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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

failed to take into account the fundamentals of reform processes. The second possible reason for the failure of the reforms is that even if the blueprint for reform was a correct one. The following section presents a brief review of the literature on financial liberalization prior to the crisis.were based on a misunderstanding of the very foundations of a market economy. privatization of public financial institutions and promotion of competition in financial markets. its purpose being to help the reader understand what ideas might possibly have guided policymakers in Asia. 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. Furthermore. elimination of directed credit. 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 policies prescribed by the western economists. If this were the case. Round 1: Deregulation When McKinnon (1973) and Shaw (1973) published their respective books in 1973. Thus. and removal of foreign exchange controls. Concluding remarks are presented in Section IV. financial liberalization might have been regarded merely as deregulation of interest rates. who lacked the understanding of the political process of reform in those transition economies. then the reforming countries were not adequately prepared in terms of the preconditions necessary for successful financial liberalization. its implementation might have strayed away from its true course because of pressures from various interest groups. academic thinking on financial liberalization has gone through several rounds of revision. Thus the McKinnon-Shaw thesis that the artificially 3 . It is followed in Section III by a summary discussion of what actually happened in financial reform in eight Asian countries selected for comparison. developing countries were pressured by western governments to open their domestic capital markets for foreign investment. when McKinnon and Shaw made their seminal contributions. we might offer two reasons why financial liberalization in Asia failed to deliver its promised result. 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. Whether a similar mistake was made in the Asian economies is the subject matter of this volume. II Financial Liberalization: From Deregulation to Institutional Reform Since 1973. Following Stiglitz’s analysis of the reform experiences of the transition economies. 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. 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). adding to our understanding of the scope of reforms necessary for achieving a market-oriented financial system.2 Likewise. For instance. 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. in Chile. according to Park (1998). Each round took place more or less as a result of a financial crisis.

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

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

another World Bank study on financial reform concludes that “. 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. 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. If banks have high net worth. which in turn depends on the existence of audited financial statements. 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. as such policies would increase the creditworthiness of borrowers. Which strategy and sequencing a country adopts in reforming its financial system depends on its initial conditions and the speed of institution building. The initial mix of assets in a bank is also important because. the outcome of financial reform depends on several initial conditions present in the economy when regulations are lifted. the process of reform.. The implication is clear: institutions necessary for a market economy must be created prior to financial liberalization. As a matter of fact. the bank is inclined to make a portfolio shift in favor of the asset that has been discriminated against by the former intervention. Third. Second. 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.Round 3: Institutional Preconditions The new insight into the operation of financial markets led. Thus a recent World Bank study on the relationship between financial and real sectors. et al. institutionbuilding is a path-dependent process. 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. in the early 1990s.recommendations for any country’s financial system need to be ‘tuned’ to the institutions and culture of the country” (Caprio. They argue that financial liberalization should be coordinated with policies promoting growth and stability of the real sector. Increasing recognition of the importance of institutions such as the legal. they have the incentive to protect it by acting in a risk-averse way. If banks have low or no net worth prior to reform. 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. 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. Jr. First. Thus. p. Gertler and Rose 1994. Likewise. 1994)..5 According to Caprio (1994). credit appraisal and rating. it is dependent on the overall net worth of banks and the initial mix of their assets at the time of reform. and Vittas 1997. being freed of former constraints. 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. it is dependent on the initial stock of information capital. Jr. developed equity markets. Caprio 1994. and the 6 .4 Such institution building requires government activism. to a new round of debate on financial liberalization with the focus shifting from government to market failure (Akyuz 1993.3). as such. and adequate channels for the flow of information. Drees and Pazarbasioglu 1998). Villanueva and Mirakhor 1990.. For example.

