Financial Liberalization and the Economic Crisis in Asia Chung H.

Lee University of Hawaii at Manoa, East-West Center, and European Institute of Japanese Studies Stockholm School of Economics I Introduction The Asian economic crisis of 1997-98 was an unfortunate outcome of the confluence of “weak” domestic financial systems in Asia and volatile international capital movements brought about by the globalization of financial markets (Dean 1998, Goldstein 1998, Montes 1998). Given the technological advances in information and communications of the late 20th century, globalization of financial markets was perhaps inevitable, although its rapid progress since the 1980s was abetted by a widely accepted notion that free capital movements were better than less-than-free capital movements (Caprio 1998, Eichengreen 1998). As it turns out, however, this notion, which is based on a simple extension to financial markets of the idea that free trade in goods increases economic efficiency and is thus welfare improving, requires many qualifiers if it is to be valid. The Asian economies that suffered dearly from the 1997-98 crisis were victims of this notion about free capital movement. We now know that if a country is to benefit from free international capital movement it must have, inter alia, a sound and strong financial system that can deter panic movements of capital and withstand systemic shocks from such movements if they are in fact to occur. What is ironic about the crisis of 1997-98 is that it took place in the so-called Asian miracle economies, which had been held up in numerous writings on Asia’s economic success of the past fortysome years as an exemplary case of sound economic policies leading to rapid economic growth. As generally reported in those pre-crisis writings, the Asian economies all maintained sound macroeconomic policies and carried out “financial liberalization” presumably removing government intervention and its distortionary effects from their financial markets. But, these same economies are now accused of having “weak” financial systems if the following statement is typical of the recent condemnations of the Asian financial systems (Lim 1999, p.80): Inadequate regulation, banking supervision, accounting standards, financial transparency, legal protection and accountability in corporate governance, combined with pervasive market imperfections, government interventions in business, and the common (and locally rational) practice of relying on political or personal relationships to advance and protect one’s business ventures (‘crony capitalism’)–all led to a high proportion of ‘bad loans’ and “bad investments”.1 If the above quote correctly captures the true state of the Asian financial systems one must wonder what the reforms, supposedly carried out in those economies in the name of financial liberalization, did in fact accomplish. There are opposing views on this issue, some even arguing that financial liberalization was a wrong policy for the Asian economies. According to Wade and Veneroso (1998), financial liberalization was an inappropriate policy that only weakened a system that had served well in Asia. As they see it, the Asian economies had a

unique financial system that was successful in mobilizing large amounts of savings and channeling them into productive investments. It was a system based on long-term financial relations, which some now call “crony capitalism,” between firms and banks and with the government standing ready to support both of them in the event of a systemic shock. What financial liberalization had done in these economies was to weaken this unique financial system by trying to restructure it in the Anglo-American model. Kumar and Debroy (1999) likewise argue that financial liberalization in the Asian economies weakened the role of government in overseeing and supporting private enterprises, which was an essential component of their developmental strategy. In the absence of a government agency overseeing individual firm strategies and combining it with a broader sector or national strategy, individual firms overexpanded their capacity, engaging in unrelated and unwarranted diversification. Such expansion became the root cause of the crisis when the firms were faced with demand slowdown in Japan, emergence of massive excess capacity in some of the main export industries, sharp decline in unit values, and rising interest rates that raised debt service obligations. Thus, according to Kuman and Debroy, the Asian crisis essentially represents a case of market failure and not of government failure. There are others who do not go as far as Wade and Veneroso or Kuman and Debroy in categorizing the financial systems in Asia as uniquely Asian but nevertheless argue that the standard financial liberalization policy is based on the acceptance of neoclassical laissez-faire doctrine and is, therefore, inappropriate for many developing countries (Hellman, Murdock, and Stiglitz 1997). A preferred financial regime for those who take this view is “financial restraint” in which the government imposes some restrictions on financial transactions but the rents therefrom are captured not by the government but by the financial and production sectors. Another view of financial liberalization in Asia is that while it was basically a right policy for Asia was incorrectly implemented. For instance, according to Camdessus (1998), the managing director of the International Monetary Fund, what weakened the Asian financial systems was an inappropriate or “disorderly” manner of financial liberalization that did not pay enough attention to the proper phasing and sequencing of capital account liberalization. Masuyama (1999) also argues that financial liberalization in Asia was carried out without due consideration for readiness and sequencing, adding that the policy was often undertaken under foreign pressure, influenced by liberalization ideology and the self-serving motives of foreign financial institutions. Radelett and Sachs (1998) also make the argument that financial liberalization in the crisis countries was carried out in a “haphazard and partial” manner, making their economies vulnerable to a rapid reversal of international capital flows. This debate over what the policy of financial liberalization has or has not done to the Asian financial systems raises questions about what the actual “model” was that guided financial reforms in Asia and how they were actually implemented. These are the questions that must be addressed if we are to find out, as the debate points out, whether financial liberalization, as was then understood by policy makers in Asia then, was a misguided policy or whether, even if it was a correct policy, it was inappropriately implemented. Economic reform, whether for an entire economic system or even for a financial system, is not a simple task. For it to succeed it needs to be based on sound economic theories as well as correctly carried out in accordance with its blueprint. Some of the recent experiences in economic reform suggest, however, that such may not have been the case in a number of instances. For instance, according to Stiglitz (1999), the reform policies prescribed for the transition economies of the former Soviet Union 2

