The Great Economists

by Linda Yueh

  The third-generation financial and currency crisis took place in Asia in 1997–98. What distinguishes the Asian financial crisis from the first two is that it was a financial crisis that led to a currency crisis. When foreign investors suddenly pulled their money from Thailand after years of capital inflows into the country, it led the Thai baht to collapse. There was a ‘sudden stop’ of cash inflows that had been lent to Thai businesses. The crisis spread to Malaysia, Indonesia, Hong Kong and South Korea. To try to retain the foreign money to which their businesses had grown accustomed, these economies had to raise interest rates, which hurt growth. (It was similar in that sense to the ERM crisis.) When money flowed out of these countries, their currencies collapsed as investors had no need to keep hold of them any longer. That is why it is known as a financial crisis first and foremost.

  What was surprising about the third-generation crisis was that it affected Asian economies, which, unlike Latin America in the early 1980s, were viewed as growing well and did not have huge trade or fiscal deficits. Yet the five economies initially involved were mired in crises that hurt their growth for years. The other worrying trait of the third-generation crisis was contagion, the impact of the Asian financial crisis also being felt in emerging economies around the world. It affected Russia in 1998, Turkey in 1999 and Brazil and Argentina by the early 2000s. This was not because these economies traded much with or invested a great deal in the affected Asian nations, but probably because investors became indiscriminately wary of all developing markets, plunging those economies into crisis too. Argentina, on the other side of the world from where the crisis began, ended up with the largest sovereign default in modern times until Greece took that title a decade later.

  This history highlights that the most vulnerable to crises are those emerging economies with the greatest exposure to foreigners owning their debt. When creditors no longer want to hold that debt, it is more expensive for countries to borrow on debt markets because they have to pay a higher interest rate to attract lenders. The reason foreign debt is in focus is because when their loans and other investments, dubbed ‘hot money’, leave the country, those investors will sell that nation’s currency too. A weaker currency then makes it more expensive to repay debt that is denominated in US dollars, which worsens the debt problem. Borrowing in US dollars is referred to as the ‘original sin’ of developing countries for this reason. This is why there is so much focus on a country’s foreign exchange reserves, so that vulnerable economies can show that they possess foreign currency sufficient to pay for their imports and debt and are less affected by currency and capital movements.

  Such crises can derail economic growth for years. A currency or financial crisis can and has prevented emerging economies from becoming rich, since an extended period of growth is a necessary trait of the countries that have overcome the middle-income trap discussed earlier. South Korea and Taiwan both grew strongly for over two decades, for example. If developing countries can grow for sustained periods, not only would poverty end in those countries, but also they might even be propelled into the ranks of the rich.

  When it comes to sustained high growth rates, there is another concern. Economic growth of emerging markets has slowed in the 2010s. Among the large emerging economies, the so-called BRIC economies owing to their initials, Brazil and Russia have struggled to grow while India and China continue to develop but at a more moderate pace. It’s a trend mirrored in the smaller emerging economies. And that raises the question as to whether the emerging market growth story may be over before they have ended poverty and become prosperous.

  But their slowing growth should not be unexpected since many of them have become middle-income countries in recent years after a couple of decades of strong growth. For the first time, emerging economies account for more than half of the world’s GDP, but, as the rich countries know from experience, richer nations grow more slowly than poorer ones. It’s not surprising that the fast-growth spell of emerging economies has slowed down.

  After China, India and the former Soviet Union opened up in the early 1990s their economies immediately benefited from access to world markets. Their integration with the global economy helped launch an era of globalization where terms like offshoring came into vogue and globalization surged: exports of goods and services increased from 20 per cent of world GDP to around 30 per cent by the 2010s. Foreign investment poured into cheaper and fast-growing emerging economies as they opened up, which helped their companies to learn from more established multinationals and contributed to a growing new middle class in those countries.

  As countries become richer, their pace of growth inevitably slows. Developing ones grow quickly because they are starting the process of industrializing and trading from scratch, so the gains are relatively larger and arrive quickly. Richer nations grow more slowly since they have to innovate and upgrade their industries in order to raise their productivity. For China, 4 per cent growth would be a cause for disappointment; for the USA it would be magnificent.

  According to Douglass North, what determines how much an economy will slow down, and thus its long-term growth prospects, is the quality of its institutions. Vietnam and Myanmar, a pair of newly globalized economies, offer useful case studies. They both hold huge promise, but also face significant obstacles. South Africa is another notable case. Let’s consider each in turn.

  Vietnam’s institutional challenge

  In 1986 the Vietnamese government launched a series of market-oriented reforms known as doi moi. Since then the country has been in transition from central planning to a ‘socialist market economy’ with the Communist Party remaining in charge. Vietnam is a sizeable country, not quite China’s 1.3 billion, but at over 90 million people its population is among the twenty largest in the world. So, Vietnam is a potentially significant economy, given its population. Like China, Vietnam instituted economic reforms in a lagging economy while retaining the communist political regime.