China.1). Malaysia. Japan. to move their financial systems toward the general model that has been adopted in most OECD countries today” (p. In the 1980’s. “. There are no magic cures that “…would alone suffice to ensure a dynamic and efficient financial system in which all deposits are safe. As he put it. As pointed out by Caprio (1994. all loans are performing. the Philippines. 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.3). Indonesia. and Malaysia suffered badly from the crisis whereas others such as Japan.. economic. in May 1990. and all bad ones rejected" (p. The following summarizes the diverse experiences of the eight countries reported in the subsequent chapters. South Korea. the focus was shifted to market failures and the institutions that are necessary for successful financial liberalization but are lacking in many developing countries. The fourth requirement for successful financial reform is the existence of a system of rules and procedures for the implementation of decisions within banks. it will have to be “tuned” to the institutions and culture of that country. Whatever system may develop. the debate on financial liberalization focused on deregulation and the free-market determination of interest rates. China. In the 1990s. He warns. the debate focused on the proper sequencing in financial reform with a focus on macroeconomic stability as a precondition for successful financial liberalization. arguing the necessity of paying attention to a country’s unique political. In other words. even before the Asian crisis of 1997-98. In the 1970s. and India escaped from the crisis with no significant effect on their economies. these requirements are not implemented overnight as their development requires time and diligence. thus relaxing exchange 7 . Countries such as Thailand. and India.level of acquisition of public and client-specific information. As part of financial liberalization Thailand also accepted. 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. 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. all good investment projects are financed. Harwood (1997) also reaches a similar conclusion. legal and institutional conditions in the development of its financial system. that such a model is premised on the existence of rich institutional environments and “world-class” supervisory systems. however. 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. which most of the emerging market countries lack. sociological. namely.. 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. 61). These countries will have to develop their own financial systems. the Article VIII of the IMF Agreements. South Korea. 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.the reformers virtually always take as given the goal.

more influential in that decision were. and a relatively stable rupiah exchange rate. Further fueling the bubble were the huge inflows of foreign capital that followed the capital account opening and the establishment of BIBFs. 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. The IMF certainly played a role in Thailand’s decision to carry out financial liberalization. As part of financial liberalization the Thai government established. but by 1995-96 their share went up to 49 percent—more than a three-fold increase in less than a decade. a few years prior to the capital account opening. fueled with credit expansion by financial institutions.controls and reducing restrictions on capital account transactions. which generated expectations of continued economic prosperity. It appears that these central bankers and bankersturned finance ministers all shared the IMF’s ethos of free market ideology. Massive capital inflows also helpted camouflage an economy burdened with large external debts and a fragile banking system. the Thai banks accounted for 14. premature. They were also expected mainly to raise overseas funds for financing trade and investment outside of Thailand. 8 . According to him. 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. according to Bhanupong. Throughout the 1980s Thailand experienced a high rate of growth in exports and income. it appears that they had not been well informed of the more recent developments in the literature on financial liberalization. Such expectations. In 1987-90. lent to borrowers in Thailand who in turn invested it mostly in the nontraded goods sector. led to a bubble in the markets for land and stocks. markets and policy instruments before opening the capital account. But. relatively low interest rates. One consequence of these deregulatory measures was a rapid increase in overseas borrowing by banks in Thailand. in 1993.7 percent of the country’s net private foreign capital inflows. If the policies they helped implement are any evidence of their thinking on what constitutes financial liberalization. however. In contrast. It was hoped that the establishment of BIBFs would turn Bangkok into a regional banking center that would replace Hong Kong and Singapore. Foreign borrowing of the non-bank sector also increased from less than 2 percent to 22 percent during the same period. 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. much of the money raised abroad was.5 percent. 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. therefore. 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. What Thailand should have done was to first develop sound financial institutions. As Bhanupong Nidhiprabha points out. during the same period the share of foreign direct investment in Thailand decreased from 25 percent to 8. the Bangkok International Banking Facilities (BIBFs) with offers of various tax incentives.