when McKinnon and Shaw made their seminal contributions. developing countries were pressured by western governments to open their domestic capital markets for foreign investment. it was a common practice in many developing countries to maintain artificially low interests due to the notion that high interest rates were detrimental to economic growth. its purpose being to help the reader understand what ideas might possibly have guided policymakers in Asia. What was deemed necessary to establish a “liberal” financial system has progressed from that of simply removing government intervention in financial markets to that of creating institutional preconditions necessary for deregulated but efficient and stable financial markets. its implementation might have strayed away from its true course because of pressures from various interest groups. who lacked the understanding of the political process of reform in those transition economies. Furthermore.were based on a misunderstanding of the very foundations of a market economy. and removal of foreign exchange controls.2 Likewise. Following Stiglitz’s analysis of the reform experiences of the transition economies. in Chile. then the reforming countries were not adequately prepared in terms of the preconditions necessary for successful financial liberalization. privatization of public financial institutions and promotion of competition in financial markets. Concluding remarks are presented in Section IV. Thus. It is possible that in many of the Asian economies financial liberalization might have been perceived and practiced as a simple mirror image of financial repression (Kaul 1999). The second possible reason for the failure of the reforms is that even if the blueprint for reform was a correct one. The first is that financial reform in Asia might have been guided by a misunderstanding of how financial markets operate in developing countries and therefore how they should be reformed. academic thinking on financial liberalization has gone through several rounds of revision. a similar mistake was made when the dogmatic hands-off policy was the guiding principle for financial liberalization in 1973-82 (Visser and van Herpt 1996). financial liberalization might have been regarded merely as deregulation of interest rates. II Financial Liberalization: From Deregulation to Institutional Reform Since 1973. The following section presents a brief review of the literature on financial liberalization prior to the crisis. Round 1: Deregulation When McKinnon (1973) and Shaw (1973) published their respective books in 1973. If this were the case. the policies prescribed by the western economists. Each round took place more or less as a result of a financial crisis. Thus the McKinnon-Shaw thesis that the artificially 3 . adding to our understanding of the scope of reforms necessary for achieving a market-oriented financial system. Whether a similar mistake was made in the Asian economies is the subject matter of this volume. we might offer two reasons why financial liberalization in Asia failed to deliver its promised result. according to Park (1998). This pressure persisted even though the western governments knew that the accounting practices and disclosure requirements in developing countries did not conform to the accepted standards and that the supervisory authorities of those countries did not enforce rules and regulations as tightly as they should. It is followed in Section III by a summary discussion of what actually happened in financial reform in eight Asian countries selected for comparison. failed to take into account the fundamentals of reform processes. For instance. elimination of directed credit.

the outcome of the reforms was not the expected sound and efficient market-ordered financial system. bankruptcy of many solvent firms. While arguing that his initial policy prescriptions were not incorrect. but because it was implemented in an environment unsuited for its success. instead. which includes the liberalization of the exchange rate for current account transactions and the liberalization of tariffs. privatizing state-owned enterprises. The second step in the sequence is the liberalization of domestic financial markets by allowing interest rates to be determined freely by the market. not because the idea of financial liberalization per se was wrong. p. Fry (1988) also focused on the necessity of stable macroeconomic policy but added a sound regulatory framework as one of the preconditions for successful financial liberalization. and Uruguay embarked upon the wholesale implementation of financial liberalization policies in the late 1970s. p. lenders and borrowers. however.1). Chile. What emerged. and no effective supervision and control (until it was too late) of the practices of financial intermediaries”(Diaz-Alejandro 1985. was “de facto public guarantees to depositors. which includes fiscal control. McKinnon (1991) gave perhaps the most comprehensive discussion of the correct sequencing of financial liberalization. “financial repression. quotas. The first step of this sequence is appropriate macroeconomic policy. Step three includes the liberalization of foreign exchanges. Round 2: Macroeconomic Stability and Imperfect Financial Markets This disastrous consequence. prompted research in the 1980s and early 1990s into the reasons for the failure (IMF 1983. The first real-life test of the McKinnon-Shaw thesis came when Argentina. freeing up onerous reserve requirements. and privatizing the banks.low interest rates and the concomitant credit allocation by government. One outcome of much soul searching on the part of the proponents of financial liberalization was a new consensus that the Southern Cone experiment was a failure. and other 4 .e. the McKinnon-Shaw thesis had a powerful effect on shaping the financial policy for economic development.” impeded economic growth was a radical departure from the normal practices of financial policy then carried out in most developing countries. balancing the government budget. Fry 1988.. McKinnon 1991).387-8) was one of the first to point out the importance of macroeconomic stability as a condition for the successful outcome of financial liberalization. McKinnon (1988. of what later became to be known as the Southern Cone experiment. Khan and Zahler 1985. He was. Given the intuitive plausibility of the proposition that freeing interest rates from government control will increase saving and bring about an efficient allocation of credit and a higher rate of economic growth. With such a financial regime in place those three countries suffered sky-rocketing interest rates. cognizant of the difficulty of creating such a regulatory framework in the developing countries where human capital and knowledgeable auditors or supervisors were in short supply. McKinnon proposes that the privatization of banks may come near the end of this step because this can only occur after the proper re-capitalization of bad loans. and ensuring an adequate internal revenue service for the purpose of tax collection. i. he now added that a certain sequence of economic reform should be followed if financial liberalization is to be successful. Unfortunately for those countries. and eventually a financial crisis in 1982. This step also includes the establishment of commercial law and the liberalization of domestic trade.

which poses problems for financial intermediaries. even if there are well-functioning equity markets. according to Stiglitz. Furthermore. which limits raising capital in the equity market.g. For many developing countries that lack well-functioning equity markets. in the former. But. and contract enforcement are inherent characteristics of financial markets and. Only in the final step are international capital flows to be liberalized. moral hazard. Jungsoo Lee 1991). Yet even when firms are large. It was now regarded as a more complex process requiring proper sequencing and macroeconomic stability as a precondition for its success (e. Small firms also lack the scale to maintain their own internal capital market capable of allocating funds efficiently among diverse subunits. there may be some rationing of funds. and unless there are well-functioning equity markets. Starting with a basic premise that financial transactions are more severely constrained by asymmetric and imperfect information and costly contract enforcement than commodity transactions. Since with imperfect information the equity market will not be able to differentiate good from bad trade restrictions. Adverse selection.and equity-rationing may occur even in competitive financial markets that are free of government intervention. In other words. evaluating. “good” firms will be reluctant to issue new shares and will rely more on internal financing for capacity expansion or new projects. credit. and disseminating information. Stigliz (1989) argues that financial markets do not operate as in a textbook model of supply and demand. the process necessary to achieve that goal was no longer regarded simply as that of doing away with government intervention in financial markets. the small scale of business enterprises in most developing countries implies greater difficulty in collecting. particularly where the political system is unstable. Cho and Khatkhate 1989. banks may prefer making loans to “safe” projects at a lower-than-the market-clearing rate. the market will generally discount the prices of good stock issues (Stiglitz 1989). financial liberalization may thus lead to an inefficient allocation of financial resources (Cho 1986). market failure is an inherent characteristic of financial markets. This is less than an optimum arrangement since with perfect information the firm would have gone to the equity market to raise additional capital. the country will miss out on the opportunity to establish some high-return projects. In other words. their equity markets are generally less developed and their economies are subject to greater uncertainty. 5 . So. Such a banking practice will exclude high-risk. Unwilling to see their net worth decrease. high-return projects from being funded by banks. consequently. Credit-rationing by banks—allocation of credit at interest rates below a market-clearing rate— may occur because of the asymmetry of information and the risk-aversion of banks (Stiglitz and Weiss 1981). instead of making loans to those who are willing to pay highest interest rates. the relative weakness of regulatory institutions impedes full disclosure and the adequate provision of information to the market..3 Paralleling this progress in the literature on financial liberalization was a new development in the theoretical literature on financial markets due primarily to the contributions made by Joseph Stiglitz. while the goal of financial liberalization–the establishment of a market-based financial system–remained the same. equity-rationing. The limited use of the equity market for raising funds due to imperfect information is more serious for developing than developed countries as.

