as constricting, cf. Andrews 1994; Armijo 1999; Bhagwati 2004; Bryant 2003; Cerny 1993 and 1995; Eichengreen 2003; Garrett and Lange 1986; Kahler and Lake 2003 (esp. Simmons and Elkins); Kurzer 1993; Matthews 1997; Mussa 2002; Pauly 1997; Przeworski and Wallerstein 1988; Ruggie 1993; Schrecker 1997; Strange 1986 and 1997; Triole 2002; Underhill 1997; etc. For the dissenters, cf. Berger and Dore 1996 (esp. Wade); Garrett 1995, 1998a, and
1998b; Garrett and Lange 1995; Hoelscher 2006; Kahler and Lake 2003 (esp. Rogowski and McNamara); Mosley 2003; Rodrik 2007; Stiglitz 2003; and Swank 1998. 5 EFMs go by other labels such as Newly Industrialized Countries (NICs) or Economies (NIEs) or Middle Income States (MISs). They are more advanced developing states with higher growth rates and greater economic potential than typical Less Developed Countries (LDCs) and are found mostly in East Asia, Latin America, and East-Central Europe.
unemployment, recession, and serious economic contraction inter alia—even riots on the
Indonesian island of Java. From the perspective of the middle and lower classes in particular, the hardship wrought by contagion was quite literally disastrous. According to the IMF, ―[t]he
magnitude of the recessions in the affected Asian countries has exceeded all initial
As the crisis receded in 1999, most observers expected a fresh round of capital account closure akin to Malaysia‘s behavior midway through the crisis. However, the Five uniformly
resisted this temptation and opted for continued openness in lieu of capital controls—due
primarily to their more pressing need for banking sector recapitalization. Once this was accomplished, chiefs of government (COGs) could contemplate how to prevent a recurrence.
But would macroeconomic reform alone suffice for the prevention of this unprecedented form of economic threat? Because their banking sectors were involved, standard fixes like bringing inflation under control would be insufficient. Indeed, in classic Washington consensus terms, the Five confronted clarion calls by finance experts from all quarters to make deeper
7institutional reforms related to effective banking sector supervision.
Though COGs throughout the region laid plans for new reform efforts, the results were mixed. As with other financial crises in recent history, post-crisis reform efforts in certain EFMs succeeded but failed in others. In light of the dramatic scale of destruction wrought by contagion, not to mention its alacrity in metastasizing, any failure to make the changes necessary to avert a new round of contagion amounts to a puzzle. In more general terms, what explains varied
6 Indeed, economic crisis quickly transmogrified into a humanitarian crisis for wide swaths of the affected states, with household wealth plummeting by as much as 70%. For example, in the early stages of the crisis, Indonesia experienced a currency depreciation of 80%, economic contraction of 14%, and an increase in inflation of 80%. The sizable spike in unemployment that resulted contributed to substantially worsened conditions, which in turn led to various forms of social unrest.
See ―The IMF‘s Response to the Asian Crisis—Factsheet,‖ http://imf.org/External/np/esr/facts/asia.html, January 17, 1999. 7 The Washington Consensus, a term coined by John Williamson, refers to the agenda of what Jagdish Bhagwati has deemed the Wall Street-Treasury Complex, whose actors include inter alia Wall Street financial firms, the Treasury Department, the State
Department, the IMF, and the World Bank. In this perspective, such actors agree on and incessantly advocate an agenda of economic liberalization writ large, what Williamson has enumerated as fiscal discipline, financial liberalization, privatization,
deregulation, trade liberalization, tax reform, secure property rights, etc. Staunchly opposed are central planning, over-regulation,
and state intervention in the economy under most circumstances. Accordingly, what is good for Wall Street is viewed as being good for the world. See Williamson 1990 and 1994; and Bhagwati 1998.
responses to twin financial crises when the stakes are so high? With a subsequent absence of manifest changes to the structure of international capital markets—i.e. the so-called international
financial architecture—there is little reason to believe that poorly performing EFMs will be able to inoculate themselves once the malady of contagion reappears in global financial markets.