This formal or informal no-exit policy encouraged moral hazard on the part of the banks. a rapid credit expansion and investments in “strategic industries” and the non-traded sector. 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. and improve the efficiency of financial resource allocation. Furthermore. which could be used as collateral. Those investments were largely financed by massive capital inflows that followed the banking sector reform in October 1988. however. The general public also supported the reforms since they generally had favorable effects on inflation. 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. 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. Over 60 percent of the debt was owed by the private sector with 90 percent of its debt being of short-term maturity. the projects that tended to be funded by the banks were investments in land. employment and economic growth.” and public utilities. Also contributing to the accumulation of non-performing loans was government intervention in the lending decisions of state-owned banks and finance companies. 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. “strategic industries. Thus. 9 . and was equivalent to 160 percent of the country’s annual GDP. Indonesia’s total external debt as of March 1997 was $135 billion. In fact. the “technocrats” supported financial liberalization because they believed that a greater presence of foreign financial institutions would bring in more external savings. Furthermore. increase domestic competition and improve the corporate culture. nearly triple of the debt in 1989. As a result. They also benefited from the privatization of state-owned enterprises.” the highly trained economists working in the Ministry of Finance and Planning Agency. until the crisis there was no exit policy that would allow state-owned banks to go bust. 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.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. which persisted in spite of the financial reform. and even private banks were protected from going bankrupt if they were owned by politically well connected groups. 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. 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. which resulted in their accumulation of non-performing loans. advanced technologies and expertise. The driving force behind economic reform in Indonesia was the “technocrats. According to Anwar Nasution. What actually happened was. buildings and other tangible goods.

Korea’s financial crisis of 1997-98 was. the government-chaebol-bank co-insurance scheme that the country utilized so effectively in bringing about rapid economic development. almost every group except the bureaucrats. Given the slowness and difficulty of reform in the real sector. 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. In Korea. Korea should have adopted a 10 . according to Yoon Je Cho. the practice of government intervention in credit allocation and the management of commercial banks. 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. as Cho sees it. While weakening the co-insurance scheme the reform also made it possible for chaebols to increase their control over non-bank financial institutions. By 1997. One of the goals of the administration was to “internationalize” the Korean economy. financial liberalization meant unlimited access to credit and a chance to establish their own financial institutions. an inevitable consequence of the financial liberalization that had been carried out in an economy with a highly leveraged corporate sector. poorly developed financial market infrastructure. But. As it turned out.Korea Korea’s financial liberalization began in the early 1980s in a piecemeal manner and without a coherent strategy. For the industrial firms. whiöch in turn would solve many of the structural problems. typical corporate firms in Korea became heavily indebted. 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. inadequate corporate governance. Such perception could not have been conducive to creating the banking or credit culture in Korea. who were averse to losing their authority over financial institutions. Although a more serious attempt at reform was made in 1991. 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. for the bankers it was freedom from government intervention. In doing so it had the effect of weakening. was in favor of financial liberalization. and to achieve that end the government relaxed or abolished many of the restrictions on financial markets and foreign exchange transactions. more or less completely. financial reform in Korea succeeded in eliminating. Yoon Je Cho argues that such structural problems should have been tackled before Korea began its financial liberalization. It was then commonly believed that those chaebols would not go bankrupt since the government could not afford to allow them to fall. the determining factor of the actual course of reform and its outcome was the push-and-pull of various interest groups. as he rightly points out. and not a well thought-out strategy for financial liberalization. The reform thus strengthening chaebols’ internal capital market while weakening the banks’s monitoring role in their corporate governance. if not destroying. By 1997. 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. and a poor credit culture. and in the case of some chaebols the leverage ratio reached close to 500. It also weakened the government’s capacity as an effective risk partner of corporate firms. and for the politicians it was a move away from an authoritarian government and a symbol of democratization.

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

in 1996 the net foreign investment in the Philippines was only $3. rendered the country relatively safe from vulnerability to the reversal of short-term bank loans.According to Chin and Jomo. as argued by Maria Gochoco-Bautista. Furthermore. Second. and in 1997 it actually went down to $762 million. 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. 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. and with injudicious policy responses to the crises it turned them into a crisis of the real economy. In the Philippines. First. In fact. It was also ill prepared to deal with the currency and financial crises that occurred with a sudden reversal of capital flows. This change in sentiments was further reinforced by contemporary developments in the region. affecting the demand side was the fact that the external debt moratorium. Also beginning in 1990. 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 . interest rate deregulation began in 1980 with the lifting of interest-rate ceilings on various categories of savings and time deposits. which had been in place since 1984. 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. the bull-run of 1996 had already reversed after February 1997 as international portfolio investor sentiments toward Malaysia soured. but what made the situation worse were the inappropriate policy responses by the government and the contrarian rhetoric of the Malaysian prime minister. various measures of financial liberalization had very little to do with the relative immunity of the Philippine economy from the crisis of 1997-98. In the Philippines. 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. But. The Philippines The Philippine financial system managed to survive the Asian financial crisis of 1997-98 relatively unscathed due to a couple of factors. 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. compared with its neighbors. delaying access to foreign debt markets by the public and private sectors. as the preceding discussion points out. 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. The small size of capital inflows was in turn largely due to two factors.5 billion. despite some erosion of financial governance from the mid-1980s a tighter regulation of the financial sector in Malaysia. 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. was lifted only in 1991. Instead.” It also had the banks achieve a high degree of capitalization. First. compared with its neighbors the Philippines experienced a surge in capital inflows relatively late and in relatively small amounts. Second.