  One leftover from the old system is that its state-owned companies dominate bank lending and account for more than half of the country’s bad debt. Vietnam is sometimes viewed as the ‘next China’ owing to its stable transition and communist rule, but there are concerns about a looming debt crisis. The creation of market-oriented institutions and the dismantling of the centrally planned apparatus that had governed the market will attempt the challenging task of altering the path of the economy, the sort of difficult ‘path dependence’ described by Douglass North.

  Among the hardest institutions to reform are state-owned enterprises. For Vietnam, the dominance of such firms, and their associated bad debt, remains a problem years after the launch of doi moi. In common with other nations, Vietnam created ‘bad banks’ or asset management companies to take the bad debts off the books of the state-owned banks. This is what China did in 1999, when it created four such companies to try to clean up the balance sheets of its big state-owned banks prior to opening up the sector when it joined the World Trade Organization in 2001. But the problem with bad debt is not just the stock, but the flow. In other words, the continued accumulation of debts from inefficient state-owned enterprises cannot be ignored.

  China in the mid-1990s took a huge step forward in privatizing or restructuring most of the state-owned firms. The number of large state-owned enterprises dropped from about 10 million to less than 300,000 by the end of that decade. It still has a sizeable state-owned sector, but a notable attempt was made to cut the flow of bad debt by increasing the efficiency of the remaining state-owned firms. This was by partially privatizing or selling shares in even the largest state-owned firms, including banks. Of course, China created other problems for itself when it used the banking system to provide most of the finance behind its large fiscal stimulus to boost the economy during the 2008 global financial crisis, discussed in Chapter 3.

  Vietnam has pledged to reform its state-owned enterprises, but it has progressed slowly. It wasn’t until 2011 that Vietnam started to reduce the number of s
tate-owned enterprises significantly, from 1,309 to 958 in the five years to 2015. And it has a lot more to privatize to get to its target of 190 by 2020. So, it has taken around three decades to reform state firms.

  Again like China, Vietnam decided not to follow the ‘shock therapy’ route taken by the former Soviet Union when it quickly transitioned from a centrally planned economy during the early 1990s. Instead it gradually introduced market forces, including allowing non-state firms to operate, so that the government could slowly reform the state-owned sector.

  Looking at the decade-long recession that the former Eastern Bloc nations experienced after their rapid transition, it probably isn’t surprising that China and Vietnam seem to have done the smart thing. However, there is an important impediment to both of their reforms, namely that undertaking a more rapid transition removes the inefficient ‘hand’ of the state. Quickly dismantling the old system prevents the build-up of vested interests and the creation of new power bases in the marketized economy by those who benefit most from the ongoing reforms and can forestall further progress. (Of course, there were numerous problems with the transition of Russia and others, including the unrealistic expectation that a private economy could just fill the vacuum if the old state one was dismantled.)

  China undertook what has been described as an ‘easy-to-hard’ reform sequence in that politically easier reforms like incentivizing agricultural output were done first, while leaving the harder reforms of the state-owned sector for later. As the theory predicted, those new power bases have made it more difficult to implement further reform. Similarly, Vietnam’s reforms seem to be mired in the inability of those who run the state-owned firms to allow them to become at least partly if not wholly privatized. In other words, those who benefited from the reforms of the economy are now hanging on to their inefficient firms, which are a drag on the banking system.

  There are consequences for the Vietnamese economy. Vietnam’s government debt is half of GDP and, importantly, over one-third is owed to foreign creditors. When the debt of state-owned enterprises is added in, the figure doubles to a sizeable 100 per cent of GDP. When the total debt owed by the government is the same magnitude of a country’s annual national output, concern over a potential debt crisis grows. To avert it would require cutting off the flow of bad debts from state-owned firms as well as pushing ahead with some degree of privatization. To achieve this will require overcoming a raft of vested interests.

  The lesson for countries tackling reforms is, as North had warned, that the power of vested interests in keeping institutions unchanged must be considered as well as the efficiency of the proposed measures. For Vietnam, it is a warning worth heeding.

  Myanmar’s fast changing institutions

  Myanmar, formerly known as Burma, has also recently opened up. It faces a different sort of challenge than Vietnam does, but is similarly reforming the very structure of its economy and its institutions in order to alter its economic path.

  Investors call the country the ‘final frontier’. The Star Trek reference aside, there is a sense of the yet to be explored about Myanmar. It is the last large Asian economy to become globally connected, and opened up only in 2011 after half a century of military rule and the release from house arrest of Nobel Peace laureate Aung San Suu Kyi.