The explanation for varied reform outcomes is found in each EFM‘s body politic. I argue
that a combination of regime type and quality of governance determines whether a given EFM succeeds or fails in its post-crisis reform efforts. Associating good governance with low corruption, the rule of law, high social capital, and low corporate ownership concentration—the
so-called ―antecedents of good governance‖—a given EFM will experience at least a semblance
of reform success where these antecedents are evident. On the other hand, if the antecedents of good governance are lacking then the EFM in question will experience a modicum of difficulty, if not out and out failure.
By combining regime type with governance, further explanation of the variance outcome can be achieved. If a given EFM‘s antecedents of good governance are positive and it is
autocratic, it will achieve ―success‖; whereas if it is democratic it will achieve only ―relative
success.‖ On the contrary, if a given EFM‘s antecedents of governance are negative and it is autocratic, its efforts will result in ―failure‖; whereas if it is democratic its efforts will result in
only ―relative failure.‖ Thus, despite the obvious irony, there can be advantages in
authoritarianism. See below for a deeper theoretical grounding of the argument, as well as justification for how success and failure are operationalized and measured.
The Asian financial crisis had several phases to it, each marked by wholesale currency flight to the degree that comparisons were instantly made with Great Crash of 1929. Phase one began in Thailand on July 2, 1997 when the Thai government allowed the baht to float. Directly
prior to this investors were betting heavily against the baht, a situation brewing for weeks as the assessment had set in that crony capitalism in Thailand was running amuck—as evidenced by the
boom in office building construction in Bangkok with an incommensurate amount of business customers to fill them at the rate they were being built. Despite an expensive defense by the
ndThai central bank, it finally abandoned the baht‘s peg to the dollar on the 2 with the immediate
result being a 15% loss of its dollar value.
The contagion quickly spread to other vulnerable currencies in the region. The first victim was the Philippine peso, which the central bank of the Philippines defended by buying pesos with dollar reserves for nine days. But on July 11 it capitulated to speculators, and three days later the Malaysian central bank gave up its defense of the ringgit and also floated. Before the month was out, speculators hit the Indonesian rupiah. Floating currencies in the region depreciated sharply, and soon the hemorrhaging economies were looking to the IMF as a literal lender of last resort. The Philippines extended a current IMF standby arrangement, i.e. program, in July; after a brief delay Thailand initiated an IMF program in August; and Indonesia finally negotiated one in November.
The second phase began with Taiwan‘s decision to float its dollar on October 17, which
was followed immediately by contagion spreading to the Hong Kong dollar. With vast reserves and a currency board, Hong Kong authorities in fact successfully defended its U.S. dollar peg; nonetheless the central bank had to buy stocks to defend trouble in the stock market index, for its sharp hike in interest rates touched off an internal contagion in the form of a broad sell-off. Bond spreads widened dramatically, and financial market volatility began to spread beyond Asia to Europe and the U.S.
Phase three was initiated by events in South Korea, which was practically the only non-surprise due to the string of business conglomerates that had failed earlier in the year—the
infamous chaebols. The won was not hit quite as badly as the other currencies in the region, as
for other reasons it had devalued significantly since 1995. Nonetheless, with Hong Kong reeling Korea experienced a sizable liquidity crisis prompting it to abandon its peg on November 21 and take out a large-scale program with the IMF in early December. Without exception, due to further speculation in the region each IMF program had to be restructured within a month or two. Before the overall crisis was finally contained, contagion had spread among other places including Russia in 1998, Brazil in 1999, and finally Argentina in 2002.
With seriously slumping demand across the region because of currency attacks, the Five slid rapidly into recession. With currency controls only China fully escaped contagion, while Taiwan was not damaged as badly in comparison to other EFMs: a sampling of downward spiking output included 40% of Indonesian people sliding below the poverty line, GDP slumping by 6% in Korea, and a 13% increase in unemployment in the Philippines. Even Japan saw
8unemployment increase by 4.3%. Whereas the Five together had attracted over $65 billion in
capital inflows in 1996, their outflows between 1997 and 1998 totaled nearly $20 billion and in
9their wake elicited dire economic consequences. ―This sequence of events was not only a shock
to the region but a shock for the economics profession and the international policy community as
The severe economic and other consequences transmitted into widespread demand for
11protection from individuals and groups alike—even from some liberal international quarters.