when combined with easy monetary policy. 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. 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. followed by the failure of 30 financial institutions in 1998. Japan In November 1997. 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. according to Thomas Cargill. financial liberalization has strengthened the monopoly power of the elite with access to bank financing. particularly from the IMF and the World Bank. 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. 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. The failure of those two financial institutions had its origin in accumulating stresses in the Japanese financial system. which in turn resulted from the failure of its regulatory authorities to resolve the non-performing loan problem and a series of policy errors. which. whose cooperation was sought by the United States to serve its larger geopolitical interests. even though the banking crisis in Japan and the financial crisis that afflicted other Asian economies were 13 . brought about the infamous bubble economy in the second half of the 1980s. 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. In other words. In fact.bank loans for their working capital and for financing of long-term investments. In other words. 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. The retention of those key elements plus an increased role for market forces created an environment in Japan that encouraged excessive risk taking. 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. As she sees it. 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. Japan’s economic and financial performance in late 1997 and through 1998 was an event independent of the Asian crisis of 1997-98. 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. 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 business elite behind these large family-owned corporations has influenced the outcome of financial liberalization and other reform programs to serve its own interests. Hokkaido Takushoku Bank and Yamaichi Securities Company went bankrupt. It will also provide the banks with the incentive to monitor closely their clients since they will need to protect their own bottom lines.

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

In spite of these reforms. ironically. 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. Vaidya. Both institutions have increased their liabilities in foreign currencies (12 percent of total liabilities in 1998 for IDBI and 22 15 .5 percent of GDP. 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. In India. The sole objective of disinvestment appears to be that of generating revenues for the cash starved government. the government debt has increased dramatically in recent years with the combined value of all its debts reaching 20. What has been accomplished so far is the piecemeal disinvestment of a small portion of government shareholdings. It is yet too early to tell whether financial liberalization has improved the efficiency of the banks and the quality of their assets. According to Rajendra R. The current system is not sustainable. 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. Perhaps. which severely limited banks’ and firms’ access to capital markets abroad. The first phase was the era of planning from 1951 to1984 when the state had strict control over resource allocation. and unless the banks adopt a commercial credit culture. thus ending the flow of new bad loans. The third phase is the post-1991 period when resource allocation is primarily market determined. Worse. doubtful or loss.GDP. But. but as the financial health of the government itself deteriorates its ability to bail out banks has come into question. In this phase India has made various attempts to liberalize its financial system and open its capital account. 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. it would be difficult to argue that the case of China supports the desirability of postponing financial liberalization. the privatization of banks in India has not progressed very far mainly due to opposition from trade unions and major political parties. 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. 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. 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. India India’s economic policy regime has gone through three distinct phases. public ownership of banks has created the mirage of invulnerability to shocks. which has had little effect on the basic character of the public sector firms. The banks in India are all burdened with many non-performing assets: in 1996. and the sooner more fundamental reforms are undertaken the better off China will be. but it has not made much progress on these fronts.7 percent of their assets is categorized as substandard. about 18. 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.