  The statistics tell the story: in 2011 just 6 per cent of the population had access to a mobile device and only about 10 per cent had a bank account. Decades of military rule have left Myanmar underdeveloped and one of the poorest countries in Asia. But that also means that, with the right sorts of institutional reforms, it has significant potential to grow quickly. It sits in the world’s fastest-growing region with well-established global supply chains, which can help an economy industrialize and grow rapidly if it is part of the worldwide manufacturing network. Unlike many smaller countries in developing Asia, Myanmar, with a population similar in size to that of South Korea, can utilize a significant home market to promote growth as well as expand its exports. This explains the interest of many multinational corporations who eye an under-served market. Plus, it is well endowed with oil, gas and minerals. Thus, Myanmar is one of the countries that can attract foreign investment for all three reasons that typically motivate multinational companies: natural resources, lower costs and new markets.

  Myanmar’s potential has certainly caught the attention of the world’s largest companies looking for the next double-digit growth economy. But opening up too quickly to investment flows has pitfalls, as seen in the numerous crises plaguing emerging economies outlined earlier. This was avoided by China, which has led to talk of the so-called Beijing Consensus serving as an alternative model for newly marketizing nations.

  In vogue after the success of China’s growth and the critiques levelled at the Washington Consensus, could the Chinese model be a model for Myanmar as it embarks on a historical opening to the global economy?

  Of course, there may not even be a consensus about the Beijing Consensus, as the Chinese growth experience cannot be easily modelled. And there are many elements of China’s marketization process that are similar to the Washington version. The Washington Consensus was a model of economic development promulgated during the 1980s and 1990s that stemmed from the IMF and US Treasury, both located in Washington, DC. The model was premised on privatization and financial and trade liberalization. As a number of developing countries failed to benefit from following these prescriptions, which was seen both in the decade-long recession of the former Soviet Union during the 1990s and in the 1980s Latin American crisis, the Washington Consensus fell out of favour and developing countries sought an alternative. Some turned to China, whose market-oriented reforms proceeded at a more gradual pace and with sequencing of key reforms. For instance, state-owned enterprises were slowly reformed and were not subject to mass privatization until a couple of decades into the reform process. China also established a non-state sector that absorbed the laid-off workers, so preventing persistent large-scale unemployment. But as discussed earlier, one consequence is that reforms are incomplete and state ownership persists.

  China is not alone in growing rapidly in the region. South Korea, Taiwan, Singapore and Hong Kong did the same, serving as a partial model for China as it enacted targeted reforms to boost global integration into production and supply chains that allowed these economies to industrialize through plugging into worldwide manufacturing. State-directed credit also helped to avoid specialization in less desirable areas such as primary (agricultural, resource) products.

  As a model of development, the Beijing Consensus in emphasizing gradual and managed opening to the world economy and slower reforms of the existing economic institutions could be more appealing than a more rapid marketization model. Key to the Beijing Consensus is industrialization, which in China’s case involved reindustrialization as existing and new industrial firms were reformed and encouraged to enter into higher tech industries. For Myanmar, which is not a transition economy, so it does not have state-owned enterprises like China to restructure, the more standard Lewis model would apply. Crafted by the Nobel laureate Arthur Lewis, this model sees economic growth occurring when workers move out of low-productivity agriculture and into more productive factories and the services economy. Although with a different stress, the end result is the same: industrialization supports economic development. That shift to industry could launch Myanmar into the rapid-growth phase experienced by other Asian countries.

  So, the Beijing Consensus perhaps offers a better set of guidelines for Myanmar than the Washington Consensus as it is derived from the experience of its East Asian neighbours. About 70 per cent of Myanmar’s population are employed in the agriculture and resources sector, which accounts for over half of the country’s economic output. It means that there is a lot of scope to industrialize, which can launch a country into fast growth as it ‘catches up’, as occurred in the East Asian ‘miracle’ economies of South Korea, Taiwan, Singapore and Hong Kong, which are among the few that h
ave become rich in the post-war period.

  However, as a latecomer and a richly endowed country, plugging into regional production chains will be key or else Myanmar risks specializing in resources and being crowded out by more competitive foreign firms. It is in the right region to exploit that potential, since about half of the world’s consumer electronics are produced in Asia. It means Myanmar has the potential to grow in a diversified manner and could develop rapidly if it industrializes. But the bumpier road travelled by some of its Southeast Asian neighbours suggests that success cannot be taken for granted. And it will depend on government policies, also including in the crucial area of social stability. The East Asian ‘tiger’ economies of Hong Kong, Singapore, South Korea and Taiwan had also enacted land reform and other forms of redistribution that allowed their growth to be accompanied by greater equity. By contrast, China’s lack of such policies contributes to it having levels of inequality that are causing social resentment. That is another lesson to note from the growth experience of its neighbours. Institutional reforms, such as adopting redistributive policies to promote income equality alongside industrialization, can allow Myanmar to develop economically without the high levels of income inequality seen in China. These are the very sorts of reforms that Douglass North would propose. Myanmar has already begun to alter the path of its economy and, if successful, then the once bright economy in Southeast Asia can re-emerge and take its place in the fastest growing region in the world.