Instead of typical calls for trade protectionism, the desire of societal actors to be inoculated against future crises generated substantial pressure for cutting off volatile capital inflows, i.e. financial protectionism in the form of capital controls. In spite of this, when the crisis receded
8 Flynn 1999, 16. 9 Bhagwati 2004, 199. 10 Haggard 2000, 4. 11 Jagdish Bhagwati, ―The Capital Myth,‖ Foreign Affairs 77, 3 (May-June, 1998); The Economist, ―Keeping the Hot Money
Out,‖ January 24, 1998, ―Capital Controversies,‖ May 23, 1998, and ―Of Take-Offs and Tempests,‖ March 14, 1998; Barry
Eichengreen, 1999; Paul Krugman, ―Whatever Happened to the Asian Miracle?‖ Fortune, August 18, 1997, ―Curfews on Capital
Flight: What Are the Options?‖ Krugman web page, October 12, 1998, and ―An Open Letter to Prime Minister Mahathir,‖ Krugman web page, September 1, 1998; Los Angeles Times, ―Los Angeles Times Interview: Stanley Fischer,‖ October 8, 1998;
and markets stabilized, more immediately COGs were conscious of the acute need to revitalize their capital-starved banking sectors; lobbied extensively by business elites and cronies alike, they chose largely to maintain their previous level of current and capital account openness, and
12in certain cases increase it.
Fortunately for them recovery soon commenced, marked by an impressive return of GDP growth and significantly strengthened currencies. By the end of the 90s numerous prognosticators updated their 1998-99 predictions of ongoing EFM economic despondency with expectations of a return of unmitigated growth, effectively going from one extreme to the other. However, looking toward the longer term the economic, political, and social damage among the Five also engendered a critical new national interest across them, viz. a shared understanding that a recurrence of this type of crisis was to be avoided, practically at all costs.
Observers also emphasized prospects for EFM ―lesson learning,‖ speculating that the
Asian crisis could ultimately prove to possess a silver lining—functioning as the impetus for
13some overdue reform à la ―creative destruction,‖ sort of Schumpeter at the macro level.
The main lesson is that prevention is still by far the best option. Sound macroeconomic
policies are a key aspect of prevention in this regard. Another is sound banking: 14effective supervision of financial institutions.
In this vein Goh Chok Tong, Singapore‘s Prime Minister at the time, inveighed that the crisis
generated four potentially positive outcomes: greater economic opening-up, greater awareness
and Dani Rodrik, 1997, and ―Should the IMF Pursue Capital-Account Convertibility?‖ Essay in International Finance, No. 207,
Princeton University. 12 Nearly all EFMs retained their pre-crisis degree of financial sector openness despite widespread pressure for reverting to financial closure (i.e. capital controls, etc.). Malaysia was the lone exception, introducing controls in September, 1998 and lessening them somewhat in February, 1999 (and eventually fully). 13 Some contend that, if post-contagion lessons are learned and EFMs engage in proper reforms, the Asian financial crisis and its aftermath would be an exemplar of Schumpeter‘s ―creative destruction.‖ Yet, to be precise, when Schumpeter coined this term and deemed it ―the essential fact about capitalism,‖ he was referring to capitalism‘s incessant cycles of industrial production,
involving destruction of the old and creation of the new—essentially, business cycles. Certainly these involve unemployment
(also cyclical) as well as firm failures, but nothing of the sort and scale as was recently experienced by contagion-ridden EFMs.
See Schumpeter, 1942. 14 ―The IMF‘s Response to the Asian Crisis—Factsheet,‖ http://imf.org/External/np/esr/facts/asia.html, January 17, 1999.
of the need for corporate governance, greater concentration on actual competitive strengths, and
15greater understanding of the tribulations of globalization.