Villanueva and Mirakhor (1990) point to the importance of institutional reform prior to financial liberalization by calling for the development of financial “infrastructure” such as adequate legal and accounting systems. being freed of former constraints. institutionbuilding is a path-dependent process. Villanueva and Mirakhor 1990. it is dependent on the overall net worth of banks and the initial mix of their assets at the time of reform. Drees and Pazarbasioglu 1998). Second. and adequate channels for the flow of information... they have the incentive to protect it by acting in a risk-averse way. Gertler and Rose (1994) propose that the government should focus its attention on creating an efficient system of contract enforcement as well as a viable borrowing class.5 According to Caprio (1994).3). The implication is clear: institutions necessary for a market economy must be created prior to financial liberalization. Increasing recognition of the importance of institutions such as the legal. Demirguc-Kunt and Detragiache 1998. supervisory and regulatory systems and the importance of building such institutions as a precondition for financial liberalization has led to the realization that institutions are historical products and. For example. developed equity markets. if the existing regulations are on investment in the real estate sector it is likely the banks will diversify into that sector when those regulations are lifted. As a matter of fact. and Vittas 1997. Gertler and Rose 1994.4 Such institution building requires government activism. Third. and the 6 . The initial mix of assets in a bank is also important because. Likewise. If banks have low or no net worth prior to reform. Jr. the outcome of financial reform depends on several initial conditions present in the economy when regulations are lifted. First. as such. which in turn depends on the existence of audited financial statements. credit appraisal and rating. Caprio 1994. This debate led to the general conclusion that the developing countries do not have the institutions necessary for free-market policies and that such institutions do not come into being quickly and spontaneously. as such policies would increase the creditworthiness of borrowers. the success of financial reform depends on the initial stock of human capital as bankers need to have skills in risk assessment and the ability to gather information about new potential credits if they are to make correct loan decisions. it is dependent on the initial stock of information capital. p. Jr. another World Bank study on financial reform concludes that “.Round 3: Institutional Preconditions The new insight into the operation of financial markets led. 1994).recommendations for any country’s financial system need to be ‘tuned’ to the institutions and culture of the country” (Caprio. the process of reform. If banks have high net worth. They argue that financial liberalization should be coordinated with policies promoting growth and stability of the real sector. the bank is inclined to make a portfolio shift in favor of the asset that has been discriminated against by the former intervention. et al.. Thus a recent World Bank study on the relationship between financial and real sectors. to a new round of debate on financial liberalization with the focus shifting from government to market failure (Akyuz 1993. in the early 1990s. and the effect of reform on the mobilization of savings and the efficiency of resource allocation concludes that financial reform is not an all-or-none choice and thus cannot follow a rigid or unique sequence (Caprio. their behavior according to the new set of rules will likely be risky as it is in their interest to make high-risk loans to regain profitability. Thus. Which strategy and sequencing a country adopts in reforming its financial system depends on its initial conditions and the speed of institution building.

The following summarizes the diverse experiences of the eight countries reported in the subsequent chapters. arguing the necessity of paying attention to a country’s unique political. however. namely.the reformers virtually always take as given the goal. 61). in May 1990. to move their financial systems toward the general model that has been adopted in most OECD countries today” (p. economic. the debate on financial liberalization focused on deregulation and the free-market determination of interest rates. He warns. thus relaxing exchange 7 .. As he put it. and India. This brief review of the literature on financial liberalization shows that there has been a progressive widening of the definition of financial liberalization in each of the successive rounds of debate on the topic. Countries such as Thailand. the Philippines. it will have to be “tuned” to the institutions and culture of that country. the debate focused on the proper sequencing in financial reform with a focus on macroeconomic stability as a precondition for successful financial liberalization.1). Indonesia. South Korea. Harwood (1997) also reaches a similar conclusion. the Article VIII of the IMF Agreements. Thailand Financial liberalization in Thailand began in the early 1990s when the government abolished interest ceilings and promoted the development of capital and bond markets. sociological. In the 1970s. Japan. Malaysia. which most of the emerging market countries lack. and all bad ones rejected" (p. III Summary of the Country Studies The eight Asian countries selected for study of their experiences in financial reform and the possible linkage to the crisis are Thailand. There are no magic cures that “…would alone suffice to ensure a dynamic and efficient financial system in which all deposits are safe. As pointed out by Caprio (1994. In other words. legal and institutional conditions in the development of its financial system. each round triggered by either the failure of financial liberalization in achieving its intended goals or new theoretical insights into the workings of financial markets. In the 1990s. In the 1980’s. Whatever system may develop. South Korea. even before the Asian crisis of 1997-98. these requirements are not implemented overnight as their development requires time and diligence. all loans are performing. the focus was shifted to market failures and the institutions that are necessary for successful financial liberalization but are lacking in many developing countries.level of acquisition of public and client-specific information. that such a model is premised on the existence of rich institutional environments and “world-class” supervisory systems. and Malaysia suffered badly from the crisis whereas others such as Japan. As part of financial liberalization Thailand also accepted. These countries will have to develop their own financial systems. The fourth requirement for successful financial reform is the existence of a system of rules and procedures for the implementation of decisions within banks.. serious writings on financial liberalization no longer took the textbook model of supply and demand as the norm for the financial market and regarded financial liberalization as that of simply doing away with government intervention. and India escaped from the crisis with no significant effect on their economies. “. China. Caprio (1997) acknowledges that financial reform in practice has come to mean the transformation of the financial system to mimic the financial systems of the OECD countries. all good investment projects are financed. China.3).