as pointed out by Park (1998). those western governments would have waited for institutional preconditions to be established in the developing countries before pressuring them to open their financial markets. What made the situation worse was that they had been under pressure to deregulate financial markets from western governments that were. It is hard to imagine that. following the right sequence. Cuts in spending would have to be made on social welfare such as health and education. and social interactions among individual actors and thus influence the path of economic development 16 . unrealistic to expect them to develop the necessary preconditions for financial liberalization in a matter of a few years. to cut various subsidies while trying to increase the tax base or implement tax reforms. 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. that warnings had not been given that financial liberalization needed to be preceded by such preconditions. doubtful whether. 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. The fiscal expediency of this arrangement for the government has been a deterrant to any attempt for financial liberalization in India. 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. Given that those countries are still in the early stages of establishing effective. Since the mid-eighties successive governments have tried. It is not. and such a reallocation of resources would cause a severe social cost in a poverty-stricken economy like India. Because of this currency mismatch these institutions are vulnerable to a shock arising from currency depreciation. given their own domestic political agenda. democratic political and legal systems. 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. So far they have succeeded in thwarting all moves toward bank privatization. primarily interested in getting equal access to and outright opening of financial markets for financial companies from their own countries. the importance of institutions in economic development has long been recognized since they structure political. without much success. even if they had not been. privately owned financial system. It is. The banks are the weakest link in India’s financial system because of the large number of nonperforming assets they currently hold. What the studies show is that in a number of cases the policy makers appear to have been oblivious of such warnings. the policy makers would have been able to carry out financial liberalization in an orderly manner. economic. 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. Resulting fiscal deficits have forced the government to require the banks to hold its debts at low interest rates.percent for ICICI) but have lent them to domestic firms with only rupee payoffs. however. In fact. as pointed out by Cole and Slade (1998). as discussed in the above review of the literature on financial liberalization. it would be.

at worst. 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. social. the informal institutions may have to change to accommodate the imported formal institutions. may have rather disastrous effects. 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.7 For instance. at best. p. alternatively. 1990 and 1991. customs. p. laws. and. and cultural changes to take root. 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. or sheer imitation. In the latter case it may be years. before the formal institutions become effective since informal institutions are slow to change. In fact.6): It will be years. It will require modifying imported institutions to fit in with indigenous informal institutions or. especially those involving capital formation. if there is any. unlikely to have the expected positive effects on performance. Western law teams stand by. if not a generation. What.(North 1981. 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. which were based on the standard reform package prescribed by Western economists (Murrell 1995). Williamson 1985). according to Brzeski (1994. traditions. in some cases decades. this is a conclusion reached by some of the observers of the Eastern and Central European reform experiences. But it will take time for the complementary psychological. That formal institutions need to be compatible with informal institutions for them effecitve is basically the conclusion that Lin and Nugent (1995. however. keen to provide legal expertise. Perhaps only demography--a generational succession--can bring about those changes. and codes of conduct are culturespecific and slow to change. taboos.6 It is also well recognized that formal institutions such as constitutions. 17 . before the Rechtsstaat can create an environment favorable to private activities. 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.

with the world’s fourth largest population. and they had had little experience in foreign exchange and securities trading and international banking in general. risk management. 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. signed his diktat . fiscal discipline. deregulation.” The Washington Consensus.e. in the early 1990s. With regard to financial liberalization Williamson very much followed the McKinnon-Shaw hypothesis. “[i]t was the ‘Washington consensus’ that guided the responses of all those crucial actors and therefore dictated policy requirements to the crisis countries. “[t]he Washington Consensus should become like democracy and human rights. The pictorial symbol was of course the colonial posture assumed by the Managing Director of the International Monetary Fund as the President of Indonesia. 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. as defined by Williamson (1994). 10 As in the transition economies of the former Soviet Union. It consisted of. 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. tax reform. the Asian financial crisis is also a consequence of economic reforms that were carried out without the necessary institutional preparation. that is. appropriate exchange rate policy. and property rights.8 9 As the country studies in this volume amply demonstrate. 18 . Financial institutions had not developed expertise in credit analysis.11 In fact. 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. Ellman 1994). which began to emerge among the multilateral and other policy institutions centered in Washington D. there was neither central planning nor a functioning market economy in the transition economies.C. As remarked by Bergsten (2000). Such an institutional hiatus was perhaps mostly clearly demonstrated in Korea. was representative of their focus on stable macroeconomic policy as the most important policy for economic development. government intervention in financial markets) but failed to create new institutions in a timely manner to replace them. a part of the basic core of ideas that we hold in common and do not need to debate endlessly” (1998. and due diligence. trade liberalization. They failed to install a new system of prudential regulation needed to safeguard the stability and soundness of financial institutions (Park 1998).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. privatization.. the influence of the Washington Consensus continued even after the crisis when it dictated policy requirements to the crisis countries. 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. to establish a financial regime in which interest rates are market-determined and credit allocation is free of government intervention. 111). abolishment of barriers to foreign direct investment. appropriate public expenditure priorities. financial liberalization created an institutional hiatus as it removed one set of institutions (i. financial liberalization. In other words.