Nonetheless, even on the back of stock market and GDP resurgence, EFMs afflicted by the Asian financial flu have struggled to digest these lessons and reconstitute their economies in structural terms. For once the crisis abated, responses to the contagion stimuli began to diverge. While the Five achieved surprisingly rapid macroeconomic convalescence, only certain states achieved marked internal reconstitution in terms of advanced neoliberal reform. Indeed, certain EFMs have fared better at this task than others, despite an array of shared economic and political characteristics.
This paper seeks to explain why states with numerous characteristics in common are responding differently to highly similar external conditions. More specifically, it asks why, in the wake of the Asian crisis, certain EFMs have proved more proficient at implementing advanced neoliberal reforms—particularly prudential reforms in their banking and corporate
sectors—than others, despite similar crisis experiences, similar stages of economic development, similar demands being leveled at them by various external actors—from political actors like the
IMF, the U.S., and other G-7 states, to market actors such as institutional and portfolio
16investors—and even similar recovery experiences.
The fact that certain EFMs are managing to implement so-called ―second generation‖
neoliberal reform while others are not, despite an amalgam of similarities, is puzzling. Some contend that any EFM reform at all is puzzling, given long-standing proclivities for Asian values, cronyism, and rent-seeking in the region. But the spate of recent twin crises, particularly those in Latin America and East Asia, has leveled the playing field of market actors‘ perceptions—whether individual investors, institutional investors, or G-7 finance officials. EFMs now are not
15 ―A Survey of South-East Asia,‖ The Economist, February 12, 2000. 16 I focus specifically on the Asian crisis (and its aftershocks) because it constitutes a new more virulent form of crisis, not only
of the aforementioned twin variety, but also because of three novel developments: the more rapid rate of diffusion, the greater
propensity for contagion compared to the Tequila crisis, and the fact that even economically viable countries were implicated (cf.
only expected to achieve a deeper, more fundamental package of reforms, but they also face similar incentives for doing so, from the degree to which EFMs and their firms are currently in competition with each other for foreign short-term capital, to the widely perceived necessity to avoid a second round of crises.
Nonetheless, similar incentive structures are not translating into similar outcomes. Indeed, the similarities extend still further, including recent democratization experiences, increasingly democratic elections, reasonable macroeconomic governance, sound macroeconomic policy, relatively stable macroeconomic conditions, acceptance of a significant role for markets in resource allocation, deep integration into the international economy (in terms of both current and capital accounts), the self-reinforcing character of internationally-oriented growth, high savings and investment rates, and a strong societal emphasis on education. In terms of common economic factors which contributed to their proclivity for being inflicted by contagion, a lack of transparency about corporate financial affairs, ineffective or non-enforced prudential supervision of banks, and the presence of implicit guarantees on exchange rates, bank safety, and certain other business practices, have each been widely prevalent.
Thus, the East Asian EFMs are not for nothing continually grouped together by journalists and academics. What significant differences there are among EFMs recently buffeted by financial crises—differences in political and economic institutions—are largely captured by
my dependent and independent variables, and relate directly to covariance in the theoretical framework. Yet, notwithstanding this cluster of similar characteristics, similar reformist outcomes are not being achieved.
The reforms alluded to are not so-called ―first generation‖ reforms,which economists
17place in the reform category of ―macroeconomic stabilization.‖ Reforms of this type constitute
Paul Krugman , ―What Happened to Asia?,‖ 1998 mimeo). Nonetheless, looking at different crises/responses over time does
have appeal. 17 I do not equate reforms with policies; however, it is must be noted that the desirable achievement of a consistent, favorable
policy outcome over time (contrasted with a history of failure in a specific policy area) is tantamount to reform. For example,
after a history of high inflation a given government may choose to adopt a low inflation policy using the instrument of high
the consistent achievement over time of low interest rates, current account surpluses (or minimal deficits), low inflation, positive fiscal balances, stable exchange rates (or strengthened currencies), high savings rates, etc.—standards by which, for the most part, the Five have made
impressive recoveries post crisis-alleviation (up until their very recent imported slowdown).