but by 1995-96 their share went up to 49 percent—more than a three-fold increase in less than a decade. the domestic players such as central and commercial bankers and independent think-tank economists who walked in and out from the public domain of regulators and private financial institutions. Massive capital inflows also helpted camouflage an economy burdened with large external debts and a fragile banking system. premature. led to a bubble in the markets for land and stocks. They were also expected mainly to raise overseas funds for financing trade and investment outside of Thailand. according to Bhanupong. which generated expectations of continued economic prosperity. Further fueling the bubble were the huge inflows of foreign capital that followed the capital account opening and the establishment of BIBFs. In 1987-90. What Thailand should have done was to first develop sound financial institutions. In contrast. As part of financial liberalization the Thai government established.5 percent. It appears that these central bankers and bankersturned finance ministers all shared the IMF’s ethos of free market ideology. Such expectations. relatively low interest rates. Indonesia Until Indonesia became engulfed in a crisis in 1997 it had all the outward signs of a healthy economy—a moderate rate of inflation. Bhanupong argues that the opening of the capital account prior to establishing prudential regulations and especially the establishment of the BIBFs were a major policy blunder for Thailand.controls and reducing restrictions on capital account transactions. however. Foreign borrowing of the non-bank sector also increased from less than 2 percent to 22 percent during the same period. much of the money raised abroad was.7 percent of the country’s net private foreign capital inflows. fueled with credit expansion by financial institutions. a few years prior to the capital account opening. Although such macroeconomic indicators were often cited as signs of sound economic fundamentals they were in reality largely artificial phenomena created by implicit and explicit government subsidies. One consequence of these deregulatory measures was a rapid increase in overseas borrowing by banks in Thailand. Throughout the 1980s Thailand experienced a high rate of growth in exports and income. and a relatively stable rupiah exchange rate. But. The IMF certainly played a role in Thailand’s decision to carry out financial liberalization. therefore. during the same period the share of foreign direct investment in Thailand decreased from 25 percent to 8. the Thai banks accounted for 14. in 1993. It was hoped that the establishment of BIBFs would turn Bangkok into a regional banking center that would replace Hong Kong and Singapore. markets and policy instruments before opening the capital account. As Bhanupong Nidhiprabha points out. more influential in that decision were. lent to borrowers in Thailand who in turn invested it mostly in the nontraded goods sector. If the policies they helped implement are any evidence of their thinking on what constitutes financial liberalization. the Bangkok International Banking Facilities (BIBFs) with offers of various tax incentives. According to him. 8 . local financial institutions in Thailand were ill prepared to handle the large size of capital inflows that the country experienced and its capital account opening was. it appears that they had not been well informed of the more recent developments in the literature on financial liberalization.

which persisted in spite of the financial reform. and improve the efficiency of financial resource allocation. Indonesia’s total external debt as of March 1997 was $135 billion. They also benefited from the privatization of state-owned enterprises. With the support from the central bank and with little opposition from major groups in the country they were able to carry out a number of economy-wide reforms. “strategic industries. In fact. until the crisis there was no exit policy that would allow state-owned banks to go bust. Furthermore. Those investments were largely financed by massive capital inflows that followed the banking sector reform in October 1988. The driving force behind economic reform in Indonesia was the “technocrats. increase domestic competition and improve the corporate culture. and was equivalent to 160 percent of the country’s annual GDP. The general public also supported the reforms since they generally had favorable effects on inflation. a rapid credit expansion and investments in “strategic industries” and the non-traded sector. Furthermore. Also contributing to the accumulation of non-performing loans was government intervention in the lending decisions of state-owned banks and finance companies. the projects that tended to be funded by the banks were investments in land. What it has failed to do in a commensurate manner was to strengthen the legal and accounting systems that are necessary for the effective enforcement of prudential regulations and supervision. employment and economic growth.What appeared to be a high rate of economic growth in the early 1990s was mostly associated with unproductive investments in “strategic industries” and the non-traded goods sector. and even private banks were protected from going bankrupt if they were owned by politically well connected groups.” and public utilities. 9 . As a result. Over 60 percent of the debt was owed by the private sector with 90 percent of its debt being of short-term maturity. which is exactly what happened when foreign lenders refused to roll over the country’s huge short-term debt. poor governance rooted in an unaccountable judiciary and a corrupt government bureaucracy also contributed to the ineffective implementation of whatever prudential rules and regulations the country had adopted since 1991. which could be used as collateral. by 1997 Indonesia became highly vulnerable to a currency crisis. increased competition from the new entrants put pressure on the existing financial institutions to take on riskier projects when many of their credit officers did not have the expertise necessary for evaluating new sources of credit and market risks. the “technocrats” supported financial liberalization because they believed that a greater presence of foreign financial institutions would bring in more external savings. however. Even the politically powerful business groups in the highly protected sectors of the economy went along with the reforms as they could now take advantage of liberalized capital markets and implicit guarantees on external borrowing. advanced technologies and expertise. This formal or informal no-exit policy encouraged moral hazard on the part of the banks. which resulted in their accumulation of non-performing loans. buildings and other tangible goods. According to Anwar Nasution. Thus. One factor that contributed to Indonesia’s banking crisis was the failure to establish an appropriate exit policy to accompany the liberal entry policy that was introduced in 1988. nearly triple of the debt in 1989.” the highly trained economists working in the Ministry of Finance and Planning Agency. What actually happened was. Indonesia is a country with an adequate provision of prudential rules and regulations as it has adopted many of such rules and regulations since 1991 upon recommendations made by the Committee on Banking Regulation and Supervisory Practices under the auspices of the BIS.

more or less completely. Another factor behind the rapid pace of financial deregulation was the government’s desire to make Korea the second Asian country to join the OECD. Although a more serious attempt at reform was made in 1991. But. financial liberalization meant unlimited access to credit and a chance to establish their own financial institutions. It was then commonly believed that those chaebols would not go bankrupt since the government could not afford to allow them to fall. it was only with the inauguration of the Kim Young Sam administration (1993-98) that the pace of financial deregulation accelerated. both domestic and foreign. almost every group except the bureaucrats. who were averse to losing their authority over financial institutions. One of the goals of the administration was to “internationalize” the Korean economy. By 1997. In spite of such widespread support for financial liberalization there was no clear consensus on what financial liberalization constituted of and how it should be carried out. Korea’s financial crisis of 1997-98 was. While weakening the co-insurance scheme the reform also made it possible for chaebols to increase their control over non-bank financial institutions. financial reform in Korea succeeded in eliminating. By 1997. was in favor of financial liberalization. Yoon Je Cho argues that such structural problems should have been tackled before Korea began its financial liberalization. for the bankers it was freedom from government intervention. typical corporate firms in Korea became heavily indebted. the determining factor of the actual course of reform and its outcome was the push-and-pull of various interest groups. the practice of government intervention in credit allocation and the management of commercial banks. if not destroying. and not a well thought-out strategy for financial liberalization. as Cho sees it. poorly developed financial market infrastructure. Such a high leverage ratio was bad enough for economic stability but what made the situation worse was that because of the large size of some chaebols no single financial institution could impose on them the necessary debt discipline. as he rightly points out. and for the politicians it was a move away from an authoritarian government and a symbol of democratization. and to achieve that end the government relaxed or abolished many of the restrictions on financial markets and foreign exchange transactions. and a poor credit culture. In Korea. an inevitable consequence of the financial liberalization that had been carried out in an economy with a highly leveraged corporate sector. For the industrial firms. whiöch in turn would solve many of the structural problems. In doing so it had the effect of weakening. inadequate corporate governance. and in the case of some chaebols the leverage ratio reached close to 500. Such perception could not have been conducive to creating the banking or credit culture in Korea. the government-chaebol-bank co-insurance scheme that the country utilized so effectively in bringing about rapid economic development. before the crisis many influential observers in Korea thought that that would not be necessary since financial liberalization would automatically bring about an efficient financial system. The reform thus strengthening chaebols’ internal capital market while weakening the banks’s monitoring role in their corporate governance. Korea should have adopted a 10 . As it turned out. Given the slowness and difficulty of reform in the real sector. It also weakened the government’s capacity as an effective risk partner of corporate firms.Korea Korea’s financial liberalization began in the early 1980s in a piecemeal manner and without a coherent strategy. according to Yoon Je Cho.

