Is the Asian Flu Fatal?

Why Asia's economies got sick--and what can be done to cure them.

James K. Glassman from the May 1998 issue

(Page 2 of 11)

But nonetheless, these countries all had serious structural problems. Most notably, while they developed wonderful manufacturing sectors, they have lousy, backward, primitive, uncompetitive financial sectors. Maybe short-term capital controls can mask those problems, but they can't make them go away. In the long term, if East Asia is going to continue on this miraculous growth path, they are going to have to clean house in the financial sector.

Glassman: But specifically how did that structure contribute to the current crisis?

Lindsey: The banks lent to a bunch of unworthy borrowers. They lent to build factories that weren't needed. They lent to build high-rises that were never going to be occupied. There was an enormous misallocation of capital.

Glassman: Directed by the government?

Lindsey: Sometimes, yes. In the case of South Korea, in the case of Indonesia, credit allocation was often a matter of national industrial policy. But even in other situations, in Thailand, also in Indonesia, you have enormous amounts of capital allocation going through banks as opposed to equity markets. You have these small clubby banks that are all run by ex-government ministers lending to cousins or pals of the people in power. You have an entire system of taking those wonderful Asian savings rates and pumping them out into the economy in a way that just ignores market criteria.

Mallaby: I could perhaps add a bit to that with the specific case of South Korea, which is what I know best. It's to say that it's not just the Asian model which is a problem here. It's actually the attempt to get away from that model which in some sense causes the crisis.

In the 1970s, Korea industrialized through a process of government-directed lending. At that time, the banks were told to lend to heavy industry. This industry grew massively fast, rather inefficiently because money was being pumped in without really paying attention to whether these projects were viable.

Then in 1979, when President Park Chung Hee was assassinated, a new team of top economists took over, which represented a shift from Japanese-trained economists who believed in the Asian model to MIT- and Harvard-trained economists who did not. This new team of Western-trained economists decided in 1980 to get away from state-directed lending. They said to these chaebol [large corporate conglomerates] and banks, "We're not going to direct your lending any more." These guys had spent 10 years being told, "We are directing your lending," and therefore by extension, "If it goes wrong, we will bail you out." So when the state direction was eased off a little bit, the chaebol and the banks invested crazily, all over the place. They went totally nuts.

The government put on the controls again in the 1980s. Then there was a period of relaxation and massive expansion of investment because the controls had been taken off. Then the government put on the controls again.

This is why South Korea has followed a boom-bust cycle since 1980. What I think is interesting here is the attempt to unravel the Asian model because it was perceived as long ago as 17 years ago, 18 years ago, to be a mistake. It proved extremely difficult because every time you tried to loosen state controls, investment would balloon again. This is actually what is going on in this current crisis.

The chaebol were enjoying a period of relative liberalization in economic policy in the middle 1990s. Because of that, they were allowed to do massive investment and finance these investments by this great big borrowing, much of it in dollars.

When I was there, for example, in 1995, there were already too many car factories, but Samsung [one of the big chaebol] had just been given a permit to get into the car industry. And Samsung decided, "OK, we will build a lot of cars. We'll build a huge factory. We'll do all these other investments." Samsung's expansion plans proposed to add to South Korea's economy over the next few years the size of Sweden's whole GDP. That is what happens when you have got countries which are used to being directed by the government [that are] suddenly told, "OK, now you are free."

Allan H. Meltzer: I would simplify it down to three factors. The first was South Korea's size; it's the 11th largest economy in the world. In income it's the size of Los Angeles County. Now we would not think to have a banking system in Los Angeles County that was completely concentrated on Los Angeles County, because we would know that as soon as the entertainment industry went down, the banking system would go down.

The second problem was that they compounded the problem by having, permitting, encouraging debt-to-equity ratios which were astronomical. There are companies there which have four times the amount of debt outstanding as they have equity, as compared to the heavily debt-burdened European companies, which have 80 percent, 80-20 split, or the United States, where it's about 15 percent.

The third thing is one aspect of the Asian model. While I agree with much of what Sebastian just said, I disagree on two points. One is that in the 1980s Korea picked the chemical industry, and it put a lot of money into the chemical industry. It turned out to be a bad investment. Most of the banks were left holding a lot of worthless paper.

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