Rather, this paper is concerned with ―second generation‖ neoliberal reforms, what in the financial sector are referred to as prudential reforms—i.e. supervisory laws and regulations
involving the regulatory rules for banking / financial sectors, corporate sectors, labor markets, property rights regimes, privatization, and deregulation in general, which meet international
18standards (here the focus in on the banking and corporate sectors). This reform type constitutes
a deeper level of structural change involving the alteration or creation of economic institutions. This endogenization of institutions constitutes the next generation of reform. While first generation reforms contribute to short-term GDP growth, their second generation counterparts function as antecedents of greater productivity rates and thus long-term growth; in light of the need to alter deep-seated institutions, they are also more difficult to achieve.
For example, throughout 1999-00 largely positive first generation achievements have given rise to impressive output figures as well as marked reversals in investment climates and capital flows—from rising bond prices/falling yields to significantly increased levels of equity, portfolio, and direct investment. Longer-term growth, however, will depend on whether EFMs can underpin their national political economies with neoliberal economic institutions, i.e. second
19generation reforms. Without these deep-seated structural reforms, GDP rates of 3-5% during upturns will be expected to stagnate, shy of the 6 – 8% rates necessary to reduce high
unemployment rates and poverty levels leftover from the 1990s, not to mention put into place
interest rates. The actual achievement of low inflation is a policy outcome. The sustained achievement of low inflation over time,
given historical difficulty in this policy area, constitutes a reform. Reforms are never permanent, although policy reforms (first
generation) are more easily reversed than institutional reforms (second generation) See Introductions in the following for discussions of macroeconomic stabilization reforms: Williamson, 1994, and Sturzenegger and Tommasi, 1998. 18 Examples of prudential regulations can be found among banking sector regulations, e.g. capital adequacy ratios, loan provisioning and classification rules, removal of credit and interest rate controls, openness to foreign bank competition, and rules
governing market risk, exchange risk, large exposures, connected lending, etc.
20safety nets that many COGs now espouse. COGs are thus playing the game of how to change
(and to what degree) in order to augment the initial recovery, meet the higher expectations of citizens, and prevent the recurrence of crisis in particular (in large part by pleasing investors).
With respect to how the credibility issue is tied to being vulnerable to twin crises, the reform task is imperative. According to a recent study of the Asian Development Bank (ADB), second generation reform gives rise to market confidence, which in turn gives rise to greater
21GDP growth than there otherwise would be. Staunch pressures to engage in serious structural
reform stem from three primary sources: 1) market actors (rating agencies and different classes
of investors—firm-based, institutional, and portfolio—all of whom ―vote‖ via exit/return), 2)
external political actors (international organizations—the UN, the World Bank, and the ADB—
and foreign governments—the U.S., the G7, and ASEAN), and 3) internal groups and
individuals (agencies and policy-makers who perceive the national interest of preventing a twin crisis recurrence). Although COGs and their governments continue to pursue reform in response to these pressures, the outcomes of these efforts are far from uniform.
Yet, prior to considering second generation reforms, the East Asian Five first had to manage the crises. This involved two steps. First, they had to stabilize the situation, which typically comprised speculative currency attacks, short-term capital withdrawals, declines in equity markets, and capital market borrowing terms deterioration, inter alia—all of considerable
orders of magnitude. Stabilization efforts included preventing payments breakdowns, dealing with insolvent financial institutions, preventing further loss accumulation, and generally restoring financial system confidence. Second, the Five had to sustain the initial stabilization, largely by warding off currency attacks, recapitalizing weak but solvent banks, and eliminating non-performing loans; this step is part crisis management and part prevention.
19 Claessens, Djankov, and Klingebiel 1999, 25. 20 ―Reforms Promise Better Things to Come,‖ Financial Times Survey, March 24, 2000. 21 Zhuang, Edwards, Webb, and Capulong 2000.