But. alternatively. In other words. and as a matter of fact it has surpassed the commercial banks as a source of corporate finance since the early 1990s. the Malaysian currency. These measures had the effect of attracting huge amounts of portfolio investment into Malaysia in the early and mid-1990s. had been in effect pegged to the U.8 per dollar. financial liberalization is a process that needs to be framed in full cognizance of the economic structure of a country. the extent of the development of financial market structure such as accounting practice. Being modeled after the AngloAmerican system.S. but ill-considered official Malaysian responses turned what should have been an inevitable correction into massive collapses of the rinngit and the KLCI. when the Malaysian Stock Exchange was established. the stock market fell severely with the Kuala Lumpur Stock Exchange Index (KLCI) falling from 1300 in February 1997 to 500 in January 1998. however. that financial liberalization should be regarded as a process that takes time and involves much more than deregulating financial markets. According to Chin Kok Fay and Jomo. and supervisory capacity. The Malaysian stock market then even acquired a reputation as a kind of casino with active trading fueled by a heady optimism and a frenzy of speculation over corporate takeovers. As investors scrambled to get out of their position in the ringgit. But what has compromised the soundness of the Malaysian banking system was the increasing dominance of it by Bumiputera since the 1970s and the consequent use of financial policy as an instrument of inter-ethnic economic redistribution and other related public policies. Since then the stock market has become an important source of corporate finance in Malaysia. Much of money raised in the equity market did not. In the early 1990s the Malaysian government launched a financial market liberalization program to promote Malaysia as a major international financial center. dollar since the1980s. Malaysia Compared with those in other developing countries. Korea should have implemented real sector reforms much faster or at least in tandem with financial sector reform. with the strengthening of the dollar from mid-1995 there emerged a widespread sense that the ringgit had become overvalued and would consequently depreciate to RM2. go to productive investments as more than 50 percent of it was used in the acquisition of the existing public sector assets being privatized. that public trading in stocks and shares began to be undertaken.gradual approach to financial liberalization. To attract foreign capital the government allowed foreign institutional investors to acquire equity in Malaysian corporations and also reduced the tax rate on their profits to 10 percent. granting loans and other specified activities and are kept at the arm’s length from corporate governance and management. the banks are restricted in their operation to accepting deposits.88 to the dollar in January 1998. Although share trading in Malaysia goes as far back as the 1870s it was only in May 1960. Or. the exchange rate reaching as low as RM4.S. K.7 or 2. What actually happed in mid-July 1997 was a far greater depreciation. credit analysis and rating. according to Cho. keeping pace with reforms in the corporate sector and the regulatory regime. reforms in other sectors of the economy. a “correction” in the currency and share markets had been well due. 11 . Malaysia’s financial system is relatively well developed with its history going back to the British colonial era. The ringgit. The lesson from the Korean experience is..

First. In the Philippines. In the Philippines. Second. The small size of capital inflows was in turn largely due to two factors. compared with its neighbors. affecting the supply side of foreign capital was the fact that the relatively poor economic performance of the Philippines made it a less attractive place for foreign investment. Malaysia’s eagerness to make itself a key financial center in Southeast Asia was not supported by a system of well-conceived prudential regulations necessary for managing the much more volatile and greater portfolio investment inflows that such a center brought about. delaying access to foreign debt markets by the public and private sectors. The Philippines The Philippine financial system managed to survive the Asian financial crisis of 1997-98 relatively unscathed due to a couple of factors. compared with its neighbors the Philippines experienced a surge in capital inflows relatively late and in relatively small amounts. rendered the country relatively safe from vulnerability to the reversal of short-term bank loans. interest rate deregulation began in 1980 with the lifting of interest-rate ceilings on various categories of savings and time deposits. financial liberalization in the Philippines has failed to bring about its theoretically expected outcome of a higher rate of economy growth as it was undertaken without correcting fundamental structural distortions in the economy. Second. the long history of import substitution has created a business elite whose interests are deeply entrenched and run counter to greater market competition and liberalization. as the preceding discussion points out.” It also had the banks achieve a high degree of capitalization. But. Furthermore. despite some erosion of financial governance from the mid-1980s a tighter regulation of the financial sector in Malaysia. In spite of various measures of financial liberalization the market structure of the financial sector has remained basically the same: Commercial banks are still owned or controlled by large family-owned corporations that rely on short-term 12 . Also beginning in 1990. and with injudicious policy responses to the crises it turned them into a crisis of the real economy. as argued by Maria Gochoco-Bautista. various measures of financial liberalization had very little to do with the relative immunity of the Philippine economy from the crisis of 1997-98. As a matter of fact. over the preceding three years the central bank of the Philippines implemented various measures to strengthen its prudential framework and regulatory oversight over banks and to align domestic banking standards with international “best practices. in 1996 the net foreign investment in the Philippines was only $3. the central bank started to dismantle the various measures of control that it had imposed during the economic crisis of 1984-85 and other measures that had been put in place over the preceding four decades. but what made the situation worse were the inappropriate policy responses by the government and the contrarian rhetoric of the Malaysian prime minister. which had been in place since 1984. It was also ill prepared to deal with the currency and financial crises that occurred with a sudden reversal of capital flows. In fact. the bull-run of 1996 had already reversed after February 1997 as international portfolio investor sentiments toward Malaysia soured. Instead. it was rather the success in attracting foreign portfolio investments to its stock market that increased the vulnerability of the Malaysian economy to the shifting sentiments of international investor.5 billion. was lifted only in 1991. This change in sentiments was further reinforced by contemporary developments in the region.According to Chin and Jomo. and in 1997 it actually went down to $762 million. affecting the demand side was the fact that the external debt moratorium. First.