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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. They regard Korea. November 7. and the attainment of positive real interest rates. it also happened in some of the crisis countries in Asia as a result of financial liberalization. Reforming Financial systems: Historical Implications for Policy. the Philippines. Dimitri (eds. No. there is a long list of “longstanding” weaknesses in banking and financial supervision.Wade. the Philippines 22 . 2. “Two Views on Asia: The Resources Lie Within. 1994.” The author’s work for this project is in part supported by the Swedish Foundation for International Cooperation in Research and Higher Education (STINT). Gerard. _____________ and Mahar. In addition. and Vittas. A Survey of Financial Liberalization. Sukhdave. Hussin. “Financial reform in Malaysia” in Caprio.). Robert and Frank Veneroso. 1997. and their related businesses). Awang Adek. As the country studies in this volume show.” The Economist. Hawaii) project entitled “Financial Liberalization and the Economic Crisis in Asia. The Political Economy of Policy Reform. Sing Lim Chee. John (ed. In their survey of the financial liberalization undertaken in the late 1970s and early 1980s in Asia (Indonesia. Korea. Princeton University. Zainal Aznam. These weaknesses are over-extension and concentration of credit (in real estate and equities) and liquidity and currency mismatches. New Jersey. Cambridge University Press. Essays in International Finance. poor public disclosure and transparency. pp.). 211. Goldstein (1998) also identifies financial-sector weaknesses as one of the causes of the Asian financial crisis.19-21. NOTES 1. Washington DC: Institute for International Economics. Ismail. and Sri Lanka in Asia) Cho and Khatkhate (1989) found a mixed outcome of financial liberalization. Alowi. Princeton. 1998. *This is the introduction to an East-West Center (Honolulu. lack of independence of bank supervisors from political pressures for regulatory forbearance. Yusof. Molly. Malaysia. Department of Economics. According Stiglitz (1999). excessive government ownership of banks and/or its involvement in bank operation. mangers. It includes lax loan classification and provisioning practices. Williamson. Malaysia. mobilization of savings. 3. November 1998. “connected lending” (lending to bank directors. Jr. and Sri Lanka as successful cases judged in terms of the rate of growth and stability of the financial system. and Singh.

Nam (1994). 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. Until then the government should carry out intervention in the financial markets in a diminishing degree spread over a period of time. et al. design and phasing are no less important. 7. for example. 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 trade. 9. according to Nabli and Nugent (1989. the liberalization of domestic trade and prices. (1994). 9). p. and the legal system underlying the financial system as a whole. deriving guidance from market-related indicators. and (3) their predictability in the sense that the rules and constraints are understood as being applicable in repeated and future situations. According to a post-crisis study of Asian financial systems. 8. Although they acknowledge the desirability of financial liberalization they also recognize that its modality. Although there is no clear consensus on the definition of institutions there appear to be. current account convertibility. most of the pre-crisis studies give the impression that financial reform in Asia was cautiously. generally lagged behind financial liberalization (Masuyama 1999). 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. the creation of a social safety net. Chang and Pangestu (1994). These are (1) the rules and constraints nature of institutions. 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.85). In fact. gradually undertaken and in the right sequence. (2) the ability of their rules and constraints to govern the relations among individuals and groups. p. 6. 4.as a failure.” 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. According Taylor (1994. which requires time and explicit effort. Rather. . three basic characteristics that are common to most definitions of a social institution. in East Asia the progress of institution building. and Indonesia as a case of “modest success. and Yusof. privatization. and the creation of the legal framework for a market economy. industry. 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 standard reform package consists of macroeconomic stabilization. See.

according to Kaufman (1998). 10. 11. it was only since the 1980s that the regulatory requirement for a sound financial system was sufficiently recognized in the United States and Japan. 24 . 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.1992). In fact.