the fundamental structure of the Japanese financial regime and of other financial regimes modeled after the Japanese system would eventually have generated some type of economic and financial distress. Another consequence of the favored access to bank financing by the large corporate groups was that it has allowed them to avoid going to the equity market. The failure of those two financial institutions had its origin in accumulating stresses in the Japanese financial system. according to Thomas Cargill. the close ties between large corporations and banks are an instrumental factor in the perpetuation of monopolies and the resulting inefficiencies in the Philippine economy. even though the banking crisis in Japan and the financial crisis that afflicted other Asian economies were 13 . In other words. when combined with easy monetary policy. The business elite behind these large family-owned corporations has influenced the outcome of financial liberalization and other reform programs to serve its own interests. brought about the infamous bubble economy in the second half of the 1980s. Hokkaido Takushoku Bank and Yamaichi Securities Company went bankrupt. In fact. which in turn resulted from the failure of its regulatory authorities to resolve the non-performing loan problem and a series of policy errors. whose cooperation was sought by the United States to serve its larger geopolitical interests. The absence of genuine reforms in the economy resulted in periodic balance-of-payments crises that made the Philippines and its ruling elite to depend on external financing and aid. followed by the failure of 30 financial institutions in 1998. It will also provide the banks with the incentive to monitor closely their clients since they will need to protect their own bottom lines. Japan In November 1997. breaking the ties will induce the corporations to observe good corporate governance since they will need to ensure access to loans from banks and equity capital from capital markets. Especially during the Marcos regime many of the inefficiencies in the economy were allowed to continue since they protected the interests of Marcos and the ruling elite. The experience of the Philippines shows that simply deregulating interest rates or liberalizing the foreign exchange market and opening the capital account do not necessarily raise market competition nor change the orientation of industries from an inward-looking to an outward-looking one. which. Cargill argues that although Japan began financial liberalization in the mid-1970s the reform remained incomplete as it kept some of the key elements of the pre-liberalization financial regime. particularly from the IMF and the World Bank. The retention of those key elements plus an increased role for market forces created an environment in Japan that encouraged excessive risk loans for their working capital and for financing of long-term investments. Japan’s economic and financial performance in late 1997 and through 1998 was an event independent of the Asian crisis of 1997-98. Gochoco-Bautista argues that breaking those ties is critical if the Philippine economy is to become more competitive and efficient and if financial liberalization is to have a better chance of success than in the past. In other words. According to Cargill. In other words. As she sees it. financial liberalization has strengthened the monopoly power of the elite with access to bank financing. This has made it easier for the owners to retain their ownership control while insulating corporate management from harsh judgments of the equity market. The return of democracy after the demise of the Marcos regime did not totally erase the structural weaknesses of the past as political challenges limited the ability of the government to pursue needed reforms.

banks are subject to excessive taxation. No widely available financial disclosure framework was. they were both an inevitable consequence of a systemic fault in their financial systems. Those elements include nontransparent regulation and supervision. Banks and other financial institutions have a weak financial condition because they have been required to lend almost exclusively to state-owned enterprises at artificially low interest rates. which are the largest recipients of bank loans. and its short-term debt accounted for only 13 percent of the total external debt. however. Yet China remains. and that is why certain key elements of the old financial system remained in spite of the reform. That would mean doing away with the elements of the pre-liberalization regime that it has retained and. In Japan. In fact. China China avoided the Asian financial crisis primarily because its financial system was relatively closed and “semi-repressed” with its currency inconvertible on the capital account. the “convoy system” for dealing with troubled financial institutions. Japan has made significant progress in that direction but its future continues to remain uncertain. pervasive government deposit guarantees. This will be a significant burden on China’s fiscal capability.4 percent of 14 . its external debt was modest relative to its official holdings of foreign exchange. the development of the regulatory monitoring system lagged behind market developments. In spite of a series of financial reforms China’s financial system still remains semi-repressed: the interest rate structure is distorted. according to Cargill. Cargill argues that for Japan to get out of its economic malaise it needs to carry out a complete financial liberalization. and credit is allocated bureaucratically and mostly to state-owned enterprises. especially given that consolidated government revenues in 1998 were only 12. close linkages among politicians. neither a new market ideology nor external pressures had much to do with the way it carried out financial reform. On the eve of the Asian financial crisis the taxes paid by the four largest state-owned banks equaled about one-sixth of central government revenues. according to Nicholas Lardy. among others.independent of each other. This incomplete liberalization has led. and the postal savings system and the Fiscal Loan and Investment Program. a sign that most of the bank loans were used to pay wages and taxes and to finance growing inventories of unsold or unsellable goods and not to finance fixed investment but instead. Fiscal implications of restoring the health of the banking system are enormous. Furthermore. and regulatory authorities. It was mainly pressures from various domestic interest groups that brought about financial reform. their debt-equity ratio increased from 122 percent in 1989 to 570 in 1995. China had an extraordinarily strong balance of payments position in the run up to the crisis. financial institutions. and administrative guidance also could not keep pace with the fast changing financial environment. vulnerable to a domestic banking crisis. made available to replace the main bank system. to the unraveling of the main bank system that in the past served as an effective system for evaluating and monitoring risk. are themselves in poor financial conditions. In addition. China’s banking system is in a precarious condition because state-owned enterprises. Lardy estimates the cost of doing so as 25 percent of China’s GDP. Further weakening the banks is the fact that the government has been using them as a major source of its revenues.

Lardy concludes that China’s experience in the Asian financial crisis supports the view that premature capital account liberalization increases a country’s vulnerability to a currency crisis. India India’s economic policy regime has gone through three distinct phases. Vaidya. But. the privatization of banks in India has not progressed very far mainly due to opposition from trade unions and major political parties. public ownership of banks has created the mirage of invulnerability to shocks. The third phase is the post-1991 period when resource allocation is primarily market determined. It is yet too early to tell whether financial liberalization has improved the efficiency of the banks and the quality of their assets. which has had little effect on the basic character of the public sector firms. What has been accomplished so far is the piecemeal disinvestment of a small portion of government shareholdings. Perhaps. It is obvious that the situation will only get worse unless the authorities are willing to cut off the flow of new lending to unprofitable state-owned enterprises. the government debt has increased dramatically in recent years with the combined value of all its debts reaching 20. about 18. The sole objective of disinvestment appears to be that of generating revenues for the cash starved government. but it has not made much progress on these fronts.7 percent of their assets is categorized as substandard. less than one half of what it would take to restore the health of the banking system. what helped India escape from the Asian crisis with relatively little damage to its economy was the lack of progress in capital account opening. ironically. it would be difficult to argue that the case of China supports the desirability of postponing financial liberalization. many restrictions are still in place on the banks’s ability to allocate credit and the government remains the owner of all the major commercial banks. which severely limited banks’ and firms’ access to capital markets abroad. Both institutions have increased their liabilities in foreign currencies (12 percent of total liabilities in 1998 for IDBI and 22 15 . The second phase was a period of partial deregulation from 1985 to 1991 when the state retained a major role in resource allocation even though the private sector was given greater freedom in investment decisions. This high ratio of non-performing loans is a result of “social control” imposed on state-owned banks in the years prior to 1991. as he points out. but as the financial health of the government itself deteriorates its ability to bail out banks has come into question. Worse. thus ending the flow of new bad loans. Two development banks in India—the Industrial Development Bank of India (IDBI) and the Industrial Credit and Investment Corporation of India (ICICI)—are not actually banks as they do not take deposits from the public and as they specialize in the provision of long-term loans. In this phase India has made various attempts to liberalize its financial system and open its capital account.GDP. Since 1991 there were two important reforms in India’s financial sector—deregulation of interest rates and freeing of pricing restrictions on the new issues of shares on the stock market.5 percent of GDP. The first phase was the era of planning from 1951 to1984 when the state had strict control over resource allocation. and the sooner more fundamental reforms are undertaken the better off China will be. and unless the banks adopt a commercial credit culture. In spite of these reforms. doubtful or loss. The banks in India are all burdened with many non-performing assets: in 1996. In India. The current system is not sustainable. According to Rajendra R.

it would be. The fiscal expediency of this arrangement for the government has been a deterrant to any attempt for financial liberalization in India. It is not. to cut various subsidies while trying to increase the tax base or implement tax reforms. What the studies show is that in a number of cases the policy makers appear to have been oblivious of such warnings. It is. The banks are the weakest link in India’s financial system because of the large number of nonperforming assets they currently hold. It is hard to imagine that. the policy makers would have been able to carry out financial liberalization in an orderly manner. Resulting fiscal deficits have forced the government to require the banks to hold its debts at low interest rates. Given that those countries are still in the early stages of establishing effective. unrealistic to expect them to develop the necessary preconditions for financial liberalization in a matter of a few years. Because of this currency mismatch these institutions are vulnerable to a shock arising from currency depreciation. Since the mid-eighties successive governments have tried. and social interactions among individual actors and thus influence the path of economic development 16 . privately owned financial system. the importance of institutions in economic development has long been recognized since they structure political. IV Conclusion: Institutional Hiatus and the Failure of Economic Reform A general conclusion that the country studies in this volume lead to is that the countries most affected by the crisis did not have the institutional preconditions for a safe and sound. What made the situation worse was that they had been under pressure to deregulate financial markets from western governments that were. as pointed out by Cole and Slade (1998). however. and such a reallocation of resources would cause a severe social cost in a poverty-stricken economy like India. So far they have succeeded in thwarting all moves toward bank privatization. Such an arrangement would not have been possible if the banks were not state-owned and -controlled and were thus free to make their own portfolio decisions. given their own domestic political agenda. The argument that there are institutional precondition necessary for financial liberalization comes as no surprise to anyone whose understanding of the workings of the market economy is not based solely on its simplistic representation typically found in economics textbooks. even if they had not been. doubtful whether. following the right sequence. that warnings had not been given that financial liberalization needed to be preceded by such preconditions. those western governments would have waited for institutional preconditions to be established in the developing countries before pressuring them to open their financial markets. Their bankruptcy would put the entire economy under enormous strain because the government would have to render budgetary support to rescue them even when it is under a stringent budget condition itself. as discussed in the above review of the literature on financial liberalization. primarily interested in getting equal access to and outright opening of financial markets for financial companies from their own countries. as pointed out by Park (1998). without much success. Another factor that has impeded financial liberalization in India is the opposition to bank privatization by the extremely powerful labor unions that belong to the banking industry. In fact.percent for ICICI) but have lent them to domestic firms with only rupee payoffs. democratic political and legal systems. economic. Cuts in spending would have to be made on social welfare such as health and education.

It will require modifying imported institutions to fit in with indigenous informal institutions or. Western law teams stand by. makes it difficult to carry out economic reform in a developing country is that even if formal institutions can be borrowed from more advanced economies they may not be compatible with the country’s informal institutions and as a result they may not be effective. In the latter case it may be years. this is a conclusion reached by some of the observers of the Eastern and Central European reform experiences. the informal institutions may have to change to accommodate the imported formal institutions. at best. social. in some cases decades. which were based on the standard reform package prescribed by Western economists (Murrell 1995). unlikely to have the expected positive effects on performance. especially those involving capital formation. and. traditions. before the formal institutions become effective since informal institutions are slow to change. p.6): It will be years.6 It is also well recognized that formal institutions such as constitutions. laws. In fact. at worst. according to Brzeski (1994. before the Rechtsstaat can create an environment favorable to private activities. however. But it will take time for the complementary psychological. 2362) reach after an extensive review of the literature on institutions and economic development: [M]ere transplantations of successful institutions from DCs to LDCs is.(North 1981. and cultural changes to take root. That formal institutions need to be compatible with informal institutions for them effecitve is basically the conclusion that Lin and Nugent (1995. keen to provide legal expertise. may have rather disastrous effects. Williamson 1985). alternatively. What this observation by Lin and Nugent suggests is that economic reform involving changes in institutions is not a task that can be simply guided by some general theory. 1990 and 1991. p. 17 . taboos. Where to start and how to bring out the reforms in a country are questions that can be answered only with serious consideration of the country's existing institutional structure and human and physical endowments. Statutes can be altered easily enough. and property rights may be established in a relatively short period of time whereas informal institutions such as sanctions. or sheer imitation. if not a generation. if there is any.7 For instance. What. and codes of conduct are culturespecific and slow to change. customs. Perhaps only demography--a generational succession--can bring about those changes.

and property rights. to establish a financial regime in which interest rates are market-determined and credit allocation is free of government intervention.e. fiscal discipline. that is. tax reform. When restrictions and control measures were removed from the financial markets neither financial institutions nor the supervisory authorities were ready for the newly liberalized financial regime. deregulation. A testament to how strongly the Washington Consensus affected the thinking of some policy-makers of the West can be found in Williamson’s assertion that.11 In fact. 111). was representative of their focus on stable macroeconomic policy as the most important policy for economic development. With regard to financial liberalization Williamson very much followed the McKinnon-Shaw hypothesis. as defined by Williamson (1994). They failed to install a new system of prudential regulation needed to safeguard the stability and soundness of financial institutions (Park 1998). signed his diktat .Thus what the dismantling of the central planning apparatus and the importing of alien formal institutions did in the transition economies was to create an “institutional hiatus” in the absence of informal institutions that would have supported the effective functioning of the imported formal institutions. a part of the basic core of ideas that we hold in common and do not need to debate endlessly” (1998. the Asian financial crisis is also a consequence of economic reforms that were carried out without the necessary institutional preparation. “[t]he Washington Consensus should become like democracy and human rights. with the world’s fourth largest population. government intervention in financial markets) but failed to create new institutions in a timely manner to replace them. The pictorial symbol was of course the colonial posture assumed by the Managing Director of the International Monetary Fund as the President of Indonesia. It consisted of. In other words. and due diligence. appropriate exchange rate policy. and the price of this institutional hiatus was a severe contraction in output and employment that these economies had suffered (Kozul-Wright and Rayment 1995. financial liberalization.” The Washington Consensus. As remarked by Bergsten (2000). privatization.C. risk management. appropriate public expenditure priorities. 18 . Such an institutional hiatus was perhaps mostly clearly demonstrated in Korea. Another point that we can infer from the studies reported in this volume is that financial liberalization in Asia was influenced more by the so-called Washington Consensus and less by the more nuanced approach to financial reform that had been developing in academic writings. Financial institutions had not developed expertise in credit analysis. the influence of the Washington Consensus continued even after the crisis when it dictated policy requirements to the crisis countries. 10 As in the transition economies of the former Soviet Union. in the early 1990s.8 9 As the country studies in this volume amply demonstrate. trade liberalization. abolishment of barriers to foreign direct investment. there was neither central planning nor a functioning market economy in the transition economies. Ellman 1994). “[i]t was the ‘Washington consensus’ that guided the responses of all those crucial actors and therefore dictated policy requirements to the crisis countries.. and they had had little experience in foreign exchange and securities trading and international banking in general. financial liberalization created an institutional hiatus as it removed one set of institutions (i. which began to emerge among the multilateral and other policy institutions centered in Washington D. The supervisory authorities were not monitoring and regulating their international financial activities as much as they should have because they were pressured to overhaul the regulatory system to make it more compatible with a liberalized system.

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Awang Adek. Princeton University. pp. November 1998. Robert and Frank Veneroso. there is a long list of “longstanding” weaknesses in banking and financial supervision. it also happened in some of the crisis countries in Asia as a result of financial liberalization. and Sri Lanka as successful cases judged in terms of the rate of growth and stability of the financial system. _____________ and Mahar. Malaysia. 211. Korea. mangers. Department of Economics.19-21. Williamson. NOTES 1.). In addition. Ismail. November 7. 3. “connected lending” (lending to bank directors. Gerard. 2. These weaknesses are over-extension and concentration of credit (in real estate and equities) and liquidity and currency mismatches. Hussin. Cambridge University Press.Wade.). excessive government ownership of banks and/or its involvement in bank operation.” The author’s work for this project is in part supported by the Swedish Foundation for International Cooperation in Research and Higher Education (STINT). Hawaii) project entitled “Financial Liberalization and the Economic Crisis in Asia. Goldstein (1998) also identifies financial-sector weaknesses as one of the causes of the Asian financial crisis. Malaysia. Princeton. Zainal Aznam. No. In their survey of the financial liberalization undertaken in the late 1970s and early 1980s in Asia (Indonesia. Molly. and their related businesses). and Singh. mobilization of savings. It includes lax loan classification and provisioning practices. the Philippines. privatization in the transition economies of the former Soviet Union did not “tame” political intrusion into market processes but provided an additional instrument by which special interests and political powers could maintain their power. and the attainment of positive real interest rates. and Sri Lanka in Asia) Cho and Khatkhate (1989) found a mixed outcome of financial liberalization. Washington DC: Institute for International Economics. 1998. “Financial reform in Malaysia” in Caprio. 1997. According Stiglitz (1999).” The Economist. New Jersey. John (ed. A Survey of Financial Liberalization. “Two Views on Asia: The Resources Lie Within. They regard Korea. Essays in International Finance. 1994. The Political Economy of Policy Reform. Sukhdave. Reforming Financial systems: Historical Implications for Policy. As the country studies in this volume show. Dimitri (eds. the Philippines 22 . Jr. poor public disclosure and transparency. *This is the introduction to an East-West Center (Honolulu. Yusof. lack of independence of bank supervisors from political pressures for regulatory forbearance. Alowi. Sing Lim Chee. and Vittas.

most of the pre-crisis studies give the impression that financial reform in Asia was cautiously. for example. Although there is no clear consensus on the definition of institutions there appear to be. in our review of the relevant literature published prior to the Asian crisis we failed to find any mention of inappropriate or disorderly financial reform. According to a post-crisis study of Asian financial systems. et al. and (3) their predictability in the sense that the rules and constraints are understood as being applicable in repeated and future situations. industry. Although they acknowledge the desirability of financial liberalization they also recognize that its modality. Nam (1994). Rather. The standard reform package consists of macroeconomic stabilization. For them to be effective in reducing the transaction costs there must be also "institutional capital"--the accumulated institution-specific human capital of both the individuals who operate an institution and those subject to this institution (Schmieding 23 5. p. .85). and the legal system underlying the financial system as a whole. the blame for this institutional hiatus goes to the “Bretton Woods institutions and their favored consultants” as their policies have little to do with putting institutional prerequisites for modern capitalism in place. according to Nabli and Nugent (1989. See. in East Asia the progress of institution building. p. According Taylor (1994. design and phasing are no less important. 4. (1994). which requires time and explicit effort. Chang and Pangestu (1994). and the creation of the legal framework for a market economy. privatization. Until then the government should carry out intervention in the financial markets in a diminishing degree spread over a period of time. the liberalization of domestic trade and prices. three basic characteristics that are common to most definitions of a social institution. deriving guidance from market-related indicators. gradually undertaken and in the right sequence. and Yusof. current account convertibility. In fact. the creation of a social safety net. generally lagged behind financial liberalization (Masuyama 1999). Establishing new institutions means more than just creating new administrative bodies and passing new laws and regulations. This obviously makes it difficult to know whether any particular reform is inappropriate or not until the country is actually afflicted by a crisis.” The policy implication that they draw from the survey is that financial liberalization should be carried out in a gradual manner with government playing the role of market-promotion. 6. 8. 9). 9. and Indonesia as a case of “modest success. (2) the ability of their rules and constraints to govern the relations among individuals and groups. 7. They argue that before full liberalization is carried out there should be in place wellfunctioning nonbank capital markets and substantial progress in structural adjustment should have been made in a failure. These are (1) the rules and constraints nature of institutions.

In a paper written before the Asian crisis Goldstein (1997) warned that any emerging market economy undertaking the pace of financial liberalization to proceed much faster than the strengthening of banking supervision should be included in the likely list of future banking trouble spots. it was only since the 1980s that the regulatory requirement for a sound financial system was sufficiently recognized in the United States and Japan. In fact. 24 . 11. 10. according to Kaufman (1998).1992).

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